In a new paper titled, “Borrowing from the Future: 401(k) Plan Loans and Loan Defaults,” Olivia S. Mitchell, Wharton professor of business economics and public policy, analyzes the loans people take from their 401(k) pension plans, why they take these loans and what happens when these borrowers leave their jobs. The paper was co-authored by Timothy (Jun) Lu from Peking University, HSBC Business School, and Stephen P. Utkus and Jean A. Young, both from Vanguard Center for Retirement Research.

Knowledge at Wharton asked Mitchell to summarize her research and talk about its implications for business practitioners, consumers and regulators. 

An edited transcript of the conversation follows. 

Knowledge at Wharton: Please briefly describe your research.

Olivia Mitchell: My research in this area has been focusing on the loans that people take from their 401(k) pension plans. It’s quite common for employers to allow loans from the pensions, and in fact, we find that at any given time, about one fifth of all workers have taken a loan. Over a five-year period, as many as 40% take loans. So it is a common practice.

We have investigated why people take loans, what happens when they do, and in particular, what happens when they terminate their jobs. At that point, they have to pay back their loans in full or incur income tax plus a 10% penalty. So, we’re concerned about whether people are using their 401(k)s as piggy banks.

What we found was that plan loans are very widespread. Many people take multiple loans that are usually repaid, except in the event of people terminating their jobs. So, we conclude from this that 401(k) plans obviously are intended to support retirement saving. But they’re also used as a form of support for pre-retirement consumption.

Knowledge at Wharton: What are some of the key takeaways from your research?

“What we found was that if people are permitted to take multiple loans, they are more likely to borrow.”

Mitchell: The key takeaways of the research have to do with the way 401(k) plans are designed and how plan sponsors construct them. It’s very common for plans to allow loans. In fact, I didn’t even know that our own company allows plan loans before I started the research. Employers need not permit the loans, but if they do, they have to think carefully about constructing the environment in which people take the loans. For example, what’s the interest rate? People have to pay back to themselves the loans plus interest. What is the potential for taking out multiple loans?

What we found was that if people are permitted to take multiple loans, they are more likely to borrow. And they borrow double the amount. All those decisions are up to plan sponsors, who need to think carefully about how they structure the 401(k) environment for their employees.

Knowledge at Wharton: Which, if any, of your conclusions surprised you?

Mitchell: When I started on this research, I had no idea that 401(k) loans were so widespread. What didn’t surprise me was that those most likely to borrow from their retirement accounts are young people, low paid people and people likely to be liquidity constrained. What did surprise me was that so many people default on their loans at the point of job termination. It’s expensive to default. You have to pay income tax plus the tax penalty. I think most people don’t realize how big a burden that can be. So we need to get the word out in terms of the cost of defaulting on the loans.

Knowledge at Wharton: What are some of the practical implications of your findings?

Mitchell: Some in policy circles have suggested that loans should be completely outlawed — that is, that workers should be encouraged to save in their 401(k) plans, but they should be prohibited from borrowing at all. I think that’s the wrong message because employers understand that if they’re going to encourage the workers to contribute to their plans and the workers are low paid, they need to have the confidence and flexibility to be able to borrow if they get into a pinch.

The right message is that loans can be structured judiciously and thoughtfully, and that the way they’re structured makes a big difference to employee behavior.

Knowledge at Wharton: What new strategies or approaches would you suggest as a result of this research?

Mitchell: As a result of my research, several conclusions follow. Plan sponsors need to think carefully about how they’re allowing access to the plans. For example, instead of allowing multiple loans, which seems to be taken by the employees as an opportunity to borrow, maybe allow one loan at a time. And maybe potentially cap the amount that can be borrowed at a time, so that people have the access in the event of hardship and need, but they’re not necessarily seeing it as a revolving credit card.

Knowledge at Wharton: Is there any news event or trend that is relevant to your research?

Mitchell: There has been a lot of attention, especially since the financial crisis, about Americans’ need to save more and their need to set aside more for retirement. My research falls directly into this interest area. There has been substantial policy attention to encouraging saving through 401(k)s as tax-qualified accounts. There’s been a lot of attention to automatic enrollment and automatic escalation, where people boost their saving rates over time.

“People are not particularly aware of the financial consequences of taking out a loan, especially if they become unemployed.”

There’s been very little attention to what we call the “decumulation phase” — that is, how people manage the money on the way out of the pension. Loans are a part of it and also pay-outs at retirement. That’s what needs additional analysis.

Knowledge at Wharton: What misperceptions held by the public or media might your study dispel?

Mitchell: There have been a number of research studies recently arguing that people are taking loans willy-nilly without paying attention to the consequences. I do believe that people need to be educated much more about the fact that they pay themselves back, which is good — but they also forego the opportunity to earn investment earnings on the money that they borrowed along the way.

Also people are not particularly aware of the financial consequences of taking out a loan, especially if they become unemployed. So both of those topics need a lot more attention in the workplace as well as in policy circles.

Knowledge at Wharton: What sets your research apart from other studies done on this topic?

Mitchell: We have been very fortunate … to have a research collaboration with the Vanguard Group, which is a senior partner here at the Wharton School. Steve Utkus … is head of the Retirement Research Center at Vanguard. He and I have been working on 401(k) plans and investment behavior for several years. This research was made possible only because of the collaboration with Vanguard, which gave us access, under restricted conditions, to the 401(k) plans that they administer.

Knowledge at Wharton: Do you plan to conduct further research in this area?

Mitchell: Retirement savings is a passion of mine — retirement security, in particular. We are continuing to do research with Vanguard on the 401(k) plan market place, looking at, for example, what happens when companies introduce target date plans as investment options. How do people change their portfolios? What impact will this have on their future returns and risks?