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Industry Voices

Commentary: Benefits heresy – increased use of plan loans improves financial wellness

The Plan Sponsor Council of America's 61st annual survey showed 30.6% of participants had a plan loan as of the end of 2017 — up 5 percentage points from a year earlier. The average loan outstanding was $9,330, 1.2% of plan assets.

Most benefits professionals would say this is cause for alarm. Ten years earlier, only 24.1% had loans, averaging $8,309, 2.8% of plan assets. So, while the percentage with loans increased, the percentage of plan assets borrowed noticeably declined.

Best liquidity option

No one should ever borrow from their qualified plan to live beyond their means.

However, firsthand experience confirms participants who take advantage of plan loans rather than the much more expensive alternative of consumer debt often improve their household wealth and retirement asset accumulations.

Surveys, like the American Payroll Association's "Getting Paid in America," show 71% of Americans live paycheck to paycheck — a one-week delay in the next paycheck would cause some or significant financial difficulty. The Federal Reserve's report on the "Economic Well-Being of U.S. Households" confirms 41% of adults do not have $400 to pay an emergency expense. The National Foundation for Credit Counseling reports that 38% of households carry a credit card balance. The Federal Reserve reported that revolving debt (mostly credit cards) was $1.027 trillion — $5,839 per adult with a credit card, with an average interest rate of 16%, and where 28% of payments were missed or delayed. The Center for Financial Services Innovation reports approximately 12 million Americans take payday loans each year, averaging $375 at a 400% interest rate and average cost of $520.

Department of Labor and IRS regulations require a reasonable rate of interest. Today, plan loans typically charge 1% to 2% above prime; most plans charge between 5% and 6%. Consider the aggregate annual return for the past six years for the Bloomberg Barclays U.S. Aggregate Bond index: -2.02% (2013), 5.97% (2014), 0.55% (2015), 2.65% (2016), 3.54% (2017) and 0.01% (2018).

So, a plan loan at 6% that avoids more than 16% consumer debt will improve household wealth (or reduce debt). And, given recent bond returns, if the participant maintains her investment allocation by treating the plan loan as a fixed-income investment, retirement assets also will increase.

In fact, research by Geng Li and Paul A. Smith of the Federal Reserve confirmed many workers would improve financial wellness by increasing use of plan loans.

Eliminate hardship withdrawals

Firsthand experience also confirms most participants may improve their household wealth and retirement asset accumulations when they take plan loans instead of hardship withdrawals.

The IRS recently published a notice of proposed rule-making regarding Bipartisan Budget Act of 2008 changes that liberalized hardship withdrawals. In the past, a participant needed to first obtain a plan loan where available. The 2018 legislation removed that requirement and is likely to result in increased leakage starting in 2019.

Workers will complain if you eliminate hardship withdrawal provisions. But, if you concurrently deploy 21st century, best practices loan functionality, retirees may someday thank you.

Figure 1 Plan loan usage over time
 For plans permitting loans
Percentage of participants with loans24.1%23.1%23.8%24.4%24.0%26.2%14.6%25.0%25.8%30.6%
Average loan amount per borrower$8,309$8,760$8,619$8,873$9,503$10,385$6,216$9,390$8,042$9,330
Percentage of plan assets loaned2.8%2.5%2.4%2.1%2.2%1.8%0.7%1.6%0.8%1.2%

Dispelling plan loan myths

There are a lot of myths about plan loans, critics assert:

  • Participants with plan loans save less. Maybe, maybe not. Yes, participants who borrow have lower contribution rates, on average, than participants who don't borrow. But that's the wrong comparison. Instead, compare participants with plan loans against those with consumer loans. Importantly, liquidity via a plan loan enables workers to leverage the tax preferences and employer match. Liquidity encourages workers to save beyond monies earmarked solely for retirement.
  • Investment returns are reduced. Not always true. Loan principal should be viewed as a fixed-income asset and loan interest is the return on investment. If the participant retains her desired investment allocation (treating the loan as a fixed-income investment, rebalancing as needed), there is no "loss" of investment returns to the retirement account. In fact, in down markets the participant may even benefit from the loan principal being "out" of the market.
  • Leakage is increased. Not always true. Loans are not leakage unless they are not repaid. Leakage may actually decline where liquidity is maintained after separation.
  • Loan interest is double taxed. Not true. Those asserting double taxation might be comparing loan interest payments with pre-tax contributions. That is an apples-to-kielbasa comparison. Yes, the loan is repaid with after-tax dollars — generally the same as for any consumer loan. And loan interest becomes taxable income when distributed — generally the same as for any other return on investment. Two exceptions: First, if the loan is a residence loan secured with a mortgage, loan interest may be tax deductible. Second, where the loan principal is Roth assets, interest may be tax-free as a distribution of earnings on Roth assets.

Plan loans are bad, evil, harmful

However, perhaps the biggest "myth" about plan loans is that they are harmful to retirement savings. It's true that loans that are defaulted at separation of service can undermine retirement preparation and contribute to leakage, but plan sponsors can avoid evil and harm by:

  • Demanding 21st century loan processing (electronic banking). Allow electronic loan payments from bank accounts after separation. Electronic banking also may reduce leakage when separated participants take loans instead of taxable distributions which may be subject to penalty taxes.
  • Delaying loan defaults until the last possible date (generally, the end of the calendar quarter following the calendar quarter in which the last loan payment is made).
  • Reminding participants to maintain their desired investment allocation when a loan is initiated.
  • Deploying behavioral economics tools/processes. For example, start by creating a "commitment bond" — where a participant acknowledges and confirms repayment of the loan regardless of any change in circumstance; acknowledgment that the loan won't trigger taxes, so long as it is repaid; and the only person harmed by a loan default is the participant.

Jack Towarnicky is the Westerville, Ohio-based executive director of the Plan Sponsor Council of America. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.