Administration January 22, 2019

Updating Loan Policies to Discourage Participants from Taking Plan Loans

Changes to maximum loan amounts and number of loans, as well as the imposition of fees and higher interest rates on loans can be written into loan policy statements in an effort to discourage this type of plan leakage.
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Art by Hye Jin Chung
Art by Hye Jin Chung
Art by Hye Jin Chung

While the retirement plan industry is primarily focused on helping participants invest more money, it is equally important to discourage them from taking out loans or hardship withdrawals, says Snezana Zlatar, senior vice president and head of full service product and business management at Prudential Retirement in Woodbridge, New Jersey.

“Dipping into retirement savings early, suspending contributions to defined contribution (DC) plans, or both, can reduce workers’ retirement savings on average by 14%, delaying retirements and costing employers more for salaries and benefits as their workforce ages, according to MassMutual’s analysis,” says Tom Foster, national spokesperson for the firm’s workplace solutions unit in Enfield, Connecticut. And the younger the participant, the greater the impact because of their savings time horizon.

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For example, a 29-year-old who takes out a hardship withdrawal reduces his retirement readiness by an average of 20%, whereas a 60-year-old who takes out the same amount reduces his retirement readiness by only 3%, Foster notes.

Of course, retirement plan sponsors always have the option of barring loans, but that could have the unintended consequence of lowering participation in the plan because employees want to be able to access their money, Foster says. This is undoubtedly why the 2018 PLANSPONSOR Defined Contribution Survey: Plan Benchmarking report found that 79.3% of all plans make loans available.

Unfortunately, “when employees know they have quick and easy access to their 401(k) plans, often, they begin to view their retirement plan as a revolving credit line,” says Amy Ouellette, director of retirement services at Betterment for Business in New York. “That said, every six months an issue could crop up, leading participants to layer one loan on top of another.”

On top of that, with the average job tenure in the U.S. being just over four years and the period to repay a loan being five years, if a participant with a loan should leave their employer before the loan is due, the entire balance is due within 60 days, she adds. If it is not repaid and the participant is under the age of 59-1/2, it is treated as a distribution, she continues. That means the taxes that were withheld on the contributions will be due in addition to a 10% penalty, Ouellette says.

Changing loan policy statements to discourage loans

Thus, there are changes to loan policy statements (LPS) that retirement plan sponsors should consider when making loans available, experts say. While the Department of Labor (DOL) permits loans up to $50,000 or half of the participant’s balance, whichever is lower, sponsors might consider altering their LPS to limit that to $20,000 or $30,000, Foster says.

Sponsors might also want to create a screening process that includes requiring participants to read materials about the adverse consequences of taking out a loan, have them sign that document and make this part of the LPS, he adds. “That might be a way to get participants to rethink taking out a loan.”

The LPS should also permit only one loan at a time and create windows of time between each loan that act as barriers, says Andy Heiges, group manager for advice, retirement income and financial wellness at T. Rowe Price Retirement Plan Services in Baltimore, Maryland. Many retirement plans do not permit participants to contribute to their 401(k) when they are repaying back a loan, which Heiges thinks they should permit.

Sponsors should also consider amending their LPS to permit participants to continue repaying back the loan after being separated from the company, says Chad Parks, founder and chief executive officer of Ubiquity Retirement +  Savings. However, “the plan sponsor and the recordkeeper have to agree on this policy, and the sponsor may not want to be burdened with ensuring that the participant continues to send in their payments proactively, since the money will no longer with automatically withdrawn from their paychecks,” he points out.

Imposing a loan origination and maintenance fee on the loan could also serve as a deterrent, Zlatar says. Related to this is increasing the interest amount that a participant pays, says Marina Edwards, senior director, retirement, at Willis Towers Watson in Chicago. The most common interest rate that sponsors impose on retirement plan loans is one percentage point above the prime rate, Edwards notes. Sponsors may want to amend their plan documents to change that to two percentage points, she says.

“The interest rate must be reasonable, and the IRS has informally stated at conferences that prime plus 2% would be reasonable,” she says. Not only might this act as a deterrent, but because the interest rate goes back to the participant’s account, plan sponsors like this because it ensures that the participant is putting more money into their retirement account, Edwards adds.

Using financial wellness to discourage loan use

Beyond changes to the loan policy statement, it is also very important to provide financial education to employees, particularly about budgeting, says Josh Sailar, investment adviser with Miracle Mile Advisors in Los Angeles.

“Offering a financial wellness program that goes beyond the 401(k) plan on budgeting is important,” Ouellette agrees. That is why Betterment has advice built into its platform, she says.

In line with this, it is important to encourage participants to create an emergency savings fund, Sailar says. Zlatar agrees that this is a vital step sponsors should take to possibly preclude participants from taking out loans, noting that Prudential research found that 63% of Americans could not afford even just a $500 emergency, and 31% would consider retirement plan loans or withdrawals to cover those expenses.

This is why last July, Prudential created a post-tax emergency savings fund feature within its retirement plan platform. In line with this, Sailar says it is important for sponsors to offer other savings vehicles, such as 529 college savings plans and health savings accounts (HSAs).

Finally, sponsors need to be aware that the IRS and DOL often find in their retirement plan audits that sponsors make mistakes with regards to monitoring loans, according to Edwards. For instance, if a participant goes on leave and is still required to make payments to their loan, often the sponsor fails to follow up on that, she says.

“We encourage plan sponsors to work with their recordkeepers to do an independent compliance review of their plan loans,” Edwards says. “They need to check the loan status of their plan to check for such things as whether or not some loans are past five years. That would be a problem.”
Compliance January 18, 2019

Nondiscrimination Testing Part I: Required Testing and Due Dates

Sponsors of all retirement plan types need to know what nondiscrimination testing is required for their plan and what information needs to be gathered to correctly perform these tests.
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Art by Brian Stauffer

Nondiscrimination tests for defined contribution (DC) and defined benefit (DB) plans are based on plan years, so for those plans with a calendar year plan year end, the time to think about nondiscrimination testing is now.

Testing required by plan type

For 401(k) plans, required nondiscrimination testing includes Section 410(b) coverage testing, the average deferral percentage (ADP) test on employee deferrals, the average contribution percentage (ACP) test on employer matching contributions and certain after-tax employee deferrals, and top heavy testing.

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David Levine, ERISA attorney and principal with Groom Law Group, Chartered, in Washington, D.C., adds that in certain cases—for example, when plans may offer different matching contribution formulas for different employee locations—a benefits rights and features test may need to be performed.

For 403(b) plans, coverage testing and ADP testing is taken care of by the universal availability requirement, which provides that if an employer permits one employee to defer salary into a 403(b) plan, the employer must extend this offer to all employees of the organization. Exceptions include:

  • Employees who are eligible to defer to a governmental 457(b) plan;
  • Employees eligible to defer to a 401(k) or another 403(b) plan of the employer;
  • Employees who are nonresident aliens with no U.S.-earned income;
  • Employees who are students performing services described in Section 3121(b)(10); and
  • Employees who normally work fewer than 20 hours per week.

ACP testing is required for 403(b) plans, but according to Levine, no top heavy testing is required.

For profit sharing plans without a 401(k) deferral option, coverage testing, minimum participation testing and top heavy testing are required. In addition, Employee Retirement Income Security Act (ERISA) Section 401(a)(4) testing is required. Amy Ouellette, director of retirement services at Betterment for Business in New York City, says this is called general nondiscrimination testing.

Levine says the same testing is required for money purchase pension plans as for profit sharing plans.

For defined benefit (DB) plans, including cash balance plans, general nondiscrimination, top heavy and minimum participation testing is required. Levine and Mark Carolan, senior associate with Groom Law Group, agree that testing for employee stock ownership plans (ESOPs) requires its own discussion.

For governmental plans, Levine says no testing is required; the Economic Growth and Tax Reconciliation Relief Act of 2001 (EGTRRA) and the Pension Protection Act of 2006 (PPA) formally carved them out.

Due dates

Most testing does not have specified due dates. According to Ouellette, the timing of testing is typically dictated by requirements for corrections. For example, excess distributions to correct ADP and ACP testing failures are due 2 1/2 months after plan year end, so that testing is usually done in time to make those distributions. Ouellette explains that plan sponsors have up to 12 months to make corrections—which can instead be made by a qualified nonelective contribution (QNEC) to all non-highly compensated employees (NHCE). But if the employer is making corrections by a distribution of excess amounts, those corrections need to be made by 2 1/2 months following plan year end to avoid excise taxes on those distributions.

For coverage, top heavy and general nondiscrimination testing, when a QNEC contribution is required to be made by the plan sponsor, testing should be done in time to make those contributions by the deadline offered for plan sponsors to get a tax deduction for those contributions. See the 2019 ERISA Plan Compliance Calendar.

Preparing for nondiscrimination testing

Ouellette says Betterment asks for two sets of information to be provided by plan sponsors, in the forms of a census and questionnaire. The questionnaire is critical she says, as it can affect who is considered a highly compensated employee (HCE) or a key employee. The questionnaire asks about changes in ownership, acquisition of new entities and new partners. For example, a 5% owner may have married someone in the company or hired his son.

According to Carolan, census data includes hire dates, termination dates, deferral elections, contributions made during the year, and proper employment status. These could be active, eligible but not participating, leave of absence, etc. He says some recordkeepers and third-party administrators (TPAs) will help generate this data from the payroll interface, but plan sponsors need to make sure the data is correct; they cannot blame the recordkeeper if it is not.

Ouellette says Betterment tries to make it as easy for clients as possible. “We download what was given to us throughout year and send it to the plan sponsor to make sure it is correct.” She points out that employees who are eligible, but not participating, are included in ADP and ACP testing.

It is also important to properly determine who is an HCE for ADP and ACP testing and who is a key employee for top heavy testing. The Internal Revenue Service (IRS) defines “highly compensated employee” as an individual who:

  • Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
  • For the preceding year, received compensation from the business of more than the limit announced by the IRS (See Maximum Benefit and Contribution Limits Table 2019), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

A key employee is an employee (including a former or deceased employee) who at any time during the plan year was an officer making more than the amount announced by the IRS (also in the Maximum Benefit and Contribution Limits Table) for the plan year being tested; was an owner of more than 5% of the business; or was an owner of more than 1% of the business and making more than $150,000 for the plan year.

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