CHICAGO--()--Navigant (NYSE: NCI) today released a policy brief by Navigant Economics that suggests the leakage of funds in 401(k) plans due to involuntary loan defaults may be as high as $37 billion per year nationwide, depending on the source of the data on loans outstanding and the assumed 401(k) loan default rate.
“The same logic implies that 401(k) borrowers would be more inclined to protect their loans against involuntary default.”
According to the brief’s authors, Drs. Robert Litan, a Senior Fellow in the Economic Studies program at the Brookings Institution and Hal Singer, Managing Director with Navigant Economics, Americans have been borrowing against 401(k) plans with increased frequency during the recent economic downturn. In fact, the Investment Company Institute, the national association of U.S. investment companies, estimates that the percentage of plan participants in the United States with a 401(k) loan increased from 15 percent in 2006 to 18.5 percent in 2011. If a participant loses his/her job, becomes disabled or dies with a 401(k) loan outstanding, then the loan generally goes into default and his/her retirement account is debited the loan amount plus applicable taxes and penalties.
“Of course, participants are not deliberately defaulting; they only do so when they have no other option,” commented Litan. “According to a study conducted by the Financial Literacy Center, almost 10 percent of all 401(k) participants with loans from 2005-08 defaulted on their loans for reasons relating to job separation.”
Because the 401(k) loan default rate in that sample (10 percent) was associated with an unemployment rate that is roughly half of today’s unemployment rate (4 percent versus 8 percent), and because 401(k) loan default rates are correlated with unemployment rates, Litan and Singer project significantly higher 401(k) loan default rates since the onset of the Great Recession in late 2008. Higher 401(k) default rates imply more leakage from Americans’ retirement accounts.
When a participant loses his/her job with a 401(k) loan outstanding, the loan is due in full in 60 days and failure to meet that accelerated time table results in substantial losses from the retirement account. From a policy perspective, some have recommended that limiting the number or size of loans or permitting the loan to be ported to a new plan provides a solution. While such prescriptions may reduce the likelihood of default, Litan and Singer conclude that none of these options provide liquidity and deal with the welfare of the borrower who actually defaults. Changing the law to allow automatic enrollment into loan protection provides an option that could stem the leakage currently impacting retirement savings by providing guaranteed coverage at an affordable rate. This would be analogous to the standard protocol that requires mortgagors who make smaller down payments to enroll in private mortgage insurance.
“There is a growing literature on the 'nudge' value of default rules. It has been shown, for example, that individuals are more likely to contribute to their own 401(k) in the first instance if the default rule is automatic contribution with an opt out rather than the previous opt in system,” Singer explained. “The same logic implies that 401(k) borrowers would be more inclined to protect their loans against involuntary default.”
Navigant Economics, a part of Navigant, provides economic and financial analysis of legal and business issues to law firms, corporations and government agencies. It includes more than 30 Ph.D. economists and over 100 consulting professionals, many of whom are affiliated with leading academic institutions including the University of Chicago, Georgetown University, Northwestern University and the George Mason University School of Law. More information about Navigant Economics can be found at www.naviganteconmics.com.
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