When talking to plan sponsors about ways to de-risk their plans by strengthening their loan programs, most say they’ve already done that. After watching the number of outstanding loans climb ever higher — along with the soaring levels of employee financial stress — they took steps to reduce the borrowing in their plans. Studies now show these well-intentioned efforts might have missed the mark.
Some plan sponsors took practical steps, such as reducing the number of loans allowed, or limiting the amount of money participants could borrow to what they defer into the plan. Other tactics included waiting periods between loans and stepping up education warning employees about the potentially harmful effects of borrowing from retirement accounts.
What happened after all these reasonable attempts? Surprisingly, studies show loan volumes continue to rise. When employees needed money, they got creative — they adjusted their borrowing to changes in plan rules, took out more money when fewer loans were allowed, and managed the timing of loans more carefully when certain limits were imposed. Limiting loans to employee money only makes a meaningful difference when employer contributions make up a significant part of the overall plan balance, and participants tend to borrow the maximum amount.
401(k) loans are a fact of life and are here to stay. They are a gateway to participation for many and likely to continue growing along with plan assets. The problem is not loans per se, the real risk is when loans default. Yet many plan sponsors remain unaware of the size and scope of loan defaults each year (over $6 billion a year and counting) or, even more worrisome, their fiduciary obligation to address them. The Department of Labor views plan loans as investments, requiring the same level of scrutiny as other plan options.
Loan defaults cause permanent retirement plan leakage, and the impact to participants — including taxes, penalties, and lost earnings over their careers — far exceeds amounts originally borrowed. Even worse, defaults often lead to cash outs, compounding the problem.
More harmful still are loan defaults caused by a reduction in force, where the participant would have repaid the loan but for the unexpected loss of their job. Some plan sponsors are beginning to experiment with post-separation repayments, but so far employees without a job aren’t rushing to sign up.
Insuring against defaults
Today, plans can manage this situation in a way that guarantees results: loan insurance. Loan insurance prevents the default in the first place. It protects 401(k) plan assets from losses associated with loan defaults by repaying an outstanding loan balance if a borrower loses his job and is unable to do so. Protecting the loan comes at no cost to plan sponsors (participants pay a small premium alongside their regular loan payments), but guarantees that participants suffering from involuntary job loss don’t also suffer loan defaults.
Loan insurance does not attempt to influence the number of loans taken out, or the amounts being borrowed, but it does effectively address loan defaults, the true risk of retirement plan loan programs. By repaying a loan before it defaults, loan insurance keeps all participants on track for the retirement outcomes they deserve.
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