401(k) Plan Loans - Thoughts for Employers
This was a fun episode as Todd Cowman from the Principal Financial Group and I explored the polarizing and sometimes confusing topic of participant loans in 401(k) or other corporate retirement plans. This is an important topic for employers to understand, and based on the title I gave it, in my opinion, 401(k) loans are not a black and white, inherently good or evil, or for the last description, simply a binary conversation.
Borrowing from your retirement plan is essentially stealing from your future to pay for your past or current financial needs. As Todd and I discuss on the podcast, there is the fundamental disadvantage of double taxation on the interest you pay on your loan. Also, if you have to suspend or reduce your salary contributions to afford your loan payment, then you are not only impacting your future retirement savings, but you could be missing employer matching dollars as well. And finally, you have the risk of lost earnings if your investment selections would have generated a higher rate of return than the interest rate on your loan. To hear a very strong and valid argument against having 401(k) loans in your plan click here to listen to a prior episode I recorded with Pete the Planner.
However, keeping all of the points in mind, sometimes a loan from your retirement plan might have distinct advantages to solve a pressing financial need for a participant. What if the only other alternative to a 401(k) loan is a credit card cash advance at 24.99% interest? What if not having a loan option sends a participant to a payday loan center? On the flip side, what if your loan interest rate actually outperforms the return of their investment portfolio? What if the potential to take a 401(k) plan loan gives a young millennial at your company the confidence to start making 401(k) contributions earlier in their career than they would have if they were concerned about having their money locked for the next 30 - 40 years?
With all that said, this is not my first day in the industry. I recognize that people take retirement plan loans to pay for vacations, to cover what some could deem as small short term needs where there might be other options available. I also recognize that some people have multiple loans and that once a loan is paid off they apply for a new loan as soon as allowed by their plan. While none of these examples are good or will likely lead to a positive retirement outcome for those individuals, plan sponsors should not take a black or white view of loans in an effort to curb abuses.
First, get comfortable with the real pros and cons about loans, don’t just blindly follow an ideology that is being espoused by the industry. If you don’t already, get to know your population and understand how they are using retirement plan loans. Then, create a loan policy which will align with your philosophy on the proper usage of retirement plan loans and will be realistic based on your employee demographic. Also, in the current era of financial wellness, consider providing additional resources to participants who have a loan, for example creating a budget, managing debt or other topics. Finally, monitor utilization and revise your policy over time.