A Look At Plan Loans

A recent survey of defined contribution plans shed light on the effect of plan loans on participants’ account balances.  The survey revealed that the average outstanding loan balance represented approximately one-fifth of a participant’s account.  The survey zeroed in on a major issue with plan loans, which is loan default.

A loan default occurs when a participant terminates employment with an outstanding loan balance and fails to repay the outstanding balance.  Most plan loan policies provide for an acceleration of loan payments upon termination, and a requirement that the participant pay the outstanding balance within a short period of time following the separation from employment.  If a participant is unable to pay the outstanding balance back, this balance is treated as a distribution subject to taxation and in some cases an additional 10% penalty if the participant is less than 59 1/2 years old.

In a typical 403(b) plan, with the exception of the tax implications, participants do not feel the true impact of the loan default until they receive a distribution of their account balance.  This is because one major vendor does not debit participants’ accounts when they take a plan loan.  Rather, the vendor issues the loan directly to participants and sets aside a portion of the participant’s assets in his or her annuity contract as collateral for the loan.  The collateralized amount remains in the participant’s account and the vendor does not remove it until he or she becomes eligible for a distribution.  In essence, the 403(b) plan participant will not notice the additional ramifications of the default until a distributable event occurs and his or her distribution is reduced by the amount held as collateral for the outstanding loan.  Additionally, because there is no visible impact on the participant’s account from the default prior to the distributable event, the participant has no incentive while working to ever repay the outstanding balance and ensure that he or she receives his or her full account balance at distribution.

Nevertheless, providing participants with the option to borrow against their retirement account appears to be a motivating factor in participants’ decision to actually contribute towards retirement.  A 2012 survey revealed that a number of plan participants cited the ability to take a loan from their plan as a “strong influence” in their decision to contribute to their retirement plan.[1]  However, the problem arises when participants begin to treat their retirement account like a personal loan bank by taking multiple loans, which then increases the risk of a default.  Such repeated borrowings from plan accounts also defeat the purpose of a retirement plan, which is to provide a way for participants to save for retirement.

Unfortunately, even with education, participants will only do what the plan allows them to do.  This was reflected in the survey which revealed that when plans allowed participants to take out at least two loans, majority of the participants with outstanding balances had at least two loans.  Therefore, plan sponsors facing loan issues should consider amending their loan policy.  One way to control the risk of loan defaults is to limit plan loans to employee deferrals.  Another alternative is to allow only one outstanding loan at a time.  It is possible for plan sponsors to control the problem with plan loans without having to take this benefit away from participants.

 

Founded in the 1950s, Carroll Consultants, Ltd. has experienced professionals with a wealth of knowledge about retirement plans. If you have any questions about this article or our services, please contact Marcie Carroll, at mcarroll@cclbenefits.com, or (610) 225-1210.

This material is not intended to provide specific legal or other professional advice.



[1] See 2012 Ariel/Aon Hewitt Study: “401(k) Savings Disparities Across Racial and Ethnic Groups.”