Explain 401(k) Plan Loans’ Upsides and Downsides

Allowing 401(k) plan participants to take out loans against their account balances has always been a double-edged sword.

On the one hand, loans give participants a sense that their money will not be off-limits for decades and that they can access those funds if they need to, which may give them peace of mind to contribute at a higher salary-deferral rate.

On the other hand, 401(k) plan loans add a level of administrative complexity for plan sponsors. Moreover, these loans remove money from the plan that should be invested for retirement. Although participants are expected to pay the loan back with interest, chances are good that those assets would have earned a higher return by being invested in the financial markets.

In addition, if a participant takes out a loan and is unable to repay it for any reason, the loan amount is considered an early withdrawal (if the participant is under age 59 1/2) and subject to income taxes and a 10 percent penalty.

“Many employers see 401(k) loans as a necessary evil, or ‘safety blanket’ for employees,” said James F. Sampson, managing principal of Cornerstone Retirement Advisors LLC in Warwick, R.I. “Employee concerns about putting money aside without access to it for 30 or 40 years can be eased a bit knowing that they can get a loan if they need it.”

Indeed, perhaps the most compelling reason to allow 401(k) plan loans is that doing so can convince certain employees to participate in and contribute to the plan. According to the 2012 Ariel/Aon Hewitt study 401(k) Plans in Living Color—A Study of 401(k) Savings Disparities Across Racial and Ethnic Groups:

• 34 percent of black employees and 29 percent of Hispanic employees say the ability to take a loan from their plans if they need the money is a “strong influence” in their decision to invest in the plan.
• By contrast, only 17 percent of Asian-American and 13 percent of white employees make this claim.

In addition, because employees taking out 401(k) plan loans are not subject to the financial due diligence another lender would conduct, they can more easily gain access to needed funds if they would not qualify for other financing. While this type of situation could increase the likelihood of a loan default if the participant is unable to pay it back, eliminating loans altogether could push an employee into even more dire financial circumstances.

Emergency Loan Programs

This fact is not lost on employers that have begun offering employees access to short-term loans from a third-party vendor that can be repaid through payroll contributions. One example is the University of North Carolina at Chapel Hill’s Emergency Loan Program, “established to provide University employees with an alternative to borrow money for short-term emergency situations.”

While neither 401(k) plan loans nor short-term loan programs represent an ideal borrowing scenario, both types of loans can serve as last resorts to help employees avoid even worse outcomes, such as bankruptcy, eviction or foreclosure.

Managing Participant Risk

Given that nearly all 401(k) plans allow plan loans, the key challenge for plan sponsors is to implement safeguards to prevent abuse of this option. Offering plan loans is “a valuable and viable plan design option, but it needs to be coupled with education on the ramifications and pitfalls associated with taking a loan,” said Chris Dugan, retirement planning communications manager at Standard Insurance Co. (The Standard) in Portland, Ore. “Offering a loan feature can be a good thing given the right situations.” For example, taking out a loan to purchase a home is a good use of a 401(k) loan, while using those funds for a vacation likely is not.

Another key drawback of plan loans is the fact that participants often reduce their plan contributions as they funnel that money into repaying the loan. To get plan participants to weigh the pros and cons of loan-taking, The Standard now presents a pop-up window when participants apply for a plan loan online.

“[The window] gives them a friendly warning and the opportunity to think twice about taking out a loan,” Dugan said. “The application includes some education around the financial ramifications in terms of their retirement savings.” Based on feedback so far, Dugan said this approach is influencing participant behavior and some individuals are choosing to not complete the loan application process.

There are a number of other ways plan sponsors can minimize the downside of 401(k) plan loans. One way is to reduce the number of plan loans participants can take. “When participants have fewer loans available, they are likely to have less money outstanding in loans,” said Rob Austin, director of retirement plan research with Aon Hewitt in Charlotte, N.C. He also recommended adding a loan repayment option where money is debited directly from employees’ paychecks; this can help prevent employees from defaulting on the loan because of missed payments.

Another option is to limit the amount employees can borrow to the amount of their own deferrals to the plan. Using this approach, employees would not be able to borrow any funds in their accounts that came from employer matching or discretionary contributions; they could only borrow what they themselves contributed to the plan.

Loan Fees as Disincentive

Loan origination fees can help reduce the number of loans taken out and the total amount borrowed, Austin pointed out. As the table below shows, “a company with a loan origination fee that is less than $50 has an average outstanding balance of all loans that is close to $10,500,” Austin said. “If the loan fee goes over $100, the average loan amount drops to just over $5,800.”

Having these types of fees in place is likely to cause employees to think twice before taking out frivolous loans. “Loans are meant to be a means of last resort in case of emergency, but I find that too many employees abuse the feature with such easy access to their funds,” said Ted Haughey, senior vice president of CBG Benefits in Boston.

Joanne Sammer is a New Jersey-based business and financial writer.