PLANSPONSOR: Can you describe the retirement plan loan default issue and its significance for plan sponsors?
GEORGE White: 401(k) plans are compromised by the leakage caused by loan defaults. The issue is bigger than most plan sponsors realize. A Wharton study found that $6 billion in loans default annually, and 86% of loans default when participants lose their jobs and are unable to repay. The majority go on to cash out, and when you factor that in, you’re looking at over $20 billion dollars lost each year. But it’s largely gone unnoticed because only 8% of loan defaults are separately reported on Form 5500. The good news is this leakage is unnecessary and can be prevented with simple loan insurance.
PS: What are the risks to plan sponsors if they ignore loan defaults?
White: The risks are substantial. Loan defaults drain participants’ 401(k) accounts. The true cost of a loan default includes taxes, penalties and associated cash outs, not to mention the lost savings and earnings opportunity over a participant’s career. The sponsor has greater fiduciary risk. Under the Employee Retirement Income Security Act [ERISA] fiduciaries are obligated to preserve account balances in the event of a loan default, but the current practice of sending a collections notice is ineffective because people who have lost their jobs aren’t in a position to repay the loan. And plan sponsors are at greater risk of an audit, based on a Department of Labor [DOL] notice that loans are on their radar.
PS: Why did you pursue a product-based solution over some other measures available to plan sponsors?
White: Because we believe that while those measures are well-intentioned, they don’t go far enough. Loans are an essential feature for 401(k) plans because they create a path to participation for many employees. Eliminating or restricting loans can end up increasing your hardship withdrawals. Some plan sponsors are beginning to allow ongoing repayment of loans after termination. We’ve talked to firms that are doing this and they’re not seeing a pickup in successful repayments because most people that borrow don’t have the money to repay, especially if they’ve lost their jobs.
PS: Talk about Custodia’s solution to this issue.
White: Our program is called Retirement Loan Eraser. When a participant loses his or her job, it will repay the outstanding loan balance before the participant defaults. It’s a fully automated, seamless solution that stops the leakage, especially the premature distributions. The insurance is guaranteed issue coverage through an A-rated carrier. There is no cost to plan sponsors. The loan protection is borrower-paid with just a few dollars more added to a loan repayment. When you consider the millions that the industry has spent on financial wellness without a clear return on investment, loan insurance preventing 401(k) loan defaults makes sense. A plan sponsor will be able to measure the positive impact on their plan right away.
PS: Can you tell us more about how it works?
White: Once a plan sponsor adds the program participants automatically receive loan insurance when they borrow. By preventing the loan default, 401(k) loan insurance allows participants to keep their balance and their retirement savings on track. The insurance kicks in and pays the loan balance for three eligible events: involuntary job loss, disability or death. So if a participant is laid off, for example, the policy would repay the loan before it defaults, saving taxes, penalties and lost earnings that can grow to exceed several times the loan value. That improves retirement outcomes.
PS: How do plan sponsors add this to their plan?
White: This simple loan protection feature is easy for plan sponsors to adopt through their recordkeepers. Plan sponsors can call Custodia Financial at 214-393-3511 or visit us online at www.loaneraser.com to learn more.
George White is Executive Vice President and COO of Custodia Financial. Mr. White has also held senior leadership positions in the retirement business at Fidelity Investments and Newport Group during his career.