A Plan Feature Run Wild

Art by Claudi Kessels

In the 1980s, when 401(k) plans were a new idea for financing retirement, a provision to borrow against them was an inducement to get participants in the door.

“We sold the idea as, ‘Hey, if you ever need it, your savings will be available to you in the form of a loan,’” recalls Jamie Greenleaf, lead adviser at Cafaro Greenleaf, in Red Bank, New Jersey. “Unfortunately, that plan design became the norm,” she adds.

Participant loans were allowed by 82% of about 3,500 plans responding to the 2020 PLANSPONSOR Defined Contribution (DC) Survey and, at plans with over $200 million in assets, by more than 90%. About 11% of participants had outstanding loans at that point—also, more frequently at larger plans—with a median balance of about $9,000.

But 401(k) loans put a portion of participants’ invested assets on hold and can deal setbacks to contributions and participation. Accordingly, many advisers see these diminishments as working against the goals of financial wellness programs and retirement readiness. “My opinion is that taking loans is at odds with financial wellness,” says Josh Dietch, head of retirement thought leadership at T. Rowe Price Group, Baltimore. Invoking a football image, Dietch observes, “Wellness is offense, meant to build people’s financial resilience. Loans and hardship withdrawals are defense.”

Given that so many plan sponsors have designed loans and hardship withdrawals into their defined contribution plan, what do the few holdouts have in mind? “We have a few sponsors that don’t allow them,” Greenleaf says. “Their view is that ERISA [Employee Retirement Income Security Act] says they are fiduciaries and must act in the best interest of the beneficiaries. They see that DC plans have replaced traditional pensions, and thinking back to those days, if a participant needed money, he couldn’t raid the pension plan.”

But most sponsors did build in loan provisions, allowing two or three loans. “They quickly realized they were becoming banks and loan administrators,” notes Gregg Levinson, senior director of retirement at consultants Willis Towers Watson in Philadelphia. “And in the days before repayment through payroll, people paid by check. That was a real disaster.

“Those sponsors whose plans do offer loan provisions are probably envious of the few who don’t,” he adds.

Loan Impact Over a Lifetime

“Many of us won’t have enough saved for retirement to begin with, let alone if we’re borrowing and taking money from it prior to retirement,” says Greenleaf. “So those sponsors [that don’t allow loans] are protecting the benefit, which really is what ERISA tells us we have to do.”

The impact of a loan on a final balance can be striking. Principal Retirement and Income Solutions in Des Moines, Iowa, provides participants with a slate of educational materials on loans, including a simulation showing that a $5,000, five-year, 5% loan against a $20,000 balance early in one’s working years can reduce the final account balance by over 20%. “There’s a difference in what might be earned in the market versus the rate of interest the participant pays on the loan,” says Renee Schaaf, head of the Principal operation. “But, not infrequently, people reduce their contributions, and they have to pay loan fees. All of those things create a big impact over a lifetime.”

“That’s not to mention double taxation,” says Kylee Bruno, director of retirement plan consulting and wealth management at StoneStreet Renaissance (SS/RBA), a member firm of GRP Financial and Hub International, in Pearl River, New York. “The employee repays the loan with after-tax dollars, and, when he takes it out in retirement, he’ll pay taxes again.”

All of that said, “When a person runs across a hardship where he may lose his home, or college tuition is much more than he’d planned, I do think hardship withdrawals have a place in the financial wellness ecosystem,” Greenleaf says.

Moreover, the presence of a loan feature can be a plus for encouraging participation and contributions, says Gilliane Isabelle, chief distribution officer for AIG Retirement Services, in Houston. “When someone is debating whether he wants to enroll, sometimes the loan feature is a security blanket, and knowing he can borrow might allow him to save a little more.”

“But loan and withdrawal features are the genie in the bottle—once they’re out, you are not going to take them away,” says Levinson. As a result, the adviser must navigate them with his clients as best he can.

One strategy is convincing them to limit loan access. Bruno recalls a client with a 403(b) plan that allowed five loans at once. “We talked it down to two, but we’re going to keep pushing that and showing it the industry reports that recommend it should allow only one.”

A second line of attack is to guide the behavior of the population of borrowers, through targeted communications supplied by a united front of advisers, recordkeepers and sponsors.

A first step identifies the motivations of two groups.

One of those groups, Greenleaf says, is “those people who get into a jam and need a source of liquidity.”

The second group is “people who use their 401(k) as a ‘holiday club’ account,” says Dietch. “As a recordkeeper, you don’t want to shame people, but we see these behaviors and communicate them to employers.”

Francis Investment Counsel, in the Milwaukee suburb of Brookfield, however, did an exercise to determine why one client’s workers were taking loans. “The primary reasons were medical circumstances and that the loans cost less than credit cards,” says Ed McIlveen, the firm’s chief investment officer (CIO). “We would want to do everything possible to leave that type of borrowing intact, for people looking to manage their lives in sensible ways.”

Either way, in looking for plan loans, participants are apt to search online first, so effective communications and projections from recordkeepers are essential.

Personal Communications

Advisers and recordkeepers agree that a personal communications approach will likely be most effective. “For participants to be confident they’re making the right decision, someone has to sit down with them, one on one, and employers should be able to provide that,” McIlveen says. “It’s labor-intensive and time-consuming, and, as much as the industry has tried to mechanize decisions, a loan discussion just can’t be automated.”

A year into the pandemic, advisers can survey its impact on participant borrowing activity, and some have been finding it less than was originally feared. “We saw that people were concerned about the economy, but largely they stayed the course,” says Schaaf. “Participation was stable, and 95% stayed with their investment allocations. We saw an uptick, in our base, of about 6% in loans and withdrawals, but most people did a good job of not overreaching.”

Levinson concurs. “Now is the time to take advantage of that shift in attitudes,” he says, “and to have more conversations about emergency savings that can reduce borrowing from 401(k) accounts.”