Are plan loans the newest financial wellness tool?
Considered by many a necessary evil and administrative burden, loans exist to give participants access to their money in times of need.
The Bi-Partisan Budget Act of 2018, which went into effect this year, included provisions to make it easier for participants in qualified retirement plans to take hardship withdrawals.
Perhaps the biggest change in the liberalization of the hardship rules was the removal of the requirement of participants to exhaust all plan loan options first, before qualifying for hardship. Other changes included the following:
- Expanding the money sources eligible for hardship withdrawal to include matching contributions, earnings on both elective and matching contributions, and monies from other sources such as profit sharing and stock bonus plans
- Expanding the circumstances for hardship distribution (i.e. what qualifies as an immediate and heavy financial need)
- Making it easier for participants to demonstrate the need by allowing verbal representation
- Easing the requirements for a hardship determination, which previously was to demonstrate “immediate and financial burden” by now allowing the participant to make a written or electronic (including phone recording) declaration of insufficient cash or liquid assets to satisfy a financial need
Early evidence of the impact of the rule changes was first reported by Fidelity in May of this year. Hardship withdrawals spiked in the first quarter for those plans which adopted the changes, showing a 40% increase in hardships over the prior year, and a 7% drop in loans. Several large sponsors we have spoken with also report an increase in hardship following the rule changes.
More recently, a plan sponsor survey from the PSCA also reported an impact, albeit somewhat lesser, that about 18% of plan sponsors who implemented the change are seeing an increase in hardship withdrawals.
Other firms have recently reported broader leakage statistics, including TransAmerica’s 19th Annual Retirement Survey, where they observed 29% of full-time workers to have taken a loan, early withdrawal and or hardship withdrawal in 2019.
While the magnitude of the increase in hardships is unclear, and it will be important to continue to measure the impact, this rule change appears to be having its intended effect: to make it easier for participants to access their money in times of need.
However, what of the unintended consequences? Hardship distributions are, almost always, an immediate—and permanent—reduction in future retirement benefits, including not only the amount withdrawn, but also the taxes, penalties, and earnings over the remaining years to retirement.
While the law allows for a restoration of the hardship amount to avoid the tax burden, it’s hard to conceive of those financially stressed enough to take the hardship ever actually returning that money to their pool of retirement assets.
Let’s also consider that this increase in leakage has occurred during a period when our economy and employment have been particularly strong. Should we not also be concerned with the level of hardship leakage that’s likely to occur in a less robust economic cycle?
What’s old is new again: the loan as financial wellness tool
Enter the plan loan. The loan feature, while considered by many to be a necessary evil and administrative burden, exists to give participants access to their money in times of financial need. According to numerous industry studies, it is a feature that encourages greater plan participation and savings rates by creating emergency liquidity in times of need.
Both participation and contributions would suffer in its absence, and it remains a popular feature, with over 90% of 401(k) plans allowing for loans. Further, as reported by the Pension Research Council, on average, 20% of participants have loans outstanding at any given time, and over a five-year period, 40% of participants are observed to have taken a loan.
The big difference between loans and hardships is that the loan feature has a far better chance of preserving retirement security, especially if protected or insured against default. Loans are designed to be paid back, and for the most, repayment is facilitated seamlessly through payroll deduction.
Roughly 90% of borrowers pay back their loans, including the added interest required by ERISA and the plan’s loan policy, preserving long-term retirement security. As such, one of the benefits of the loan is that it is a foil against the permanent loss of retirement security that results from a hardship distribution.
Sponsors are well-served to consider this preferable alternative, since the primary purpose of the retirement plan is to provide retirement benefits, and the liberalization of the hardship rules coupled with the corresponding increase in hardship withdrawals seems to run contrary to that purpose.
We have seen how plan design can undermine participant outcomes, just as we’ve seen how it can improve outcomes. The best example of this may be the significant expansion of automatic enrollment into QDIAs, with the bulk of assets flowing into second generation target date funds.
Optimizing the loan feature
So what is a sponsor to do? Congress made it clear that they want participants to be able to access their money in times of emergency financial need. And research such as the recent study by Greenwald & Associates and Custodia Financial entitled “Missing Voices: What 401(k) Participants Can Add to the Loan Conversation” has shown that, for many participants, workplace savings is the only pool of assets they have.
Furthermore, the research has shown that the retirement plan is viewed not just as a long-term retirement savings vehicle, but also a source of short-term emergency funding.
This should have some implication for plan design, namely, how do we give participants emergency access to their money, while at the same time, not undermine the long-term goal of an adequately funded retirement? Hardships should still be considered an option of last resort. Sponsors are not required to adopt the hardship changes but should consider what options participants have options for emergency needs, which brings us back to the plan loan as a flexible wellness tool.
Plan loans were designed to address the concern that Congress had when it enacted the Bi-Partisan Budget Act of 2018 and eased hardship requirements. No doubt, sponsors need to continue to give participants access to their money; however, loan programs should be redesigned to maximize the chances of achieving the primary goal of the plan: retirement security.
The focus on loan leakage over the last several years has confirmed the problem with unprotected loans at point of job separation, when 86% of borrowers default in both the case of voluntary and involuntary termination. Better protections are required to prevent these losses and the projected $2.5T drain from retirement security over the next 10 years.
To optimize the loan feature, there are a few things that sponsors can do. First, they should educate participants about the importance of long-term savings—which means paying the loan back.
However, the Greenwald & Associates research mentioned earlier tells us that the timing of that education is critical. When participants are initiating a loan, they’re under financial stress and not particularly receptive to education. Once their crisis has been averted—say, right after a loan has been approved—they’re a lot more likely to pay attention, so ongoing messaging reinforcing the importance of paying back the loan, and what options are available upon job separation, is valuable.
Next, to help those terminating voluntarily, they should explore more effective solutions for transferring balances and loans to new employer, as well as implement post-termination payments via ACH, coupled with better communication and facilitation of these features.
And finally, for those terminating involuntarily who are the most financially at-risk, plan sponsors should adopt loan insurance as automated protection, an immediate and measurable way to address the problem.
Participants need the help. As Greenwald found in its research, participants are financially stressed, particularly over the prospect of job loss when carrying a loan, and asking for a “safety net.” Eighty-one percent found participant-paid loan insurance appealing, and 67 percent said that they’d consider increasing their contributions if this safeguard was in place.
There’s no silver bullet, but together these elements will go a long way in reducing employee stress, stopping leakage, and preserving retirement security.
The biggest defined contribution gains over the past 20 years have come from automation: auto-enrollment, auto-escalation, and auto-diversification. Solving loan leakage to help improve retirement security should be no different.
