More sponsors cut a break on 401(k) loan repayment

More companies are giving departing employees the option to continue paying off their 401(k) loans in installments instead of having to pay them in full before leaving.

"Plan sponsors say, 'If there's a way to allow people to pay us back over time — kind of like how the original loan was first set up — let's go ahead and do that,' " said Rob Austin, the Charlotte, N.C.-based head of research at Alight Solutions.

Indeed, the number of employers permitting former employees to continue paying off their loans has grown significantly over the past few years. In 2018, about 43% of plan sponsors offered this option, up from 13.3% in 2016, according to Callan LLC.

For Hilton Worldwide Holdings Inc., the decision to add the feature was easy, said Casey Young, the company's Memphis-based director of global retirement programs. "If we can allow participants a flexible option to repay the loans, we should do so," he said of Hilton's decision in 2013.

More importantly, he said, the loan repayment option would prevent many participants from defaulting on their loans, an event that could significantly erode their retirement savings.

Participants often default because they are unable to repay their loans within 60 to 90 days after leaving their companies — the typical window that most companies require.

As a result, they are hit with federal and state taxes on their loan balances plus a 10% early withdrawal penalty if they're younger than 59 ½. Making matters worse, many are forced to cash out their entire 401(k) accounts to satisfy loan obligations, slashing their long-term retirement prospects.

"They took the loan because they don't have the money, and so if we require them to pay back this large sum at once, it doesn't really naturally follow that they have the money to pay it back," Mr. Young said.

Most defaults occur when workers leave their employers, said Olivia Mitchell, a professor of business economics and public policy and executive director of the Pension Research Council at the University of Pennsylvania's Wharton School in Philadelphia.

In a study published in the National Tax Journal in March 2017, Ms. Mitchell and co-authors Timothy (Jun) Lu, Stephen Utkus and Jean Young found that 86% of employees who have 401(k) loans when they leave their jobs default because employers tend to require repayment in full.

For participants, the lost retirement savings can be significant. In a report last year, Deloitte calculated that $2.5 trillion in potential future account balances will be lost due to loan defaults from 401(k) accounts over the next 10 years. The estimate represented the cumulative effect of loan defaults, including taxes, early withdrawal penalties, lost earnings and early cashouts of participants' full plan balances.

By Deloitte's projections, this represents roughly $300,000 in lost retirement savings for a typical defaulting borrower over his or her career.

For Home Depot Inc., the decision to make loan repayments available to departing employees stemmed from a desire to help them preserve their retirement savings. It was an "associate- and retirement income-friendly" measure to help employees avoid a default, said Don Buben, Home Depot's Atlanta-based director of executive compensation, equity programs and the company's $8 billion FutureBuilder 401(k) plan.

"This flexibility allows more participants to restore their balance and continue using the 401(k) to build retirement savings rather than having an outcome that ultimately takes money out of their retirement savings, perhaps permanently," Mr. Buben said.

In addition to helping employees, Home Depot — like Hilton — saw the move as a way to plug a source of plan leakage. While the company could not quantify the severity of the leakage, it was "at a higher level than we wanted it to be," Mr. Buben said.

The uptick in the number of companies offering the option makes sense given the stark difference between the loan default rates between active employees and those who leave, said Alight Solutions' Mr. Austin.

With this in mind, many sponsors feel compelled to act in the best interest of all plan participants, active or not, Mr. Austin said.

"There's a large contingent out there that says this is a pretty easy thing that we can add to our plan," Mr. Austin said, referring to loan repayments options for former employees.

Jamie McAllister, a senior vice president and defined contribution consultant in Callan's Chicago-based fund sponsor consulting group, echoed similar views, saying sponsors are responding to paternalistic instincts to protect participants from defaulting on loans and getting needlessly penalized on taxes.

Allowing participants to continue paying off their loans also helps employers retain plan assets, something that more sponsors are seeking to achieve, she said.

"We've been seeing more and more plan sponsors saying, 'we've created these best-in-class plans, so we really want as many participants as possible to stay in it,'" Ms. McAllister said.

United Technologies Corp., which has long allowed former employees to continue paying off their loans, added the feature largely to support its strategy to retain participant assets.

"The UTC savings plan has always been a place where former employees can keep their money. UTC recognizes that this benefits all of the people in our plan by increasing economies of scale and lowering costs for everyone," said Kevin Hanney, senior director of pension investments at UTC in Farmington, Conn.

Still, companies like UTC, Home Depot and Hilton are in the minority, with many opting to focus on current employees.

Some plan sponsors say they "tend to make more enhancements for people that are actively employed than ones that are not actively employed,'" Mr. Austin said.

The slow adoption of post-employment loan repayment features may also be tied to technology barriers, Callan's Ms. McAllister added. "In the past it's been a little more cumbersome to let participants do that," she said.

While it's fairly routine today to set up direct loan payments from a participant's bank account, it wasn't the case just five years ago, according to Ms. McAllister.

In fact, even today some record keepers might not have the infrastructure to allow payments other than through a payroll feed with current employees, she said.

"If the record keeper has that limitation, then the plan sponsor is going to be handcuffed as well," she said. Overall, though, she sees more plan sponsors letting participants continue to pay off loans post-employment, particularly as sponsors increasingly adopt policies for retaining assets of former employees.

"Almost 70% of plan sponsors seek to retain the assets of their participants rather than not," she said. "As we see that number grow, we expect more plan sponsors to allow the continuation of loan payoffs."