The COVID-19 pandemic has exposed many financial vulnerabilities, both for companies and employees, and it has highlighted how company-sponsored retirement savings plans are sometimes used as dual-purpose vehicles. Although they were originally designed to fund retirement in the post-pension era, many are now also acting as short-term emergency savings funds.
With the passage of the Coronavirus Aid, Relief and Economic Security (CARES) Act, defined contribution (DC) plan sponsors face important decisions with respect to their plan design, specifically whether or not to adopt the special distribution and loan limit increases for those affected by the coronavirus. It is a good time for plan sponsors to consider additional design changes that could help preserve long-term retirement security, especially ones that address participant challenges related to job loss, given the unprecedented economic fallout from the COVID-19 pandemic.
DC Plan Loans versus Hardships
Some DC plan providers have suggested it is preferable that participants tap into their retirement savings via the coronavirus-related distribution (CRD) option for participants rather than by taking a loan because of the tax advantages of the CRD, including a waiver of tax penalty and normal tax liability spread over three years. Individuals can also pay back a CRD and avoid the taxes altogether, but does anyone really expect them to? Participant loans, on the other hand, have the existing infrastructure to facilitate repayment, including automatic deduction from payroll in most cases, spreading payments over a period of up to five years. As long as the loan is repaid, there is no tax liability.
Others have pointed to the challenge a financially constrained participant would likely have repaying the maximum-allowed $100,000 loan under the CARES Act. However, according to Fidelity, so far the median CRD has only been $5,500—an amount similar to the historical median loan amount, and a fairly modest monthly payment over a typical five-year period if a participant is also eligible to take that money as a loan. Further, research has shown that the loan feature helps increase participation and savings rates.
The problem with taking a loan from the plan is the participant’s chance of defaulting, which happens most commonly upon job separation. A few years ago, a study by the Pension Research Council at the University of Pennsylvania’s Wharton School in Philadelphia found that 86% of employees who have loans from their retirement plan accounts default when they leave their jobs because most employers require repayment in full.
The COVID-19 pandemic has caused a loss of more than 36 million jobs and counting. Congress has increased access to DC plans to help affected employees and former employees meet today’s emergency financial obligations and, for many, a CRD that is likely to be a permanent hit to retirement savings may be the only option as loans are predominantly only available to active employees. However, some employees already have loans outstanding, and many active employees who may have seen a reduction in pay and/or hours, or have been affected at the household level, may take out new loans. Because sponsors are already making loan policy decisions as a result of the CARES Act, there is no better time to consider other policy changes that can help ensure these loans get paid back after a job separation event and preserve long-term retirement security.
Extended DC Plan Loan Repayment Helps Mitigate Leakage
Plan sponsors that haven’t done so already should consider allowing participants who leave the company with a plan loan outstanding to continue to repay that loan on a periodic basis. Historically, plans have required that outstanding loans be paid back immediately and in full upon separation. The law allows for some period of time to repay the loan, typically by the end of the calendar quarter following the quarter of separation, but plans may also adopt their own more stringent requirements.
Over the past several years, in an attempt to prevent leakage and retain participant assets in plans, some sponsors have changed their loan policies to allow for these former employees to continue to repay their loans, either via coupon book payments or direct deductions via ACH [automated clearing house] from a bank checking or savings account, typically facilitated by the plan recordkeeper. Adoption of this feature has tended to be more common across larger plans, but the trend is growing and worth considering. While it may not provide much needed liquidity to those who are already financially stressed because they lost their job involuntarily, it could be a highly effective solution for those changing jobs who still have income. This year, Callan reported that 55.7% of sponsors were offering this option, and Alight’s 2020 “Hot Topics in Retirement and Financial Wellbeing” report said 58% of sponsors surveyed were allowing continuation of loan repayment.
Providing a ‘Safety Net’ for Those Who Lose Their Jobs
Another emerging solution for consideration is loan insurance, which can automatically and measurably prevent loan defaults after involuntary separation, including job loss, disability and death. While loan insurance won’t cover voluntary terminations, coupled with the ability to continue to make loan repayments, it offers a highly effective safety net for those who lose their jobs involuntarily.
Recent enhancements to loan insurance have expanded the options for protection—and lowered the costs—ranging from simply covering a separated employee’s loan payments for a set period of time to allowing them to keep their loan current while they seek re-employment, to providing full payoff of their outstanding loan. Plans adopting loan insurance would amend their loan policy to provide insurance for every new loan taken and can also allow existing borrowers the opportunity to opt into the coverage during a brief enrollment window.
The combination of these loan policy changes presents sponsors with effective, easy-to-implement solutions to enable safer access to the emergency liquidity that many participants need in the COVID-19 era, while also further preventing plan leakage and improving retirement outcomes. Both come at little or no cost to the plan sponsors.
Given the unprecedented financial crisis upon us and the growing level of unemployment, coupled with the role of the company sponsored retirement plan as the only form of emergency savings for many families, retirement security risk has never been greater. Thoughtful plan design changes today will go a long way toward preventing a significant retirement crisis down the road.
Rennie Worsfold is an executive vice president at Custodia Financial, responsible for retirement loan eraser distribution. He is part of the leadership team at Custodia Financial, a consortium of retirement industry experts with the purpose of safeguarding Americans’ retirement savings and improving retirement outcomes by eliminating 401(k) loan defaults. Worsfold recently completed a three-year term as a member of the U.S. Department of Labor (DOL)’s ERISA [Employee Retirement Income Security Act] Advisory Council.This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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