Retirement Account Loans: The New Home Equity Loan?

Here is the good news and the bad news about retirement plan loans. Few active employees default on these loans (3%). And if they don’t stop or reduce their contributions to their retirement accounts, these loans have little impact on their overall retirement savings. ”As long as folks keep saving and getting those matching dollars it’s not very harmful to their future retirement income,” observes Hess.

However, those who stop contributions to their retirement savings while they repay the loan can significantly sabotage their retirement savings. Using EBRI’s Retirement Security Projection Model, the report found that not contributing “during the loan repayment period is expected to erode future retirement income by 10% to 13%, depending on the type of enrollment (automatic or voluntary) and the participant’s income level.” Hess also notes that once someone stops contributing to their retirement account, “it can be difficult to get started again.”

And for those who leave or lose their jobs, things can be downright ugly. In that case, the average default jumps to nearly 70%, and even higher — 80% — for those in their twenties. One of the reasons for this high default rate is the fact that most plans require an employee to repay one of these loans within 60 days of leaving or losing their job.

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It’s not just retirement savings that takes a hit in these cases. If employees are under the age of 59 ½, the remaining balance will be treated as an early withdrawal and the employee will be subject to taxes and a 10% penalty.

The study offered a number of recommendations employers could implement to deter these loans, including adding annual fees or maintenance fees, allowing only one loan at a time, implementing a waiting period between loans, and allowing loan repayment after termination. Increasing employee financial education about the impact of these loans on retirement savings was also suggested.

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U.S. Senators Herb Kohl (D-WI) and Mike Enzi (R-WY) specifically referenced the report when they introduced the Savings Enhancement by Alleviating Leakage in 401(k) Savings Act of 2011 (SEAL Act) which would, among other things, give employees more time to pay back a loan. Under the SEAL Act, employees would have until they file their taxes the next time to repay an outstanding loan. (Note there is nothing preventing employers from giving terminated employees more time to repay their loans; typically it’s just considered an additional administrative burden for the employer.) It would also prohibit plans from issuing debit cards that can be used to access these funds, and would limit the number of loans participants can take to three at one time.

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The study recommendations and proposed legislation contain good ideas, but they don’t get at the underlying question that was not answered by this survey: Why are more employees tapping their retirement accounts for loans? And what can be done to address that problem? The fact that the most likely profile of someone taking out a retirement loan is a middle-aged female with a lower paying job suggests that this money is probably going to pay essential expenses, and not being frittered away on a new kitchen or a vacation.

And that makes these loans potentially as serious a problem as home equity loans. After all, if Americans who drained their home equity now drain their retirement accounts, what’s next?

Image: swimparallel, via Flickr.com