Plan Leakage Spells Risk for Employees and Employers Alike
Four ways for employers to not only reduce their potential risks, but also help employees become retirement ready.
When participants borrow from their retirement plans, they may be reducing their retirement income, while increasing your risk.
According to the Investment Company Institute, in 2018, 55 million Americans had retirement plans worth a total of $5.63 trillion. While this is impressive, the news may not be all good. About 19 percent of plan participants take loans from their retirement plans. And, in fact, the ability to borrow from retirement plans is part of what makes them attractive to employees. However, according to recent reports, unpaid loans and service distributions may be endangering the retirement readiness of employees.
Deloitte estimates that participants will default on $7.3 billion in loans in 2018 — and that this leakage will actually lead to nearly $2.5 trillion in retirement shortfalls over the next 10 years alone. This will have repercussions on employees and employers alike.
The Trillion-Dollar Shortfall
Employees may access their retirement accounts for a number of reasons, including:
- Paying for medical expenses or other emergencies
- Buying a home or paying for home renovations
- Paying for college or paying off student loans
- Paying down high-interest debt
- Buying a car
While the majority of participants repay their loans with interest, it is estimated that about 10 percent default on the loans, which has tax consequences and other penalties if they are under age 59½. To make matters worse, those who default often decide to pull the rest of their balance out as well. These defaults and cash outs may have farther reaching effects than participants may understand. Consider that defaults and cash outs can have:
- Tax consequences that may push the participant into a higher tax bracket
- An additional 10percent financial penalty if the participant is under 59½ years of age
- Opportunity costs for lost investment returns and lost compounding over time
According to the Deloitte study, these consequences are what will potentially lead to a $7.3 billion default to become $2.5 trillion in retirement shortfalls over the next decade.
Challenges for All
Loan defaults may have a significant impact on an employee's retirement readiness, potentially causing them to:
- Not be ready for retirement when expected
- Delay retirement
- Be unable to generate enough retirement income
According to the U.S. Department of Labor, plan sponsors have an obligation to ensure that loans do not cause losses to the plan or impair an employee's ability to generate income. Additionally, they view loans as investments that require the same fiduciary oversight as other plan options. So, loan defaults can increase plan sponsor risk and add to fiduciary burdens.
What Can Employers Do?
There are ways for employers to not only reduce their potential risks, but also help employees become retirement ready. For example, employers may be able to leverage:
- Educational programs that can help employees better understand the impact of unpaid loans, hardship withdrawals, and cash outs
- Financial wellness programs that may help employees to better manage their finances and potentially avoid the situations that might cause them to need a loan
- Different plan design options that may enable them to limit the number of loans or loan amounts
- Plan sponsor tools that can help them complete their administrative tasks on time, while helping to ensure employees are paying back their loans on time
At ADP Retirement Services, our team is committed to driving efficiency and helping organizations like yours work smarter, not harder. Learn how we stay ahead of the curve to reduce your administrative burden and free up your valuable time, so you can focus on your business and the people who keep it running.
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