Loan Education Critical in Rising Interest Rate Environment

For plan sponsors, a rising interest rate environment poses a few new challenges. The first increase in the Federal Funds in almost a decade on December 16, 2015 was widely viewed as a possible catalyst for stock and bond market volatility. However, to date there has been no widespread stock market panic…or sell-off. But market allocations and performance may not be the factor most affected by rising rates.

Many plan sponsors are experiencing a rising interest rate cycle for the first time. The obvious implications of rising interest rates to a retirement plan are how managers will reallocate fixed-income assets within a fund and how participants will change their allocation choices. Historically, stocks have declined in rising interest rate environments as the cost of borrowing funds to expand operations increases. In the bond markets, the price of a bond has an inverse relationship to the interest paid; thus, as interest rates increase, the price of a bond on the secondary market will decrease. There is no telling what the future will bring for the markets, but for those participants looking to borrow against their 401k plans, the implications for rising rates can be significant.

Many existing loans may not be affected by the higher rates, but those seeking new loans should be advised of the changes and the implications of having to pay more interest to repay their loans. Plan sponsors need to take an active role in educating participants of the specific issues they face in taking loans against their retirement plan. Rising interest rates do have a “silver lining” of sorts since participants are paying themselves the higher interest; it is a way to get more money into their plan.

On the other hand, there are risks associated with higher interest loans. Higher rates on loans may increase the risk of default and many plans require loans to be paid in full upon a job change for example, further exacerbating risk default

Loan education is a critical part of the broader learning process for participants and should include forward-looking scenarios such as the impact of rising rates. With the Federal Reserve signaling three to four rate hikes in 2016 alone, participants may see the end of easy money from their retirement plans.

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