If your retirement plan allows loans and/or hardship withdrawals, it may be leaking money. Plan leakage refers to participants allowing their account balances to shrink because of either loans or hardship withdrawals. Plan loans do not always result in permanent leakage when they are repaid, but they still can have adverse long-term consequences for participants.
How do plan loans leak?
Plan loans can cause several basic problems for participants. For example, while participants are paying themselves with the plan loan interest, there is an opportunity cost associated with not having borrowed funds invested in financial markets, as they otherwise would be if they remained in the plan. In addition, because a participant has to make principal and interest payments on the loan, this typically constrains participants’ ability to maintain the pace of their previous salary deferrals.
In the end, many participants default on plan loans, resulting not only in adverse tax consequences, but diminished retirement savings. Finally, from the sponsor’s perspective, plan loans increase overall plan administration costs to the ultimate detriment of plan participants.
Should your plan allow loans?
None of this is to suggest that having a plan loan provision — which is entirely optional — is a bad idea. Most plans do allow loans. Why?
The main reason is to encourage plan participation by the full demographic spectrum of employees who might otherwise not join the plan, fearing that they would essentially lose access to their savings without the ability to borrow from their accounts. Also, when employees encounter a financial emergency and have to borrow money, they can probably do so at a lower cost through a plan loan, particularly when factoring in the interest payments that will accrue to their own accounts. Similarly, an employee who is carrying high interest rate loans would probably come out ahead in the long (and short) run by paying off that debt with a plan loan.
In addition, if an employee with shaky personal finances cannot access credit at a reasonable cost from other sources, a financial crunch could drive him or her to take a hardship withdrawal — a welcome form of relief during a difficult time (though a leading contributor to plan leakage).
How Can You Prevent Leaks?
How can one strike a balance between maximizing participation with a plan loan provision and the unintended consequence of plan leakage? Consider the following:
- Incorporate Preemptive Education
Instead of just explaining plan loan procedures, incorporate financial education into the material that plan participants must read before requesting a loan. Such content might include a list of good (retiring higher-cost debt) and bad (discretionary purchases like expensive vacations) reasons for borrowing. Also, hold mandatory seminars for employees to explain the various consequences of plan loans.
- Limit the Number of Allowable Plan Loans
IRS rules cap loan amounts at the greater of $10,000 or 50% of the participant’s vested account balance, or $50,000, whichever is less. However, the rules do not limit the actual number of loans that participants can take out if the total amount borrowed stays within those limits. But, the more loans employees can take out, the easier it might be for them to wind up hitting the aggregate debt ceiling. Perhaps limit participants to one loan per plan year.
- Charge Loan Origination Fees
Research confirms that the higher the loan fee, the fewer participants with an outstanding plan loan. According to an Aon Hewitt study, 28% of participants have outstanding loans when the fee is below $50, but only 20% do when the fee is $100 or more.
- Set Additional Plan Loan Limits
Employers can further limit loan amounts (for example) with a loan limit formula based entirely on employees’ accumulated deferrals, but not amounts reflecting your matching contributions. Other limits include requiring that once a plan loan is paid off, another loan cannot be taken for a period of time, as well as setting a minimum loan requirement and limiting the reason for a loan to the same requirements that hardship distributions have.
Tightening things up
Another leak-prevention tactic that you can employ concerns the loan principal and interest payment process. Putting it on a payroll deduction basis should help ensure that loans are retired as promptly as possible. The plan sponsor should ensure that loans are being paid back as soon as possible and should monitor the deductions. These tactics, adopted in a coordinated manner, should amount to more than a duct tape solution to plan leakage. Integrating them into a larger participant long-term financial education and retirement readiness campaign can go a long way toward tightening up participants’ accounts.