Should you insure a loan from your 401(k) plan? It sounds like a needless expense. After all, when you borrow from your 401(k) you are borrowing from yourself. Yet academics are beginning to conclude that an insurance policy against a 401(k) loan default may be the best way to protect retirement savers from themselves.
Policymakers have long been concerned with 401(k) plan leakage—money that leaves the plans and is never replaced. This happens through hardship withdrawals and when workers shift employers and cash out a portion of their account before rolling proceeds into an IRA or their new employer’s plan. Aon Hewitt found that a staggering 42% of job switchers cash out some part of their 401(k) savings.
Another troubling source of leakage is loans that never get repaid. Fidelity found in 2010 that a record 22% of 401(k) plans had a loan outstanding. That’s not as bad as it may sound because most loans get paid back. But the default rate on these loans has skyrocketed since the recession; today defaults result in annual 401(k) plan leakage of up to $37 billion, according to a new study from Robert Litan at Brookings and Hal Singer at Navigant Economics.
The vast majority of 401(k) loan defaults are involuntary, owing to job loss. The authors suggest that the default rate from job loss has doubled since the recession—to about 20%. When workers are terminated they generally have 60 days to pay back any 401(k) borrowing. If they fail to do so, they default and the loan is automatically deemed a distribution subject to income tax and early withdrawal penalties.
Given the retirement savings crisis in America, it’s in everyone’s interest that money leaking out of retirement savings plans be minimized. Policymakers have looked at a range of options, including limiting borrowers to one loan at a time and reducing the maximum loan from 50% of assets (but no more than $50,000) to 25% of assets. They have considered extending the payback period to 12 months, allowing a grace period while collecting unemployment insurance and permitting workers to bring their loan with them to a new employer’s plan.
Now comes a proposal that workers be asked to purchase insurance against involuntary default before they are allowed to borrow from their 401(k). The insurance would work a lot like private mortgage insurance, which some banks require of some borrowers before extending a home loan. This policy would guarantee that any outstanding loan against 401(k) savings would be repaid if the loan goes into default due to job loss through death, disability or termination. The authors write:
“Congress created the ability to save for tax-deferred retirement along with the ability to borrow against these savings. It is time to correct this regulatory distortion that prevents a vibrant insurance market in 401(k) loans, and to allow American workers the ability to access protection of their hard- earned retirement savings.”
It’s not clear how much the insurance would cost. But the authors say fees need not be imposed on the 70% to 80% of plan participants who never borrow, and that while the insurance should be automatically purchased with any loan it should also feature an opt-out for those who don’t want to pay for it.
The potential taxpayer costs associated with a vastly under-saved population are enormous. Protecting 401(k) savings from job loss makes a lot of sense.