Does Plan Design Influence Participant Loan Behavior?
Concerns about retirement plan “leakage” continue to emerge. But could plan design play a role in encouraging — or discouraging — current trends?
The short answer is yes, according to research
based on an administrative dataset for DC plan participants covering the five-year period from July 2004 to June 2009 from 882 plans, and over 900,000 participants observed monthly.
The research, from the National Bureau of Economic Research (NBER), indicates that employer loan policy does, in fact, have a sizeable effect on 401(k) borrowing. For example, when a plan sponsor permits multiple loans rather than only one loan, each individual loan tends to be smaller, though the probability of plan borrowing nearly doubles and the aggregate amount borrowed rises by 16%. The researchers note that this suggests that employees perceive that easier loans are actually an encouragement to borrow (i.e., an “endorsement effect”).
Previous research suggests that roughly one in five DC plan participants have an outstanding loan at any point in time, and nearly 40% borrow from those accounts over a five-year period. Other research has suggested that the availability of plan loans encourages higher retirement plan contributions by making tax-deferred retirement accounts more liquid, and a new study estimates that fully 90% of loans are repaid on a timely basis, though that may mean that the remaining 10% turn out to be “leakage” from the retirement system.
Job Change and Leakage
The researchers also noted that multiple loans at the time of job change is associated with more defaults, and that while the size of the effect is small, “this effect is statistically significant after controlling for aggregate loan balances, implying unobserved heterogeneity of credit demand and self-control among these groups of borrowers.” In other words: “Borrowers are going to borrow.”
The researchers found that the vast majority — 86% — of employees who leave their jobs with a plan loan outstanding do default, exposing them to both penalty and income tax obligations. Moreover, workers at firms allowing multiple loans have default rates that are higher by 1.7%. On the other hand, participants having only a single loan when multiple loans are allowed are 2.2% less likely to default, compared with workers in plans allowing a single loan, suggesting some underlying heterogeneity in credit demand.
They also found that the economic turmoil of 2008-09 did not dramatically change borrowing and default patterns with these loans. In fact, participants were less likely to borrow during the downturn, and default rates remained stable.
The research also indicates that plan loan interest rates are generally low and have no significant impact on borrowing behavior.
The research also estimated that leakage as a result of loan defaults was around $6 billion a year, which they described as an order of magnitude lower than retirement plan leakage due to account cash-outs upon job change, which a 2009 Government Accountability Office (GAO) report estimated at $74 billion in 2006. Assuming an effective tax rate of 10% and factoring in the 10% penalty associated with early distributions, the researchers estimated the tax revenue flowing to the federal government associated with defaulted DC plan loans to be more than $1 billion per year.
The researchers acknowledged that “liquidity-constrained” participants are more likely to default, but noted that the size of these effects is small relative to the high default rate broadly — a finding they said implies that other factors may be at work, such as low financial literacy, impatience or inattention. “Many borrowers may simply be surprised by an unanticipated job change and its effect on an outstanding 401(k) loan,” they said.
In conclusion, the researchers noted that while some have argued that 401(k) loans should be restricted, “based on our results, those concerns seem overstated, particularly when compared to leakage from account cash-outs upon job change.” They did note that limiting the number of loans to a single one would be likely to reduce the incidence of borrowing and the fraction of total wealth borrowed, thereby reducing the impact of future defaults. They also suggested that limiting the size and scope of loans, such as restricting them to a quarter of account balances, could help limit their impact on retirement security.