Ill-advised money moves and financial regrets take on many forms. That’s the bad news, but in better news, advisors can certainly help clients avoid financial missteps or take steps to ameliorate those mistakes after they’ve been committed.
If there is a silver lining regarding financial regrets, it’s that these issues can be fixed and they highlight the need for more ordinary investors to connect with advisors. In another bad news/good news scenario, the list of potential financial errors/regrets is long, but in nearly all cases, these mistakes can be avoided or improved upon with the help of an advisor.
For clients, the first and most important step is telling an advisor an upcoming financial move that could be regrettable in the future. Taking loans against one’s 401(k) plan is a prime example. Chances are the client is embarrassed or feeling some element of shame about tapping a retirement plan to deal with near-term expenses, but advisors can put on their psychology hats and help clients get past those feelings because 401(k) loans are indeed financial mistakes.
While 401(k) loans might not be something advisors deal with on a daily basis, new research from the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI) indicates it’s a subject that should be on advisors’ radars.
Number of 401(k) Loans Rising
Of note to advisors is the point that number of 401(k) loans taken by workers has increased dramatically in recent years.
“While the likelihood of having a plan loan in any given year is relatively low, more participants had loans at some point between year-end 2016 and year-end 2020,” according to the EBRI. “Overall, 29 percent of 401(k) participants in the sample had an outstanding loan at some point in the five years analyzed, compared with 18 percent at year-end 2016.”
In more good news/bad news, the amount of 401(k) loans in dollar terms usually isn’t large and they’re mostly being taken by younger workers who have the benefit of time, but data also suggest a participant with a large account balance is also more likely to take these loans.
“At year-end 2017, 64 percent of participants with new loans and total account balances greater than $100,000 took out 10 percent or less of their account balance as a loan compared with 16 percent of those with balances of $10,000 or less,” adds EBRI. “Similarly, those with smaller accounts tended to be more likely to take a larger share: 57 percent of those with new loans and balances of $10,000 or less at year-end 2017 took out more than 20 percent of their balance, compared with 14 percent of those with balances of $100,000 or more.”
More Bad Reasons Than Good
At the end of the day, advisors should talk clients out of 401(k) loans because the cons far outweigh the pros. Those include obvious points such as lost opportunity cost and the borrower repaying more than what was loaned. That’s just how loans work.
Additionally, many clients likely aren’t aware of the fact that they if lose their jobs or change employers, they’re still on the hook for the original 401(k) loan.
Further highlighting the need to discourage clients from these loans are two more points. First, installment loans of the personal variety can encourage borrows to indulge bad habits, taking out more loans to cover the older ones, thus “living off of loans.” Second, because 401(k) loans are made against existing assets, the interest rates are usually fair, but that’s not always positive because it doesn’t encourage rapid repayment, meaning these obligations can hang over clients’ heads for extend periods. There’s nothing desirable about that.