Sponsors’ Approach to Loans Affects Retirement Plan Leakage

When a plan sponsor permits multiple rather than only one loan, the probability of plan borrowing nearly doubles, researchers found.

A study concludes that retirement plan loan policy is economically meaningful in shaping participant borrowing.

In “Borrowing from the Future:  401(k) Plan Loans and Loan Defaults,” researchers Timothy (Jun) Lu, from the Peking University HSBC Business School; Olivia S. Mitchell, from the University of Pennsylvania Wharton School; and Stephen P. Utkus and Jean A. Young Jean Young, from the Vanguard Center for Retirement Research in Malvern, Pennsylvania, say their administrative dataset tracks several hundred plans over five years and shows 20% of retirement plan participants borrow at any given time, and almost 40% do at some point over five years. They estimate loan default “leakage” at $6 billion annually.

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According to the research report, published by the National Bureau for Economic Research (NBER), when a plan sponsor permits multiple rather than only one loan, each individual loan tends to be smaller, but the probability of plan borrowing nearly doubles, and the aggregate amount borrowed rises by 16%. The researchers contend that this suggests employees perceive that easier loan access is actually an encouragement to borrow.

Looking at defaults, the study found only one in ten participants who borrow from their retirement actually defaults, but the vast majority (86%) of employees who leave their jobs with a plan loan outstanding do default. In addition, workers at firms allowing multiple loans have default rates that are higher by 1.7 percentage points. Participants having only a single loan when multiple loans are allowed are 2.2% less likely to default compared to workers in plans allowing a single loan.

“The fact that many workers do borrow from and default on their plans has led some to argue that 401(k) loans should be restricted,” the report says. “Based on our results, those concerns seem overstated, particularly when compared to leakage from account cash-outs upon job change.” However, the researchers conclude that “limiting the number of loans to a single one would be likely to reduce the incidence of borrowing and the fraction of total wealth borrowed, thereby reducing the impact of future defaults.”

The research report is available for purchase or free download here.