Borrowing from Yourself: The Determinants of 401(k) Loan Patterns

This paper explores the determinants of people’s decisions to take 401(k) loans. We argue that 401(k) plans do not simply represent retirement saving, but they also provide a means of saving for precautionary purposes. We model factors that rationally would induce people to borrow from their pension plans, and we explain why people do not often use 401(k) loans to replace their more expensive credit card debt. Next we test our hypotheses using a rich dataset and show that people who are liquidity-constrained are more likely to have plan loans, while the better-off take larger loans when they do borrow. Plan characteristics such as the number of loans allowed also influence borrowing and loan size in interesting ways, while loan interest rates have only a small impact. Authors’ Acknowledgements The authors thank Abba Krieger, Gary Mottola, William Nessmith, Greg Nini, Ning Tang, Steve Utkus, Jean Young, and seminar participants at the Department of Insurance and Risk Management of the Wharton School for helpful comments. They are also grateful to Vanguard for the provision of recordkeeping data under restricted access conditions; to the Pension Research Council at the Wharton School, the Bradley Foundation and TRIO Pilot Project Competition for generous research support. The research reported herein was performed pursuant to a grant from the U.S. Social Security Administration (SSA) funded as part of the Retirement Research Consortium. The opinions and conclusions expressed herein are solely those of the authors and do not represent the opinions or policy of SSA, any agency of the Federal Government, The Wharton School, Vanguard, or any other institution with which the authors may be affiliated. ©2010 Lu and Mitchell. Borrowing from Yourself: The Determinants of 401(k) Loan Patterns More than 62 million US private sector workers are covered by defined contribution (DC) plans, and these plans hold over $2.8 trillion in assets (U.S. Dept. of Labor 2007). A majority of these plans permits participants to take a loan from their plans: for instance, 85% of all participants were in plans that offered loans in 2006 (Vanderhei and Holden 2007). Plan loans allow participants to tap into their saving before retirement. By law, participants may borrow up to half their account balance currently, capped at $50,000. They do not need to pay income tax or other penalties as long as they repay on time, and the interest goes to their own accounts. But if a loan taker leaves his job, he is required to pay back all of the remaining loan balance within 60 days. If he fails to do so, the loan is considered to have defaulted, and he must pay income tax plus a 10% penalty tax on the balance outstanding. Furthermore, those who borrow from their 401(k)s may end up contributing less to their pension accounts after taking the loans, which could reduce their retirement account balances in the long run. With the recent economic downturn, there are also concerns that 401(k) loans might be climbing due to participants’ inability to obtain other forms of credit. For all of these reasons, plan sponsors and policymakers have expressed increasing interest in learning whether 401(k) loans are sensible in the pension context. In this research, we explore the factors that affect peoples’ decisions to take 401(k) loans. We construct a two-period utility maximization model to compare borrowing from 401(k) accounts and from credit cards. We predict that lower 401(k) loan interest rates, lower expected investment returns during the loan period, and higher credit card interest rates, are predicted to