Are plan loans the newest financial wellness tool?

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The Bipartisan Budget Act of 2018, which took effect this year, included provisions to make it easier for qualified retirement plan participants to take hardship withdrawals.

Perhaps the biggest change in the liberalization of hardship rules was the removal of the requirement that participants first exhaust all loan options in the plan, before qualifying for hardship. Other changes included the following:

  • Expand the sources of money eligible for the hardship withdrawal to include matching contributions, earnings on elective and matching contributions, and money from other sources, such as profit sharing and stock bonus plans.
  • Expand the circumstances for the hardship distribution (i.e., what qualifies as immediate and dire financial need)
  • Make it easier for participants to demonstrate need by allowing verbal representation
  • Simplify the requirements for a hardship determination, which was previously to demonstrate an “immediate and financial hardship” by now allowing the participant to make a written or electronic (including telephone recording) declaration of insufficient cash or liquid assets to meet a need financial

Fidelity first reported the first evidence of the impact of the rule changes in May this year. Hardship withdrawals rose in the first quarter for those plans that adopted the changes, showing a 40% increase in hardship from a year ago and a 7% drop in loans. Several big sponsors we’ve spoken to are also reporting an increase in difficulties after the rule changes.

More recently, a survey of plan sponsors from the PSCA It also reported an impact, albeit somewhat smaller, that about 18% of plan sponsors who implemented the change are seeing an increase in hardship withdrawals.

Other companies have recently reported broader leakage statistics, including TransAmerica’s 19th Annual Retirement Survey, which found that 29% of full-time workers had taken a loan, early retirement, or hardship retirement in 2019 .

While the magnitude of the increased hardship is unclear, and it will be important to continue to measure the impact, this rule change appears to have the desired effect: making it easier for participants to access their money in times of need.

However, what about the unintended consequences? Hardship distributions are almost always an immediate and permanent reduction in future retirement benefits, including not only the amount withdrawn, but also taxes, penalties, and earnings for the remaining years until retirement.

While the law allows for a restoration of the hardship amount to avoid the tax burden, it is hard to conceive of those who are financially stressed enough to accept the hardship putting that money back into their retirement asset pool.

Consider also that this increase in leakage has occurred during a period when our economy and employment have been particularly strong. Shouldn’t we also be concerned about the level of distress flight that is likely to occur in a less robust business cycle?

The old is new again: the loan as a tool for financial well-being

Enter the loan plan. The loan feature, while considered by many to be a necessary evil and an administrative burden, exists to provide participants with access to their money in times of financial need. According to numerous industry studies, it is a feature that encourages higher plan participation and savings rates by creating emergency liquidity in times of need.

Both participation and contributions would suffer in its absence, and it remains a popular feature, with more than 90% of 401(k) plans allowing loans. Additionally, as reported by the Pension Research Council, on average 20% of participants have outstanding loans at any given time, and over a five-year period, 40% of participants are seen to have taken a loan.

The big difference between loans and hardships is that the loan feature has a much better chance of preserving retirement security, especially if it is protected or insured against default. Loans are designed to be repaid, and for the most part, repayment is seamlessly facilitated through payroll deduction.

Approximately 90% of borrowers repay their loans, including the additional interest required by ERISA and the plan’s loan policy, preserving long-term retirement security. As such, one of the benefits of the loan is that it is a buffer against the permanent loss of retirement security that results from a hardship distribution.

Sponsors would do well to consider this preferable alternative, as the primary purpose of the retirement plan is to provide retirement benefits, and the liberalization of hardship rules along with a corresponding increase in hardship withdrawals appears to defeat that purpose. .

We have seen how plan design can undermine participant outcomes, just as we have seen how it can improve outcomes. The best example of this may be the significant expansion of QDIA auto-enrollment, with most of the assets flowing into second generation target date funds.

Optimization of the loan function

So what’s a sponsor to do? Congress made it clear that they want participants to be able to access their money in times of emergency financial need. And research like the recent to study by Greenwald & Associates and Custodia Financial titled “Missing Voices: What 401(k) Participants Can Add to the Loan Conversation” has shown that for many participants, workplace savings are the only set of assets they have.

In addition, research has shown that retirement planning is viewed not only as a long-term retirement savings vehicle, but also as a source of short-term emergency funding.

This should have some implication for plan design, namely, how do we give participants emergency access to their money while not undermining the long-term goal of an adequately funded retirement? Difficulties should still be considered a last resort option. Sponsors are not required to adopt hardship changes, but must consider what options participants have for emergency needs, which brings us back to the plan’s loan as a flexible wellness tool.

The plan’s loans were designed to address concerns that Congress had when it enacted the Bipartisan Budget Act of 2018 and eased hardship requirements. Sponsors must certainly continue to give entrants access to their money; however, loan programs must be redesigned to maximize the chances of achieving the primary goal of the plan: retirement security.

The focus on loan leakage in recent years has confirmed the problem of unprotected loans at the time of job separation, when 86% of borrowers default on both voluntary and involuntary termination. Better protections are required to prevent these losses and the projected $2.5T drain from retirement security for the next 10 years.

To optimize the lending feature, there are a few things sponsors can do. First, they must educate participants about the importance of long-term savings, which means paying back the loan.

However, the Greenwald & Associates research mentioned above tells us that the timing of that education is critical. When participants are starting a loan, they are under financial stress and are not particularly receptive to education. Once their crisis has been averted, for example immediately after a loan has been approved, they are much more likely to pay attention, so continued messages that reinforce the importance of paying off the loan and the options available after job separation are valuable.

Next, to help those who voluntarily terminate, they should explore more effective solutions for transferring balances and loans to the new employer, as well as implementing post-termination payments via ACH, along with better communication and facilitation of these features.

And finally, for those who involuntarily cancel their contract and who are at greater financial risk, plan sponsors should adopt loan insurance as automated protection, an immediate and measurable way to address the problem.

The participants need the help. As Greenwald discovered in his research, participants are financially stressed, particularly about the possibility of losing their job when they take out a loan and ask for a “safety net.” Eighty-one percent found participant-paid loan insurance attractive, and 67 percent said they would consider increasing their contributions if this protection were put in place.

There is no silver bullet, but together these elements will go a long way toward reducing employee stress, stopping leakage, and keeping retirement secure.

The biggest defined contribution gains in the last 20 years have come from automation: auto-enrollment, auto-escalation, and auto-diversification. Solving the loan drain to help improve retirement security should be no different.

Rennie Worsfold is Executive Vice President of Financial Custody, responsible for the distribution of Retirement Loan Eraser. Rennie is part of the leadership team at Custodia Financial, a unique consortium of retirement industry experts embracing a clear purpose: safeguarding Americans’ retirement savings by eliminating 401(k) loan defaults. . Rennie recently completed a three-year term as a member of the US Department of Labor’s ERISA Advisory Council.

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