Experts agree that taking a loan from your 401(k) plan is rarely a good idea. But research suggests participant loan-taking from 401(k) plans is on the rise, particularly since 2008, when layoffs and financial turmoil left many American workers with nowhere else to turn for funds.
"We have seen an increase [since 2008], and I don't think that's very surprising, given the economy today," says Denise Preece, assistant vice president of field services with OneAmerica.
According to Aon Hewitt, nearly 28% of active participants had a 401(k) loan outstanding at the end of 2010, a record high. Nearly 14% of participants initiated new loans last year, slightly higher than in previous years. The average balance outstanding was $7,860, or 21% of these participants' total plan assets.
And while the majority of participants - 68% - had only one loan outstanding, 29% had two loans outstanding simultaneously, and 3% had more than two loans.
Loan usage varies significantly based on the participant's situation, according to the Aon Hewitt research. Middle-aged and middle-income participants are most likely to have outstanding loans, while women with lower salaries are more apt to take loans than their similarly paid male counterparts. Women also are more likely than men to take more than one loan at a given time.
Even the time of year affects whether or not participants are likely to take loans from their 401(k), says Catherine Golladay, vice president, participant services at Charles Schwab. In the fall months, particularly September, there's always a fairly dramatic increase in the number of loans taken. Likewise, in the spring, especially in March, there's always a dramatic decrease.
"You can look at typical behavior and draw some assumptions," she says. "In September, one typical thing someone might do is look at a 401(k) loan as an opportunity to help them fund their education. That's the time frame when tuition is due. My hypothesis on the spring is, unfortunately, I think individuals may be using their tax [refunds] as a way to help them smooth out cash flow if they've gotten behind. So they look to that as a resource and don't go to their 401(k)."
Multiple loans
Allowing plan members to take several loans concurrently is probably not in their best interests, agree industry experts. When Sens. Herb Kohl (D-Wisc.) and Michael Enzi (R-Wyo.) introduced the Savings Enhancement by Alleviating Leakage in 401(k) Savings Act of 2011 in May, they included a clause that would have limited the number of loans participants could take from their 401(k) at any one time to three. That was withdrawn later, however, since it's up to plan sponsors to decide how many loans participants are allowed to take at once. (See sidebar for the legislation's major provisions.)
"Loans are not a protected benefit, and the employer can choose to manage it how they want," explains Patrick Shelton, managing member of Benefit Plans Plus.
Not all bad
Loans are not all bad, however, says Pamela Hess, director of retirement research at Aon Hewitt, and 401(k)'s are an appealing way to access money because you're essentially borrowing from yourself.
"If it's a short-term need and the 401(k) fits the bill, it really doesn't do long-term harm, as long as it's not constant loan-taking, you pay it back and you keep saving," she says.
The problem is many participants may not realize that if they lose their jobs, or even change employers, that loan is due pretty quickly - usually within 60 days. "And a lot of people can't pay it back or don't pay it back, and then they owe taxes on that money as well," says Hess. "It becomes a permanent withdrawal from the system."
Discouraging borrowing
Preece says she's heard more discussion over the past few months about making it harder for participants to access loans.
"We've had a couple of plan sponsors who've not wanted participants to have the ability to request a loan on the Internet, for example," she says. "I don't think there's a wholesale shift in that, but it's interesting that it is more of a topic of discussion than it was, say, two years ago."
There are a few things employers can do to discourage excessive loan-taking. First, they can amend the plan document so that employees are only allowed to take one or two loans at a time. Some employees will take a loan from their 401(k) to help with a down payment on a house. "That's usually something that's part of a longer-term plan, not a case of someone using a loan to manage cash flow or for a quick fix," says Golladay.
Second, an employer can add a loan fee. "You don't want to hurt people who need money," notes Hess. "But having a loan fee does help curb some of the excessive loan taking. Consider a $75 fee, for example. For people who need the loan and are taking a significant amount, $75 is probably not going to be a big deal. However, it can deter people who are maybe taking smaller amounts."
Third, plan sponsors might consider adding a time-out between loans, say, 60 days, experts suggest.
Don't start
If a 401(k) plan doesn't already have a loan provision, keep it that way, advises Golladay.
If there is not a loan provision in a plan, I'd be hard-pressed to think of a reason why you'd want to add that," she says. "I wouldn't recommend it as something you should do." Common thinking many years ago was that plan sponsors should have a loan provision in place because it would help with enrollment - more employees would participate in the plan if they knew they could access their money in an emergency. But Golladay says she's not sure that argument holds true anymore, now that auto-enrollment in plans and auto-escalation of contributions have become more prevalent.
"We don't see many people opting out of those, so employers might want to challenge their common thinking around loan provisions," she says.
Says Shelton: "Our philosophy as retirement plan consultants is basically to discourage loans. 401(k) plans are not a checking account. When we're talking to our plan sponsors, we're encouraging them to not offer loans, first of all, and if they do, to make it as restrictive as possible. Have a minimum loan amount of $1,000, for example, and charge a fee."
Most important, employers should encourage those who do take loans to continue saving.
"Do a targeted message, for example, saying, 'You took a 401(k) loan this month. Don't forget to keep saving,'" suggests Hess. "Personalized communications can have a big impact."
Davis is managing editor of EBA's sister publication, Employee Benefit News.
SEAL Act provisions
In May, Sens. Herb Kohl (D-Wisc.) and Mike Enzi (R-Wyo.) introduced the SEAL Act to help address retirement savings inadequacy.
"As the frequency of retirement fund loans have gone up, the amount of money people are saving for their retirement has gone down," says Kohl. "The gap between what Americans will need in retirement and what they will actually have saved is estimated to be a staggering $6.6 trillion. While having access to a loan in an emergency is an important feature for many participants, a 401(k) savings account should not be used as a piggy bank." Major provisions in the SEAL Act include:
*Extending the rollover period for plan loan amounts. Currently, when an employee loses his job, he has to either repay the entire outstanding loan balance or default on the outstanding loan and incur tax penalties. The SEAL Act allows an employee to contribute the amount outstanding on a loan to an IRA by the time they file their taxes for that year.
*Allowing 401(k) participants to continue to make elective contributions during the six months following a hardship withdrawal. The way things stand today, an employee is prohibited from contributing to his or her 401(k) for at least six months following a hardship withdrawal. The SEAL Act would allow participants to continue making contributions during the six months following a hardship withdrawal.
*Banning products that promote 401(k) plan leakage, such as 401(k) debit cards. Although 401(k) debit cards aren't prevalent, a number of different companies have offered them in the past, and some continue to market them online. The SEAL Act would ban these types of products.
