Understanding Why Employees Access 401(k) Loans
The International Foundation of Employee Benefit Plans (IFEBP) reports that most plan sponsors consider loan provisions essential to their 401(k) retirement plans.
Knowing a loan is available can increase plan participation and saving rates from participants who might otherwise hang onto their money instead of putting it into a retirement account.
The number of 401(k) plans permitting loans has increased over the past decade. According to T. Rowe Price, more than 90% of plans allow participants to take out loans.
Though access to loans has increased, the percentage of participants seeking loans has declined over the long term. The IFEBP notes that in recent years, loan frequency has fluctuated more. This is likely due to inflation and the increased cost of living.
Seeing the importance of 401(k) loans is one piece of the puzzle. Understanding why employees take out loans can further inform your plan strategies.
Why plan participants seek loans
A report from the insurance company Principal says participants typically borrow from a 401(k) plan to access low-risk funds for short-term financial needs.
According to the report, the following are the top reasons participants take out 401(k) loans:
- Debt
- Essential expenses (food, utilities, transportation, insurance, etc.)
- Medical expenses
- Mortgage/rent
- Remodeling or fixing a house
- Other expenses
Paying down debt is the leading cause of 401(k) loans across all generations. Baby boomers are more likely to take a loan to remodel or fix a house. Younger generations are more likely to use the money for essential expenses, medical expenses, and mortgage and rent payments.
Financial and retirement security remain top of mind
Those borrowing from 401(k) plans don’t do so lightly. Most participants take loans to cover necessities, not vacations, luxuries or nonessential items.
According to Principal, just 8% of participants took a plan loan without considering the pros and cons.
Plan participants most often cite the following advantages of 401(k) loans:
- Lower interest rates than credit cards, payday loans and other personal loans
- Rapid access to funds
- Interest gets paid back to their retirement account
- Ability to borrow more money than from other types of loans
- Favorable terms and conditions
Disadvantages include:
- Risking retirement security
- Potentially losing out on market growth
- Making after-tax loan payments
- Incurring taxes and penalties for loan default
The report found that participants who take loans still prioritize retirement security. More than 80% kept the same deferral rate while paying down their loan, and 8% actually increased their rate. Only 7% decreased their deferrals, and just 4% stopped deferring money toward retirement.
Strategies to support plan participants
The financial services firm Fidelity recommends providing financial education. Information on budgeting, saving and investing may save plan participants from needing a loan.
Not all employees facing financial challenges need to borrow from a 401(k). Educating employees on other options can reduce the need for plan loans. Examples include:
- Personal accounts (checking, saving, brokerage, etc.)
- Emergency savings accounts
- Credit card transfers to lower interest rates
- Personal loans
- Home equity lines of credit
- Tax-free and penalty-free withdrawals from a Roth IRA
As a plan sponsor, you can establish allowable reasons for plan participant loans. Using the data above, you may want to limit loans to the top challenges, such as debt, medical costs and essential expenses.
Surveying your employees can help you understand their financial challenges. That knowledge allows you to tailor plan provisions to organizational and workforce needs.
Principal suggests designing a plan that limits participants to one loan at a time. This strategy decreases the risk of them defaulting on a loan and owing taxes and penalties. It also reduces your organization’s administrative burden of keeping track of additional loans, amounts and terms.
Another consideration is limiting how often participants can take a loan. The management consultancy DWC notes that plans can bar participants from taking another loan for a set time after they repay a previous loan. The length of time is up to you. However, it must be written into your plan provisions and applied equally to all participants.
Principal says setting an interest rate that helps offset potential market losses from reduced account balances can boost retirement security for plan participants with loans. According to DWC, the Department of Labor requires plans to charge a reasonable interest rate. A reasonable interest rate means around the same rate that a typical lender would charge a borrower in similar circumstances. Many plans add 1% or 2% to the prime interest rate, a benchmark many banks use. Adding percentage points to the prime rate can meet regulatory requirements and help plan participants keep their retirement goals on track.
Learn more
For more information on 401(k) loans, talk to your insurance broker or benefits adviser. They can help you examine your plan design and explore solutions to meet plan goals and participants’ financial needs.