Essentials to Limit Loans and Hardship Withdrawals

Plan sponsors should educate their employees about distributions, and they can help their workers set up emergency savings accounts to avoid tapping into retirement funds.

Though research from Vanguard determined that retirement plan loan and hardship withdrawal activity decreased in 2020, experts say employers should consider enacting procedures to limit retirement plan distributions while still offering help to their participants in emergencies.

Last year, the Coronavirus Aid, Relief and Economic Security (CARES) Act allowed participants to withdraw up to $100,000 from their retirement plan, penalty-free, until December 30. According to data from Vanguard, 5.7% of participants who had the option withdrew retirement assets through coronavirus-related distributions (CRDs). Nonetheless, Vanguard says, hardship withdrawal activity was down 29%, and other non-hardship withdrawal activity was down 16%, compared with 2019.

Meanwhile, loan activity fell by 20% in 2020 compared with the previous year, Vanguard research found. Additionally, 13% of participants had an outstanding loan in 2020 compared with 16% in 2016.

Even though the globe faced periods of market volatility and economic uncertainty during the beginning of the coronavirus pandemic, Sri Reddy, senior vice president of retirement and income solutions at Principal, credits legislative efforts—including the expansion of state-run unemployment plans, the CARES Act and the Paycheck Protection Program (PPP)—with stabilizing market insecurity.

Having the option to take out a loan or withdrawal might also have calmed participants who were worried about the market, Reddy adds. And he says he believes offering loans and withdrawals can incentivize participants to save more. He notes that of the CRDs taken in 2020, the average withdrawal was $17,000, according to Principal research. “What the data tells us is that when you have access to funds available in a plan, people tend to contribute more and more consistently,” he says.

However, taking a plan loan or withdrawal shouldn’t be the first course of action participants take in a financial emergency, he cautions. Along with providing consistent education and communication on withdrawals and plan loans, Reddy recommends plan sponsors establish an emergency savings account benefit for participants so they don’t have to turn to retirement plan assets in times of need.

“Recognize that there will be a group of people who use their retirement as a rainy-day reserve, and those people will take loans and withdrawals, but we don’t want to drive that behavior either,” he says. “Take this into consideration and make sure that they’re educated on that. That’s why we always talk about setting up an emergency savings account outside of the 401(k).”

Educating participants on plan loans and withdrawals means participants are better informed on the benefits and understand the logistics behind them, he continues. For example, plan sponsors can tell participants that loans can turn into withdrawals if a participant leaves the employer—whether voluntarily or involuntarily—before paying off the debt. “You might think you’re taking out a loan but if you leave your employer, that could end up being a withdrawal where you pay penalties on those,” Reddy explains. 

Vanguard also provided insights to action for plan sponsors, including recommending they consider plan rules that balance the financial emergencies of participants who do not own a rainy-day savings account with preserving retirement funds. Vanguard Strategic Retirement Consulting (SRC) recommends plan sponsors limit participants to one outstanding loan at a time, consider plan savings sweeps, set minimum limits for hardship withdrawals to twice per year, and set a “cooling off” period of 30 days to six months between loan payoffs and taking a new loan.