When participants borrow from their retirement plan, they may be reducing their retirement income, while increasing your risk.
According to the Investment Company Institute, in 2018, 55 million Americans had retirement plans worth a total of $5.6 trillion. While this is impressive, the news may not be all good. About -19% of plan participants take loans from their retirement plans. And, in fact, the ability to borrow from retirement plans is part of what makes them attractive to employees. However, according to recent reports, unpaid loans and in-service distributions may be endangering the retirement readiness of employees.
Deloitte estimates that participants will default on $7.3 billion in loans in 2018—and that this leakage will actually lead to nearly $2.5 trillion in retirement shortfalls over the next 10 years alone. And this will have repercussions on employees and employers alike.
The Trillion-Dollar Shortfall
Employees access their retirement account for a number of reasons, including:
- Paying for medical expenses or other emergencies
- Buying a home or paying for home renovations
- Paying for college or paying off student loans
- Paying down high interest debt
- Buying a car
And while the majority of participants repay their loans with interest, it is estimated that about 10% default on the loans, which has tax consequences and other penalties if they are under age 59 ½. And to make matters worse, those who default often decide to pull the rest of their balance out as well. These defaults and cash outs may have farther reaching effects than participants may understand. Consider that defaults and cash outs can have:
- Tax consequences that may push the participant into a higher tax bracket
- Additional 10% financial penalty if the participant is under 59 ½
- Opportunity costs for lost investment returns and lost compounding over time
According to the Deloitte study, these consequences are what will potentially lead to a $7.3 billion default to become the $2.5 trillion in retirement shortfalls over the next decade.
Challenges for All
Loan defaults may have a significant impact on an employee’s retirement readiness, potentially causing them to:
- Not be ready for retirement when expected
- Delay retirement
- Be unable to generate enough retirement income