A Novel Solution to Retirement Plan Loan Defaults

By George White

Employers need the flexibility to manage their workforce, now more than ever. But it’s also important to treat employees fairly, especially those on the lower end of the wage scale who are more likely to borrow from their retirement plan.

Studies show that 20% of employees borrow a median $4,600 from defined contribution retirement plans to help with expenses ranging from housing to help with tuition. Employees also borrow for unforeseen medical expenses, since most plans require participants to take loans before hardship withdrawals. For many workers, 401(k) loans represent the best form of credit available: quick approvals that are less expensive than borrowing from a bank or credit cards. But they come with a risk: if loans default they represent permanent plan leakage.

Unfortunately studies also show a whopping 86% of employees default on their plan loans after losing their job. It’s not hard to see why: When an employee decides to leave their job, they control the timing and can plan ahead for expenses, including an outstanding loan. Yet when an employee loses their job unexpectedly (due to workforce reduction, for example), they miss this critical planning period and almost universally default. This might explain why most plans don’t see a meaningful reduction in loan defaults after adding post-separation repayment provisions.

The true cost of defaults: taxes, penalties—and lost earnings that are never recovered

How much do these defaults cost? The average worker owes income taxes and penalties on the outstanding loan amount, but that’s just the beginning. The earnings they lose will far outweigh the taxes and penalties. In fact, one analysis showed every 1,000 jobs an employer cuts will cost those employees more than four million dollars in loan default-related losses over their working careers.
Each time an employer lets go of workers they incur severance costs designed to improve the welfare of those employees, but there is no protection for outstanding retirement plan loans that default. This can’t continue.

Employee-paid loan insurance is an affordable, sensible solution

Corporate benefits managers and executives who recognize the hidden impact of defaulted loans are turning to a novel solution: loan insurance specifically designed for 401(k) plans.

One such loan insurance program is called Retirement Loan Eraser (RLE), offered by Custodia Financial, an early-stage FinTech company comprised of retirement industry executives. Custodia partners with the plan recordkeeper to deliver RLE to retirement plan clients and their participants. Once a plan adds RLE, participants are automatically covered when they take a loan. If they lose their job during the repayment period, RLE keeps the employee on track for retirement by repaying the loan before it defaults.

What makes RLE attractive to today’s benefits managers, besides a reduction in plan leakage? It’s self funded. Plan sponsors are not charged a fee to protect employee assets from default. The employees borrowing pay a few extra dollars per loan payment for protection.

401(k) loan insurance makes good financial sense for everyone involved. You can learn more about Custodia’s unique and timely program online at www.loaneraser.com.

About the author:
George White is a financial services industry executive who has spent his career managing and advising employee retirement benefit plans. Contact the author at gwhite@custodiafinancial.com or follow his company on LinkedIn.