401(k) Loan Defaults Skyrocket

Defaults on 401(k)s now might total $37 billion a year.

Aug. 8, 2012 -- More and more Americans are borrowing from their 401(k)s to pay their bills, but fewer are putting any money back. Result: They are defaulting on loans made to themselves with their own money.

A new study estimates that such defaults might total $37 billion a year, a sharp increase from 2007, when defaults totaled only $665 million. Student loan defaults, by contrast, total about $8 billion.

The study -- titled "401(k) Loan Defaults: How Big Is the Leakage and What Can Policymakers do to Preserve Americans' Nest Eggs?" -- is the work of co-authors Robert Litan, a senior fellow at the Brookings Institution, and Hal Singer, a managing director of Navigant Economics.

About 95 percent of 401(k) participants, the authors say, belong to plans that permit borrowing. The penalties for borrowers who default are daunting. Someone who fails to repay a 401(k) loan in 60 days not only pays an income tax penalty; he or she also pays a 10 percent charge for early-withdrawal and forfeits what would have been the tax-free compounding of the money.

"Individuals with 401(k) plans borrow from them as a last resort," the co-authors write, "because the loans are meant for retirement, not ongoing living expenses. Nonetheless, when times are tough -- as they have been since the beginning of the Great Recession -- many more people with 401(k) plans have no other choice but to borrow from their accounts to maintain even a reduced standard of living."

As troubling as defaults of $37 billion are, they write, more troubling still is that "the problem is most acute for economically disadvantaged groups."

A second study, by Aon Hewitt -- global consultants on human capital, benefits and retirement issues -- finds that the percentage of 401(k) savers who have taken out loans has risen from 22.4 percent in 2005 to 27.6 percent in 2010. The highest percentage of borrowers are in the 40-49 age group. Almost all employers who participated in the study (94 percent) described themselves as concerned about excessive loan usage.

Aon Hewitt's study proposes solutions to the loan default problem that include:

-- Adding or increasing loan application fees. Research shows, the study says, that an application fee in excess of $75 can lead to fewer loans;

-- Reducing the number of loans allowed. Most plans (58 percent) allow employees to take out more than one loan;

-- Limit the available loan balance to employee money, and prohibit borrowing from money contributed by the employer;

-- Imposing a waiting period. The study recommends, "Consider a waiting period, say 6 to 12 months, that forces employees to have a loan fully repaid, before they are able to initiate a subsequent loan."

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