A Delicate Balancing Act

When it comes to allowing employees to use the money in their 401(k) plans before retirement by taking a loan or a hardship withdrawal, employers must strike a delicate balance between granting access to the assets and making sure participants understand the implications.

As most HR executives are aware, employees sometimes find themselves in financial difficulty. For many, a 401(k) plan loan or hardship withdrawal becomes an important financial lifeline and a way out of that difficulty. But do employees rely too heavily on loans and hardship withdrawals rather than looking for a solution that does not involve retirement assets?

Loans are readily available in most 401(k) plans. A 2011 Harvard University study found that 90 percent of 401(k) plans offer a loan option and more than 20 percent of participants in those plans have taken a loan at some point. The study also found that 401(k) plan loans equal about 2.5 percent of overall assets among plans with a loan option.

For employers, offering 401(k) plan loans and hardship withdrawals is optional. Some employers see plan loans as a line of defense against more-extensive and permanent removal of 401(k) plan assets.

“Loans are a good provision to have,” says Stacey Hudson, SPHR, vice president of human resources at Preferred Family Healthcare in Kirksville, Mo., with 750 employees. “We place limits on loans, and I think we would have more hardship withdrawals if we didn’t have a loan option.” Unlike plan loans, hardship withdrawals do not have to be paid back and are subject to income taxes and a 10 percent penalty tax.

In some cases, taking out a plan loan really is the best choice for employees, and most employers do not want to get in the way. “I have seen some people who take out a loan to consolidate debt that carries 20 percent interest,” says Randi Miller, a human resources and benefits analyst with Allied Container Systems Inc. in Walnut Creek, Calif. “Even though this is not great for the participant’s retirement, the plan loan was the best option.”

Pros and Cons

The case against hardship withdrawals is a relatively easy one to make. Removing plan assets and paying the required taxes on that withdrawal can be devastating to an employee’s retirement security. Employees must pay applicable federal, state and local taxes on any hardship withdrawal, plus a 10 percent excise tax on that amount if the employee has not reached age 59½. This forces some employees to withdraw additional money from the plan to cover those taxes.

The case against plan loans is murky. Some argue that plan loans provide employees access to plan assets, which are then repaid with interest by the employee.

However, there are opportunity costs associated with plan loans. When participants take 401(k) assets out of plan investments, they lose out on the returns on those investments. Moreover, some 401(k) plans do not allow participants to contribute to the plan when they have loans outstanding. There is also a danger of 401(k) plan participants viewing their plan assets as a “piggy bank” to be tapped as needed rather than as assets invested for the purpose of securing retirement income.

Proponents of plan loans and hardship withdrawals argue that these features are reassuring to some employees. “It can be hard to get people into the plan when they are very young if they have no access or limited access to their 401(k) plan assets,” says Lori Lucas, defined contribution practice leader with Callan Associates in Chicago. “The presence of a loan feature can get people into the plan earlier, which can offset—and even more than offset—the damage that loans can do to the average participant’s savings over time.”

Critics argue that the rate of default on 401(k) plan loans creates a higher level of asset leakage from plans than employers may realize. Research conducted by Navigant Economics estimates that annual leakage from defaulted loans could be as much as $9 billion per year from total 401(k) assets, which were an estimated $3.1 trillion in 2011.

During the recession, this leakage was significant. The study estimates that total leakage from defaults between mid-2008 through mid-2012 could have been as high as $37 billion, largely due to employees who were unable to repay outstanding loans after losing or leaving their jobs.

Plan Design

These issues require employers whose 401(k) plans have loan and hardship withdrawal options to thoughtfully design and administer those components of the plan.

Although employers must comply with Internal Revenue Service regulations regarding plan loans, they still have plenty of leeway to structure loan features. IRS regulations limit loan amounts to no more than 50 percent of plan assets. Beyond that, employers can:

• Place limits on the number of loans a participant may have outstanding at any given time.
• Set a waiting period between paying off one loan and taking out another.
• Set the interest rate—the prime rate plus 1 percent, for example—and the maximum repayment period for loans.
• Set the payback mechanism—usually an automatic payroll deduction.
• Determine whether a loan must be paid in full when an employee leaves the company. Some plans allow new employees to roll over their loans into a new plan when they roll over their assets.

The decisions employers make when designing loan features can affect loan use. For example, the Harvard study found that the interest rate the plan charges can affect participants’ likelihood of using the option. Not surprisingly, the lower the interest rate, the more loans participants take out. Moreover, the size of these loans tends to be smaller when the plan places a lower limit on the number of outstanding loans allowed, requires a shorter repayment period and charges a high interest rate.

Participant Education

Beyond loan design, employers can focus on helping employees understand the risks of taking out loans and the impact it can have on their retirement security. At the same time, employers need to consider whether the widespread use of online administration systems is creating a new problem. With loans available with just a few clicks of a mouse, are employers and record keepers making it too easy to take out plan loans?

Employees may find it easier to borrow from a 401(k) than to obtain financing elsewhere. As a result, “many employees probably choose plan loans because they are the easiest to get, and quickly, without thinking through what that means,” says Kevin Seibert, managing director of the International Foundation for Retirement Education in Barrington, Ill.

“Taking out a loan from a 401(k) plan is really pretty painless,” agrees Marina Edwards, a senior consultant with Towers Watson in Chicago. “You don’t have to deal with other loan processes or procedures that you face when borrowing money from a financial institution. You click the button online, and three days later the check arrives.”

To keep the number of plan loans low, HR professionals can monitor annual or monthly reports to see if loans are climbing or spiking. If the number of loans and loan inquiries is getting alarmingly high, they can take that as a sign that it is time to provide some participant education about loans and their impact on retirement savings.

“Most employers are not comfortable cutting off loans entirely, so they can engage in some targeted education instead,” Edwards says. This could include an e-mail blast to the targeted population, an article in a participant newsletter, or a pop-up screen or flashing link when participants look for information on plan loans or try to apply for one.

For smaller companies, the answer could be a one-on-one approach to employee education. When employees of Carana Corp., a consulting firm based in Arlington, Va., with about 350 employees, take out a loan, they have to interact directly with an HR professional. In the process, they can get some insight into what taking out a loan means for their retirement savings.

“We talk through what the plan allows and what the participant may want to consider,” says Elisa Zlotowitz, SPHR, HR manager at Carana. “Ultimately, it is their decision, their money, and we want them to be able to meet their needs. However, I want them to have this information before they go ahead.”

In Miller’s experience, 401(k) plan loans tend to be taken out by employees with lower incomes, yet she notes that the loans are not widespread or frequent enough to be problematic. Problems do occur when employees take out a loan and then end up defaulting “not so much of their own accord but simply because the employee leaves the company or gets laid off without having repaid the loan,” she says.

Like Carana Corp., Allied Container Systems Inc. requires participants to interact with HR when taking out a loan. “We are able to have a one-on-one conversation with them to discuss the ramifications and the repercussions of taking out a loan, including how repayment works,” Miller says.

Given the sporadic nature of the work performed by Allied employees, Miller emphasizes that if an employee chooses to leave the company, the loan must be repaid in full. If the employee cannot repay the loan and defaults, the amount outstanding will be considered an early withdrawal from the plan and subject to income taxes and a 10 percent penalty. “The message is that if you have other opportunities for borrowing, maybe this is not the best option for you,” she says.

The author is a New Jersey-based business and financial writer.