Protecting Retirement Savings: The Retirement Loan Eraser TM

Transcription

1 Protecting Retirement Savings: The Retirement Loan Eraser 1 Protecting Retirement Savings: The Retirement Loan Eraser TM Bruce L. Ashton (310) Bruce.Ashton@dbr.com COMMENTARY BY BRUCE ASHTON APRIL 2015

2 Protecting Retirement Savings: The Retirement Loan Eraser 2 Introduction the Retirement Risk Retirement for participants in 401(k) and other defined contribution plans is at risk. Despite the claims of some pundits, this isn t because of a flaw in the system. Instead, it s often because of unwitting and unintentional consequences of how employers operate the system that s in place. Retirement risks come in a number of shapes and sizes. With varying degrees of difficulty, virtually all of them can be avoided, and new tools are being developed to help reduce most of them. One risk in particular, the erosion of retirement savings caused by involuntary participant loan defaults, is being addressed in a new program specifically designed to eliminate this problem. The new tool is called the Retirement Loan Eraser (or RLE), developed by Custodia Financial. TABLE OF CONTENTS Introduction 2 The Retirement Loan Eraser 3 Discussion of RLE Protection 4 Conclusion 7 RLE Highlights RLE addresses the serious problem of participant loan defaults when an employee is laid off, becomes disabled or dies. RLE insures the plan and, indirectly, a participant s account against such a default. During uncertain economic times, it protects employee retirement savings and gives plan sponsors a level of risk management protection as well. The following show how the program works and debunk a number of common myths:: RLE doesn t encourage loan defaults and it doesn t give participants a windfall. RLE is not expensive in light of the protection it provides. RLE doesn t violate ERISA or the Internal Revenue Code. RLE isn t hard to implement from an administrative perspective. RLE doesn t create undue fiduciary risk. On the last point, a plan sponsor may face greater risk of participant complaints if it fails to offer participant loan protection. For this reason, sponsors should consider asking their plan provider for this protection. The Loan Risk Where available, a substantial proportion of participants borrow from their retirement accounts, up to the maximum of 50% of their account. Generally, they do so out of necessity, not folly. Participants who need extra money may be required to take a loan rather than a hardship (or other in-service) distribution, in part because it is not subject to current income taxation and in part because of the expectation that it will be paid back. 1 1 In plans that provide for hardship distributions, participants are required to take all loans available to them before they are able to take a hardship distribution. See Treas. Reg. Section 1.401(k)-1(d)(3)(iv)(E)(1). The law and Drinker Biddle s analysis contained in this commentary are general in nature and do not constitute a legal opinion or legal advice that may be relied on by third parties. Readers should consult their own legal counsel for information on how these issues apply to their individual circumstances. Further, the law and analysis in this commentary are current as of April 2015.

3 Protecting Retirement Savings: The Retirement Loan Eraser 3 A common loan term is that the remaining balance on the loan comes due when a participant terminates employment, regardless of the reason. In most cases, the participant doesn t have the resources to repay the loan balance at that point, especially when the termination is a result of a layoff, reduction in force or other involuntary termination or is caused by death or disability. So when the participant loses or changes his job, there is a substantial likelihood that he will default on the loan. One study indicates that these defaults occur in about 86% of the cases, which results in annual retirement savings leakage estimated at $6.0 billion. 2 The impact of this level of leakage is profound. To illustrate the problem, since the average age of borrowers is 42, assume that the average years to retirement of affected participants is 23 years, assume that the leakage could have been prevented, and assume a 5% annual rate of return on the $6.0 billion. Under these assumptions, the total lost opportunity cost (and lost retirement savings) to participants for just one year is almost $18.5 billion. And if this level of leakage persists for many years into the future, the loss in retirement savings is enormous. The practical impact of this statistic is a massive cutback in the retirement savings of affected participants. Even though the participant may have amortized a portion of the loan through payroll withholding prior to his termination of employment, the amount still owed may represent a sizeable portion of the participant s retirement savings 3.which he may not have the resources to repay. Thus, a substantial portion of the participant s account balance (the unpaid balance of the loan) is simply lost when the participant s account is distributed and the defaulted loan is offset against his account, resulting in retirement leakage which is preventable. To help address this problem, the Retirement Loan Eraser has emerged to provide protection for participant retirement savings, a solution that doesn t involve a difficult fiduciary decision and is administratively easy to implement. The Retirement Loan Eraser RLE protection is similar in concept to debt cancellation insurance, but with a significant twist. Instead of insuring the debtor in this case, the participant it insures the plan and in essence the participant s account. Think of it as creditor protection insurance. Here s how it works. The loan policy of an individual account plan (e.g., a 401(k), 403(b), 457(b) or other type of defined contribution plan) is modified to establish debt cancellation as a term of participant loans. The decision to require this as a loan term is a settlor or employer decision, not a fiduciary one (though the decision of which creditor protection program to offer is a fiduciary decision). When a participant initiates a loan, he will be notified that the loan will receive automatic RLE debt protection coverage and will be given access to information regarding the causes and consequences of a default, the terms of the coverage and the cost. The participant is also given the opportunity to opt out. If he does not affirmatively opt out, then coverage will begin at the end of the notice period. In addition, the participant will have the right at any time during the term of the loan to cancel the RLE coverage. Providing the program on an opt out rather than opt in basis means that participants will have access to affordable coverage without the need for individual underwriting. In the case of a participant who accepts the RLE coverage, if the participant defaults on the loan as a result of a participant s death, disability 4 or involuntary unemployment for a specified period of time, the plan agrees to forgive the outstanding balance of the participant s loan pursuant to the debt cancellation provision of the loan policy. The plan is protected from loss, however, because a component of the RLE coverage consists of a commercial liability insurance policy issued 2 Lu, Timothy (Jun), Mitchell, Olivia S., Utkus, Stephen P. and Young, Jean A, Borrowing from the Future: 401(k) Plan Loans and Loan Defaults, PRC WP , Pension Research Council Working Paper, Pension Research Council, Wharton School, University of Pennsylvania (February 2014). 3 Investment Company Institute, 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2012 (December 2013). 4 Disability is defined as a participant s inability to perform the necessary duties of any occupation for which he/she is fitted by education, training and experience after 180 days of continuous disability.

4 Protecting Retirement Savings: The Retirement Loan Eraser 4 by an A.M. Best A rated carrier (the CLIP ). 5 The CLIP is owned by the plan and covers its loss from the forgiveness of the defaulted loan. The premium for the CLIP is an expense of the plan which can be paid directly by the participant outside of the plan with after-tax funds, thus not reducing the participant s account balance. Alternatively, the premium may be withdrawn directly from the participant s plan account balance, similar to a loan fee charged by a provider, as a non-taxable payment of a plan expense. Payment from the CLIP enables the plan to avoid exercising the lien it holds on a participant s retirement benefit in the event of a loan default and replenishes the participant s account with cash. In this sense, the CLIP acts as alternative collateral for the plan in granting a loan. There are two elements of cost in RLE protection: (1) the CLIP premium payable to the insurance company that issues the policy; and (2) an administrative fee. These two costs are assessed as a single debt protection fee to the plan. Unless the participant opts out, he pays the fee for the RLE coverage as a condition of receiving the loan, much like paying the costs of administering the loan. In the event of a covered claim, before the plan distributes the defaulting participant s account and offsetting the unpaid loan balance, the plan collects the balance from the insurer under the CLIP and releases its lien on the participant s account. The funds collected from the CLIP are then allocated to the participant s account, so that when it is distributed, the participant receives his full account balance without reduction for the loan default caused by the unanticipated termination of employment. Discussion of RLE Protection A number of questions doubtless come to mind when first considering the RLE protection, and anxiety over the answers may create myths in the minds of plan sponsors and fiduciaries. Among the myths: Doesn t the coverage encourage loan defaults? Doesn t it give the 5 There are currently no fewer than three carriers prepared to write this insurance. Each is rated by A.M. Best A or better. The specific carrier is selected based on which is then offering the best rates. participant a windfall? Is the protection really necessary? Doesn t it violate the terms of ERISA and the Internal Revenue Code? Isn t it expensive? Isn t there a fiduciary risk in offering it? Doesn t it require a lot of extra administration? Let s consider each of these. Doesn t the coverage encourage loan defaults? No, not at all. RLE protection is only available in the case of an involuntary termination of employment due to death, disability or action by the employer to sever the participant from employment. Not to be overly dramatic, but these can be considered to be catastrophic events. The protection is not available if the participant voluntarily changes jobs or simply elects to stop paying on the loan. Since participants rarely choose to be fired or laid off, and since death and disability are generally unpredictable events, participants are not in a position to manipulate the system to obtain the benefits of the coverage in the absence of one of the specified catastrophic events. Doesn t it give the participant a windfall? Again, the answer is no. What RLE protection does is preserve the participant s account balance if one of the catastrophic events befalls him (or his family). In the absence of such an event, the participant would go on working, loan payments would continue to be deducted from his paycheck and in due course, the loan would be paid off and his account balance would be fully restored. But this can t happen if he dies or becomes disabled. It can t happen if the employer terminates his job. The loan balance goes into default, is declared to be a deemed distribution and becomes taxable to the participant. However, by paying a premium to cover the plan s loss if a catastrophic event occurs, the participant is able to make sure that he receives the full benefit credited to his account that can be rolled over to an IRA or to the plan of a new employer. It does not change the tax status of the funds in the plan or create basis in the account the participant still has to pay tax on the defaulted portion of the loan.

5 Protecting Retirement Savings: The Retirement Loan Eraser 5 Is the protection really necessary? The answer is that -- like any other form of casualty insurance you hope not. Do you want your house to catch on fire so you can make a claim on your fire insurance? Do you want to become disabled so you can make a claim on your disability insurance? No, but if one of these events happens, you sure feel better if you have that coverage. This is equally true in the context of participant loans, especially when the likelihood of a default in the event of an involuntary termination of employment is so high. RLE protection falls into the same category. Is it really necessary? It isn t so long as you have 100% assurance that you won t suffer a covered catastrophic event. Isn t it expensive? It depends on the value you place on the protection it affords. Let s look at the facts. The median participant loan is $4, The typical monthly fee on participant loans currently charged by recordkeepers (or other service providers) ranges from $4.00 to roughly $10, solely to administer the loan. This fee is payable regardless of the loan s size. While the fee covers the recordkeeper s extra administrative costs, from a participant standpoint, the fee is likely viewed as one imposed for the privilege of borrowing his own money out of the plan. The cost of the RLE program to protect the median $4,600 plan loan against involuntary default is approximately $11 per month. In other words, the premium is a payment for protection against a catastrophic event. Compare this to the cost of cell phone insurance, where the typical premium is $12 per month to protect a $500 device. When the $11 premium is added to the monthly principal and 6 Lu, Timothy (Jun), Mitchell, Olivia S., Utkus, Stephen P. and Young, Jean A, Borrowing from the Future: 401(k) Plan Loans and Loan Defaults, PRC WP , Pension Research Council Working Paper, Pension Research Council, Wharton School, University of Pennsylvania (February 2014)..In the study, the median loan amount borrowed was $4,558 in 2010 US dollars. This has been rounded to $4,600 for simplicity. interest payment on the loan, the total payment increases from $85 on an unprotected loan (assuming a 4.25% interest rate) to $96 on a loan protected under the RLE program. One way of looking at the RLE premium is that it raises the effective interest rate to approximately 6.5% (though the premium isn t characterized as interest). While the RLE is not designed to encourage participant loans, if a participant needs money to meet an emergency, a loan from his 401(k) plan is preferable to a payday loan or credit card advances, which have significantly higher interest rates and do not offer the benefit of automatic payroll withholding for repayment. A 2009 study by the Federal Reserve Board, Washington, D.C. reported households could have saved as much as $5 billion in 2007 by shifting expensive consumer debt to 401(k) loans. 7 The RLE program utilizes prevailing underwriting standards in the debt cancellation industry to create protection that is available at the time of borrowing at less than half the cost of comparable coverage in the market. 8 For a participant who doesn t need the protection afforded by the RLE program, you could say it is expensive. On the other hand, the opt out feature allows any participant to forego coverage at any time; and for a participant who is laid off or becomes disabled or dies, having the protection can preserve a significant portion of his retirement savings. In that sense, the cost is nominal compared to the benefit it offers. 7 Li, Geng and Smith, Paul A. New Evidence on 401(k) Borrowing and Household Balance Sheet, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. ( ) (the Fed Report ). 8 United States Accountability Office, Consumer Costs for Debt Protection Products Can Be Substantial Relative to Benefits but Are Not a Focus of Regulatory Oversight (March 2011). The report states: Fees for the nine largest credit card issuers debt protection products range from $0.85 to $1.35 per month for every $100 of the outstanding balance. Stated in comparable terms, the cost of RLE protection is $0.46 per month per $100 of outstanding balance.

6 Protecting Retirement Savings: The Retirement Loan Eraser 6 Isn t there a lot of fiduciary risk in offering the RLE protection? There are some fiduciary considerations, but there could also be fiduciary risk in not offering the protection. Requiring the protection as a part of the loan policy is an employer (or settlor ) decision and not a fiduciary one, so if any employer decides to require that participants have (or at least be offered) the protection, this does not entail fiduciary risk. However, the way a fiduciary implements the loan policy is a fiduciary act, and this raises two concerns that a fiduciary will have. First, the decision on which provider to select to implement the requirement would be one that the fiduciaries would need to make. They would need to evaluate the options that are available in the market (to the extent there are alternatives to the RLE program) and would need to decide whether the selection of that product and provider is a prudent decision. If there is only one provider, the fiduciaries will need to evaluate the terms, conditions, costs and benefits of that provider and its product offering. While this may sound difficult, it is no different from any other decision that fiduciaries are required to make every day about service providers and products offered to their participants. It requires engaging in and documenting a prudent process and making an informed and reasoned decision. In the context of the RLE program, Custodia Financial provides support to the plan fiduciaries to facilitate the process of making this decision. Second, in light of the fact that loan protection is available, fiduciaries may need to consider whether it is prudent to offer a loan without protection, regardless of whether the employer elects to include it in the loan policy. The fiduciary responsibility under ERISA is to act in the interest of participants for the exclusive purpose of providing retirement benefits. Although there is currently no guidance indicating that a failure to provide loan protection would violate this responsibility, fiduciaries may nevertheless need to consider whether they can properly fulfill their duty to the participants if they fail to take steps to offer the RLE program or one similar to it when a loan is made. This consideration may be particularly true for fiduciaries of plans sponsored by an employer in an industry with volatile swings in employment. That is, if there is a reasonably high possibility that a significant portion of the workforce will be laid off, would it be prudent to approve loans which is a fiduciary act without at least offering loan default protection? For the employer this question leads to the need to consider the business risk of not offering the protection, especially in a world of ever-increasing class action litigation involving plans. This risk could arise, for example, where a company is looking to downsize, where it will be laying off a portion (perhaps a large portion) of its workforce. It is probable that some percentage of the laid off employees will have participant loans, and it is entirely possible that some of them will have received approval from the plan fiduciaries to take a loan after the decision to downsize has been made but before it has been announced. These are the very employees who need the RLE protection the most. In this context, the courts have said that where fiduciaries have material information that may affect an employee s decision respecting his benefits in the plan, it is a breach of duty to withhold that information. This obviously creates a difficult situation for fiduciaries who are also plan officials, some of whom may even have been involved in the layoff decision. In a public company, they are precluded from disclosing the layoff program before the information is made public. But it may also be harmful for the participants to deny approving loans until the announcement is made, since it would cut them off from funds at a time when they have a significant need. On the other hand, if that company s plan requires as a part of its loan policy that employees have the RLE protection unless they opt out, the impact of the layoff decision on participant loans is virtually eliminated because the benefit of the laid off employee is protected, even when he defaults on the loan. Doesn t it violate the terms of ERISA and the Internal Revenue Code? And doesn t it require a lot of extra administration?

7 Protecting Retirement Savings: The Retirement Loan Eraser 7 This question encompasses a host of issues under the Internal Revenue Code and ERISA. The short answer is that does not violate any of the Code requirements for qualified plans or participant loans and does not create prohibited transactions under ERISA. While requiring the protection as a part of the loan policy is an employer and not a fiduciary decision, the decision on which provider to select to implement this requirement would be one that the fiduciaries would need to make. In the context of the RLE program, Custodia Financial provides support to the plan fiduciaries to facilitate the process of making this decision. For current purposes, since all the administration is handled outside the plan, and all other plan administrative protocols remain the same, it does not create additional administrative complexities for the plan, its recordkeeper or custodian. Perhaps the only issue of concern is whether the protection needs to be valued for purposes of reporting on the annual Form 5500, since the protection is a plan asset. Arguably, it does not have to be separately reported. This is based on FASB guidance on the reporting of loans. 9 Under this guidance, the value of the RLE protection would be embedded in the value of the note representing the loan and would not need to be separately identified. In any case, for plans that offer the RLE protection, Custodia Financial will provide guidance and information to the plan and, where appropriate, its auditors, regarding the proper reporting. 9 In Accounting Standards Update No , Plan Accounting Defined Contribution Pension Plans (Topic 962) (September 2010), the Financial Accounting Standards Board implemented the rules related to the valuing of participant loans. The standard, newly adopted in 2010, requires loans to be reported at their outstanding balance. This is an new exception to the rule that a plan s investments be reported at fair value. Conclusion There is a clear need to protect retirement savings from events outside the participants control. This is especially true in the case of participant loans, where a participant stands to lose a substantial portion of his account balance if his job terminates involuntarily, especially given the fact that there is a statistically overwhelming probability that he will default on his loan if that occurs. As noted, participants may be steered towards taking a participant loan rather than an early withdrawal, because of the perception that this better preserves retirement savings. But an involuntary loan default has the same effect as an early withdrawal. The issue may be best summed up in a recent Federal Reserve Board publication:..allowing participants some pre-retirement access to their savings can increase 401(k) participation and contributions, particularly among younger and more liquidity constrained households. Given that 401(k) loan programs exist, it seems appropriate to design them in such a way that minimizes financial risks to participants and maximizes 401(k) participation and contributions. 10 [Emphasis added] Where a plan offers the RLE protection, it ensures that participants will not suffer the leakage that a loan was meant to prevent. RLE protection offers a solution to the leakage problem, one that is simple to implement and provides valuable protection to participants who elect to accept it. 10 See the Fed Report, supra note 6, at page 5. CALIFORNIA DELAWARE ILLINOIS NEW JERSEY NEW YORK PENNSYLVANIA WASHINGTON DC WISCONSIN 2014 Drinker Biddle & Reath LLP. All rights reserved. A Delaware limited liability partnership One Logan Square, Ste Philadelphia, PA (215) (215) fax Jonathan I. Epstein and Andrew B. Joseph, partners in charge of the Princeton and Florham Park, N.J., offices, respectively.