Borrowing from a 401(k) is often treated as something participants should avoid whenever possible. Taking money out of a retirement account means less money invested for the future, right?
Not necessarily.
In a recent Fiduciary News article, Christopher Carosa, CTFA examines whether 401(k) loans deserve a more nuanced look, starting with an important difference between loans and withdrawals.
A withdrawal removes money from a participant’s account, eliminating its potential to continue compounding toward retirement. A loan gives the participant access to money today but creates an obligation to repay the principal to the account, generally with interest.
That doesn’t mean taking a 401(k) loan is always a good financial decision. But it does mean loans and withdrawals can have very different consequences for retirement savings.
Mr. Carosa explores an argument from retirement industry expert Jack Towarnicky that takes the idea a step further. Mr. Towarnicky contends that a properly managed plan loan can essentially convert part of the participant’s retirement account into a fixed-income investment.
From the participant’s household perspective, the loan is debt. But from the retirement account’s perspective, the participant owes the account principal plus interest at a stated rate. If a participant needs to borrow anyway, Mr. Towarnicky argues, a plan loan could also cost less than borrowing from a commercial lender, potentially reducing the household’s overall borrowing costs.
Viewing the loan that way raises another consideration: asset allocation.
A participant who previously divided a portfolio between stocks and fixed income may assume the investments remaining in the account still reflect that allocation after taking a sizable loan. But if the outstanding loan balance is considered part of the account’s fixed-income exposure, the participant’s overall allocation may look quite different.
As Mr. Carosa notes in the article, there are important caveats. The argument depends on the loan being repaid, and loan’s relative value depends on the participant’s alternatives and circumstances. Selling investments to fund a loan also means giving up whatever gains or losses those investments might subsequently experience.
For plan sponsors, fiduciaries and advisors, the article suggests an opportunity to broaden participant education around 401(k) loans. Rather than treating borrowing as inherently good or bad, education can help participants understand the tradeoffs involved, including borrowing costs, repayment obligations, lost investment exposure, and the potential effect on asset allocation. Participants can then weigh those considerations alongside their immediate financial needs and longer-term retirement goals.
