There was a time when a good friend convinced me to go with a car lease instead of a purchase. I never had leased a car, but she pointed out all of the great reasons why leasing was better. I ran out and leased a high-end SUV for three years. When my lease was up, I opted for a new SUV and another three-year lease. It was midway through my second lease when it hit me: I wasn’t building up any equity, only making payments toward a car I was never going to keep. While leasing worked well for my friend, it didn’t make good financial sense for me. The same philosophy can be applied to retirement plans and participant loans. What may work beautifully for one company may be a nightmare for another. Let’s take a closer look to understand why.
Not all companies are created equal. Not all plans are designed exactly the same. The best plan design is one that is tailored to your company’s goals and objectives. One plan design may favor partners or shareholders while other plans are designed to recruit top talent. Some plan sponsors are adamant about having a loan provision, others are opposed. It all comes down to what works best for you and your plan.
Following are some advantages and disadvantages of having a loan provision:
- Easy to administer. Borrowing against your own 401(k) plan balance is as simple as logging into your retirement account and clicking a button or turning a one-page form into your HR manager. The process will take less time than a bathroom break.
- Built-in collateral. Unlike going to a bank where you may need a sizable savings account as collateral, with a loan from a qualified retirement plan your remaining plan balance is what is held as collateral.
- Plan benefit. Plan participants view the loan provision as a positive because they are paying themselves back with interest, not a bank. Loan interest rates are set by the plan sponsor and competitive with the marketplace.
- Added plan expense. Most recordkeepers and TPAs have a cost associated with loan withdrawals and annual loan maintenance which may be covered by the plan sponsor. This small per-participant expense can add up very quickly.
- Risk of defaulting. If a participant terminates employment with a remaining loan balance, they will have the pay the entire loan balance or default on the loan. A participant will incur taxes and possible early withdrawal penalties when defaulting on a loan.
- 401(k) leakage. Participants having such easy access to their own retirement account can help foster unnecessary distributions, thereby chipping away at something that was put in place for future retirement.
So how do you know if a loan provision is right for your plan? There are two things that should factor into your decision: Infrastructure and mindset.
Do you have the proper infrastructure to manage participant loans? Who is handling the daily administration for the plan? Who is taking care of payroll? These questions speak to your infrastructure.
Third Party Administrators work closely with practice managers and HR staff to assist with the loan process. It is the responsibility of the plan sponsor to ensure repayments begin timely to keep the loan on track. Loan repayments are payroll deducted so it becomes a very streamlined process once it is in place. A common mistake in the initial phase of a participant loan is the payroll department or outside vendor never being informed of the loan which means repayments do not begin timely. A participant may think that it would be reasonable to merely tack on missed payments to the end of the loan, but that is not what the law has in mind. Sixty months is the maximum time the law gives to repay a loan. If you do not have a strong infrastructure, a loan provision may be difficult to manage.
Mindset is the second key factor in determining if loans are well suited for your plan. Do you view your plan as a retirement vehicle or a savings vehicle? There are plan sponsors who encourage plan participants to save for retirement. Their plans do not allow for withdrawals except in cases of termination of employment or retirement. Participants understand the inflexibility and respect it.
On the flip side, there are plan sponsors with a different mindset when offering a retirement plan. Life happens. There are times when participants get in a crunch and a plan loan may be the only solution they have. Plan sponsors want to make sure participants know their retirement plan balance may be available today as a financial resource if necessary. If the infrastructure is in place as well as the mindset, loans may work really well for your plan.
I have been in the TPA business for almost 20 years and hear both sides of the loan debate. Yes, it can be a nice benefit to offer to participants. And yes, loan contagion is real. By that I mean it is all too common for someone to share with a colleague they took a loan against their 401(k) balance for home repairs or emergency dental work. Consequently, the conversation at the coffeemaker prompts someone else to take a loan against their 401(k) balance to pay down a high credit card balance and another for a child’s college tuition.
While you want to empower your plan participants to save for retirement, there will be a few participants in the world who see their balance as a savings account-- not a retirement plan. This decision is yours and there is really no right or wrong answer.