Defaults on 401(k) Loans On The Rise: But This Is A Non-Issue for Clients of Advisors Hot

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Americans are increasingly borrowing from their 401(k) plans and increasingly defaulting on those loans, according to just published research.

A report on 401(k) loan defaults says money being drawn out of retirement plans prior to retirement, what industry folks refer to as “leakage,” is a lot larger than a number of industry and government reports have indicated.

In fact, leakage of funds in 401(k) plans due to involuntary loan defaults may be as high as $37 billion per year nationwide, depending on the source of the data on loans outstanding and the assumed 401(k) loan default rate, according to the report from Navigant Economics, 401(k) Loan Defaults: How Big Is the Leakage and What Can Policymakers Do to Preserve Americans’ Nest Eggs?

Another recent report shows that the percentage of plan participants in the U.S. with a 401(k) loan increased from 15% in 2006 to 18.5% in 2011, according to the Investment Company Institute, the lobbying group for the mutual fund industry.

This trend is problematic for many reasons according to the authors of the report, Robert Litan, a senior fellow in the Economic Studies program at the Brookings Institution and Hal Singer, a managing director with Navigant Economics.

For instance, if a participant loses his/her job, becomes disabled or dies with a 401(k) loan outstanding, then the loan generally goes into default and his/her retirement account is debited the loan amount plus applicable taxes and penalties, Litan and Singer write in the report.

"Of course, participants are not deliberately defaulting; they only do so when they have no other option," Litan says in a release. "According to a study conducted by the Financial Literacy Center, almost 10% of all 401(k) participants with loans from 2005-08 defaulted on their loans for reasons relating to job separation."

When a participant loses his/her job with a 401(k) loan outstanding, the loan is due in full in 60 days and failure to meet that accelerated time table results in substantial losses from the retirement account. From a policy perspective, some have recommended that limiting the number or size of loans or permitting the loan to be ported to a new plan provides a solution, the report states.

While such prescriptions may reduce the likelihood of default, Litan and Singer conclude that none of these options provide liquidity and deal with the welfare of the borrower who actually defaults. “Changing the law to allow automatic enrollment into loan protection provides an option that could stem the leakage currently impacting retirement savings by providing guaranteed coverage at an affordable rate. This would be analogous to the standard protocol that requires mortgagors who make smaller down payments to enroll in private mortgage insurance,” the authors say.

Advisors, meanwhile, report that very few of their clients are taking out 401(k) loans are even fewer are defaulting on their 401(k) loans.

For instance, Gregory Carroll, a managing partner at Sterling Wealth Management Group in Carlsbad, CA, with $100 million in assets under management, says he doesn’t advise too many 401(k) participants on this option. But for the participants that do ask him for advice, “we usually tell them that this should be the last option for them, this money is for retirement first.”

Says: Carroll: “The only time they should consider taking a loan from their 401k, is when the cost of all other options is ridiculously high or unavailable.”

Michael Baras, CFP, a member of the Financial Planning Association of Long Island dissuades his clients from tapping into 401(k) money by “educating them that this is not the ‘client’s’ money but their future (older client's) money.”

Says Baras: “It is not a piggybank and there are serious penalties involved when funds are not paid back in a timely basis.”

Like Carroll, Baras says the money in a 401(k) is a last resort.  “These funds aren't to be used for lifestyle expenses like an extra vacation, a boat or a new vehicle,” he says. 

To highlight the point, he asks his clients how they intend to repay the money within the time frame and then he shows them how much the actual cost of an early withdrawal will be with taxes, penalties and the setback it will make to their retirement plans when not replaced.  “It is best to help them realize why they engage an independent advisor who looks out for their real needs and try to readdress the issue why they need the funds and what alternative actions or sources that can be used to accomplish their goals without derailing their existing plan,” says Baras.Meanwhile, Gil Armour, CFP of SagePoint Financial, Inc. says 401(k) loans can be tempting but he usually tells clients to use caution before taking one.  “It does entail a dedicated payback of the loan via payroll deductions,” he says.  Plus, as we noted above, if the participant leaves the company, the remaining balance of the loan is due as a “balloon payment”, typically within 60 days.  The unpaid amount is subject to ordinary taxes plus penalties.

“The other drawback of the 401(k) loan is that the money isn’t earning anything until it gets replaced,” says Armour.  “If loan privileges are abused over the years by taking many of them, it can dramatically reduce the ultimate size of the retirement nest egg.”

And still others And, in the rare cases where they are taking out 401(k) loans and/or defaulting on those loans, advisors had this to say: “The moral is - - think twice before you take a 401(k) loan, and only do it if you can commit to paying it back," Armour says.

For more background on the 401(k) leakage issue, read Nevin Adams op-ed in EBRIef.

Read also "Retirement savings get raided by 35% of laid-off workers."

And lastly read "Americans borrow heavily from 401(k)s but loan defaults are up."

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