Plan loans are often an overlooked feature within defined contribution plans. The rules governing defined contribution plans allow plans to provide loans, but do not mandate that an employer make it a plan feature. For Plans that allow loans, the regulations generally permit a participant to borrow half their vested assets up to a maximum of $50,000. While the availability of this feature does not often encourage savings, the lack of availability of this feature can deter savings because participants may fear not having access to their money.
According to the most recent edition of How America Saves (an annual survey published by Vanguard), four out of five 401(k) Plans allowed for loans; however only 15% of participants had a loan outstanding. Additionally, the percentage of participants with loans has remained within a tight range over the past decade. The average outstanding participant loan balance was approximately $9,700 and only about 1% of Plan assets were being borrowed by participants.
According to the Plan Sponsor Council of America’s 2018 61st Annual Survey of Profit Sharing & 401(k) Plans, the clear majority (84.4%) of Plans permit participant loans. Additionally, the more participants within a Plan, the more likely the Plan is to offer loans. Of those Plans that do offer loans, 63.5% use a formula of the Prime Rate plus 1% to calculate the loan interest rate. The survey also found that participants are most commonly charged a loan origination fee (74% of plans), which averages $81. However, the fee charged generally decreased based on the number of participants in the Plan.
Fiduciaries have a responsibility to protect participant assets and part of that can be to monitor the loan activity taking place within a Plan. Loan “leakage” has become an important topic for Plan Sponsors and your recordkeeper (in conjunction with PEI) can help you monitor this process. Best practices suggest that certain “guardrails” be put in place to ensure that Plan assets are used as a “retirement benefit” as opposed to a “checking account”. In general, the best practice is to allow no more than one outstanding loan at any time. While certain employers may have valid reasons for allowing multiple loans, the operation and administration of a Plan is cleaner when only one outstanding loan is allowed. Additionally, if participants know they are only able to have one outstanding loan, it may give them pause before taking a new loan and as a result their assets may continue to grow within the Plan. Other best practice features may be to institute a $1,000 minimum to help ensure that participants don’t churn loans and only initiate the process when they truly need the funds. If they are charged an origination fee each time this may also reduce the frequency of loans as well.
Finally, it may be worth considering amending the Plan terms to allow terminated participants to make loan repayments directly to the recordkeeper. Many recordkeepers have the ability to receive and process payments directly from participants. This may allow a terminated participant to avoid the tax consequences of no longer making repayments after his employment has ended. This feature could benefit the Plan and its participants in avoiding loan defaults from non-payment. Lastly, Plan Sponsors should establish and follow a process to regularly work with their recordkeeper to monitor loans and notify those who are at risk of being defaulted.