While the retirement plan industry is primarily focused on helping participants invest more money, it is equally important to discourage them from taking out loans or hardship withdrawals, says Snezana Zlatar, senior vice president and head of full service product and business management at Prudential Retirement in Woodbridge, New Jersey.
“Dipping into retirement savings early, suspending contributions to defined contribution (DC) plans, or both, can reduce workers’ retirement savings on average by 14%, delaying retirements and costing employers more for salaries and benefits as their workforce ages, according to MassMutual’s analysis,” says Tom Foster, national spokesperson for the firm’s workplace solutions unit in Enfield, Connecticut. And the younger the participant, the greater the impact because of their savings time horizon.
For example, a 29-year-old who takes out a hardship withdrawal reduces his retirement readiness by an average of 20%, whereas a 60-year-old who takes out the same amount reduces his retirement readiness by only 3%, Foster notes.
Of course, retirement plan sponsors always have the option of barring loans, but that could have the unintended consequence of lowering participation in the plan because employees want to be able to access their money, Foster says. This is undoubtedly why the 2018 PLANSPONSOR Defined Contribution Survey: Plan Benchmarking report found that 79.3% of all plans make loans available.
Unfortunately, “when employees know they have quick and easy access to their 401(k) plans, often, they begin to view their retirement plan as a revolving credit line,” says Amy Ouellette, director of retirement services at Betterment for Business in New York. “That said, every six months an issue could crop up, leading participants to layer one loan on top of another.”
On top of that, with the average job tenure in the U.S. being just over four years and the period to repay a loan being five years, if a participant with a loan should leave their employer before the loan is due, the entire balance is due within 60 days, she adds. If it is not repaid and the participant is under the age of 59-1/2, it is treated as a distribution, she continues. That means the taxes that were withheld on the contributions will be due in addition to a 10% penalty, Ouellette says.
Changing loan policy statements to discourage loans
Thus, there are changes to loan policy statements (LPS) that retirement plan sponsors should consider when making loans available, experts say. While the Department of Labor (DOL) permits loans up to $50,000 or half of the participant’s balance, whichever is lower, sponsors might consider altering their LPS to limit that to $20,000 or $30,000, Foster says.
Sponsors might also want to create a screening process that includes requiring participants to read materials about the adverse consequences of taking out a loan, have them sign that document and make this part of the LPS, he adds. “That might be a way to get participants to rethink taking out a loan.”
The LPS should also permit only one loan at a time and create windows of time between each loan that act as barriers, says Andy Heiges, group manager for advice, retirement income and financial wellness at T. Rowe Price Retirement Plan Services in Baltimore, Maryland. Many retirement plans do not permit participants to contribute to their 401(k) when they are repaying back a loan, which Heiges thinks they should permit.
Sponsors should also consider amending their LPS to permit participants to continue repaying back the loan after being separated from the company, says Chad Parks, founder and chief executive officer of Ubiquity Retirement + Savings. However, “the plan sponsor and the recordkeeper have to agree on this policy, and the sponsor may not want to be burdened with ensuring that the participant continues to send in their payments proactively, since the money will no longer with automatically withdrawn from their paychecks,” he points out.
Imposing a loan origination and maintenance fee on the loan could also serve as a deterrent, Zlatar says. Related to this is increasing the interest amount that a participant pays, says Marina Edwards, senior director, retirement, at Willis Towers Watson in Chicago. The most common interest rate that sponsors impose on retirement plan loans is one percentage point above the prime rate, Edwards notes. Sponsors may want to amend their plan documents to change that to two percentage points, she says.
“The interest rate must be reasonable, and the IRS has informally stated at conferences that prime plus 2% would be reasonable,” she says. Not only might this act as a deterrent, but because the interest rate goes back to the participant’s account, plan sponsors like this because it ensures that the participant is putting more money into their retirement account, Edwards adds.
Using financial wellness to discourage loan use
Beyond changes to the loan policy statement, it is also very important to provide financial education to employees, particularly about budgeting, says Josh Sailar, investment adviser with Miracle Mile Advisors in Los Angeles.
“Offering a financial wellness program that goes beyond the 401(k) plan on budgeting is important,” Ouellette agrees. That is why Betterment has advice built into its platform, she says.
In line with this, it is important to encourage participants to create an emergency savings fund, Sailar says. Zlatar agrees that this is a vital step sponsors should take to possibly preclude participants from taking out loans, noting that Prudential research found that 63% of Americans could not afford even just a $500 emergency, and 31% would consider retirement plan loans or withdrawals to cover those expenses.
This is why last July, Prudential created a post-tax emergency savings fund feature within its retirement plan platform. In line with this, Sailar says it is important for sponsors to offer other savings vehicles, such as 529 college savings plans and health savings accounts (HSAs).
“We encourage plan sponsors to work with their recordkeepers to do an independent compliance review of their plan loans,” Edwards says. “They need to check the loan status of their plan to check for such things as whether or not some loans are past five years. That would be a problem.”