Would you plug a leak if it cost $6 billion a year?
That’s the amount of “leakage” or lost retirement savings that results from retirement savers defaulting on their loans from 401(k) plans each year, according to a 2014 report, “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” by the Pension Research Council (PRC) at the Wharton School, University of Pennsylvania. One in 10 loans from 401(k) plans is defaulted, the PRC reports, typically by employees who have tight financial circumstances and lack liquidity options to address financial emergencies.
The leakage is a barrier to helping American workers—many whose retirement savings can be charitably described as anemic—to effectively preparing for retirement. Consider that 54 percent of Americans have less than $25,000 in retirement savings and 26 percent have less than $1,000, according to the 2016 Retirement Confidence Survey by the Employee Benefits Research Institute. Retirement plan sponsors need to do everything they can to encourage savings as well as overall financial wellness to help employees avoid having to borrow from their retirement savings.
Financial advisors and benefits professionals can help plug the proverbial “hole in the bucket” by recommending that employers offer voluntary benefits that complement retirement plans, providing alternative sources of emergency cash. These voluntary benefits are designed to help employees address financial emergencies such as a critical illness, disability, accident, big car repair bill or other misfortune without cracking open their retirement savings.
The problem of retirement plan loans and defaults is ubiquitous. The PRC reports that 90 percent of retirement plan participants have access to loans on their retirement savings accounts, and participants whose employers allow multiple loans at the same time are nearly twice as likely to take a loan from their 401(k). The PRC’s analysis of 401(k) and other retirement savings plan loan activity finds that those who can least afford to tap into their retirement savings are the most likely to do so:
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Loans from plans that allow multiple loans are often smaller, consistent with participants accessing cash to cushion financial shocks.
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Participants ages 35-45 have the highest propensity for taking loans. Those folks are at the age typically associated with raising families, buying homes and saving for education expenses.
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Low liquidity households are more likely to default on loans. Borrowers are more likely to have higher defined contribution account balances but lower total financial assets, higher debt and more credit constraints.
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Many loan defaults are made by employees who are younger or low earners with tight finances and meager savings. When a financial emergency strikes, they have few options other than digging into their retirement savings.
The problem is a reflection of Americans’ low savings rate overall. Bankrate.com’s 2016 Financial Security Index finds that 29 percent of Americans have no savings to address emergencies and 21 percent don't have enough savings to cover three months' expenses. It’s no wonder that one of the biggest sources of stress in the workplace is personal financial issues. Thirty-seven percent of workers say managing their personal finances is “somewhat difficult” or “very difficult” and 40 percent say personal financial problems are a distraction at work, according to the 2015 MassMutual Benefits Security Study.