Make 401(k)s a Vault, Not an ATM

If they want to, employers can make the loan process harder for plan participants.
Experts agree that taking a 401(k) loan rarely is a good idea. Still, research suggests the number of plan participants doing just that is on the rise, particularly since 2008, when layoffs and financial turmoil left many American workers with nowhere else to turn for funds.

“We have seen an increase [since 2008], and I don’t think that’s very surprising, given the economy today,” says Denise Preece, assistant vice president of field services with OneAmerica.

According to Aon Hewitt, nearly 28% of active participants had a 401(k) loan outstanding at the end of 2010, a record high. Nearly 14% of participants initiated new loans last year, slightly higher than in previous years. The average balance outstanding was $7,860, which represented 21% of these participants’ total plan assets.

And while the majority of participants (68%) had only one loan outstanding, 29% had two loans outstanding simultaneously, and 3% had more than two loans.
Loan usage varies significantly based on the participant’s situation, according to the Aon Hewitt research. Middle-aged and middle-income participants are most likely to have outstanding loans, while women with lower salaries are more apt to take loans than their similarly paid male counterparts. Women are also more likely to take more than one loan at a given time, as compared to men.

Even the time of year affects whether or not your participants are likely to take loans from their 401(k), says Catherine Golladay, vice president, participant services, with Charles Schwab. In the fall months, particularly September, there’s always a fairly dramatic increase in the number of loans taken. Likewise, in the spring, particularly in March, there’s always a dramatic decrease.

“You can look at typical behavior and draw some assumptions,” she says. “In September, one typical thing someone might do is look at their 401(k) loan as an opportunity to help them fund their education. That’s the time frame when tuition is due. My hypothesis on the spring is, unfortunately, I think individuals may be using their tax returns as a way to help them smooth out cash flow if they’ve gotten behind. So they look to that as a resource and don’t go to their 401(k).”

Allowing plan members to take several loans concurrently is probably not in their best interests, agree industry experts. When Senators Herb Kohl (D-Wis.) and Michael Enzi (R-Wyo.)

introduced the Savings Enhancement by Alleviating Leakage in 401(k)s Act last May (see “SEAL Act provisions” sidebar), they included a clause that would have limited to three the number of loans participants could take from their 401(k) at any one time. That provision, however, was later withdrawn, since it’s up to plan sponsors to decide how many loans participants are allowed to take at once.

“Loans are not a protected benefit and the employer can choose to manage it how they want,” explains Patrick Shelton, managing member of Benefit Plans Plus.
Loans are not all bad, however, says Pamela Hess, director of retirement research with Aon Hewitt, and 401(k)s are an appealing way to access money since participants essentially are borrowing from themselves.

“If it’s a short-term need and the 401(k) fits the bill, it really doesn’t do long-term harm. As long as it’s not constant loan taking, as long as you pay it back and keep saving,” she says.

The problem is many participants may not realize that if they lose their jobs, or even quit their job to go somewhere else, that loan is due pretty quickly – usually within 60 days. “And a lot of people can’t pay it back or don’t pay it back, and then they owe taxes on that money as well,” says Hess. “And then it becomes a permanent withdrawal from the system.”

There are a few things employers can do to discourage excessive loan taking. First, amend your plan document so that employees are only allowed to take one or two loans at a time.
Some employees will take a loan from their 401(k) to help them with a down payment on a house. “That’s usually something that’s part of a longer-term plan, and it’s not a case of someone using a loan to manage cash flow or for a quick fix,” says Golladay.

Second, consider adding a loan fee if you don’t already have one. “You don’t want to hurt people who need money,” notes Hess. “But having a loan fee does help curb some of the excessive loan taking – a $75 fee, for example. For people who need it and are taking a significant amount, it’s probably not going to be a big deal, but it can deter people who are maybe taking smaller amounts.”

Third, consider adding a timeout between loans. For example, make employees wait, say, 60 days before letting them take another loan.

Finally, encourage those who do take loans to continue saving. “Do a targeted message, for example, saying ‘you took a 401(k) loan this month. Don’t forget to keep saving,'” suggests Hess. “Personalized communications can be really impactful.”

And if your plan doesn’t already have a loan provision, keep it that way, advises Golladay. “I’d be hard-pressed – if you didn’t have a loan provision in your plan – to think of a reason why you’d want to add that,” she says. “If at this point you don’t have a loan provision, I wouldn’t recommend it as something you should do.”

Preece says she’s heard more discussion over the past few months about making it harder for participants to access loans. “We’ve had a couple of plan sponsors who’ve not wanted participants to have the ability to request a loan on the Internet, for example,” she says. “I don’t think there’s a wholesale shift in that, but it’s interesting that it is more of a topic of discussion than it was, say, two years ago.”

Common thinking many years ago was that plan sponsors should have a loan provision in place because it would help with enrollment – more employees would participate in the plan if they knew they could access their money in an emergency. But Golladay says she’s not sure that argument holds true anymore, now that auto-enrollment in plans and auto-escalation of contributions have become more prevalent.

“We don’t see many people opting out of those, so employers might want to challenge their common thinking around loan provisions,” she says.

Says Shelton: “Our philosophy as retirement plan consultants is basically to discourage loans. 401(k) plans are not a checking account. When we’re talking to our plan sponsors, we’re encouraging them to not offer loans, first of all, and if they do, to make it as restrictive as possible. Have a minimum loan amount of $1,000, for example, and charge a fee.”




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