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The Loan Danger

Borrowing from 401(k) can be a bad deal all around.

April 2008
by Randy Myers/CFO Magazine

See this year's 401(k) Special Report.

The credit crunch has come home to roost in many unlikely places, from the student-loan market to the municipal-bond arena. Here's another improbable victim: your human resources department. The subprime crisis and its many ripple effects are prompting more financially strapped homeowners to borrow from their 401(k) plans. That not only puts their long-term fiscal health in jeopardy, but also places a large burden on their employers.

"Loan programs may be the single most disliked and burdensome administrative difficulty associated with operating 401(k)s," says employee-benefits attorney Fred Reish of Reish Luftman Reicher & Cohen in Los Angeles. Too often, he says, discrepancies between the amortization schedule created for the loan and the repayment schedule created by a company's payroll vendor go undetected until a retirement plan is audited by the Internal Revenue Service, whereupon the employer must scramble to set things right. "It's a nightmare," agrees consultant Kendall Storch, director of retirement services with Boston-based Longfellow Benefits. "The tracking of the loans, the managing of the repayments, the fallout if for some reason the payments get off schedule — it all becomes a big hassle."

It's no picnic for employees, either; they face a raft of difficult calculations when deciding whether to tap a 401(k), and often don't understand the potential long-term (or even short-term) impact of such a move.

Emergency Room
Plan sponsors aren't required to offer loan programs, but a majority do. Companies routinely add a loan feature to their 401(k) plans in the belief that more employees will participate if they know they can access the funds in an emergency. But many experts say that view is misguided, and some finance chiefs agree. David Magers, executive vice president and CFO of Country Insurance & Financial Services, a privately held insurance, banking, and asset-management company, says he thinks "the defining reason employees don't sign up is cash flow. They're having trouble paying the rent."

Nonetheless, Bloomington, Illinois-based Country offers 401(k) loans because, as Magers says, "we realize there are going to be occasions when not allowing employees access to that money could put them in a position of hardship. There are times when they may need to borrow."

Hard Times
Like now, for instance. Major 401(k) providers report 13 to 19 percent jumps in loans and hardship withdrawals, with the fourth quarter of 2007 seeing a major spike in such activity. The appeal for employees is understandable, at least on the surface: you pay interest to yourself. In fact, in the first few years of this decade, when the stock market and money-market funds on average were earning 1 percent or less, an employee repaying a loan at, say, 7 percent (a typical rate is 1 percent over prime) actually earned a better rate of return than he or she might have under most other scenarios.

But far more often loans work against employees, in a number of ways. "If employees are busy paying back their loans, they can rarely also continue to contribute at their previous level," warns Jeanne Brutman, an independent financial adviser in Jackson Heights, New York. "This greatly impacts the future value of their account, as the missed contributions are not compounding over time."

Even more risky, as Richard Reyes, owner and founder of Wealth & Business Planning Group LLC in Maitland, Florida, points out, is the chance that employees won't be able to pay back their loans. When that happens, a loan becomes, in IRS lingo, a "deemed withdrawal," subject not only to ordinary income-tax rates but also, if the participant is under the age of 59 1/2, a 10 percent penalty tax.

Defaults are especially common when participants quit or lose their jobs, since 401(k) loans then become due in full — just when participants are least likely to be able to pay them back. While this termination provision is routinely spelled out in the plan's summary plan description and other documents — protecting employers from claims that it wasn't disclosed — it often catches plan participants by surprise.

Reyes recalls one highly compensated client who took out a $50,000 loan from his 401(k) plan just before unexpectedly losing his job. "He had no way to pay back the loan, so he had to pay income taxes on it at the highest marginal rate, plus a 10 percent penalty because he was under the age of 59 1/2," Reyes recalls. "He didn't have the money to pay that tax bill either, so he had to take even more money out of his IRA, and this created a snowball effect. He lost everything."

Russ MacMannis, vice president of finance for $200 million Barker Steel, in Milford, Massachusetts, says about 25 percent of the participants in his company's 401(k) plan have loans outstanding at any given time. Some are clearly struggling. "We see cases where people reduce or suspend their regular deferrals just to pay back their loans," he adds. "And we have a small group of people who never see a full paycheck except during the three-month waiting period we require between loans."

Indeed, many employers enforce a waiting period between the repayment of a loan and the resumption of regular contributions into an account, which is yet one more way that taking a loan can diminish an employee's long-term savings. Some don't allow for the simultaneous repayment of a loan and continuing contributions into an account. And, of course, employees will miss out on any employer matching contributions during periods in which they are repaying loans but not putting any "new" money into their accounts.

All of this comes at a time when 401(k) plans face an additional form of peril: stagnation. According to Deloitte, after years of strong growth, participation in 401(k)s appears to be "topping out." For example, in 2000 there were approximately 687,000 defined-contribution plans in the United States. By 2004 that number had actually dropped by about 50,000. Meanwhile, 52.9 million employees participated in such plans in 2002, a number that dropped by 700,000 participants two years later. Add to that anecdotal evidence that many workers lack the financial literacy to understand simple concepts like the effects of compound interest (in a recent Journal of Monetary Economics article it was noted that only 18 percent of adults could answer a simple question regarding how much $200 in a savings account would be worth two years later if the account paid 10 percent per year), and it seems that 401(k) account management is something many workers struggle with.

What to Do
Given all that, it's not surprising that Reish advises employers not to offer loan programs unless they truly deem it necessary to get employees to participate in their 401(k) plans. Employers who do offer loans can take measures to minimize both the administrative pain that such programs generate and the potential for abuse by employees.

  • First, limit participants to one loan at a time. "We used to allow two loans, and it was just exponentially more difficult to administer," observes MacMannis. "You have to keep track of which payment is for which loan. We also found that it was really being abused by employees."
  • Next, require that participants wait some period of time after paying off a loan — say, six months — before allowing them to take out another one. Otherwise, loans can become a permanent crutch. "We absolutely have clients where people use the loan program like a revolving door," says Storch. "It defeats the whole purpose of having a retirement savings plan."
  • In extreme cases, employers can allow loans only for the same limited reasons the IRS allows hardship withdrawals from 401(k) accounts, such as to pay for un-reimbursed medical expenses or to prevent the loss of a home (see "Hardship Withdrawals" at the end of this article). And, even though employees are paying interest to themselves, setting the rates higher may prompt some to explore the options at their local bank or credit union.

Finally, employers can do more to educate employees about the potential hazards of taking money out of their retirement plans, from the tax bite to the payback provisions to the long-term impact it can have on the size of their retirement nest egg (see "The Price You Pay" at the end of this article). Companies devote plenty of time and energy to encouraging employees to join 401(k) plans; they would do well to devote just as much to explaining why it's important to stay in, and why loans so often amount to getting out.

Hardship Withdrawals

Loans are one way that participants in 401(k) plans can take money from their retirement accounts before retiring. The other is through a hardship withdrawal. Unlike loans, hardship withdrawals need not be paid back. However, they can have onerous tax consequences. Except in very limited circumstances, they are taxed at ordinary income rates, and, if the participant is under the age of 59 1/2, they also carry a 10 percent penalty tax. The Internal Revenue Service allows hardship withdrawals only for very specific reasons: to cover un-reimbursed medical expenses, to purchase or repair a primary residence, to avoid eviction from or foreclosure on an existing residence, to pay for tuition or related educational costs, or to pay for a funeral.

Employers aren't required to offer hardship withdrawals, but most do. Country Insurance & Financial Services has managed to keep them to a minimum, however, in part by requiring that before participants take a withdrawal they first exhaust their loan limits, which the IRS sets at 50 percent of an account balance up to a maximum of $50,000. While its 401(k) plan has approximately 4,300 participants, Country processes only about five hardship withdrawals per year, says CFO David Magers. By contrast, about 600 participants have loans outstanding at any one time.

The Price You Pay
Employees who borrow from their 401(k) plans can pay a big price if the cost of repaying such loans prevents them from continuing to make regular contributions to their plans. Matt Riebel, president of Nationwide Retirement Solutions, a unit of Nationwide Financial Services, offers this example of a 35-year-old with a current account balance of $30,000 who takes out a 5-year, $8,200 loan:
  Continues making $2,000 annual deferrals during
loan-repayment period
Discontinues $2,000 annual deferrals during loan-repayment period
Account value at age 35

$30,000 $30,000
Annual deferrals during
loan-repayment years
$2,000 $0
Annual deferrals after
loan-repayment years
$2,000 $2,000
Annual ROI 7% 7%
Account value at age 65 $417,289 $354,866
  Difference: $62,423 (15%)

Source: Nationwide Retirement Solutions

Randy Myers is a contributing editor of CFO.com.

© CFO Publishing Corporation 2008. All rights reserved.