Multiplication ‘Fables’

Did you hear the one about loan defaults adding up to $2.5 trillion in potential retirement savings shortfalls over the next 10 years? How about the “$210 Billion Risk in Your 401(k)”?

Those reports were based on an “analysis” by Deloitte that claims to find that “…more than $2 trillion in potential future account balances will be lost due to loan defaults from 401(k) accounts over the next 10 years…” That’s right, $2 trillion lost “due to loan defaults” (the Wall Street Journal apparently picked the figure that matched the impact on a “typical 401(k) borrower” – more on that in a minute).

Now, when you see headlines putting a really big number on what you already suspect is a problem – in this case “leakage” – roughly defined as a pre-retirement withdrawal of retirement savings – well, you could hardly be blamed for simply accepting at face value the most recent attempt to quantify the impact of the problem.

A closer look at the assumptions behind that analysis, however, puts things in a different light.
The Deloitte paper leads with the question “How can we keep loan defaults from draining $2 trillion from America’s 401(k) accounts?” – but despite the positioning of the premise that this is a leakage issue, the loan default turns out to be only a small part of the problem.

The Deloitte authors outline the assumptions underlying their conclusions in the footnote of the 12-page document. Specifically, they draw many of their starting points from a 2014 study, “An Empirical Analysis of 401(k) Loan Defaults,” which found that with 86% of the participants that terminated employment with loans outstanding defaulted on those loans – and took their entire account balance out at the time of loan default. That report also noted that the average age¹ of the loan defaulter was 42. The Deloitte authors also draw from Vanguard’s “How America Saves 2018” that the average loan default was approximately 10.1% of the total account balance.

And then, with that as a foundation, the Deloitte authors begin to build.

The Deloitte modeling assumption relies on the notion that the vast majority of participants who default on these loans take their whole balance out of the plan. Rather than using the 86% assumption from the 2014 study, they scaled it back to a more conservative assumption that (only) 66% of participants that defaulted on their loan also took their entire account balance. They then back into the total account balance that those individuals would ostensibly have ($47.8 billion, assuming that their loan is 10% of their total balance) that they claim, based on the earlier assumptions, would be withdrawn in addition to the outstanding loan amounts. They then project growth in those totals assuming that everyone in that group is 42 (the average age of a loan defaulter) all the way out to age 65, assuming a 6% return over that period – and wind up with $2.5 trillion!

Now, there are so many assumptions imbedded in that calculation – and so many that act as multipliers on the original assumptions – it’s hard to know where to start.

To put it in individual terms, the Deloitte analysis assumes that every borrower is 42 years old, that two-thirds of these that default not only do so on a loan of $7,081 (the average outstanding loan amount), but go on to cash out their remaining account balance of $70,106 (assuming, of course, that the loan amount is approximately 10% of the balance). They then assume – and this is the assumption based on complete speculation – that there was no subsequent rollover, nor any renewal of contributions anywhere over the rest of their working lives – while also assuming that they could have attained a 6% return on those monies over that extraordinary period of time if only they hadn’t cashed out.

Still with me?

What’s obvious is that the bulk – indeed, the vast majority – of that projected impact comes not from the highlighted loan defaults – which are, in fact, a mere fraction of the terminating participants’ 401(k) balance – but from what the Deloitte authors term the “leakage opportunity cost” – basically it’s the “magic” of compounding applied to both the defaulted loan and the other 90% of the participant account balance… at a 6% rate of return over nearly a quarter century.

They say that two “wrongs”² don’t make a right – and that’s particularly true when multiplication is involved.

It’s not that the math isn’t accurate. It’s just that the answer doesn’t “figure.”

Nevin E. Adams, JD

1. There are always potential problems with extrapolating conclusions from averages. That said, the 2014 study from which those averages are drawn note that participants who defaulted on their loan were more likely to have larger loan balances than those who repaid, and to have lower household incomes and smaller 401(k) balances – in sum, not exactly “average.” ↩
2. The paper also makes some curious comments about loans and fiduciary liability – but we’ll deal with those in a future post. ↩