In a time of growing concerns over compliance issues,
the success or failure of a 401(k) plan increasingly
centers on generating participation among younger
employees-many of whom could not care less about
retirement. The reality is that the "twentysomething" crowd
is concerned, if not preoccupied, with many other financial
priorities: a down payment for a first home, an automobile,
educational expenses, or travel and entertainment outlays.
As a result, they either underfund their contribution, or
do not participate at all.
That is the attraction of 401(k) loan provisions. A
liberal, well-designed participant loan policy has the
practical effect of turning a retirement plan into a
savings plan that can be tapped for any reason. The ability
to borrow from a plan removes a major psychological
impediment to 401(k) participation-the perception that
401(k) money is "gone," that it is inaccessible prior to
retirement except for extreme emergencies or at the cost of
severe tax penalties.
Of course, some critics oppose liberal loan provisions
on the premise that they encourage spending rather than
saving (see "401(k) loans: Employers create new
restrictions in battle to reduce costs," Plan Sponsor, May
1995). Others object that, by removing assets from their
equity investments, participants may suffer high
opportunity costs during a year like 1995, when major
market indexes soared by more than 30%. One also hears that
by using 401(k) assets for purposes other than investment,
the participant will end up with less money in his or her
account at retirement, and that loans are a headache for
the administrator.
But borrowing against one's 401(k) assets does not keep
those assets from building up, or gaining value. Loans earn
interest, which compounds tax-free in the plan. In fact,
loans earn higher interest as plan investments than do
money market funds or GICs.
Also, to the extent that the borrowing participant pays
the cost of a loan, and that loan is enough to compensate
the vendor, the "headache" of loans becomes another profit
center for the vendor. Given this format, the employer has
no reason to care, and employees definitely prefer having
total discretion over their assets, rather than having
arbitrary limitations imposed on them.
Furthermore, the advantages of a 401(k) loan facility
can attract a participant who otherwise would forgo
participation entirely. In other words, 30% of zero is
still zero for a non-participant. Secondly, data and
experience demonstrate that the vast majority of people use
loans carefully and prudently, and for purposes that are
far from frivolous.
The Profit Sharing/401(k) Council of America estimates
that only $900 million in loans are outstanding in a $77
billion universe of 401(k) assets. With loan amounts capped
by law at $50,000, the proportion of assets that
participants can borrow will shrink as total contributions
grow. Interest is pegged at what a local financial
institution would pay for a comparable loan-generally, 2%
above prime.
Compelling arithmetic
The arithmetic favoring 401(k) participation is
compelling. Younger employees can accumulate savings twice
as fast in a 401(k) as they would by saving after-tax
dollars. For example, $200 per month in a 401(k)
accumulates to $10,000 in just three and half years,
assuming a 10% annual rate invested in the stock market. An
employee in the 34% marginal federal and state tax bracket
would be lucky to accumulate $6,000 in after-tax earnings
over the same time period. (This, again, is based on a 10%
annual return: $200 x 66% [less the 34% tax rate] = $132;
$132 x 42 months at 6.6% [less 3.4% tax rate] = about
$6,200.)
Accessing money through a 401(k) loan is not a taxable
event. And the participant replaces the funds in her plan
with interest, so she can use them for a future
pre-retirement financial goal-effectively making the
participant her own banker. When I discuss 401(k)s with an
audience of "twentysomething" employees, I argue for them
to use the plan to meet their short-term as well as
longer-term financial objectives by following these four
steps:
l Choose a financial goal that can compete successfully
with all of the other items on which you are tempted to
spend money, such as a down payment on a home, an
automobile, or a consumer purchase.
l Access the money through the loan provision and become
your own banker.
l Pay the loan back over time. This way you will develop
a "war chest" of funds that will help you to meet
intermediate-term goals, such as a larger home or college
tuition for your children.
Two examples: cars and
tuition
You can dramatize your message using an automobile
purchase as an example. The average person buys a new or
used car every five years, and tends to finance the
purchase for five-year periods. So assume, for this
example, that our plan participant does this four times
over 20 years. The amount financed each time is
$10,000.
In this example, assuming a 10% interest rate, the
individual will have paid about $30,000 in total interest
on the four car loans. If the same participant had
deposited enough in a 401(k) to finance each loan by
herself, using plan assets, that $30,000 would have gone
back into her own account over 20 years.
To take this example a step further: If that $30,000
earned 10% interest it would double every 7.2 years,
meaning that a participant who started a 401(k) at age 25
would have accumulated an extra $240,000-almost a quarter
of a million dollars-by age 65.
Another illustration that resonates with Generation X
audiences is college loans. A student loan clings like a
barnacle for years after graduation. A younger person who
starts saving today through her 401(k) plan to cover the
eventual cost of a graduate degree, will ultimately make
payments with pre-tax dollars. When she leaves her job to
get that additional degree, the worst that may happen is
that she will collapse her 401(k) account during a time
when, as a student, her income is minimal anyway. It could
be that her only income will come from what would then be a
rollover IRA-but the only tax would be a 10% penalty. A
close examination of the arithmetic shows that this
scenario is far more favorable than incurring student loans
and paying both principal and interest in after-tax dollars
for many years into the future.
Avoiding "nuisance loans"
Unfortunately, many plan sponsors have yet to grasp the
win-win implications of liberal loan provisions. They limit
loans to just 50% of account balances, inhibit borrowing by
insisting on a minimum loan size, or require approval from
a committee panel that must play God in determining whether
the participant has offered acceptable reasons for the
loan.
Other sponsors are distracted by the cost and bother of
"nuisance loans," in which participants-it is
believed-routinely tap 401(k) assets for small amounts. A
good antidote to nuisance loans is to impose an
installation fee and an ongoing annual maintenance fee, and
let the participants make their own decisions. If an
employee desperately needs $900 for an emergency auto
repair, she should not be denied access to her money, as
long as she comes to terms with the installation cost of a
loan.
Another factor that inhibits 401(k) loans is big
financial institutions' lack of enthusiasm for them.
Lenders make more money selling investment products than
money market funds, so they usually encourage participants
to choose the former. Unfortunately, this is bad advice for
all concerned-plan sponsors, participants, and
vendors-because it results in participants contributing
less money overall. Participants miss out on an opportunity
to leverage their 401(k) savings more effectively, and key
management employees are often required to cease
contributions at amounts below the annual dollar maximums
because the plan is in danger of not complying with 401(k)
nondiscrimination tests.
Clearly, then, loans are a resounding win for everyone
involved with 401(k) plans-and they cost the plan sponsor
nothing. Make sure that you do not shortchange
yourself-both as a sponsor and as a participant-by
underutilizing the powerful advantages of liberal loan
provisions.
- Stephen J Butler