What Are the True Costs of 401(k) Loan Defaults After a Big Lay-off?

By Kevin Crews, Operations Director, Custodia Financial

Every time we hear about another big name company announcing layoffs we are quick to say, things like, “well that makes sense,” or “wow, that’s surprising,” and then we move on with our day because we are all busy and have other things to focus on.  What is missed by most with this news is how the people being laid off are impacted.  Are they getting a severance package?  Will they be able to find another job before their next rent or mortgage payment is due?  Did they have an outstanding loan on their 401(k)?  Will they be able to repay it before it defaults?  There are many recent examples, and just one is a FORTUNE 500 retailer who announced their intent to lay off 2,000 employees in the coming years.  That number represents just about one and half percent off all the company’s employees.  On the surface that doesn’t sound like a lot, but if we peel back the cover a bit, we can estimate that those 2,000 employees make up over $48 million of the total of their 401(k) plan.  If a fifth of the 2,000 employees had a loan out, which evidence suggests that they do, that equates to approximately $984K in outstanding loans that either will need to be repaid by the impacted employees, or risk defaulting, costing the employees’ taxes, penalties, and lost earnings.  If the employee is unable to pay the loan back, there is an even bigger cost to the employee that is not talked about nearly enough.  How will this missing or defaulted amount impact the employee’s financial wellness and more specifically the employee’s retirement savings?

By now you are probably thinking that $984K is not a large number, given the size of this company.  What you may be missing though is how this $984K, if defaulted, could impact these employees at retirement.  According the U.S. Bureau of Labor Statistics, in 2019 the average age of a person working in the Retail Trade within the Clothing Store category was just under 32 years old.  If we then assume that the average age of each off the 400 with a loan is 32, then their average horizon to retirement is 33 years out.  Finally, if all the above is true and we applied a modest 6% growth rate to this amount for the next 33 years the $984K grows to over $7M in lost retirement savings for these employees.

Given this description of the issue, what can be done to combat it?  The solution is surprisingly simple.  The solution Retirement Loan Eraser (RLE) would have eliminated the risk of these loans defaulting.  RLE is a simple solution that automatically improves financial wellness and retirement readiness by preventing 401(k) loan defaults.  In fact, if RLE would have been added before this layoff all outstanding loan balances would have been repaid to the employee’s 401(k) account—saving over $7 million in retirement security. We can’t turn back the clock, but we can make sure that employees in the future are protected by putting a safety net in place.