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Defined Contribution Cracks Draining the Pool?
Last Updated: July 14, 2015
Reducing leakage to keep participants on track for retirement
Part 1: Modifying Your Loan Program
One of my favorite parts of summer is swimming. Growing up I loved helping my parents get the pool ready. My job was to make sure the water level stayed at a certain level. This was fairly easy to do until the liner got damaged after a storm when a glass table top shattered and pieces fell into the pool and punctured the liner in several places. You guessed it….our pool started to leak. It was a slow leak, at least it seemed that way, because I could just simply turn on the hose and let it refill each day. It wasn’t until my parents received the next water bill that this slow, almost unnoticeable leak was actually becoming a major cost. Retirement plans can often have similar type leaks. Be it because of plan design or participant behavior, seemingly small outflows of funds leave the plan. Like the increased water bill from the pool, the cost of plan leakage can have an effect on your participant’s ability to replace their incomes in retirement. In this two-part series, we will identify the most common leaks to defined contribution plans and ways plan sponsors can reduce their effects on participant’s retirement outcomes. Sometimes plan sponsors will offer participants the ability to access their retirement accounts by way of borrowing the funds. By offering these loans, participants may be more encouraged to participate when they know they will have access to their savings if needed. In the latest Vanguard’s “How America Saves 2015[1]”, 77% of plans currently have loan features. Loans allow participant to gain access to monies for any purpose without having to report the income for taxes or without having to pay early withdrawal penalties. However this ease of access can make it temping for participants to utilize the retirement plan as a source of credit for discretionary needs rather than as a vehicle to prepare for retirement. In the same survey, 17% of participants have outstanding loans with an average balance of $9,700, representing 2% of plan assets. Now this 2% might seem small, but when looking at only those participants with loans, it represents approximately 10% of their account balance. A participant can normally borrow up to 50% of their account balance to a max of $50,000 and will pay back the loan through payroll deduction while employed. The challenge comes into play if a participant with a loan leaves employment. The unpaid balance is due in full within 60 days of termination. If the participant can’t pay back the loan in full, then it is considered in default and they will be taxed on the outstanding balance, and incur the 10% early withdrawal penalty if they are under age 59 ½. In my experience working with participants, many do not have the extra funds to pay the loan back if defaulted. Many also decrease their contributions to account for the increase in payroll deduction for the loan payments. Let’s look at an example:
Let’s assume a participant age 40 wants to borrow $10,000 (1/2 or their $20,000 account balance). We will also assume he contributes $100 per pay period, gets two paychecks each month, and that his investments will average an 8% return over time. If the participant takes the loan out for 5 years at 5% interest, they would have to pay $94.27 per pay period to repay the loan. If the participant cannot afford the $100 contribution and the loan payment, they might reduce or eliminate their contributions until they pay back the loan. At this point, the participant is no longer funding the retirement plan, they are simply replenishing it and this could lead to reduced income later on. In this example by taking a loan, the balance at age 65 was reduced by $77,813. That difference could mean a reduction of more than $6,749 a year for 25 years of retirement income.
We understand as advisors that individuals have a hard time seeing the potential true cost of these types of decisions. If this person were to leave employment, would they have the funds to repay the loan in full? Furthermore if they can’t, they now have the added cost of the taxes and possibly the penalty as well. Because of this, would they be inclined to keep the rest of the balance in the plan? Roll it into an IRA? Or like many would they cash it out as well because the remaining balance is now needed to help cover the tax effect of the defaulted loan. We will focus more specific on cash-out distributions in the next section. However, it is important for a plan sponsor to understand how a participant may think through a situation, if it is the plan sponsor’s goal to help their participants prepare for retirement.
A plan sponsor can take some steps to help balance out the participants desire to access to their money while also keeping the focus and purpose of the plan as a retirement savings vehicle. As a plan sponsor you could:
- Impose additional limits on the loan amounts.
- Limit the number of loans available: If you are going to allow loans, consider only allowing one (1) loan at a time.
- Impose waiting period before a new loan can be requested.
- Require the spouse of a married participant to consent to a plan loan.
- Allow post-employment loan payback options.
- Consider increasing or imposing processing charges.
- Provide ongoing communication to employees regarding potential dangers of loan usage.
- Provide financial planning consultation with a CFP® professional prior to loan request.
