Over the past few months, several articles have weighed in on participant loans from defined contribution (DC) plans, nearly all with the same refrain: loans are bad. Some go a bit further: loans must be stopped. One piece, for example, opined that 401(k) loans “should not be allowed in any retirement plan other than for hardship reasons,” calling plan loans “the worst investment anyone could possibly make.”
Ultimately, for plan sponsors looking to help participants adequately prepare for retirement, one primary task is to craft plans that work best for each one’s workforce. Revisiting loan policies in pursuit of those goals—but with sufficient flexibility to encourage maximum participation in the first place—is a good way to start.
The IRS restricts loan amounts to no more than 50% of account balances (generally); repayment to up to five years (except for purchase of a primary residence); and the total borrowed over the past 12 months to a maximum of $50,000 (always). It also allows use of the funds for any purpose.
In addition to those required limits, a sponsor may craft a better-tailored loan policy for its workforce by considering:
• How much (and how often) its participants are borrowing
• Participants’ reasons for loans (if known, officially or anecdotally)
• Deferral rates and account balances
• Relative financial sophistication of plan participants
• Participant input and any other relevant factors
Here are some loan policy terms a sponsor may wish to consider:
Lower limits: Cap loan amounts to less than 50% of vested account balances. A cap of 20% of the vested balance, for example, will help ensure that a participant keeps at least $4,000 invested for retirement for every $1,000 borrowed. (The “help ensure” bit refers to the fact that participants often will qualify for hardship or other withdrawals after taking loans. On that note, plans should consider steps to cut down on hardship withdrawals; a well-crafted loan policy may be just the ticket.)
Faster repayment terms: Limit loan repayment to one year, for example, rather than five years, with a primary residence exception. Requiring faster repayment may also help reduce the instances and severity of loan defaults, under which the outstanding balance is treated as a taxable distribution.
Minimum payments: Require that scheduled loan payments not fall below a specified percentage of compensation—1%, for example.
Waiting periods: Require that any participant who pays off a loan (whether on schedule or with a full payoff) wait a certain specified time—say, 90 days or even a full year—before taking a new loan, to help minimize “revolving-door” loans.
Allow more than one loan out at a time: Although counterintuitive to retirement saving, it may reduce a participant’s urge to take more than his or her immediate need. To minimize the negative impact on retirement savings, this option may be best incorporated with other limits above.
Another approach might allow a participant more than one loan at a time, but restrict the additional loans to loans satisfying special financial-hardship criteria—either as defined by the IRS safe-harbor eligibility for hardship-based withdrawals, or as differently defined by the plan’s document or loan policy.
By taking steps to tailor the plan’s loan policy rather than doing away with loans altogether, a sponsor can strike a good balance between encouraging retirement savings and allowing participants some financial flexibility when they need it.