April 1, 2011 (PLANSPONSOR.com) – A Financial Literacy Center working paper suggests that overall, one in ten plan loans results in a default, and eight of ten workers who leave a job with a plan loan outstanding then default on that loan.
The researchers found “deemed distributions” due to loan defaults amounted to $600 million in 2007, representing 0.2% of $3.7 trillion in assets held in DC plans, so loan defaults in aggregate terms are thus small, compared to total assets held in DC plans. However, the analysis found loan defaults may be costly for particular groups of participants such as the economically vulnerable or financially unsophisticated.
The researchers analyzed a dataset consisting of over 100,000 retirement plan participants who terminated employment with a pension loan outstanding, during the three-year period July 2005 - June 2008. Among 401(k) plan borrowers terminating employment, approximately 80% defaulted on their loans and 20% repaid them.
The working paper said participants who defaulted on their loan were more likely to have larger loan balances than those who repaid; defaulters also had lower household incomes, smaller 401(k) balances, and lower non-pension financial wealth. “This suggests that loan defaults may arise from liquidity constraints around the time of employment termination,” the researchers wrote.
The study found other plan and participant factors also matter. For instance, participants leaving their employer with multiple loans outstanding are more likely to default, compared to those with a single loan (even after controlling for total amount borrowed and demographics). This suggests that there is unobserved heterogeneity in credit demand or in behavioral factors such as self control among plan borrowers. Thus participants who taking out one large loan may be more likely to plan for the need to repay in the event of job termination.
Alternatively, participants with several loans might fail to plan ahead, and thus take several small loans as the need arises, or perhaps they keep borrowing as their plan balance rises over time. In other words, having a one-loan per person limit might protect participants from accumulating more debt than they otherwise might.
The researchers found local economic conditions have little impact on 401(k) loan defaults during the period analyzed. The working paper is at http://www.rand.org/pubs/working_papers/2010/RAND_WR799.pdf.