Develop a reasonable plan loan policy

Developing a reasonable plan loan policy may help entice employees to enroll in a plan, but it’s important for a plan sponsor to develop a policy that supports the main purpose of the plan — helping participants achieve a financially secure retirement.

The issue

20% of plan participants who were eligible for a loan at the end of 2014 had an outstanding loan.1 Loans can be a useful plan feature. The availability of loans may help make a plan more attractive. Employees may be more motivated to enroll when they know that if a serious need arises, they have access to their savings at a relatively low interest rate.                                                              
But, loans can have a negative impact on retirement readiness and can put employees’ retirement savings at risk. If a loan policy isn’t carefully thought through, loans may cause a plan sponsor’s fiduciary position to be called into question.

Impact on retirement savings

It makes sense that small loans generally have a relatively small impact on plan savings and larger loans have a larger impact — depending, of course, on the difference between the interest rate of the loan and the return on plan investments. But whatever the size of the loan, participants holding more than one loan multiply their risk of harming their long-term retirement goals. And, although active participants rarely default on plan loans, the default rate is almost 70% among those who are terminated while they have an outstanding loan, which often can deal a significant blow to their retirement security.2

Here are some hypothetical examples of how loans may affect plan savings:

Amount
of loan
Interest
rate
Investment
return
Payback period
(in years)
Years to
retirement
Lost savings if
paid on time
Lost savings
if default
$5,000 4.5% 7% 5 30 $1,841.09 $51,382.72
$10,000 4.5% 7% 5 30 $3,682.18 $102,765.44
$50,000 4.5% 7% 5 30 $18,410.91 $513,827.22

Recommendations

Some participants may lack knowledge and understanding of plan loans. This can be avoided by educating participants about the impact of loans and requiring or suggesting that they speak to a financial professional before taking a loan. As you establish or review your loan policies and make them more manageable for your employees, keep in mind these suggestions:

  • Limit plan loans to hardship reasons only.3
  • Adopt a uniform loan policy for the plan that’s applicable to all vendors and investment platforms.
  • Permit only one loan at a time.4
  • Require payroll withholding to pay the loan.
  • If a loan payment is in arrears, apply the maximum allowable IRS cure period to keep the loan from going into default.
  • Develop procedures for collecting and monitoring loans for terminated participants.
  • For 403(b) plans: Manage compliance across all vendors.


1Jack VanDerhei, Sarah Holden, Luis Alonso, and Steven Bass, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2014,” EBRI Issue Brief, No. 423, and ICI Research Perspective , Vol. 22, No. 2, Employee Benefit Research Institute (EBRI) and Investment Company Institute (ICI), April 2016.
2Aon Hewitt, “Minimizing Defined Contribution Plan Loan Leakage,” October 2013.
3Adam J. Miloro, “How to Reduce Employee Cravings for 401(k) Loans,” Employee Benefit News, http://www.benefitnews.com/opinion/how-to-reduce-employee-cravings-for-401-k-loans, May 15, 2013.
4This bullet and all following: Steven E. McInally, “The Wide World of Participant Loans,” 2013 Mid-Sized Retirement & Healthcare Plan Management Conference, San Francisco, California; March 20, 2013.

This material is provided by The Lincoln National Life Insurance Company, Fort Wayne, IN, and, in New York, Lincoln Life & Annuity Company of New York, Syracuse, NY, and their applicable affiliates (collectively referred to as “Lincoln”). This material is intended for general use with the public. Lincoln does not provide investment advice, and this material is not intended to provide investment advice. Lincoln has financial interests that are served by the sale of Lincoln programs, products and services.