Participants are often told that taking a 401(k) loan or a hardship withdrawal should be their last resort when looking for short-term funds, as taking money from a retirement account could hamper long-term savings and set them back for retirement.

But with more penalty-free emergency withdrawal provisions available to participants—thanks to the SECURE 2.0 Act of 2022—the 401(k) plan is providing more flexibility and liquidity than ever before. While some view this as a negative, a recent research paper using Vanguard recordkeeping data found that participant contribution behavior is “remarkably stable” during and after loan origination and hardship withdrawals.

“I think the promise of [the SECURE 2.0 provision] was that it would cause more people to participate in 401(k) plans or to save more and increase rates in 401(k) plans if they knew that the money was accessible to them in a hardship or a pinch,” says Fiona Greig, global head of investor research and policy at Vanguard, one of the authors of the paper. “The downside though, of these expanded liquidity options, is that they could lead to leakage. They could cause more people to take withdrawals and ultimately result in lower balances.”

Treating Withdrawals as Loans

As a result, authors of the paper suggested that plan sponsors could implement an “automatic repayment” feature into their plans that encourages or defaults participants into repaying their withdrawal through payroll deferrals that are incremental to their regular elective contributions—essentially treating the withdrawal as if it were a loan.

According to the paper, “Does 401(k) loan repayment crowd out retirement saving?” participants who took loans or hardship withdrawals in 2021 rarely elected to reduce their contribution rate after the distribution. In addition, the vast majority of 401(k) loan takers who remain employed long enough to repay their loans through payroll deferrals do so successfully, the researchers found.

Vanguard data revealed that 26% of loan takers and 24% of hardship withdrawal takers in 2021 voluntarily decreased their contribution rates at some point in the two years following issuance. The share of participants who voluntarily increased their contributions at some point during the two-year issuance period is essentially the same, with 26% of loan takers and 24% of hardship withdrawal takers doing so.

In addition, the researchers found that most participants could handle paying back a $1,000 withdrawal within a two-year period through a two-percentage-point increase in their contributions. Under SECURE 2.0, participants could take emergency withdrawals of up to $1,000 per year without a penalty.

Greig argues this shows that a design feature that triggers participants to increase their contribution rate by a percentage point or two could cause them to repay their emergency withdrawals quicker.

She adds that if a participant is contributing 8% of pre-tax pay per month, for example, while paying back their loan, they would typically revert back to their prior contribution rate once they are done paying off the loan. She suggests that plan sponsors could change their design to invite people to stay at the 8% rate after they finish paying off their loan, thereby contributing more after the repayment period.

“Loan terms can vary based on the sponsor and the size of the loan,” Greig says. “With a larger loan, you might be paying it back over the course of five years, so this automatic increase [could] happen further out, depending on how long the term of the loan is.”

Looking Beyond 401(k) Data

However, Greig notes that participants all have unique circumstances, and the paper is limited to 401(k) data and does not track broader financial data.

“We can’t rule out that although [participants] seem to continue to be able to save while repaying [their loans], we don’t know that they aren’t elsewhere increasing their credit card debt or falling behind on other loan payments,” Greig says.

Rebecca Liebman, co-founder and CEO at financial wellness platform LearnLux, says looking at 401(k) data only reveals a portion of a participant’s financial well-being.

“There’s a lot of other data that we see in credit card debt, medical debt, student debt, emergency savings data, credit score data … that is impacting these decisions,” Liebman says. “When you’re only looking at 401(k) data, you are getting a skewed picture of financial health in your organization, because if you look at the macro trends, people are living in debt. People are pulling that money from somewhere.”

Liebman adds that some of the companies with which LearnLux works have added programs in which, if a participant initiates a 401(k) loan, it requires them to meet with a LearnLux planner or go through a LearnLux lesson to better understand if they are making the best financial decision before confirming the loan.

She emphasizes that it is important for participants to ensure they have emergency savings, as well as a debt-payoff plan, so they know where they can find liquidity, in order to avoid taking loans from their retirement plan.

Power of Auto Features

Kelli Send, a senior vice president at Francis LLC, says she does not necessarily believe that people are in better financial condition just because they are able to pay back their loans. Because of electronic pay stubs, Send argues that many people are not checking their pay stub every two weeks and are therefore not realizing that an extra $80 came out of their paycheck because of their 401(k) loan, for example.

“We’ve made auto features so amazing in 401(k) plans, and it’s generally been a very good outcome,” Send says. “But it has lessened the attention required to manage your 401(k), which may perhaps lead to this positive behavior that Vanguard is seeing.”

Send adds that another issue with 401(k) loans is that because the workforce is very mobile, if a participant leaves a company without fully repaying their loan, it becomes a premature plan withdrawal, which then is subject to taxes and penalties.

“This whole [mindset of] ‘I’m not paying attention because I don’t have to and I have these auto features’ also makes people inattentive when they leave an employer and they still owe $8,000, and their 1099 at the end of the year [says] you need to show the $8,000 as income,” Send says.

Send says she is not against 401(k) loans, but she advises plan sponsors to not allow participants to take unlimited loans, because it could result in employees having several outstanding loans at one time.

Overall, Greig argues that plan design and choice architecture is “really powerful” and that people often blindly follow the defaults.

“That’s why we’re pointing at [shaping] the choice architecture to promote faster repayment or continued savings after loan repayment,” Greig says.