Loan Defaults Sap $37B From 401(k)s Each Year

Roughly 10% of these loans default each year, draining $37 billion from 401(k) balances, Navigant said, citing 2005-08 data from the Financial Literacy Center. Many of these defaults, also known as 401(k) leakage, are due to a job loss, since upon leaving a company, a participant’s loan is due in full within 60 days, Navigant noted.

Given the fact that the unemployment rate averaged 4% during the 2005-08 time frame, and that it has since risen to 8%, 401(k) leakage has undoubtedly also gone up, said the authors of Navigant report, Dr. Hal Singer, managing director with Navigant Economics, and Dr. Robert Litan, a senior fellow in the economic studies program at the Brookings Institution.

“Of course, participants are not deliberately defaulting,” Litan said. “They only do so when they have no other option.”

Industry experts have suggested that the Department of Labor change 401(k) regulations to permit plan participants to port a loan to another retirement plan, or limit the number of size of 401(k) loans in the first place. Singer and Litan said another solution is automatically enroll 401(k) borrowers into loan protection insurance.

“There is growing literature on the ‘nudge’ value of default rates,” Singer said. “It has been shown, for instance, that individuals are more likely to contribute to their own 401(k) in the first instance if the default rule is automatic contribution with an opt-out rather than the previous opt-in system. The same logic implies that 401(k) borrowers would be more inclined to protect their loans against involuntary default.”