Advisors would agree that too many Americans are using their 401k plan as a revolving line of credit and not as its intended purpose as a savings vehicle for retirement. Many participants who take loans are not facing foreclosure, shockingly high medical bills, a collapsed roof, or a sudden death in the family.
Instead, loans are being used because Americans spend too much and have almost nothing in savings. According to a 2016 survey by GOBankingRates, 69 percent of Americans have less than $1,000 saved.
This can be frustrating for 401k advisors in the trenches with participants and encouraging them to save more for retirement. However, advisors are also in a unique position to help participants make better decisions with their money and advise employers on how to limit the use of loans.
Unfortunately, 401k loans are all too common. A report from the Employee Benefit Research Institute released last year found that 20 percent of all 401k participants who were eligible for a loan had at least one loan outstanding, and the average unpaid balance was $7,780.
Many participants only think about the short-term costs of borrowing from their 401k, and not about the long-term damage to their retirement savings. I often hear something like: “the interest rate is low and I’m paying interest to myself.” But consider the impact of a $10,000, 3-year loan at 5 percent interest for a 30-year-old participant with a $30,000 401k balance who stops contributions while repaying his loan. This small, one time loan may cost $407,630 in lost retirement savings by the time the participant reaches age 65 (based on ncpa.org’s 401k borrowing calculator and an 8 percent annualized rate of return).
Advisors have several tools at their disposal to limit 401(k) loan use. One of the best places to start is at the top, with the plan sponsor and the decision makers of the plan. If possible, try to discourage the use 401k loan provisions altogether.
If plan sponsors aren’t willing to eliminate the loan provision completely, encourage stricter requirements by allowing loans for hardship reasons only. Hardship loans allow participants to tap into their 401k, but only if they are using the funds for one of six reasons:
- certain medical expenses,
- costs relating to the purchase of a principal residence,
- tuition and related educational fees and expenses,
- payments necessary to prevent eviction from, or foreclosure on, a principal residence,
- burial or funeral expenses, and
- certain expenses for the repair of damage to the participant’s principal residence.
Eliminating loans or requiring loans for hardship reasons only will keep participants from using the 401k for non-emergency reasons and could significantly reduce the number of new 401k loans. Fewer loan applications benefit all–less headaches and administrative work for employers and potentially higher savings for participants in retirement.
Some people in the industry argue that loans increase participation and provide a safety net for participants who fall on hard times. The problem with this argument is that safety nets often have the opposite result: a perpetuation of the circumstances in which participants find themselves. According to U.S. Courts statistics, 1/3 of bankruptcy filings in the U.S. in 2013 were by repeat filers. It is habits that need to change, and advisors can help with this too.
Consider proactive discussions with participants before they have the loan paperwork in hand. In your next education meeting, talk about the damaging impact of 401(k) loans. A great tool is the calculator referenced above from www.ncpa.org, which will show participants how a $10,000 loan could really cost them $400,000 or more in lost savings.
Participants also need to better understand what will happen to an outstanding loan if they terminate employment or if the plan terminates.
A question I often ask participants is: “Can you guarantee that you will still be working here in three or five years (whenever the loan will be paid off) or that your 401k won’t be terminated during that time?”
Obviously, the answer is no, and participants need to know what the implications are for their loan. It’s also a good idea to educate plan sponsors on this issue and encourage them to have these discussions with employees prior to making a decision on a loan.
By discouraging the use of loans and expanding the 401k education program to include topics that address the basic financial needs of the plan participants, advisors can help Americans to stop using their 401k as a piggy bank and more constructively address our societal problems of lack of savings and too much debt.
Ashley M. Micciche, CRPC, QPFC, is a vice president/Investments with the Wilson Financial Group of Stifel, Nicolaus, & Company, Incorporated. Member SIPC & NYSE in Portland, Oregon. Contact her at (503) 499-6260 or miccichea@stifel.com.