I have a confession to make: I took out a 401(k) loan recently and felt guilty doing it. Many of us have been conditioned to think of a retirement plan “loan” as a dirty word. There have been many studies written about the problem of borrowing, from increased fees and expenses to the risk of incurring significant taxes and penalties, which happens frequently when a borrower leaves work with an outstanding loan.
However, what if I told you that the loan was good for me (more about this later) and may be good for your plan and participants as well? In a new working paper for the National Bureau of Economic Research, Vanguard experts Steve Utkus and Jean Young, along with Timothy Lu of Peking University and Olivia Mitchell of the University of Pennsylvania, demonstrate that loans, if structured correctly, can increase a plan’s participation rate, and the great majority of these loans are repaid.¹
When a plan offers loans, it seems to have the beneficial effect of raising contribution rates above what they would otherwise be. Economists often say that money is fungible, meaning that funds raised for one purpose can be just as easily used for another. When loans are offered, defined contribution plans seem to serve in a dual role, acting both as a retirement savings program and a source of emergency funds. For example, as the effects of the recession wore on in 2009 and 2010, we saw plan loan use jump sharply. Participants seem less eager to contribute to plans that lack this kind of emergency access, perhaps because they’re unwilling to devote their resources to only one purpose (consumption in retirement).
When we speak about dirty words in the retirement business, perhaps it is not “loan” but “leakage” that should cause the most handwringing. Leakage is the broader problem of participants spending retirement savings before typical retirement ages. It can arise from several sources besides loans, including unrestricted access to account balances upon job changes and various types of permitted withdrawals, such as hardship withdrawals. By some estimates, leakage of all types from tax-deferred accounts is estimated to reach an astonishing 30% to 45% of total annual retirement fund contributions, depending on the economic environment.²
So what can be done? To stem leakage from plan loans the best approach may be to reduce the number of allowable loans to one at a time. When a plan sponsor permits multiple loans, the propensity to borrow nearly doubles, according to our experts’ research, and the aggregate dollar amount of borrowing is 16% greater across the plan. It appears that participants may view the opportunity to take multiple loans as an implicit endorsement of borrowing by their employer.
Interestingly, a pair of researchers at the Federal Reserve also suggested that plan loans are a wise choice when borrowing. Because they tend to charge lower interest rates than commercial sources, the researchers concluded that participants could have saved $3.3 billion in 2004—almost $200 per household—by shifting debt to 401(k) loans.³
Most plan borrowers (myself included) have a good repayment record. More than 90% of loan balances are repaid without incurring any taxes or penalties. And while up to 20% of participants may have an outstanding loan at any given time, total loan balances are relatively small, accounting for 1% to 2% of aggregate plan assets in 2014.
True, unpaid loans do cause leakage. Our experts pegged the cumulative leakage from loan defaults at $6 billion annually, a higher figure than previous estimates. Yet cash-outs at termination cause far more leakage. The Government Accountability Office reported in 2009 that cash-outs reached $74 billion in 2006. Stemming this tide could require a regulatory change in Washington, such as curbing access to some or all of a participant’s retirement assets at termination.
My loan story has a happy ending. I borrowed to help buy a home in a better school district. After we moved in, I paid off the debt early. It felt good to pay the interest on the loan to myself instead of a bank. My plan helped me make a different type of investment in my family’s future without jeopardizing my retirement funds—a win-win situation, as they say. Or as an economist might put it, my plan money was fungible. Either way, it was a help to me and my family.
²Early Withdrawals from Retirement Accounts during the Great Recession, Robert Argento, Victoria L. Bryant, and John Sabelhaus, Contemporary Economic Policy, January 2015.
³Borrowing From Yourself: 401(k) Loans and Household Balance Sheets, Geng Li and Paul A. Smith, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. 2008-42.
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