401(k) Loan Defaults: How Big Is the Leakage and What Can Policymakers Do to Preserve Americans’ Nest Eggs?
During times of economic stress, Americans increasingly borrow against their 401(k) accounts to smooth consumption and to extinguish other debts. This pattern has been clearly in evidence during and since the Great Recession of 2008-09. According to the Investment Company Institute, the percentage of active plan participants with a 401(k) loan increased from 15.0 percent in 2006 to 18.5 percent in 2011. If a participant loses her job, becomes disabled or dies with a 401(k) loan outstanding, then the loan generally goes into default, and her retirement account is debited the loan amount plus applicable taxes and penalties. New data on 401(k) accounts suggest that this “leakage” from Americans’ retirement savings on an involuntary basis was in excess of $9 billion in 2009. Because this estimate is largely driven by default rates on 401(k) loans from mid-2005 to mid-2008, including default due to job loss, the amount of leakage is much greater to the extent that 401(k) loan defaults increased with the onset of the recession in late 2008.
In this policy brief, we estimate the size of the leakage in light of more realistic estimates of 401(k) loan defaults; the leakage could be as high as $37 billion per year depending on the source of the data on loans outstanding and the assumed default rate. We also highlight the disparate impact of a participant’s borrowing against 401(k) balances across racial lines. Our findings raise serious policy implications. We largely embrace policies that reduce the likelihood of 401(k) loan default, but we suggest an additional remedy that would insulate borrowers from losses upon default: that the default rule or “base setting” in a sponsor’s plan provide insurance via auto-enrollment with an opt out to participants who borrow against a 401(k) account, which is analogous to standards requiring mortgagors posting smaller down payments to purchase private mortgage insurance. Unlike mortgage insurance, in the case of 401(k) loans, the borrower is also the lender, which means that costs relating to information asymmetries are mitigated. We demonstrate that the social benefits of steering (but not compelling) plan participants towards insurance when they borrow are likely positive and economically significant.
Full report below…