Published in July 1996

Loan Provisions

By PS | July 1996

Loan Provisions: Powerful, Flexible Advantages for 401(k) Plans

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