The Potential Impact of 401(k) Loan Default Protection

Research from the Employee Benefit Research Institute shows 401(k) plan loan defaults that occur as a result of job changes or terminations are a significant, but addressable, source of retirement account leakage.

Overall, U.S. Department of Labor data indicates that 401(k) plan loan amounts tend to represent only a small portion of a given investor’s total plan assets, but a recent Employee Benefit Research Institute analysis shows that defaults on retirement plan loans collectively produce significant reductions in retirement balances.

Specifically, EBRI’s data suggests that 401(k)s could collectively preserve a whopping $1.9 trillion in participant retirement savings by enrolling participants who take out loans from their 401(k) into 401(k) loan protection, which protects employees from defaulting. According to the analysis, a typical 401(k) loan default will cost, over the course of a career, more than $150,000 for average borrowers ages 25 to 34, more than $184,000 for borrowers ages 35 to 44, more than $194,000 for borrowers ages 45 to 54 and more than $195,000 for borrowers ages 55 to 64.

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In its report, the EBRI uses its Retirement Security Projection Model to simulate the retirement income adequacy for all U.S. households between the ages of 35 and 64. The RSPM reflects the real-world behavior of 27 million 401(k) participants, as well as 20 million individuals with individual retirement accounts.

The RPSM was used to simulate the increase in the present value of the 401(k) account balances—both with and without an automatically enrolled loan protection program. The report runs a baseline scenario assuming there was no auto-enrolled loan protection program in effect and flagged each year, if any, that a 401(k) participant was assumed to have a loan default. Then, another simulation was run, assuming the protection program was in place. In basic terms, such a protection program may be set up such that a participant’s loan is automatically repaid in the event of death or disability. In the event of involuntary job loss, the insurance provider may help repay the loan while the participant looks for another job.

“Loans provide 401(k) participants with access to their retirement savings during emergencies. Unfortunately, when employees leave their jobs, they default and incur taxes, penalties, and often cash out their entire account,” says Custodia Financial CEO Tod Ruble, whose firm sponsored the EBRI research and is a provider of 401(k) loan insurance. “Loan default losses don’t have to happen, and this research clearly shows the need for employers to safeguard their workers with auto-enrolled 401(k) loan protection. Protecting loans will reduce America’s retirement savings shortfall by trillions of dollars.”

Also noted in previous research, an additional way to improve retirement income adequacy could be the use of auto portability. As with loan defaults, there is a severe leakage problem when workers without loans move to a new employer, particularly when they have only small accounts. In such cases, investors must completely start over when it comes to saving for retirement. Using technology to save both time and resources, automatic portability solutions seek to help limit leakage by seamlessly moving retirement accounts from the old employer to the new employer.