Qualified Plan Loans - Evil or Essential? - Part 2

*Note: This is Part 2 of a series on Qualified Plan Loans based on the May 22nd presentation on this topic at the World at Work, Total Rewards Conference.  

Plan sponsors who seek to do plan loans “right” often feel like they have:

• A hard row to hoe, 
• With one hand tied behind the back, while 
• Climbing uphill and at the same time, 
• Swimming upstream.

That’s because “everyone” knows plan loans are something to avoid, something that should be a last resort, something that will “Crack Your Nest Egg”, something “evil.” 

Perhaps you have reviewed recommendations by Fidelity, MassMutual, Nationwide, TIAA and many, many other service providers. Each has a specific campaign designed to curtail loans. Or, perhaps you have read one of the over 100 different articles critical of plan loans that have been published in the last ten years since the Great Recession.  

My favorites, however, are the apples to spinach examples that financial “experts” created to show just how evil plan loans can be – without disclosing the fact that most of these same “experts” are paid fees based on assets under management.¹  No surprise then that those same financial experts recommend plan sponsors curtail plan loans. Some of their recommendations include:

• Repeated, negative disclaimers as part of the application process; 
• Repeated, negative warnings about the impact of a plan loan on retirement savings – particularly the impact on investment returns;
• Limiting loans to specific hardship criteria, or documented emergencies; 
• Limiting loans to one at a time; 
• Suspending contributions for periods while a loan is outstanding; and 
• Increasing loan fees.  

Perhaps you have already taken action. Perhaps you shared these concerns with your participants.  Perhaps your participants have been schooled by their own financial advisors, including Edelman Financial Services, GuideStone Financial Services, etc. Or, maybe they have read all about it in the popular financial press; they have their choice of many articles in publications like Marketwatch, Forbes, US News, Time/Money, The Motley Fool, etc. 

However, plan loans are not evil. They are not leakage. Plan loans are not taxable events so long as they are successfully repaid. Done right, plan loans should always be preferred over taxable payments – including a hardship withdrawal while working or a pre-retirement, post-separation distribution.

As a plan sponsor, your focus should be on ensuring:

• Participants are well informed about plan loans – con’s and pro’s, and  
• Plan provisions and service provider processes use current, 21st Century functionality, to do everything possible to ensure repayment.  

Well Informed Participants

Participants considering a plan loan should always know:

• Before taking a plan loan, always consider alternatives.  
• Loans are almost always better than a hardship withdrawal. 
• Plan loans are almost always better than commercial debt like payday loans or credit card advances.
• Access/liquidity through loan provisions is a necessity for workers who live payday to payday – it allows them to save more, to leverage the tax preferences and employer contributions that are only available in a qualified plan.
• A plan loan is a fixed income investment – so, always encourage participants rebalance their account to the target investment allocation after taking a loan.
• Loan interest may qualify for one or more tax preferences.

The best plan designs are those where participants can save by relying on access to liquidity. That enables participants who live paycheck to paycheck the opportunity to save more – more than they believe they could afford to earmark for retirement.    

Plan Provisions - 21st Century Loan Processing

• Your loan processing should do everything possible to ensure plan loans are repaid. Plan sponsors should review existing loan provisions, and consider:
• “Commitment Bonds” – As part of the application process and as part of warnings, confirm in writing that the loan is to be repaid, even if the individual terminates employment.
• Electronic banking features, so that participants can not only continue repayment after separation, but initiate a loan after separation.
• Retirement Account Projections:
  o Show how failure to maintain an appropriate investment allocation could reduce account values, and 
  o Confirm the impact of a taxable default (and/or compare to a hardship distribution).
• Credit Bureau reporting. 

Most plan loan provisions default the loan once 60 days have passed without a payment. If you do not add “electronic banking” or other post-separation loan repayment processing, consider amending your plan to delay the date the loan is “defaulted” until the last day of the calendar quarter following the calendar quarter in which the first loan payment is missed. During that period, encourage the worker to repay the loan. Also, you may want to have your service provider provide a notice regarding changes that were part of the Tax Cuts & Jobs Act of 2017. A plan loan defaulted on or after January 1, 2018 can generally be “cured” so taxes are avoided by a rollover to an IRA before the participant filesa tax return for the tax year that includes the loan default.  

Here’s the process you may want to embrace as a means of increasing participation and contributions and reducing leakage – while employed and after separation:

• Enroll
• Contribute
• Get Match
• Invest
• Borrow to meet current need
• Continue Contributing
• Repay Loan
• Rebuild Account
• Accumulate for Future, Larger Need
• Repeat as Needed Up To/Thru Retirement

Bottom line, most of the “evils” of plan loans can be attributed to poor plan designs and even worse plan processing. Those writing negative articles are correct - liquidity practices of the past have negatively impacted retirement savings. But, the better course of action is not to limit plan loans, but to adopt 21st Century liquidity strategies.  

Loan processing, done right, can improve retirement preparedness.  In fact, for those who live payday to payday, liquidity from using plan loans "done right" is essential to saving enough for retirement.  

¹ Towarnicky, Qualified Plan Loans, Evil or Essential, Benefits Quarterly, 2nd Quarter 2017, Accessed 5/28/18 at:  https://www.ifebp.org/inforequest/ifebp/0200570.pdf  Specifically, note the discussion of the three examples identified in footnote 44.