People default on loans they have taken out from their 401(k) plans all the time, and those numbers have been increasing since the recession started in 2008—to the tune of $37 billion per year, according to a new report by Navigant Economics.
"401(k) Loan Defaults: How Big is the Leakage and What Can Policymakers do to Preserve Americans' Nest Eggs?" found that as of 2009, between 89 and 95 percent of 401(k) participants belonged to a plan offering loans and between 20 and 28 percent of those had a loan outstanding at some point in the past three years.
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Recent research by the Plan Sponsor Council of America showed that loans made up 2.5 percent of total plan assets among plans with a loan option in 2010. Most people who withdrew money from their retirement accounts did so to take care of an emergency, pay down debt or use for day-to-day expenses.
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According to Investment Company Institute data, 18.5 percent of active defined contribution plan participants took out a loan from their retirement account in 2011, compared to 18.2 percent in 2010, 16.5 percent in 2009 and 15.3 percent in 2008.
Using research from other organizations, Navigant surmised that the outstanding defined-contribution loan balance in 2009 for the U.S. as a whole was $104.7 billion.
When people lose their job or change jobs, participants have 60 days to repay a loan before it becomes a taxable distribution, the report said. "Because loans cannot transfer from one plan to another, the balance of the loan is due shortly after job termination—a highly inopportune time for financial liquidity."
If a participant defaults on a loan, they will lose the portion of their retirement savings associated with the loan, pay income taxes on the loan amount as if it were a voluntary distribution, and pay other penalties depending on their eligibility for a distribution. Job termination isn't the only reason participants default on their loans. Sometimes people die or are disabled, making it impossible for them to repay the loan.
Navigant believes that the leakage from retirement savings on an involuntary basis amounted to at least $9.3 billion in 2009 alone. Because this estimate is largely driven by default rates due to job loss from the recession, it could be too conservative, the report stated.
"Using the implied default rate on loans due to job loss during the recession, as well as private-sector data on loans outstanding, we estimate that the amount of the annual leakage from mid-2008 through mid-2012 could be as high as $37 billion," according to the report's authors.
To discourage unnecessary borrowing from 401(k) plans, many have advocated limiting borrowers to one loan at a time and limiting the size and scope of the loans. Another policy lever involves easing the repayment terms to reduce the number of 401(k) defaults.
The report's authors recommend that rules be amended so that plans may choose to allow 401(k) borrowers to be automatically enrolled into insurance coverage to protect them in the case of a loan default unless they opt to decline such protection.
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