The Tax Cuts and Jobs Act’s participant loan changes (which delays the account offset on loan defaults related to unemployment or plan termination) triggers something we would all rather not look at:  the “uncomfortable” manner in which ERISA’s fiduciary rules apply to loans and their administration.

These changes should cause plan sponsors and recordkeepers to consider new choices about their handling of loan defaults, something they haven’t had to do in nearly 28 years. This matters because changing a plan’s loan rules is not a minor technical act. Loans are investments subject to the same ERISA prudence rules as any other plan investment, and changes to loan procedures impacts the investment.

There is a temptation to put the loan fiduciary issues to the side, justifying it with the widely misunderstood notion that there is little fiduciary responsibility related to loan accounts because plan loans are effectively a participant “loaning their own funds to themselves.” It worthy to note, however, that the Department of Labor directly disavowed this common misperception when responding to a comment making this sort of claim to its proposed loan regs in 1989: “there is no basis in the statute for departing from the position that participant loans should function as plan investments.” (See 54 FR 30520).

When you think about it, the legal analysis is startling:

  • A participant loan is a commercial transaction between the plan and the participant.
  • The DOL regs treat loan funds as an investment account under the plan.
  • As a plan investment, the loan fund is subject to the ERISA’s prudence standard. According to the DOL, “section 408(b)(1) recognizes that a program of participant loans, like other plan investments, must be prudently established and administered….”
  • The DOL has also separately stated that plan fiduciaries “must assess and monitor loan programs.”

Things get even more uncomfortable when you look at the fundamental “prudence” regs. They require “appropriate consideration to those facts the particular investment involves, including the role the investment or investment course of action plays in that portion of the plan’s investment portfolio with respect to which the fiduciary has investment duties.”  Then fiduciaries must “act accordingly” after giving the investment that “appropriate consideration.”

Meeting this standard is typically handled in the periodic investment review of a plan’s investment funds. But when is the last time you saw this review take into account the loan fund activity under the plan? I would guess rarely, if ever. But according to a leading Wharton study (“Borrowing from the Future: 401(k) Plan Loans and Loan Defaults”, Timothy (Jun) Lu, Olivia S. Mitchell, Stephen P. Utkus, and Jean A. Young,2014) approximately 10% of loan principal is lost to defaults annually. This is made all the more pointed by the fact that the loan fund is usually one of the larger investment funds under the plan. Loans are generally utilized by 20% of plan participants at any one time, with some 40% of plan participants taking out loans over a any given five year period.  A 3(21) adviser would be expected to subject any other plan investment of this magnitude (and performance!) to periodic fiduciary review.

What makes this all very uncomfortable is that loans are a necessary evil, in large part because of the common occurrence of default and the subsequent “leakage” offset of account balances upon job loss. But 401(k) or 403(b) plans would be unsuccessful without them. Participation and contribution rates exist at their current levels due in part to loan access under the plan. It then really becomes a balancing act between implementing the basic fiduciary requirements to preserve a retirement benefit and to protect the plan’s assets with making the plan attractive to participants. Or, as the DOL has put it, “The Department does not believe that the purpose of the (loan) exemption is to encourage borrowing from retirement plans but rather to permit it in circumstances that are not likely to either diminish the borrower’s retirement income or cause loss to the plan.”

This is not an easy balancing act to perform, and it’s deceiving to believe that it could be addressed by merely providing an account offset as a way to “protect” the plan upon a default. This ignores the seriousness of reducing a participant’s retirement benefit, particularly where the default follows involuntary unemployment-effectively making it a forced default and forfeiture beyond the participant’s control.

An uncomfortable task, for sure, but one that probably should be given serious consideration.