Debit card loan programs recently have been the focus of criticism in Washington. In addition to investor alerts issued by the Financial Industry Regulatory Authority Inc. of New York and Washington and the Securities and Exchange Commission, legislation has been introduced in both houses of Congress that, if enacted, would prohibit 401(k) plans from adopting debit card loan programs.
This recent debate has revealed a number of common misconceptions about 401(k) loan products, and criticisms that rely on these misconceptions need a reality check. Commentators who have singled out debit card loan programs have failed to acknowledge Congress' intent to allow retirement plans to permit loans. Critics of debit card loan programs also have failed to recognize their advantages over "traditional" plan loan products, which generally have escaped criticism.
To provide some background, traditional loans — which have been available for many years — allow a participant to withdraw a lump sum from his or her retirement account, subject to certain overall limits. The 401(k) debit card loan program is a more recent innovation that gives participants flexibility to establish a revolving loan account in the plan without actually withdrawing funds.
Using a debit card, the participant's loan account remains in the plan, continuing to earn investment returns until the participant makes a withdrawal. The participant may withdraw as little or as much as needed at any time, up to the approved amount of the loan account. This is a significant departure from the lump sum withdrawal required under traditional loan programs.
Whether one believes that allowing plan participants to borrow from their retirement accounts is a good idea in principle, the Employee Retirement Income Security Act of 1974 specifically allows plans to adopt a participant loan program. Around 85% of all 401(k) plan participants currently participate in a plan that permits loans.
While Congress could have prohibited participant loans altogether, it did not. The decision to permit plan loans demonstrates Congress' understanding of the benefits of plan loans in encouraging greater plan participation and employee contribution rates. In this respect, the private retirement system in the United States is entirely voluntary, and employees are not required to participate in their employer's retirement plan. A number of studies of retirement plans — including a report issued by the Government Accountability Office — have concluded that loan programs increase plan participation rates and that participants contribute up to 35% more to 401(k) plans that offer loans.
In addition, nothing in ERISA prohibits a plan from adopting a debit card loan program so long as the program complies with ERISA's general loan requirements. In fact, the Department of Labor issued an advisory opinion in 1995 addressing a debit card loan program and did not raise any concerns that the program violated ERISA.
The process of applying for a traditional loan is as easy as applying for a loan account under a 401(k) debit card program. A participant can apply for a traditional loan on a plan provider's website in just a few minutes. Unlike a debit card loan, once the traditional loan is approved, the entire amount of the loan is withdrawn in a lump sum.
Participants also are required to apply for a loan account before they can obtain a 401(k) debit card; participants simply have more flexibility to draw on the loan account as needed. While debit card loans have been criticized as encouraging participants to take larger loans, loan providers have found that the average loan balance for debit card loans is around 30% to 35% less than traditional loans.
Recently introduced legislation that would prohibit debit card loans but continue to allow traditional loans makes no sense. While intended to discourage loans by making it more difficult for participants to access their money, the legislation would actually encourage participants to borrow more through a traditional loan. At the same time, the legislation ignores the fact that we all live and work in the 21st century, where this kind of debit card technology is available and has proven benefits.
Some commentators have criticized debit card loan programs because they do not restrict participants' use of loan proceeds. However, ERISA does not impose limits on how the proceeds of a participant loan may be used. The DOL and the Internal Revenue Service specifically have decided not to place limits on the use of loans because such restrictions would be unworkable and highly burdensome for plan administrators.
Commentators have produced no evidence suggesting that participants use the proceeds of a debit card loan differently than proceeds of a traditional loan. The evidence we have seen suggests that debit card loans, like their traditional counterparts, are most often used for family emergencies, such as a medical problem, education expenses, or to purchase a home. We have seen no evidence that participants use their debit cards to buy coffee at Starbucks.
Commentators have expressed concern that participants may be more likely to default on debit card loans because they are generally not repaid through payroll deduction. However, we have seen no evidence that default rates on debit card loans are greater than on traditional loans.
Commentators also have failed to acknowledge the disadvantages of a loan program that is dependent on payroll deduction for repayment. Because traditional loans are repaid only through payroll deduction, these loans generally become due upon termination of employment. A participant who is unable to repay the outstanding loan balance will be charged income tax and an additional penalty on the loan balance, and the participant's retirement savings will be reduced accordingly.
By contrast, debit card loan programs are not dependent on payroll deduction and allow participants to continue repaying their loan after termination of their employment. As a result, participants are less likely to have their retirement savings reduced by a taxable distribution. Given the increasingly mobile work force, this feature of debit card loan programs helps safeguard participants' retirement savings.
Plan loan programs have always attracted critics, and the conversation has generally focused on the negatives of participant loans. However, debit card loan programs have been unfairly singled out by recent criticism. To suggest that plans may continue to offer traditional loans but deny participants the demonstrated benefits of debit card loan programs is inconsistent with the goal of protecting participants' retirement savings.
Stephen M. Saxon is a principal with the Washington-based Groom Law Group. J. Matthew Calloway, an associate with the firm, contributed to the article.
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