Opinions May 17, 2017

A Forgotten Part of Participant Financial Wellness: Loan Defaults

Loan defaults are a preventable form of plan leakage, and stopping them can improve retirement plan participants’ financial wellness.
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With all the industry focus on financial wellness, it begs the question. Why do plans ignore an ongoing source of retirement plan leakage: defined contribution (DC) plan loan defaults? 

Access to plan loans is a widely-acknowledged necessity, since loans are known to encourage higher participation and contribution rates.  When retirement plan participants need emergency cash, they are required by regulation to take a loan before a hardship withdrawal to prevent immediate plan leakage. Yet if loans always default on termination, what does this accomplish?  Certainly not financial wellness. 

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Loan defaults hurt participants during an already stressful time 

Involuntary job loss caused by death, disability, or unemployment triggers defaults on unprotected loans, causing the same leakage as cash outs.  While unintentional, this negatively affects retirement outcomes, especially during layoffs. 

According to Challenger, Gray & Christmas, layoffs were at a seven-year high in 2016. Think about it: a participant’s account is diminished during an already stressful time when they’re out of work without income. Their retirement savings and future income are now at risk.

A bigger problem than plan sponsors realize  

The facts are sobering: According to a Wharton/Vanguard study, 86% of loans default upon job loss. These defaults often trigger full cash outs leading to even greater retirement leakage.  Unprotected DC plan loans leave a hole in the retirement safety net, causing an estimated $6 billion in annual leakage, and $30 billion when associated cash outs are included.  Is there a way to avoid this vicious cycle?  New industry developments suggest there is.

NEXT: Solutions for preventing loan defaults

Possibilities under consideration 

Recent legislation introduced in the Senate proposes giving workers additional time to repay their loans.  While measures such as this or other post-separation repayment options are a step in the right direction, they don’t address the realities or financial pressures involuntarily separated participants’ experience.  Unfortunately, these alternative repayment options don’t provide the necessary liquidity to improve retirement outcomes with certainty.

In most every plan, death, disability, and unemployment routinely create an immediate vesting of the (remaining) retirement benefit.  Why are loan defaults treated differently? 

Preserving assets is a fiduciary function  

According to a DOL advisory opinion, “Preserving assets in the event of a loan default” is a mostly overlooked fiduciary obligation and a requirement of offering loans in the first place. Using this logic, if we prevent the loan default, we preserve a participant’s entire retirement benefit.  This obligation suggests that fiduciaries consider DC plan loan insurance as a solution to provide certainty. 

Loan default prevention is the cure 

DC plan loan insurance protects against involuntary default by preventing a default, thus protecting and vesting the entire retirement account balance.  Group insurance can be included as a low cost, participant-paid automated feature within a loan program. Loan protection, along with just-in-time financial wellness communication, will encourage participants to maintain their retirement benefit rather than cashing it out.  

This solution preserves a participant’s retirement accumulation, allowing for decades of compounding asset growth before retirement distribution begins.  Loan insurance is an actionable solution that makes loan programs safer and helps participants improve their financial wellness.

Tod A. Ruble is the founder and CEO of Custodia Financial, creator of the Retirement Loan Eraser (RLE), a 401(k) financial wellness program. Tod and his team’s singular focus is to improve retirement outcomes by making loan programs safer.  

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Statements by the authors do not necessarily reflect the stance of Strategic Insight or its affiliates.
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Compliance May 17, 2017

Senate Democrats Push Back on State-Based Plans for Private Workers

A new bill introduced by Senate Democrats would reestablish an ERISA safe harbor for state- and city-run retirement plans for the private sector—and in a roundabout way the measure is likely to succeed.
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A gang of Senate Democrats have submitted a bill to the Committee on Health, Education, Labor, and Pensions, aiming to reverse recent moves by majority Republicans to roll back the regulatory safe harbors created by the Obama administration’s Department of Labor (DOL) to exempt from the Employee Retirement Income Security Act (ERISA) state- and city-run retirement plans created for private-sector workers.

The Democrats’ bill runs just seven pages and would directly amend Section 3 of the Employee Retirement Income Security Act of 1974, by adding at the end the following: ‘‘(C)(i) The terms ‘employee pension benefit plan’ and ‘pension plan’ do not include an individual retirement plan (as defined in section 7701(a)(37) of the Internal 12 Revenue Code of 1986) established and maintained pursuant to a payroll deduction savings program of a State or qualified political subdivision of a State.”

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The bill also lays out some stipulations states and cities would have to follow to ensure their safe harbor exemption from ERISA, for example that participation must be mandatory and that basic standards of communication and transparency are met. 

Conventional political wisdom clearly has its limits in the current environment, but common sense says the measure stands very little chance of passing the full Senate, or of eventually getting a signature from the anti-regulatory Trump administration. Interestingly, however, some experts have actually argued that the Democrats and Republicans in Congress are closer on this issue than they probably even realize.

The argument is that originally the states had put together this type of plan across the board using individual retirement accounts (IRA) so as not to be subject to ERISA, which made sense before the new fiduciary rule came into play during the Obama era. Readership will know that through the fiduciary rule, which is now in real jeopardy under Republican leadership, the DOL was pushing hard to have all IRA products subjected to ERISA, whatever the context in which they were delivered. Against this backdrop, the states reiterated their need to be exempt from ERISA, and the Obama-era DOL in turn issued an exemption for these state- and city-based programs to be free from ERISA standards. 

In sum, because the current administration is seeking to delay or outright kill the fiduciary rule, this in large part should remove the states’ original concern about their exposure to ERISA. In other words, the abolishment of the fiduciary rule would make all this a moot point, since the IRA plans would not be subject to ERISA anyway.

And so this is one of the many story lines in the retirement planning marketplace that will hinge on whether or not the Trump administration actually kills, rather than simply delays, the DOL fiduciary rule.

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