Thinking of Borrowing From Your 401(k)? Read This First

Borrowing from your 401(k) can be risky business. Fail to repay the loan and you may have to pay taxes plus a penalty, not to mention that every dollar borrowed from your account takes money out of the market, potentially stunting the growth of your nest egg. Researchers from the Pension Research Council at the University of Pennsylvania looked at the prevalence of 401(k) loans and how they are used. (Click here to read the study; registration is required.) Stephen Utkus, a principal at Vanguard and co-author of the paper, discussed the findings with us.

Your research found that a surprisingly high percentage of 401(k) participants take loans from their accounts at some point. Just how common is this, and why do people borrow from their 401(k)s?  
We examined only one five-year period [July 2004-June 2009], but during that period, nearly 4 in 10 participants took a loan. So I'd say loans are reasonably common over time. And though it was not the focus of this research paper, other research shows that loan proceeds are used for a wide range of purposes--housing-related (home acquisition or improvement), college expenses, or other types of expenses. People borrow from their 401(k)s for the same reason they borrow generally--they are generally early in the lifecycle, are liquidity constrained, and have a current spending need. The plan is just one way to borrow.  

Do people usually repay the full amount of their 401(k) loans? And even if they do, haven't they missed out on any investment gains (or losses) from removing the loaned amount from their account?
Ninety percent of loans are repaid--in other words, the whole amount plus interest is repaid. The lost earnings are the difference or spread between the rate of return they might have earned and the rate of interest they paid back into the account. It's worth pointing out that this spread could be much lower than the cost of credit elsewhere--by borrowing through a credit card or another unsecured credit source. So yes, you might lose some money relatively speaking on the spread between rates of return. But it's likely to be much less than borrowing at 18% on a credit card.

You mention that plan rules regarding loans can influence participant behavior. What does this suggest with regard to how employers design their plans?
The simplest way to reduce loan-taking and the amount of borrowing is to offer only one outstanding loan at a time. Given the restriction to one loan, participants will consider the option carefully and will borrow somewhat less in total than if they had the option of two or three loans outstanding at a time. So yes--have a loan feature, plan sponsor. But limit loans to one at a time.  

You also discuss 401(k) loan default rates, which don't seem to be all that alarming, except for among those who leave their jobs involuntarily.
In the aggregate, about 1 in 10 401(k) loans ends in default. The vast majority of those loans end up being unpaid because of job change. I'd point out that it isn't necessarily that individuals leave their jobs "involuntarily." They could leave voluntarily, but they are simply unaware that the loan should be repaid, or, as we demonstrate in the paper, they are liquidity-constrained and don't have other savings to pay off the loan (that is, replenish their account balance).

Based on your research, do you think 401(k) loans are a good thing, or do they lead investors into temptation and behavior that undermines their retirement security?
In a voluntary defined contribution plan, loans have certain benefits, such as encouraging higher contribution rates. And most loans are repaid. I'd probably say not that loans are a good thing, but that loans aren't a particularly terrible thing. The more likely worry about retirement security is other forms of pre-retirement access--notably, access to 100% of savings upon job change. Cashing out a distribution accounts for more leakage from retirement accounts than loans or hardship withdrawals.