Jack explains plans American retirement plan loans

This article came from a comment by Jack Towarnicky

It comes as we consider the question raised by timothy Lancaster;- “should we help employees in debt before encouraging saving.”

I don’t know what the rules are in the UK, but in the states, 80+% of 401k plans in the states have a ready made solution – 401k plan loans. All qualified plans, including pension plans, could permit plan loans.

Plan loans are tax-free liquidity.

“Done right”, plan loans improve both household wealth AND retirement preparation.

The process is:

Save

Get employer match

Invest

Accumulate earnings

Borrow to meet a short term need

Adjust your asset allocation because the plan loan principal never leaves the plan but becomes a different kind of fixed income investment

Repay the loan which continuing to make regular contributions

Rebuild the account for a future, larger need

Repeat as necessary up to and throughout retirement

What is “done right?”

Done right includes three features:

First, electronic banking. Essential because, at least in the states, people frequently change employers, median tenure of American workers has been less than 5 years for the past 7 decades.

Second, a line of credit structure. Essential so that people know what liquidity they have access to on any given day, that there are minimal limits on the number of times individuals can access liquidity, so hat they do not borrow more than they need to meet a specific need.

Third, behavioral economics tools, processes and concepts designed to maximize the likelihood of repayment. Essential options include authorizing repayment from the individual’s bank account (so that an interruption in employment isn’t an interruption in repayment), reporting the loan to the credit bureaus, having the participant effect a “commitment bond” – a promise to repay, having the participant sign off on the loan application as both the borrower (current self) and lender (future self), having the participant confirm that they have access to liquidity from another source should employment end.

Why will this improve both household wealth and retirement preparation?

First, the individual won’t take the plan loan unless it is superior to other liquidity sources – meaning that it will have a favorable impact on household wealth compared to say a cash advance on a credit card or a personal loan.

And, for the past 18 years, the plan loan interest rate is typically less than the rate on debt from a commercial source, and greater than the rate on fixed income investments offered within 401k plans.