The Wharton School Pension Research Council’s new Working Paper on” Borrowing from the Future 401k Plan Loans and Loan Defaults” finally validated what some of us knew to be true for quite awhile. Using actual participant and plan data from a very large database (not just a statistical sampling), the study found that 90% of 401(k) plans force a default on loans outstanding at the time a participant leaves employment and that, indeed, such loans actually do default at an extraordinary rate. This had never been apparent in the past because of the manner in which loan defaults are reported on the Form 5500, which then led to a great deal of cynicism by a number of commentators that this was a serious problem.
It is now clear. Defaulting loans at the time of unemployment is a significant source of retirement “leakage.”
Perhaps even more importantly is the human cost that the study’s numbers reveal. It shows that this traditional plan design imposes a severe financial hardship upon those who involuntarily lose their jobs, at a time when they can least afford it. The taxation on the forced deemed distribution and 10% penalty on loan defaults is especially cruel. Not only may it artificially inflate the marginal tax rate and impose taxes without a distribution to pay them; but then the penalty is paid regardless of the application of the marginal rate or deductions. So, even if income was so small so that one would otherwise owe little or no tax, the 10% penalty is still applied.
No big deal, you may say? Well, think again. In January 2009, 779,000 jobs were lost; the total being 4.7 million that year. Given the level of 401(k) participation rates and given the loan rates referenced in the Wharton study, a large number of those unemployed would have been penalized while losing their retirement accounts. The heaviest impacted are low and middle-income workers, which also results in a goodly amount of tax revenue to the Treasury from their misfortune.
I wrote about this in my blog of December of 2011, about the Great Recession, that
“At a time when it was necessary to provide substantial assistance to large financial institutions in many-and now we find out, often hidden-ways, those who were unemployed continued to pay a 10% penalty tax on their defaulted loans and DC distributions which were taken to keep them afloat. In effect, the unemployed were funding, even if in the smallest part, the assistance to large financial orgs which received substantial government support (and, apparently, paid large bonuses from those funds to many of their still employed executives and traders). Regardless of political persuasion, most should have difficulty with this proposition.”
The problem persists even after the recession, as participants taking plan loans often aren’t even aware of their exposure.
Limiting the availability of loans is not the solution to this problem which some suggest. Reducing the liquidity of a plan only reduces plan participation by those who we are trying to encourage to save. The Wharton study shows, instead, that plan participants resist taking loans until they really need to do so. Taking away loans takes from the participant the ability to rebuild their retirement account after they need to tap into it. Compare this to taking a hardship distribution, which can never be rebuilt.
This is just not an employee concern, either. I have worked on a number of layoff efforts, where employers really do understand this type of human toll- but business exigencies force them to move forward anyway.
Given the lack of policy action dealing with these issues, what’s left are marketplace solutions. As is so often the case, innovative financial products (designed properly, with proper transparency) can provide some of the answers which support both the employee and the employer under such circumstances. Our practice focuses on this sort of innovation (think about the likes of DC lifetime Income, MEPS, aggregation models, affiliation arrangements, and other unique programs which we cannot yet discuss openly). So it is with the loan default problem. We are working at designing and implementing credible, affordable and non-disruptive loan protection programs in the same manner as we have always promoted marketplace solutions when Congress and the regulators aren’t providing the answers needed to make the system work just a little bit better.
The Wharton study confirms the depth of the problem and the importance of addressing it. Just being cynical doesn’t cut it. There’s meaningful work to be done.