Financial Liquidity and Savings: Evidence from 401K Loans John Beshears John Beshears David Laibson David Laibson James J. Choi Brigitte Madrian
M ti Motivation ti � Previously illiquid assets becoming more liquid q � Credit cards � 1970: 7% of U.S. households have a credit card � 2002: 90% of U.S. households have a credit card � ~60% of household do not repay in full each month � Home equity loans � Defined benefit pension lump-sum payouts � Defined contribution plan loans 2
M ti Motivation ti � Previously illiquid assets becoming more liquid q � Credit cards � Home equity loans � Home equity loans � 1977: 5% of homeowners had a home equity loan � 2004: 19% of homeowners had a home equity loan y � Defined benefit pension lump-sum payouts � Defined contribution plan loans p 3
M ti Motivation ti � Previously illiquid assets becoming more liquid q � Credit cards � Home equity loans � Home equity loans � Defined benefit pension lump-sum payouts � 1991: 14% of DB pension plans offer lump sum 1991: 14% of DB pension plans offer lump sum � 2005: 52% of DB pension plans offer lump sum � Defined contribution plan loans p 4
M ti Motivation ti � Previously illiquid assets becoming more liquid � Credit cards � Home equity loans � Defined benefit pension lump-sum payouts � Defined contribution plan loans � 1993: 42% of DC participants in plans with a loan % f C option � 2005: 85% of DC participants in plans with a loan p p p option 5
R Research Question h Q ti � How does asset liquidity impact savings outcomes and wealth accumulation? � 401(k) loans � Data availability D t il bilit � Current relevance � 401(k) debit card � Senators Kohl and Shumer have recently proposed regulation to restrict 401(k) loan availability regulation to restrict 401(k) loan availability 6
Th The Headlines… H dli htt http://www.americanprogress.org/issues/2008/07/pdf/401k.pdf // i /i /2008/07/ df/401k df 8
Th The Headlines… H dli http://moneycentral.msn.com/articles/retire/basics/4714.asp 9
C iti Critical Assumptions l A ti � What would individuals do without a 401(k) loan option? � What would happen to … participation? Wh t ld h t ti i ti ? � What would happen to … contribution rates? � What would happen to … expenditures? � What would happen to … expenditures? � Would employees use other loans? � Would other financing sources be more/less costly? � Credit cards? � Hardship withdrawals? � Default? � Do participants maintain contributions after a loan? 10
Ai Aims of this paper f thi � Explain how 401(k) loans are regulated � Describe loan provisions offered by plans D ib l i i ff d b l � Calibrate impact on wealth accumulation p � Assess how savings plan participants utilize 401(k) loans utilize 401(k) loans 11
401(k) L 401(k) Loans: The Basics Th B i � Plans permitted to offer loans, but not required q � 50% of plan have a loan option (EBRI/ICI) � 85% of participants in a plan with a loan � 85% of participants in a plan with a loan option (EBRI/ICI) � Loans regulated by Treasury and DOL � Loans regulated by Treasury and DOL � Terms of the loan set by the plan within y p certain regulatory bounds 12
401(k) Loan Availability by Plan Size: EBRI/ICI (2006) 100 93 (k) Plans 90 87 86 83 80 Option 80 70 64 th a Loan O 54 54 60 60 tion of 401 43 40 27 20 20 Fract wit 0 1 to 10 11 to 25 26 to 50 51 to 101 to 251 to 501 to 1001 to 2501 to 5001 to >10000 100 250 500 1000 2500 5000 10000 Plan Size (number of participants) 13
L Loan Terms: Purpose & Amount T P & A t � Loan purpose—most (82%) plans have no restrictions on loan use (PSCA, 1999) ( , ) � Loan size—lessor of: � 50% of vested account balance 50% f t d t b l � $50,000 � Plans can set lower maximums if desired � Minimum loan amount usually $500-$1000 � Minimum loan amount usually $500 $1000 14
Loan Terms: Number and Loan Terms: Number and Repayment Period � Number of loans—no regulatory restrictions � 1 loan 52% of plans � 2 loans 36% of plans � 3+ loans 12% of plans � Repayment period (Hewitt plan Repayment period (Hewitt plan descriptions) � General purpose loans—5 year maximum p p y � Primary residence loans—longer term allowed 15
L Loan Terms: Repayment T R t � Repayment � After-tax � Principal + “reasonable” interest (Hewitt) � Prime 27% of plans � >Prime to prime+1 59% of plans � >Prime+1 to prime+2 6.2% of plans � Other � Other 5% of plans 5% of plans � Not specified 2% � Interest payments credited to participant p y p p accounts 16
L Loan Terms: Default T D f lt � Default treated as a taxable distribution � Outstanding balance subject to: � Outstanding balance subject to: � Ordinary income taxes � 10 percentage point tax penalty � Terminated employees must repay loans in full to avoid default (60 90 days) in full to avoid default (60-90 days) � Default NOT REPORTED to credit agencies (default to self) 17
Economics: Economics: Advantages of a 401(k) loan � Cited advantages of 401(k) loans � Less paperwork than other forms of credit � Less paperwork than other forms of credit � Lower interest rates (e.g., vs. credit card) � Interest paid to self rather than third party � Interest paid to self rather than third party � Interest earned may provide higher rate of return than other assets in the plan (e.g. return than other assets in the plan (e.g. money market fund) 18
Economics: Economics: Disadvantages of a 401(k) loan � Cited disadvantages of 401(k) loans � “Easy money” � increased consumption � Easy money � increased consumption � Erodes retirement income security � Borrowed money does not earn an investment � Borrowed money does not earn an investment return � Repayments made with after-tax dollars � Repayments made with after tax dollars � Default � tax penalty 19
Economics—Question #1: Economics Question #1: 401(k) loan vs. other sources of credit � Two period model � Denote B � Denote B 401(k) balances before loan 401(k) balances before loan � L Loan amount Rate of return on plan assets Rate of return on plan assets � r P � r P 401(k) loan interest rate � r L Interest rate for other credit Interest rate for other credit � r � r A Second period income � Y � τ � τ Tax rate Tax rate 20
Economics—Question #1: Economics Question #1: 401(k) loan vs. other sources of credit � Second period consumption with 401(k) loan A After-tax account balance Loan Non-loan balance Loan After-tax repayment (incl. t=2 return) payment income = − τ − + + − + + + − τ C C Y Y (1 (1 ) ) L L (1 (1 r ) ) [( [( B B L L )(1 )(1 r ) ) L L (1 (1 r )](1 )](1 ) ) L L P L = − τ + − + − τ − + τ (1 ) ( )(1 )(1 ) (1 )( ) Y B L r L r P L 21
Economics—Question #1: Economics Question #1: 401(k) loan vs. other sources of credit � Second period consumption with alternative loan After-tax account Loan After-tax balance (incl. t=2 return) payment income = − τ − + + + − τ C Y ( 1 ) L ( 1 r ) B ( 1 r )( 1 ) A A P 22
Economics Economics—Question #1: Question #1: 401(k) loan vs. other sources of credit � 401(k) loan dominates alternative credit if equation (3) >0: q ( ) − = − + − τ − + τ + + − + − τ C C ( B L )(1 r )(1 ) L (1 r ) L (1 r ) B (1 r )(1 ) L A P L A P = − + − τ − + τ + + L (1 r )(1 ) L (1 r ) L (1 r ) P L A = + − + τ − + − τ L [1 r (1 r ) (1 r )(1 )] A L P ( ) = − + τ − L r [ r ( r r )] A P P L 23
Economics—Question #1: Economics Question #1: 401(k) loan vs. other sources of credit � 401(k) loan dominates alternative credit if L [( r A - r p ) + τ ( r p - r L )]>0 L [( ) + ( )]>0 � Sign is ambiguous g g � ↑ r A makes 401(k) loan more attractive � ↑ r p makes 401(k) loan less attractive � ↑ r p makes 401(k) loan less attractive � ↑ r L makes 401(k) loan less attractive � ↑ τ ambiguous � ↑ τ ambiguous 24
Economics—Question #1: Economics Question #1: 401(k) loan vs. other sources of credit � 401(k) loan dominates alternative credit if L [( r A - r ) + τ ( r - r L )]>0 L [( r A r p ) + τ ( r p r L )]>0 � Special cases � τ =0 0 � 401(k) loan preferred if r A > r p � 401(k) l f d if � 401(k) loan preferred if r A > r p � r p = r L � In general, τ ( r p - r L ) likely to be small relative to ( r A - r p ) � τ small for many households (and <0) ll f h h ld ( d <0) � � r p close to r L after adjusting for risk 25
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