The retirement industry has long debated the need for and use of 401(k) loans. Many think that borrowing from a retirement account is sacrificing long-term financial security for a short-term fix. But what if retirement loans are just misunderstood?
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401(k) loans by the numbers
Loan requests have increased since the global pandemic and the record-breaking inflation that’s occurred in its aftermath.1 Participants seeking loans are likely looking for quick access to low-risk money to meet short-term financial priorities.
Through research initiatives, Principal® leverages large data sets to uncover the underlying causation driving behaviors. This allows for more accurate predictions and strategic decisions for plan sponsors and participants. Using insights from the Principal® Retirement Security Survey — Loans and Withdrawals, and Principal proprietary data, some misconceptions were found about retirement plan loans. It may seem counterintuitive (and somewhat surprising), but allowing employees access to the funds in their retirement account can potentially lead to upsides for both the plan and its participants.
Myth 1: 401(k) borrowers are frivolously using the money without care for their retirement readiness.
Data shows: Most loans are used responsibly to pay off debt and for essential expenses, while saving for retirement continues to be a priority.
Overall, paying off debt is the number one reason for borrowing money from a 401(k). Budgets are maxed out as the cost of basic necessities such as housing, food, and transportation increase.2 A 2022 Workplace Wellness Survey from the Employee Benefit Research Institute (EBRI) found that 80% of employees have a problematic level of debt, including credit cards, medical expenses, and student loans.3 Such financial pressures have them looking to the money in their 401(k) as a way to relieve their stress.
Saving for retirement is still a priority.
Participants borrowing from their account continue to save for retirement while paying back the loan. A strong majority, 83%, continued contributing to their retirement account at the same deferral rate as before taking the loan, while only 4% stopped deferring. It’s a strong indication many participants are able to manage their shortterm financial needs while keeping their long-term retirement goals.
Impacts on retirement saving stay top-of-mind for those borrowing from their 401(k).
Myth 2: Loans are mostly taken by younger and lower-income participants who use them like a revolving credit line.
Data shows: The average 401(k) borrower is age 43, and they evaluate the pros and cons before taking a loan.
Middle-aged participants take more retirement loans than their younger counterparts. Many have competing financial priorities at this life stage, and more tenured employees tend to have higher account balances from which to take a loan.
Participants of all income levels take 401(k) loans. Data shows that the six-figure salary isn’t the wealth milestone it once was. Sixty-two percent of all Americans say they live paycheck to paycheck, including 48% of those earning more than $100K.5 Survey results show that over 50% of those with household income greater than $100K taking loans are using the loan money to pay off debt, including essential expenses.6
Myth 3: Many 401(k) borrowers will leave the company, defaulting on their loans. This puts them at risk of being assessed a penalty and taxes, and creates additional administrative burden for the employer.
Data shows: Those taking loans are typically more tenured and established employees who anticipate paying back the loan. Only a small percentage of those with loans leave their employer with an outstanding balance.
Borrowers understand the ramifications of defaulting on a retirement loan. From the survey, 25% of participants with an outstanding loan balance say they’re concerned with the potential taxes and penalties on the remaining balance if a job loss occurs. This is likely why over a third of loan borrowers plan to pay their loan back early. Data also shows that the tenure of participants with a loan is longer than those without a loan.7
While even one employee who leaves their job with an outstanding loan can cause unwanted administrative burden, employers can take some comfort in knowing that the data doesn’t indicate a large number exiting with loans.
Myth 4: Allowing loans negatively impacts plan and participant outcomes.
Data shows: Plans that allow loans take a holistic view of plan features and see positive participant behaviors.
Plans that allow loans are more likely to also have automatic enrollment and see higher participation rates. While not a direct cause-and-effect relationship between loans and automatic features, it appears that there’s more emphasis on using plan design to encourage participation, including automated enrollment, a stated match, and offering loans.
Preconceived notions about retirement plan loans often include the idea that the average deferral rate will be much lower. Notably, the data shows that the average deferral rate of plans that offer loans and those that don’t is nearly the same at 8.5% and 8.4%, respectively.
Putting 401(k) loan insights to work
For some employers, allowing retirement loans is considered a necessity. They feel it’s needed to increase participation and provide participants access to their funds. On the flipside, allowing too many loans might hinder a participant’s retirement readiness and place additional administrative burden on the employer.
Considerations for plans that allow loans:
- Track plan health stats to keep an eye on participation rates, average account balances, abnormal increases in loan requests, and defaults.
- Track deferral rates and look for rates to stay mostly the same. Large decreases in rates are a warning sign.
- Update plan design using loan provision best practices.
Loan provision best practices:
Providing loans isn’t for every employer, but if providing loans is under consideration, review these loan best practices:
- Allow only one loan at a time. This helps reduce the administrative burden that plan sponsors may experience. It also prevents participants from juggling multiple loan payments, which could decrease their paycheck. Allowing only one loan at a time should narrow the possibility of default and potential taxes and penalties.8 A study from EBRI shows that a 401(k) loan default by those between the ages of 25 and 34 could cost more than $150,000 in lost savings over the course of their working years.9
- Add a delay period after a loan payoff. It’s not uncommon for a participant to take a retirement loan multiple times in their savings journey. Putting some time between loans can help deter them from taking additional loans or taking them too frequently.
- Charge an interest rate that helps make up potential lost market returns. Even though a participant pays themselves back, their overall retirement account balance will be affected because they don’t have as much invested after taking the loan. To help make up for the loss of compounding interest due to a lower account balance, the general practice is to charge an interest rate a couple of percentage points on top of prime.
- Set additional guardrails. Employers have leeway in establishing their 401(k) loan policy and can set stricter parameters. Constraints like not allowing for the purchase of a primary residence, or around the reasons for taking a loan, such as limiting for hardship reasons only, can help reduce frequency of borrowing. Also, limiting loans to certain funds, such as participant deferrals only, helps ensure that employer match and other contribution types remain in the retirement account to accumulate investment earnings.
Modernizing retirement plans with a financial wellness mindset
A recent survey shows that employees lack confidence in their financial decisions, and they’re looking to employers for help.10
Employers are addressing this need by providing employees with tools and services that help address their short-term financial needs with their long-term retirement goals. With such resources, there may be less need for employees to borrow from their retirement accounts.
- But employers realize that this won’t happen unless there’s also a focus on measurable engagement and utilization. This may include personalized benefits, products, or services, including education at specific life stages.
- Match student loan debt repayments. Help employees save for retirement as they pay off student loan debt.
- Support emergency savings. Employees’ budgets struggle with unexpected expenses. Those with less than $2,000 in liquid savings are twice as likely to take a 401(k) loan or hardship withdrawal.11
- Boost financial education. Only 25% of high school students receive any kind of financial literacy education.12 Take advantage of your retirement plan provider and other financial organizations to offer participants online personal financial courses.
All references to 401(k) loans include loans from 401(k) and 403(b) retirement accounts.
- Bureau of Labor Statistics, U.S. Department of Labor, The Economics Daily, Consumer prices up 9.1% over the year ended June 2022, largest increase in 40 years. July 18, 2022.
- U.S. Bureau of Labor Statistics, Consumer Price Index, 2022.
- Employee Benefit Research Institute, 2022 Workplace Wellness Survey, October 25, 2022.
- Principal® Retirement Security Survey – Loans and Withdrawals 2023.
- PYMTS and LendingClub, New Reality Check: The Paycheck-to-Paycheck Report. March 2023.
- Principal® Retirement Security Survey – Loans and Withdrawals 2023. Data shown is from loan participants only.
- Principal proprietary data, December 2022.
- EBRI Issue Brief, The impact of adding an automatically enrolled loan protection program to 401(k) plans. No. 551. February 24, 2022.
- EBRI Issue Brief, The impact of adding an automatically enrolled loan protection program to 401(k) plans. No. 551. February 24, 2022.
- PLANSPONSOR Defined Contribution Survey, 2022.
- Commonwealth’s Saving Through a Crisis Research, June 2022.
- Next Gen Personal Finance, 2022 State of Financial Education Report.
Important information
Some retirement plan features are voluntary and will require a plan amendment to make available to participants.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment, or tax advice. You should consult with appropriate counsel, financial professionals, and other advisors on all matters pertaining to legal, tax, investment, or accounting obligations and requirements.
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PQ13498A | 2023 | 072023
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Thanks for the survey data. However, your solutions are deleterious to participants’ household wealth AND retirement preparation.
https://401kspecialistmag.com/top-10-401k-plan-loan-myths-misdirections-and-misrepresentations/
Agree:
Myth 1: 401(k) borrowers are mostly responsible,
Myth 2: Borrowers are middle-age, where most select a plan loan only if it is the best available source of liquidity.
Myth 3: Studies show 90% of all plan loans are successfully repaid.
Myth 4: Loan principal never leaves the plan. It becomes a fixed income investment. Rebalance to target allocation as necessary.
Disagree: Those may be “best practices” for advisors or recordkeepers, but not for participants.
One loan at a time means people will borrow a greater amount than they need. One loan is OK if you adopt “best practice” and structure loan as a line-of-credit.
Adding a delay between loans is likely to trigger taxable distributions where liquidity is needed. If borrowers are responsible, why would you implement requirements that encourage leakage via distributions? And, if a plan loan is the best liquidity option, why would multiple loans be “too frequent”? At one time I had a home loan, a car loan and a student loan, plus credit cards. Doesn’t make me less than responsible.
The interest rate should be that of a fixed income investment, not an estimate of the equity market return. Loan principal never leaves the plan. It becomes a fixed income investment. Transfer as needed to return to target allocations after initiating the loan. Over the past 15+ years, charging a couple of points over prime would actually improve both household wealth AND retirement preparation – as that would far exceed the return on fixed income investments in the plan and would likely be less than what the participant would have paid on a loan from a commercial source.
Added guardrails make no sense. Why deny the participant access to a plan loan if it is the best source of liquidity?