BeFi Bulletin, Summer 2011

One of the ways assets "leak" out of 401(k) and similar types of defined contribution pension plans is through loans that are taken out on these plans but not repaid. Analysis suggests that a less drastic policy approach to reducing retirement plan leakage could be more beneficial than hard-line policies. In addition, making it easier to implement savings-enhancing decisions could increase retirement assets. Several recommendations apply these strategies to address retirement plan leakage.

Brigitte Madrian of Harvard discussed joint work with John Beshears (Stanford), James Choi (Yale) and David Laibson (Harvard) on retirement plan leakage in the form of loans, hardship withdrawals, and cash-outs at job change. Here, we limit our focus to her analysis and recommendations regarding leakage in the form of 401(k) loans that are not repaid. Though loans are utilized for approximately 2-3% of overall 401(k) balances, most are repaid. However, $560 million leaks out of 401(k) plans each year through these types of loans.

One potential policy solution seems simple: wouldn't disallowing 401(k) loans in the first place stem leakage and increase retirement assets? As it turns out, the full picture isn't so simple. Having loans available as an option makes 401(k) plans more attractive and leads to increased 401(k) saving. And savings rates during loan repayment are largely maintained, so no need to worry on that front. Importantly, the increased savings produced by loan availability offsets leakage due to lack of loan repayment. So disallowing loans would seem to be counter-productive.

Better policies for increasing retirement savings would hold on to the increased contributions that come from offering liquidity while also limiting the amount of subsequent leakage. Professor Madrian suggests that a less drastic approach taking into account the psychology of loan leakage could fit this bill. Her recommendations focus on the ease with which loans can be taken out and repaid, taking information about current loan ease as a starting point. When getting a 401(k) loan is easy, people take out more loans. While people are employed, loan repayment is easy to implement through payroll deductions and repayment rates are high. When employees are terminated from their jobs, loan repayment becomes more difficult logistically and leakage from 401(k)s occurs. Recommendations to consider are provided in Table 1; these would make loans harder to take out and easier to repay. One recommendation would even make it easier to increase plan contributions following loan repayment.

During loan repayment, people get used to making regularly scheduled contributions to pay off their balance. Once the loan is paid off, it could be relatively painless to keep up these payments, channeling them towards increased 401(k) contributions rather than loan repayment. Efforts to encourage such rechanneling of payments could increase retirement assets.

This idea is similar to Pay Back Yourself, proposed by Dean Karlan of Yale and Jonathan Zinman of Dartmouth. They suggest seamless conversion of loan payments to savings or investment contributions once a loan is paid off, describing application to auto loans, home equity loans, and 1st mortgages near the end of their term. This approach can harness habit formation and mental accounting; people are already used to setting aside the given amount for regularly scheduled payments. It could be bolstered by upfront commitment, in which the individual decides in advance to continual making regular payments even after the loans is paid off. It could also be bolstered with reinforcing messaging and back-end automation. As 401(k) loans are already linked to an investment vehicle, they present a particularly promising opportunity for application of these ideas.

As discussed by Jason Fichtner of George Mason University and Mark Iwry of the U.S. Department of Treasury, interventions informed by behavioral insights have the potential to produce significant changes in individuals' asset accumulation.

Table 1: Ideas for Reducing Retirement Asset Leakage Through 401(k) Loans
Source: Brigitte Madrian, "Liquidity, Loans, and Leakage in Retirement," RAND Behavioral Finance Forum 2011