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Imagine that you or someone in your family who relied on you for financial help were faced with unexpected medical bills that you could not afford with your current income. Luckily, you have managed to save a nest egg for retirement through your 401(k) plan, the most common defined-contribution retirement savings plan in the United States today, and you can simply borrow against that to keep the bill collectors at bay. Since the money is yours, there is no approval. You may borrow up to half of your retirement savings with no penalty so long as you pay it back within 5 years. Even better, the interest rate on these borrowed funds is lower than those on many other loans.
The bad news, though, is that while the money is out of your retirement account you are not receiving an investment return. You are also paying yourself a below market rate of interest, which means that as a lender to yourself you are not being paid in full. And should you fail to pay the loan back you will have to pay taxes on the monies and pay a 10 percent penalty on top of that. Finally, the interest payments you are paying yourself are helping to grow your retirement savings, but you have paid them in after-tax dollars, and will have to pay taxes on that “gain” again when you retire and receive money from the account.
Given the significant downsides to 401(k)-type loans, why do people take them? Families take these loans because they are either uninsured or underinsured for the risks they face. Over the past few years, families looked for new ways to bridge the gap between slow income growth and rapidly rising prices, especially for houses, but also for food, energy, and health care. This search more often than not led them to household credit, but as families amassed ever-larger amounts of household debt they sometimes also sought out additional financial resources, such as their retirement plans.
Now, as the housing crisis grips the country, more and more individuals are tapping their 401(k)s. Most defined-contribution, or DC, retirement plans allow individuals to borrow from their 401(k)s. At the same time, these plans have become more widespread. The result is that families leverage their future retirement security to ease their present financial insecurity.
To reduce the likelihood of workers leveraging their retirement to cover current catastrophes, policymakers must reduce the need for people to borrow. Policy solutions will require substantial improvements to income growth for America’s families, and a commitment to providing health and unemployment insurance to citizens who experience unexpected health expenditures and job loss. To understand the need for such policy actions, this report considers the evidence on loans drawn from DC plans from 1989 to 2004, the last year for which complete data are available. The data show the following.
- Even with a fairly modest loan amount of $5,000 in 2008 dollars, a worker’s retirement savings could be substantially reduced. For instance, a 401(k) plan participant who takes a loan to smooth over an economic rough patch, and makes only the loan payments, reduces their total retirement savings between 13 percent and 22 percent.
- Loans from DC plans have risen sharply. Over a period of 15 years, loans against retirement savings accounts increased almost fivefold in inflation-adjusted terms, to $31 billion in 2004, up from $6 billion in 1989—an increase of almost 400 percent. This reflects in large part the fact that many more people save for their retirement with defined-contribution plans and thus have access to these loans.
- Despite beneficial interest rates, loans from DC plans add to the overall debt burden and do not seem to substitute for other forms of debt. 401(k) plan participants who borrowed from their DC plans had median debt payments relative to income equal to 22.5 percent after 1995, while those who did not borrow paid only 18.0 percent. This difference in debt payments relative to income, 4.5 percentage points, had grown from 0.6 percentage points between 1989 and 1995.
- There have been important changes by demographic characteristics. Over the period under examination, borrowers from their 401(k)s were more equal by race and ethnicity. Loans among white 401(k) plan participants have become relatively more likely than among their African-American or Hispanic counterparts. Also, families with DC loans have gotten younger and have become more concentrated among families with high school degrees.
- The evidence shows that middle-class families in particular rely on their retirement savings accounts to provide them with easily accessible loans. This is particularly true when families buy a home, experience a spell of unemployment, and are burdened by bad health.
- There is no link between loans from DC plans and conspicuous consumption. If anything, families which exhibit a positive attitude toward borrowing for conspicuous consumption are underrepresented among families with loans from DC plans that were used for the purchase of goods and services.
The data point the way for current trends. As the economy slows, people are losing their jobs, and wage gains are falling behind sharply higher prices for energy, health care, transportation, and food. Families need to find ways to smooth themselves over the current rough patch even more so than in 2004, the endpoint of our analysis of the available data. With other venues to borrow money, particularly home equity lines, closed off due to lower house prices, tighter credit standards, and slower income growth, families are turning increasingly to the easily accessible loans from their 401(k) plans. The data through 2004 is a harbinger of the erosion in retirement security to come as families are economically squeezed from all sides.
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