Loan leakage

America’s $2 trillion retirement loan default dilemma

Deloitte’s analysis finds that more than $2 trillion in potential future account balances will be lost due to loan defaults from 401(k) accounts over the next 10 years, potentially threatening the retirement security of millions of Americans and undermining years of efforts by plan sponsors and providers to keep money in the retirement system. This figure includes the cumulative effect of loan defaults upon retirement, including taxes, early-withdrawal penalties, lost earnings, and any early cashout of defaulting participants’ full plan balances. For a typical defaulting borrower, this represents approximately $300k in lost retirement security over a career. With the growth of defined contribution (DC) plans as the primary savings vehicle for most Americans, the industry has focused its efforts on strategies to support participant retirement readiness. An overlooked issue is the significant drain on participants’ accounts caused by loan defaults. Leakage from 401(k) loan defaults not only derails retirement readiness for financially stressed employees, but it may also introduce risk to plan fiduciaries.

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A growing fiduciary risk for plan sponsors

As fiduciaries of the retirement plan assets that are critical to employees’ financial wellness, plan sponsors cannot ignore the growing risk and potential liability represented by loan default leakage. While offering plan loans is a voluntary and not a fiduciary function, many aspects of loan administration fall under the fiduciary standard, which may carry risk for plan sponsors. The Department of Labor states that loan programs should not diminish a borrower’s retirement income or cause loss to the plan, and views loans as investments, requiring the same fiduciary oversight as any other plan investment option.

Yet in practice, loans are viewed as an administrative burden passed on to the recordkeeper with minimal oversight. In the event of an economic downturn, borrowing tends to increase, and the magnitude of these losses grows, leaving fiduciary responsibility potentially exposed. A majority (90 percent) of 401(k) plans offer a loan feature and nearly 40 percent of participants have taken advantage of a loan offering to finance current consumption. Although many participants repay their loans as intended, 10 percent of loans default each year. While on the surface it may seem like a small number, the compounding effects from loan defaults add up to a much larger number in lost savings. Leakage from 401(k) loan defaults not only impairs employee financial wellness but may also place fiduciaries at risk.

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Exploring mechanisms to prevent loan leakage

Plan sponsors, providers, and policymakers have taken steps to reduce loan leakage by limiting loan options (e.g. allowable amount, for a particular purpose, number allotted), but more awareness is necessary to mitigate inherent risks tied to participant financial wellness. One of the main reasons for loan leakage is due in part to participants who are under financial stress, who typically withdraw financial assets in a time of need and are unable to repay them—resulting in default. Eliminating loans altogether is likely not the answer, as loan programs tend to increase plan participation and contribution levels. However, finding the right balance of product innovation, technology, plan design, and education considerations could help plug the leak.

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