For the past three decades, 401(k) tax-deferred savings accounts have assumed an increasingly significant role in retirement planning for an estimated 100 million American workers and their families. These “defined contribution” plans provide a convenient, efficient means for workers to save. Changes in the law and regulations — such as the ability to take loans from an account — have increased participation rates and contribution levels, making 401(k)s an even more flexible and effective financial tool. This added flexibility has been utilized by many Americans, but there is an unrecognized peril in exercising the loan option that some might not fully appreciate.
401(k) savings accounts have become so important in the landscape of retirement planning that their security and expansion became a top priority in formulating and implementing the Pension Protection Act of 2006 that was enacted during my tenure as the U.S. secretary of Labor. These initiatives included creating a more favorable environment for automatic enrollment in 401(k)s, so that many more workers would benefit from these savings mechanisms and corresponding employer matching contributions unless they decided to opt out.
The regulation succeeded in boosting the number of workers saving through 401(k)s. These savings were providential for some who were unexpectedly thrust into a difficult economic situation by the recession or other events, as many plans require that participants take a loan as opposed to a lump sum early withdrawal. In the reality of today’s tough economic environment, many consumers are reluctantly turning to their 401(k) plans during times of stress to prevent foreclosures, pay for college tuition or cover unexpected medical expenses. While conventional wisdom has traditionally sided against borrowing from retirement savings, sentiment has shifted toward borrowing from one’s own assets with the realization that other forms of credit come at a much higher cost and often are not even available to borrowers with limited means and urgent needs.
A recent report by Fidelity Investments, the leading provider of workplace retirement savings plans, found 22 percent of 401(k) participants have outstanding loans from their accounts. Other industry data indicate an average loan size of nearly $12,000 per household. In 2010, it was estimated there were more than 20 million outstanding loans, which represent about 23 percent of all eligible plans. In addition, the average size of defined contribution plan loans is expected to increase 64 percent compared with data polled in 2006. It is projected that 30 million loans, totaling nearly $350 billion, will be outstanding by 2014 — placing an even greater amount of America’s retirement savings at risk.
Many of these millions of borrowers are unaware that in the event of death or disability, the loan is considered to be in default if not repaid within 60 days. This might seem a negligible risk, but the Social Security Administration reports three in 10 workers will eventually suffer such a setback.
Upon default, the loan proceeds are treated as an “early withdrawal,” subject to federal and state taxes. Borrowers or their beneficiaries might then be left with no alternative other than using their remaining account balance to cover the tax liability, thus significantly reducing retirement account funds.
American families are losing a shocking $5 billion to $7 billion in retirement savings annually due to such defaults.
To equip 401(k) participants with a means of guarding against such defaults, a proposal is being advanced to allow auto-enrollment into loan life and disability insurance or a similar safeguard. This proposal would increase financial literacy and more informed decision-making and would also provide guaranteed protection to the 20 million Americans with outstanding retirement loans totaling about $241 billion.
Under this proposal, if a 401(k) plan sponsor makes the decision to include automatic insurance coverage, the borrower may decide to opt out of coverage, ensuring this free-market solution includes no government mandates or requirements.
With such insurance coverage in place, the unfortunate event of death or disability of the borrower would result in the insurance provider repaying the outstanding loan and also an amount sufficient for the borrower or beneficiary to pay the federal taxes due. This fully replenishes the borrower’s account balance, preventing a substantial loss of retirement savings — without any cost to the federal government.
It has long been said the only things in life that are certain are death and taxes. Automatic enrollment for insurance of 401(k) loans would add an additional certainty: Fewer Americans would suffer the unnecessary loss of retirement savings due to unanticipated and untimely misfortune in an already stressful time of need.