Saturday, March 22, 2008

Safety “Net”

Over the past several weeks, I’ve gotten a lot of calls from reporters across the country looking to understand more about what appears to be a recent uptick in the volume of loan and hardship withdrawals from 401(k) plans. By most accounts, those volumes are up—in some cases, perhaps, up by a factor of two—from a year ago.

The natural assumption is that some combination of the subprime crisis, the struggling investment markets, and/or just general economic stress is forcing participants to tap into their 401(k)s. Of course, pretty much year-in and year-out, somewhere between 10% and 12% of participants have loans outstanding (though a huge database maintained by the Employee Benefit Research Institute (EBRI) indicates that the percentage with loans outstanding has been in the high teens for a number of years, certainly among larger plans). Still, there is clearly movement afoot.

The question, of course, is what should be done about it? If savings rates and accumulated balances are already inadequate to ensure retirement security, it’s hard to imagine a scenario under which depleting them—even if only for a short time—doesn’t make a bad situation worse, IMHO.

Moreover, when people “borrow money from themselves,” as the 401(k) loan process is often characterized, they quickly find out that they are really borrowing money from the plan, collateralized by their balance. That not only means that the 401(k) loan must be repaid on a regular basis (the plan fiduciary has an obligation to oversee these just like any other asset of the plan)—it also means that, while the participant may have satisfied one obligation, they have just picked up another.

The Loan Benefit

There are, of course, reasons to take advantage of the loan benefit, for that is surely what it is. There’s the interest rate, of course—generally prime +1%. Interest that, even if it has to be funded by the participant, does at least eventually wind up in their own account, rather than some credit card company’s. Plan loans are usually relatively easy—and the ability to simply tap into money that you have set aside is certainly more appealing to one’s sense of self-reliance than prostrating oneself before some loan official.

This industry has long and consistently embraced the notion that loans were something of a necessary evil in these programs. After all, if we didn’t give participants a way to tap into those funds in an emergency, they’d be much less inclined to save—or so runs the common wisdom. Odds are, if you’ve had the opportunity to explain these loan features to reluctant savers, you’ve perhaps thrown in the notion that “you can get to the money in an emergency.”

All in all, most participants appear to have treated that option responsibly. Over the past 20 years, the number of participants with loans outstanding has remained relatively constant, and while there are certainly cases of individual abuse, the combination of plan limits, processing fees, and sheer inertia has evidently served to keep this genie in the bottle. There are, however, clear signs of a shift here—a shift likely to accelerate along with the uptick in mainstream media coverage of the issue.

This doesn’t have to be a bad thing, of course. And while there is reason for concern if this simply becomes just one more way of fueling (no pun intended) our nation’s apparently insatiable desire for “stuff,” there’s little point in having a retirement savings account if you and your family get thrown out of your home 20 years before then.

However, unsettling economic periods are not restricted to the here and now, and as important as the safety net afforded by these programs can be in the short-term, it is a net that must be repaired and restored at some point. It’s one thing to borrow from yourself, after all—and something else altogether when you simply rob Peter to pay Paul.

- Nevin E. Adams, JD

1 comment:

  1. You mention, "pretty much year-in and year-out, somewhere between 10% and 12% of participants have loans outstanding" - ranging more recently to the higher teens.

    Data from my employer's plan matches your information:
    (a) 18% have loans,
    (b) Participants are responsible borrowers, and
    (c) Little difference in deferral rates for those who borrow
    - pretty much what you would expect from those responsible enough who saved in the first place.

    Some articles I've seen assert a one-sided view. One had an example that assumed:
    (a) Participants can achieve a 10% return on assets,
    (b) People stop deferrals while the loan is being repaid,
    (c) 7% "unsecured" loans are available from other sources, and
    (d) Those who borrow from other sources do not stop deferrals.

    My 25+ years of corporate benefits experience shows few consistently achieve 10% returns, most continue their contributions while repaying loans and many would pay much more than 7% interest to a 3rd party.

    Modest access and careful, deliberate use of loans can help people save for retirement. Many studies, including research from the Center for Retirement Research, show that participation declines when we limit access to funds. Don’t forget, people must first save before they can qualify for a loan, and repayment rebuilds the account for a future use.

    While termination is an issue, many plans allow post-employment repayment. Participants in our plan can even initiate a loan after termination.

    Our priorities should not be new limits on loans, but:
    (a) Ensuring loans are more attractive than withdrawals, and
    (b) Updating loan initiation and repayment processes to 21st Century standards.

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