The CARES Act Loan Expansion: A Potential Powder Keg in a Pandemic

The COVID-19 pandemic has put people’s lives and livelihoods at risk, and Americans caught in the crosshairs need help. Congress moved quickly to pass the Coronavirus Aid, Relief and Economic Security (CARES) Act which increases health care capacity, helps workers and supports the economy. While only a small portion of the legislation concerns defined contribution (DC) plans, several provisions allow special relief for participants who certify they’ve been directly affected by COVID-19. These provisions break from norms that protect participants from jeopardizing their retirement security by tapping their accounts. That’s why the people who lead and serve institutional DC plans for millions of participants must consider the broader downstream impact before adopting the optional relief that Congress just granted.

We’ve spent our careers helping connect people’s financial realities with their retirement and personal savings goals, and, during normal times, we generally view loans as a more efficient way to access retirement funds. That’s because most of the time the loan is repaid, versus the withdrawal which is gone forever. With this crisis, we now have new rules which require different strategies.

At Alight, we’ve determined that both the COVID-19-related distribution and the ability to defer loan payments are critical benefits. We’ve also determined that the provision allowing larger loans is sub-optimal when compared to the more flexible distribution option and that increasing the loan maximum poses meaningful risk of worse financial outcomes for many participants.

Here’s why we’ve reached these conclusions:

• The new COVID-19-related distribution is available to both active and former employees, making it far more accessible to participants, and it is repayable within three years—just like a loan. Better yet, income tax is spread over three years. The reach is broader, the flexibility is greater.

• The default rates on the loan expansion are likely to be very high because of payments that most people cannot afford. For example, a five-year loan on $100,000 at typical rates results in payment of about $1,800 per month. This math just doesn’t work for most participants and could lead to a wave of defaults in 2021.

• Crucially, the defaulted loans will become a deemed distribution and incur full income taxation plus the 10% tax penalty in a single tax year, which will leave participants in a markedly worse position than if they’d taken a distribution of the same amount. What happens if or when they realize they could have taken the COVID-19-related distribution and avoided this fate?

Unless an organization feels its participants may need more than $150,000 (the $100,000 limit plus the $50,000 loan limit typically in place today) to mitigate the impact of COVID-19, the distribution offers the most value and avoids potential significant financial distress in the future.

During turbulent times, our instincts push us to offer help in every way possible—and immediately. This is a noble and empathetic response, but short-term urgency must be balanced with longer-term risk; we must also demonstrate prudence. In our view, the COVID-19-related distribution paired with deferral of loan payments is the optimal way to deliver relief to the people who need it most.

Alison Borland leads the wealth and well-being solutions for Alight Solutions, providing leadership and strategic direction to the breadth of DC, defined benefit, financial education and well-being solutions within Alight. Borland can be reached at alison.borland@alight.com.