Defined Contribution Plan Loans Can Be Expensive
At a Plan Sponsor University (TPSU) Program at Virginia Tech in Arlington, Virginia, a group of Plan Sponsors representing over 10,000 employees engaged a discussion of defined contribution (DC) loans. It’s a touchy subject with many Plan Sponsors expressing some level of discomfort with the subject matter.
Many of the 25 (plus) professionals attending the TPSU Program said that they felt awkward when it came to the subject of employees wanting to take hardship loans. “A hardship loan seems like it is very personal and I feel weird asking details when someone is experiencing personal hardship”, said a Human Resource Director in attendance.
The discomfort that many HR professionals experience in dealing with defined contribution plan loans is natural and understandable. However, upon deeper reflection periods of hardship are when people may need the honest counsel of a professional most to avoid making costly mistakes while under emotional distress.
Many people (Sponsors and Participants) rationalize loans from retirement plans in the following ways: “it’s a low-interest rate loan that I pay (interest) to myself”; “it’s their money, they are entitled to it”, “it’s none of my business, I don’t want to interfere in personal affairs.”
Let’s start with the “low-cost” myth. Borrowing money from your retirement account is not low-cost. Here are some of the costs a borrower will incur:
- Taxes on the amount borrowed
- Interest rate on the amount borrowed
- Opportunity cost on the amount taken out of the market
- Most plans do not allow contributions during periods where loans are outstanding…therefore there is the opportunity cost on the amounts that would have been contributed tax-free
- Taxes on the amount of interest rate upon redemption
On the issue of letting the employee do what they want, because it is “their money”, that is technically correct but Sponsors have a fiduciary responsibility to employees, therefore, they legally are required to act in the best interest of the employee in matters of the retirement plan. Allowing an employee to arbitrarily withdraw funds from a DC plan should be deliberated and the true costs should be disclosed and discussed with the employee, that would be in the best interest of the participant.
Changing attitudes about money management is likely to enhance retirement outcomes. Understanding the true cost of money and borrowing is a major part of that learning…and teaching process.
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