A Primer on 401(k) Loans

Although the popular press and politicians often describe 401(k) loans as a problem, classical economic theory has a more benign view. Loans from a 401(k) can relax liquidity constraints and increase household utility. Moreover, loan provisions may have the subtle effect of raising net asset accumulation by making 401(k) participation more appealing: employees who can access their 401(k) assets if they need them may be willing to put more money into an otherwise illiquid 401(k) account. Our research suggests that 401(k) loans are neither a blessing nor a bogeyman. Conditional on borrowing to finance consumption, we show that a 401(k) loan may be a reasonable source of credit in many circumstances. We further show that the net impact of 401(k) loans on asset accumulation is likely to be small (and could be either positive or negative) for a reasonable range of parameter assumptions. Our empirical analysis also suggests that it may be possible to structure the provision of 401(k) loans in ways that reduce their potential to negatively impact retirement wealth accumulation, as we find that 401(k) loan utilization is responsive to the types of loan features adopted by firms. 401(k) loan utilization is higher in plans that have lower minimum loan amounts and in plans that allow employees to take out multiple loans. 401(k) loan utilization is lower in plans that have higher loan interest rates. John Beshears Department of Economics Harvard University Cambridge, MA 02138 beshears@fas.harvard.edu James J. Choi Yale School of Management 135 Prospect Street P.O. Box 208200 New Have, CT 06520-8200 james.choi@yale.edu David Laibson Department of Economics Harvard University Littauer M-14 Cambridge, MA 02138 dlaibson@harvard.edu Brigitte C. Madrian Kennedy School of Government Harvard University 79 JFK Street Cambridge, MA 02138 brigitte_madrian@harvard.edu In Shakespeare’s Hamlet, Polonius instructs his son: ―Neither a borrower nor a lender be. ‖ The advent of the 401(k) loan has created the curious possibility of violating Polonius’s maxim twice in the same transaction: individuals can borrow from their 401(k) wealth and repay themselves. Borrowing from defined contribution savings plans, including 401(k) plans, has long been permissible, and such loans are prevalent. The Investment Company Institute reports that 18% of 401(k) participants had a 401(k) loan in 2006 (Holden, VanDerhei, Alonso and Copeland, 2007). Nevertheless, the impact of this borrowing on economic outcomes has only recently begun to attract attention in the academic and policy worlds. Anecdotally, the recent economic slowdown has caused the fraction of 401(k) participants with a 401(k) loan to rise. 1 This increase, coupled with the introduction of the 401(k) debit card, 2 motivated Senators Herb Kohl and Charles Schumer to propose legislation that would limit the number of outstanding 401(k) loans to three per participant and ban 401(k) debit cards outright (Asci, 2008). The concern is that easy access to one’s retirement nest egg will lead to excessive consumption in the present at the expense of future financial security. Although the popular press and politicians often describe 401(k) loans as a problem, classical economic theory has a more benign view. Loans from a 401(k) can relax liquidity constraints and increase household utility. Moreover, loan provisions may have the subtle effect of raising net asset accumulation by making 401(k) participation more appealing. Employees who know that they can access their 401(k) assets if they need them may be willing to put more money into an otherwise illiquid 401(k) account. Our research suggests that 401(k) loans are neither a blessing nor a bogeyman. Conditional on borrowing to finance consumption, we show that a 401(k) loan may be a reasonable source of credit in many circumstances. We further show that the net impact of 1 See, for example, Transamerica Center for Retirement Studies (2008). 2 See Burton (2008) on the 401(k) debit card. 401(k) loans on asset accumulation is likely to be small (and could be either positive or negative) for a reasonable range of parameter assumptions. Our empirical analysis also suggests that it may be possible to structure the provision of 401(k) loans in ways that reduce their potential to negatively impact retirement wealth accumulation, as we find that 401(k) loan utilization is responsive to the types of loan features adopted by firms. 401(k) loan utilization is higher in plans that have lower minimum loan amounts and in plans that allow employees to take out multiple loans. 401(k) loan utilization is lower in plans that have higher loan interest rates. This paper is the first step in a research agenda on how the availability of 401(k) loans affects wealth accumulation. The aims of the current paper are largely descriptive. In Section I, we describe the various sources of data that we use. Section II discusses the prevalence of 401(k) loans. In Section III, we explain how 401(k) loans work, how they are regulated, and the types of loan provisions that plan sponsors offer. In Section IV, we discuss how 401(k) loans affect wealth accumulation. Section V assesses how savings plan participants utilize 401(k) loans. We conclude in Section VI with a discussion of what research remains to be done in order to accurately assess the impact of 401(k) loans on wealth accumulation. I. Data on 401(k) Loans We exploit several different sources of data on 401(k) loans in this paper: participantlevel administrative data, firm-level data, household survey data, and published statistics. We briefly describe our primary data sources and the strengths (and weaknesses) that each has to offer for our analysis. The first source of data is published statistics from a joint data collection effort by the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI). The EBRI/ICI database contains administrative data on savings plan participants and their savings plans from thousands of firms that are affiliated with either EBRI or ICI. In 1996, the first year for which such data were collected, the EBRI/ICI database included almost 28,000 401(k) plans with over 6.5 million plan participants, representing 9% of all plans, 18% of all participants, and 31% of all assets (VanDerhei, Galer, Quick and Rea, 1999). Over time, the coverage of the EBRI/ICI database has expanded; in 2006, it included almost 54,000 plans with 20 million participants, representing 12% of all plans, 40% of all participants, and 46% of all 401(k) assets (Holden and VanDerhei, 2007). Although the EBRI/ICI database is not a random or stratified random sample of either savings plans or savings plan participants, the distributions of plans by total assets and by number of participants are very similar to those for the entire universe of plans, 3 making the data fairly representative at least on those dimensions. The 401(k) loan statistics published for the EBRI/ICI database include the fraction of firms offering 401(k) loans, the fraction of savings plan participants utilizing such loans, and the average outstanding balance of 401(k) loans, all reported by plan size and by participant demographic characteristics. The strengths of the EBRI/ICI statistics include their broad coverage of the 401(k) market and their consistent reporting over the 1996-2006 time period. Their weakness is that the sample of firms included in the calculations is neither constant nor completely representative over time, so it is never clear whether differences over time or across plan/participant characteristics represent true differences or just different selectivity into the sample. The second source of data is published tabulations from the Employee Benefits Surveys (EBS) conducted by the Bureau of Labor Statistics. These surveys, which have been conducted periodically since the early 1980s, were designed to be nationally representative of certain types of occupations in certain types of firms. The number of firms actually surveyed is substantially smaller than the sample of firms in the EBRI/ICI database (numbering in the low thousands rather than the tens of thousands). The strength of these data is their representativeness for the population covered by the survey design. The weaknesses of the EBS data are several: (1) the survey population covered is somewhat limited, 4 (2) there is high non-response both for surveyed firms and for the questions specific to retirement plans within the firms who did respond, 5 (3) the only loan variable reported for 401(k) plans is the fraction of savings plan participants who are in plans with a loan option, 6 and (4) this variable was only reported in the 1993, 1995, and 1997