For many years, plan sponsors have wrestled with the decision to offer loans to their plan participants. Some consider them to be a benefit and even promote them as a legal way to use tax free money while participating in the plan. According to the Employee Benefit Research Institute, 87% of plan participants can take a loan against their retirement account. Of those employees with access to take a loan, about one-fifth borrow against the retirement account. Come retirement, what are the effects of loans taken from pension funds on an employee’s account?
A few years ago, the term “Account Leakage” started to be used when reporting on the effects of participant loans. Account leakage refers to lost asset accumulation due to reduced earnings, elections to reduce contribution levels, and the cashing out of account balances when participants terminate.
Lost Accumulation Due to Reduced Earnings: When a participant takes a loan, the interest rate, which is detailed in the plan’s loan agreement, must be “reasonable” and is commonly tied to the prime rate plus 1% or 2%. Recently, the prime rate climbed to 4%. Most participant loans in existence have rates based upon 3.5%, the prime rate in effect for the last several years. With the value of the loan earning a rate of 4.5% to 5.5%, participants with loans could well underperform the returns of the investment options offered within their plan. Since the duration of most loans is 5 years, there can be significant loss of earnings that will ultimately erode their account balance at retirement.
Elections to Reduce Contribution Levels: Under the terms of a participant loan, the participant must agree to make loan payments no less frequently than on a quarterly basis. To simplify collection procedures, most employers require that loans be paid through payroll deduction which consequently reduces take-home pay. Many participants elect to reduce, or even eliminate, their contributions to the plan to alleviate the impact of the loan payment on their paycheck. Given that the most common term for a participant loan is five years, employees are losing those contributions, and the earnings on those contributions, towards their retirement.
Cash-out of Account Balances: When a participant terminates employment, they must decide what to do with their account balance from their former employer. Studies show that nearly 40% of terminated employees ask for a cash distribution and, according to Morningstar, in 2013 that added up to about $68 billion that leaked from retirement savings. When a participant loan is part of the account balance, participants are faced with an even more demanding situation. Since the majority of plans require payment of the outstanding loan balance at termination, the former employee must have the cash to repay the loan in full. As a result, over 70% of plan loans default and become a taxable distribution.
Account leakage is a significant issue in retirement planning with some experts even calling it a crisis. What is a plan sponsor to do? Some companies are offering low-cost loan alternatives to discourage employees from borrowing against the plan; leaving account balances intact. Other sponsors offer services with a financial advisor who can encourage other financial options or compare the loan program with other low-cost lending. Limiting loan availability to one at a time, encouraging early payoffs, and instituting a waiting period between the initial loan payoff and the start of the next, has helped to minimize the prevalence of a negative loan impact on the plan. Reducing the number of loans has helped many sponsors to keep participant account balances intact and to reduce the administrative burden of maintaining them.
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