On Tuesday, February 16th, I listened to an Employee Benefits Research Institute webcast on financial wellness. The speakers were Lisa Greenwald of Greenwald and Associates and Nate Miles with Wells Fargo Asset Management. One of Miles’ final presentation comments struck home.
He noted that only a few plan sponsors were interested in innovating when improving financial wellness by leveraging liquidity in 401k plans.
That’s not surprising. The myths, misstatements, and misrepresentations regarding plan loans are many.
It is baffling to me. My experience is that plan loans, done right, will enable workers to save more than they believe they can afford to earmark for a distant, future, uncertain retirement—adding revenues for the savvy recordkeeper and increasing assets under management.
Here are my top 10 plan loan myths:
Myth No. 1: Plan loans must be repaid in full upon separation
A plan can incorporate enough flexibility to enable participants to continue payments and avoid defaults through the following:
- Electronic banking, Line-of-credit structure,
- Behavioral economics tools, concepts, and processes (e.g., have the participant execute the loan application as both the borrower AND the lender (the future self), have the participant enter into a commitment bond confirming that the loan must be repaid, etc.) and
- The Tax Cuts and Jobs Act of 2017 allows repayment at any time before the date the individual files her tax return for the year in which default occurred (by April 15th, or October 15th if filing for an extension, of the following year).
Many will default despite these preparations because they would have taken a distribution anyway—perhaps to resolve those same debts.
Myth No. 2: Plan loans increase leakage, part one
Plan loans are not leakage unless they are not repaid. Some studies show 90-plus percent of plan loans are repaid. To improve the chances of repayment, add 21st Century-loan functionality as shown above. Remember that electronic banking is more efficient and less expensive—payroll deduction is so 20th Century.
Leakage from in-service, hardship withdrawals dramatically exceeds leakage from loan defaults.
Once 21st Century loan functionality is in place, why not REDUCE leakage by eliminating hardship withdrawals.
Myth No. 3: Plan loans increase leakage, part two
The majority of leakage doesn’t result from loan defaults or even hardship withdrawals, but from post-separation, pre-retirement distributions. Electronic banking enables a term-vested participant the opportunity to initiate a loan after separation. Their liquidity options would no longer be limited to distributions subject to income and penalty taxes.
Keep in mind that since the median tenure of American workers ages 25 – 64 has consistently been less than 5 years for the past 5 decades, the majority of participants in most plans, over time, won’t be the current employees, nor will it be “retirees”, however that term is defined. It will be the term vested who have separated prior to retirement.
So, electronic banking for plan loans may reduce leakage—if you consider all plan participants.
Myth No. 4: Interest on a plan loan is not tax-deductible
When properly secured, the interest a participant pays may be tax-deductible whether the loan is from a qualified plan or a commercial source.
Myth No. 5: Interest the participant pays on a plan loan is “double taxed”
Simply, those are not the “same” dollars. Loan payments are made with after-tax dollars, sometimes tax-deductible (as noted above). Interest on fixed-income investments, whether a bond or a plan loan, receives the same tax treatment when it is distributed. So, interest on a plan or commercial loan secured with a mortgage may be tax-deductible when paid. And, where the loan principal was Roth 401k assets, the interest may be tax-free when distributed.
Myth No. 6: Plan loan interest rates and fees may exceed commercial loan interest rates
Because the plan loan is secured, interest rates and fees are often less than those on loans from commercial sources—whether from a bank, a payday loan, a credit card advance, etc. Just as important, some participants are not creditworthy—they may not have another source of favorably-priced liquidity. Regardless, before borrowing, participants should always compare all liquidity options.
Myth No. 7: Loan interest may be less than the return on equity investments, harming retirement preparation
Few participants allocate 100% of assets to equities. After initiating a loan, participants should always rebalance to target allocations – including treating loan principal as the fixed income investment it is.
Where plan loan interest rates exceed returns on the fixed income investments (often true during the past ten or so years) AND WHERE IT IS ALSO LESS than the interest rate on a loan from a commercial source, a plan loan will improve BOTH a participant’s retirement preparation AND household wealth.
Myth No. 8: Plan loan repayment schedules are inflexible
No, if the plan loan is structured as a line-of-credit, a participant can borrow anytime they are eligible and make payments whenever possible – without the burden of multiple loans.
Myth No. 9: Participants may misuse their retirement assets, treating the plan as if it were a bank
There’s a problem with that? Call it the “Bank of Jack.” Here’s how it works. Save all you can, get match, invest, accumulate, borrow to meet a current need, adjust investments to target allocations, repay the loan while continuing contributions, rebuild the account for a future, larger need. Repeat as necessary up to and throughout retirement.
Remember, if the plan loan is less expensive and more efficient, the participant is much less likely to reduce or stop contributions.
Myth No. 10: A loan feature creates fiduciary responsibilities
Yes, it does. However, adding 21st Century loan capability, coupled with eliminating hardship withdrawals, will minimize most of the risk exposures from offering liquidity. Simply, plan sponsors should avoid service providers who cannot successfully deploy 21st Century plan loan functionality.
Got more plan loan myths? Send them to jacktowarnicky@gmail.com.
Disclaimer No. 1: My comments are my own based on my past experiences in plan sponsor roles, and do not necessarily reflect those of any employer or association I have been employed by or affiliated with, past, present, or future.
Disclaimer No. 2: This information was provided by individuals with knowledge and experience in the industry and not as legal or tax advice. The issues presented here may have legal implications and you should discuss this matter with legal counsel prior to choosing a course of action. This article is intended to be informational only. It is not (and you/others should not use it as a substitute for) legal, accounting, actuarial, or other professional advice. Any advice contained in this article was not intended or written to be used, and cannot be used by anyone for the purpose of avoiding any Internal Revenue Code penalties that may be imposed on such person [or to promote, market or recommend any transaction or subject addressed herein]. You (others) should seek advice based on your (their) particular circumstances from an independent tax advisor.
Jack Towarnicky provides independent benefits consulting and serves as a member of aequum, LLC and of counsel for Koehler Fitzgerald, LLC.
