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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:
- 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.