Plugging Plan Leaks
The purpose of a workplace-based retirement plan is to help plan participants accumulate assets for retirement. However, through loans or hardship withdrawal provisions, money can be taken out of the plan before participants reach retirement age. These withdrawals are completely at the plan sponsor’s discretion; no regulator mandates that workplace-based retirement plans include such features.
According to PLANSPONSOR’s 2014 Plan Benchmarking Report, most 401(k) plans include a provision for participants to take loans or hardship distributions (see “Loans vs. Hardship Withdrawals,” page 56). Overall, 79.5% of plans allow for a loan, and the percentage rises along with the size of the plan, with 73.5% of plans in the under-$1 million market, and 88.1% of plans in the over-$1 billion, allowing the loans. Similar percentages apply to provisions for a hardship withdrawal. In total, 14.4% of plan participants have at least one outstanding loan.
Since the early 2000s, loans have stayed at a fairly consistent rate, hovering around the 20% mark, says Meghan Murphy, director of thought leadership at Fidelity Investments in Smithfield, Rhode Island. “We see about 22% of our 13 million participants have a loan outstanding—about 2 million people,” she says. New loans, taken by some 10% of participants who have never taken one before, run around $9,500, far less than the maximum of $50,000 or of half the account balance.
Many plan sponsors see loans as a way to attract participants to engage in the plan, Murphy observes, but at the same time, they understand that leakage is an obstacle to actually achieving a successful retirement. “Plan sponsors understand the impact loans will eventually have on retirement savings,” she says.
About half the participants who take out their first loan repay the amount within the specified time, then return to saving responsibly for retirement, Murphy says. However, the other half of loan-taking participants go on to become serial borrowers. “They take multiple loans,” she says, noting that the more money a participant takes out, the more he will lose on compounding interest, which can dramatically affect retirement savings and outcomes.
However, participants just do not seem to grasp the power of compounding. Kent Fitzpatrick, managing director at Asset Strategy Advisors in Boston, says that the industry may not adequately convey the true cost of borrowing. “That $1,000 to $5,000 may not seem like much,” he says. “But over a 20-year investment horizon, it can be a substantial loss, because it is not just that dollar amount.”
In any event, loans and hardship withdrawals can be an avenue through which advisers can educate participants about sound financial habits and wellness. According to Jeff Feld, principal at Alliance Pension, a third-party administrator (TPA) in Chicago, many advisers who work with the firm point out that participants lose out on more than the contributions themselves. They also miss time in the market, including all the market swings, low as well as high, that can significantly build account balances over time.
Advisers might want to tailor messaging and communication to Generation X, the demographic most likely to take loans and hardship withdrawals, Murphy says. Among participants in general who withdraw money from the plan, hardship distributions account for 2%; among Gen X, it is 3%. “They are our ‘sandwich generation,’” she points out, “[supporting] children in college [and] caring for aging parents.”
Younger workers in their 20s and 30s, or Gen Y, are another demographic that can benefit from education surrounding 401(k) loans. They face a particular danger when it comes to taking premature distributions or loans from their workplace-based plans, because this age group will have access to a 401(k) plan their entire working career, she says. “It’s so important for them not to take money out of the plan,” she says.
Rescue by Design
A combination of education and plan design can work, Feld says. His firm counsels its plan sponsor clients to push the loan fee charged by recordkeepers for administration—Alliance Pension Consultants charges a one-time fee of about $180—straight to the participant. According to Feld, some providers charge lower startup fees for a loan, perhaps $95, with annual costs of $45 or $50, adding several hundred dollars to the cost of a four- or five-year loan.
Fidelity recommends a few elements of plan design that can stem some of the flow. “We encourage a waiting period between loans, such as a six-month period before they can get another one,” Murphy says, explaining that the time requirement can help participants wait out the need for the money. “They might decide they can do without it, or get it from another source,” she says.
Henry Yoshida, principal at the Maresh Yoshida Group in Austin, Texas, says his group sets up plan sponsor clients to allow only one loan outstanding at a time. “This eliminates the ability for participants to become serial loan-takers or take out a second loan to pay off their first loan,” he says.
Another feature Fidelity encourages that can reduce plan leakage via loans is allowing participants to borrow only the money they themselves have contributed, not money from a company match or from profit sharing. Loans from a 401(k) should be a last resort, Murphy feels, and participants should be reminded that, if they leave the job, they will have to pay back the money immediately. The plan can also require the consent of the participant’s spouse, another way to encourage the participant to think through the decision.
Hardship Only?
Some plan sponsors look to sharply limit participants’ ability to take money out of the plan by only permitting hardship withdrawals, Yoshida says. “If a plan sponsor is adamant about not allowing its participants to take out a 401(k) loan, this is the way to go,” he says, although he is not a proponent of this method. Forbidding loans is not a good option, he thinks—rather, limit them to one outstanding. He suggests bolstering this with a strong education program that drives home the ramifications of taking loans.
Retirement plan advisers can take an active role in educating participants about the perils of 401(k) loans and hardship withdrawals, says Yoshida, who feels the messaging is similar to the way doctors and health care professionals advise people to exercise and eat a healthy diet. “The only thing we can do as retirement plan advisers is to encourage participants to not take out loans,” he says. “The negative effects are quite obvious and, if told to participants, are shown to decrease the likelihood of a participant taking a loan.”
One of the first red flags advisers can wave at participants who want to take loans is the loss of tax-advantaged savings. “When participants repay the loan, it’s paid with after-tax dollars,” Murphy notes, “and then they have to pay tax on it again. The taxes come around again in retirement, and they’ve lost the tax-advantaged savings on however much they took out.”
Yoshida recommends dispelling the myth that 401(k) loans carry a lower interest rate than other forms of borrowing such as credit cards, car loans and mortgages. “Although the stated interest rate for a 401(k) loan is relatively low right now—typical 401(k) loan rates might be between 3.25% and 4.75%—many people don’t consider the opportunity cost of taking out a 401(k) loan,” he says. In other words, in a 401(k) loan a participant must consider the stated loan rate, plus the rate of return they could have received on that money during the outstanding loan period. This is not often discussed in traditional educational materials but is a valid point that just may make the difference between taking, or not taking, a 401(k) loan.
Financial literacy is a key part of helping participants avoid the need to take loans, Murphy says. They may need to be taught to ask themselves questions such as, “What can I do today that will benefit me in the future?”
Advisers might also turn to a few methods to warn participants of the real dangers in taking a loan, Yoshida says. “I think too little education addresses the opportunity cost. The amount of lost retirement income is less well-known than the tax consequences for defaulting or paying yourself back the interest,” he says.
If a participant were previously deferring 10% of his income to a 401(k) plan and stopped contributing in the wake of loan repayment for 10 years, he could lose $700 of monthly income in retirement, Yoshida explains. “That’s a huge blow, and I haven’t really seen this type of educational material,” he says, adding that he hopes recordkeepers begin to take note of this.
Participants who take money out of the plan really would rather not, says David Ray, managing director and head of institutional retirement plan sales at TIAA-CREF in Dallas. He cites a 2011 Fidelity survey that found nearly 40% of retirees who had taken a loan said they would not do so again, and one-third of plan participants who had not yet retired agreed with that sentiment.
“They need the money because they are facing some financial difficulty, but many of them regret it,” he says, suggesting that when participants request loans or hardship withdrawals, it could be an opportunity for substantive, meaningful conversations between the adviser and the participant. Advisers may have a chance to talk the participant off the ledge and provide guidance on other ways to manage their competing financial demands, Ray says.
Loans vs. Hardship Withdrawals
If their plan allows it, participants may take loans, which must be repaid to the plan; or, under certain guidelines determined by the Internal Revenue Service (IRS), they may take hardship withdrawals. With a few exceptions, hardship withdrawals carry penalties for participants younger than age 59.5.
Plans that allow hardship distributions clearly specify the criteria they use to determine what “hardship” means. Common definitions include medical or funeral expenses, but may forbid certain others such as the purchase of a principal residence or tuition payment. Foreclosure avoidance is often an allowed expense.
The withdrawal amount may not exceed the amount the emergency
requires. The IRS strives, through loan limits, to help participants avoid
compromising their retirement assets with these early distributions. The agency
sets loan limits at $50,000, for participants with very large balances, or
whichever is greater: $10,000 or 50% of a vested balance. —JC
Emergency Savings Accounts
Most advisers agree that encouraging participants to build up an emergency savings account is an actionable plan, although the amount of savings to strive for varies depending on the financial professional. Yoshida believes it is a responsibility of a retirement plan consultant to stress the importance of outside savings. “However, I am also practical enough to know that for the typical hard-working American, it is unrealistic to assume that an individual could accumulate somewhere between six and 12 months of expenses in an emergency savings account,” he says.
Yoshida recommends $5,000 as a realistic goal that may be more achievable than a formula such as X months of expenses. “When conducting an analysis of a particular plan sponsor client, we found that the average loan amount outstanding is typically less than $10,000,” he says. “Perhaps encouraging a realistic emergency fund will seriously lessen the likelihood of a participant taking a loan.”—JC