Borrowing from 401(k) plans and the risks of default

The trouble with saving for retirement is that it’s a long time away. Saving an adequate amount for retirement takes decades of sustained reduction in everyday consumption. Unfortunately, stuff happens on the way to retirement. Savers in the United States may want to buy something, pay off a medical bill, or make renovations to their home. In other words, they may turn to the pile of money they’ve already socked away for their (perhaps not so) “golden years.”

In the past, workers weren’t able to access their retirement savings as it was locked away in defined-benefit programs such as company pensions that paid out a fixed amount each month upon retirement. But with the rise of defined-contribution plans, such as 401(k) plans, savers can now borrow from their personal retirement savings as long as they pay themselves back.

But what factors determine whether savers will take out a loan and how big the loan will be? And what are the consequences of taking out those loans? A new paper by economists at Peking University, the University of Pennsylvania, and The Vanguard Group looks into those questions.

The paper, by Timothy Lu, Olivia Mitchell, Stephen Utkus, and Jean A. Young, looks at how employer policies affects the borrowing behavior of savers in employer-sponsored, defined contribution plans. They look at a five-year period, from July 2004 to June 2009, using data from Vanguard. At first blush they find quite a lot of borrowing going on. At any point in time during those five years, 20 percent of savers in the plan have an outstanding loan. Over the 5-year period, about 40 percent of participants borrowed at one point.

Then they delve into what features of plans cause savers to borrow more from their retirement savings plans. The key feature, according to the paper, is the ability to take out multiple loans from the plan. Some plans only allow a saver to borrow once, but others allow multiples loans over time. Lu, Mitchell, Utkus, and Young find that savers enrolled in plans that allow multiple loans are far more likely to take out loans. In fact, the probability of taking out a loan nearly doubles. More specifically, younger and lower-income savers are more likely to take out loans.

The authors think this is due to workers with the ability to take multiple loans believing that the option is endorsed by their employers. Savers might believe that employers wouldn’t allow for multiple loans unless they thought loans were a good idea.

The total amount of borrowing among those with multiple loans from these retirement savings plans is larger, by about 16 percent, even though the size of each individual loan is smaller. The total loan amount ends up being larger due to a higher number of loans for each saver.

Once these borrowers took out loans, how good were they are repaying loans? About 9 in 10 borrowers repaid loans before they left their job. But for the 1 in 10 that didn’t pay back the loans in time, 86 percent ended up defaulting. The probability of defaulting increased for borrowers with multiple loans, holding the size of the total borrowing constant.

Lu, Mitchell, Utkus, and Young point out that the “leakage” from retirement savings due to these loans and defaults is much smaller ($6 billion) compared to the cash-outs from savers switching jobs ($75 billion). Even still, the case for allowing multiple loans from 401(k) accounts isn’t very strong. Yes, these loans are boosting giving access to credit for borrowers who were constrained. But at the same time, they increase the likelihood of default.

Given the signs of a mounting retirement savings problem in the United States, should policy encourage borrowing from savings for the future?