Decades into reviewing the pluses and minuses of 401(k) defined contribution retirement plans, most employer plan sponsors have chosen to offer plan loans, which on the one hand give participants early partial access to their retirement funds but also threaten to erode those savings. A new paper suggests that plans’ loan policy can shape participant borrowing, which may give sponsors a greater sense of control as a 401(k) lender.
The April paper (available with registration) from the National Bureau of Economic Research, “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” posits that when a plan allows participants to take out multiple loans, they are more likely to borrow in the first place — and more likely to default. The NBER researchers said no previous study has explored how employer loan policy affects participant behavior and resulting defaults.
The paper looks at who borrows with plan loans and why, and who defaults on those loans.
It also found that serial borrowers’ individual loan amounts shrank, similar to what the researchers call the “buffer-stock approach to credit” that’s been noted among credit card users, but that plan borrowing probability is twice as high with a multiple-loan policy.
Avoid ‘Endorsement Effect’
Ninety percent of active contributors to 401(k) plans in the United States have access to plan loans, according to the study. Of that group, about one-fifth had a loan at any given time, an often-cited statistic that’s held steady for several years. Almost 40 percent have held a plan loan over a five-year period.
Participants with access to a multiple-loan feature in their plans borrowed greater amounts in aggregate, which the researchers warn could be seen as an “endorsement effect” that the NBER researchers said plan sponsors might want to avoid.
“[G]iven the ability to borrow multiple times, workers seem more willing to take the first loan when they retain slack capacity for future consumption shocks,” the paper said.
In addition, the study said the probability of plan borrowing nearly doubles when plans permit multiple loans. The aggregate amount borrowed rises by 16 percent, “suggesting that employees perceive that easier loans are actually an encouragement to borrow.”
For context, the study cited prior research that estimated aggregate premature withdrawals (or so-called account leakage) of all types from both 401(k)s and individual retirement accounts amount to 30 percent to 45 percent of annual total contributions. As such, these sizable outflows relative to inflows “raise the important question of how these liquidity features may influence future retirement security,” the NBER study noted.
With that many participants involved, plan sponsors face concerns about defaults. The study estimated an aggregate effect of loan defaults valued at about $6 billion a year — an amount it called higher than others’ previous estimates that relied on incomplete data, though it is still “much smaller than retirement plan leakage due to account cash-outs on job termination.” A 2009 U.S. Government Accountability Office report based on 2006 data said $74 billion was lost that year to cashouts upon leaving a job.
In reality, employer plan sponsors’ worst loan default problems may lie with former employees.
The study offered several insights on loan default patterns, most strikingly that 86 percent of participants with an outstanding loan balance when they terminate employment don’t repay it. Nine of 10 loans are repaid to plan sponsors, but the high default rate among terminated workers likely reflects that they may simply be surprised by an unanticipated job change and its effect on an outstanding 401(k) loan, the NBER paper said.
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