PS: Why loans are important in today’s DC plans?
Liebrock: Most plan sponsors and administrators responsible for the plan don’t want to have them, but they’re necessary because they give people access to their money. That access gives some people the courage to participate in the retirement plan. If you think about it, having the loan in the plan is a better solution than a hardship withdrawal. In fact, 20% of people take loans. As an adviser to 401(k) loans, I always thought it was serial borrowers—the same people taking a loan over and over again. However, when you look at the data, over a five-year period the loan option is utilized by more people than you might think
So, the role of loans in a plan is an important benefit individuals should have. They don’t have to take money out of the plan, but they should have the option.
PS: How are loans problematic?
Liebrock: We as an industry are so focused on retirement outcomes, and loans—specifically defaulted loans—play a big part in participants not being sufficiently prepared for retirement. Eighty-six percent of the employees that terminate employment default on their loan; that 86% represents $6 billion annually in defaulted loans. The future value of this loss and lost compounding creates a meaningful shortfall at retirement for these savers which can be three times the defaulted loan amount. There is a real risk for those individuals with regards to their likely retirement outcome and ability to achieve what they want for retirement.
The core problem is that when people take a loan, they lack liquidity, and when they lose their job, they lack income. So what do they end up doing? They often cash out the whole balance to pay the taxes. It really creates a bigger problem for the participant when you think about saving for retirement.
PS: What are solutions for plan sponsors to deal with these loan issues?
Liebrock: Providing education to participants about the risks of taking a loan is important; however, it should be given at the point in time when somebody is about to make a withdrawal. They may still take the money, even if they do receive that education, but at least now they are informed about the risks.
Plan sponsors can limit the number of loans participants can take, but that tends to have negative influences elsewhere. The reason they’re taking a loan is because they don’t have the income or the liquidity they need, so if they don’t get the loan, they’re probably going to decrease their contribution rate. If a plan eliminates loans altogether, it will likely see an increase in hardship withdrawals. These are all part of a negative cycle of the wrong cause and effect.
You could allow a post-separation service for repayment of the loan, which I think plan sponsors should do anyway, but unfortunately that only takes care of those individuals who actually have the liquidity or the income to repay the loan. A post-separation default creates the equivalent of a hardship withdrawal and the negative consequences that come along with it.
A loan protection solution like Custodia’s Retirement Loan Eraser™ can be an ideal solution that provides benefits to participants as well as to plan sponsors. There are three things I believe loan protection should do. Number one is that loan protection should replenish the participant’s account balance. Number two is that it must fall under the guidelines of ERISA and the IRS—it should not require you to go out and do a new plan amendment, but should fit within the confines of what you already have in place. Lastly, it should act and be able to be used easily within the administrative systems that you have in place. I believe that’s the ideal solution.
Bruce L. Ashton
Partner, Drinker Biddle & Reath LLP
Although a plan sponsor may be able to delegate the administrative part of retirement plan loans to a recordkeeper, the approval of loans is a fiduciary function, says Bruce Ashton, partner at Drinker Biddle & Reath LLP, in Los Angeles. This, of course, means plan sponsors have to act solely in the interest of the participants for the purpose of providing benefits. Statistically, if people are laid off, 86% of them are going to default on the loan—but there are steps that can be taken to mitigate that risk, he says.
A new concept is that of loan protection, which can be implemented in the loan policy. For example, Ashton says, an employer may require protection in addition to other types of security for the loan. The decision about what goes into this policy is not a fiduciary function, but the implementation of the policy is. It’s possible that a decision not to offer such protection may, in some situations, introduce fiduciary risk.
There is a product that can help plan sponsors and their participants be more successful in decreasing the likelihood of loan default, he notes. The product, Retirement Loan Eraser, covers the participant in the case of an involuntary job loss, death or long-term disability.
For plan sponsors, Ashton says, the Loan Eraser complies with Employee Retirement Income Security Act (ERISA) requirements and can help them to fulfill their fiduciary responsibilities. And, having it available in the plan does not cause any material changes as to how the plan is operated, how it functions, nor does it introduce tax or other legal implications.