Short term play but a long term loss
The Employee Retirement Income Security Act of 1974 enacted defined contribution plans as a standard employee benefit in the U.S. That shift attempted to reduce pension fund mismanagement and abuse while providing the workforce the opportunity to be involved in their retirement planning. With that responsibility came a few options. Approximately 90% of employer sponsored defined contribution plans (401(k), 403(b), and SEPs) allow employees to access funds in their retirement account for non-retirement purposes. Because employees are utilizing funds they have accumulated, the U. S. Treasury doesn’t define the loan as a traditional credit agreement. The U.S. Treasury stipulates two conditions for this arrangement.
The participant may only borrow up to ½ of their accumulated balance up to a maximum of $50k. (For a $50k withdrawal, the accumulated balance must be no less than $100k)
The participant must agree to replenish the account, with interest, at a flat dollar monthly payment (think installment/amortization schedule).
Multiple financial studies from 1997 – 2012, reviewed about 900 plans consisting of 900,000 participants. Those studies stated that at least 70% of retirement fund withdrawals were used for bills, debt consolidation or home improvement and repair. The studies went on to say that the least financially literate plan borrowers used plan loans for consumption rather than investment. Lastly, a 2010 study found that plan borrowers had lower total financial assets, higher debt and were more credit constrained. In 2024, medical bills and student loans could be added to the list of reasons employees withdraw from retirement accounts.
Of the 90% of employer sponsored defined contribution plans that allow employee borrowing, approximately 40% allow multiple loans at one time. For plans that allow multiple loans, approximately 20% of participants had an outstanding loan at any one time and over the course of 5 years, 40% of employees were borrowers. (note source) New loans average $7,800, and if multiple loans are allowed, the average across all loans is $10,000.
Short term play, long term loss
What does this data mean for an employer? The average workforce is underprepared for common expenses. The mental and emotional weight of their financial situation could translate to high stress and low engagement. Not only that, regardless of who utilizes this retirement plan option, employees are borrowing against future growth – choosing a short term play for a potentially long term loss. The immediate solution could cost them thousands of dollars in future growth. The interest rate applied to the repayment is the prime rate plus 1 - 2%. That rate is more favorable than a market credit card and depending on the current economy lower than a personal loan. However, on average, the retirement plan rate of return is likely higher than the repayment interest rate. That math means that the employee has a lower retirement fund balance, another monthly budget obligation, and an overall lower rate of return on their retirement account.
I acknowledge the myriad of factors that lead individuals to withdrawing money from a retirement account versus seeking other options. But the fundamental point is that a strong workforce with increasing readiness for life expenses leads to a healthier company and economy. Investing in your workforce by equipping them with tools for financial education and readiness could be the difference between a team too stressed to give their best, and a team that is financially secure and fully present and motivated each day.
StudioM is poised to provide financial education services to small businesses. Sessions on savings, retirement and estate planning, responsible debt and credit management are foundational to our professional development series. For additional details on available services, you can call or text (469) 615-0387, or email us at letstalk@studiomfinancial.net. Until we meet…keep working on the change.
Sources:
National Bureau of Economic Research, Bulletin on Aging & Health, September 2016 study (www.nber.org/bah/2015no2/borrowing-401ks) Underlying working paper entitled “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults”, Timothy, (Jun) Lu, Olivia S. Mitchell, Stephen P. Utkus & Jean A. Young, issued April 2015