Borrowing Against The Future

October 24, 2004

After nearly 25 years of theorizing and debate, a new pilot program is about to begin in Connecticut allowing individuals to borrow against their 401k plans via a credit card. The idea is not without controversy - proponents, like Nobel Prize laureate Franco Modigliani, believe this plan will encourage workers to contribute more to their 401k plans. Opponents, including Senator Chuck Schumer (D-NY), fear the plan will reduce the savings rate even further. As with any economic discussion, both sides seem to have merit.

Opponents of the plan worry that making it easy for individuals to borrow against retirement plans could lead to a rash of foolish spending. People who suddenly find themselves with a new source of easy money that they can borrow against are likely to spend that money. While, technically, that money needs to be paid back, under this plan after a few months any outstanding loans are converted into early withdrawals, which are taxed at the standard rate for pre-retirement deductions. I agree that this is problematic - currently to withdraw money from a 401k, one must contact one's plan administrator, who is likely to alert his customers to the penalties and taxes involved. However, when a consumer sees just how easy it is to borrow against that 401k, especially when they're given a VISA card that only charges 2.9% above prime, how likely are they to read the fine print? Given the extremely high rate of credit card debt in the US right now, do we really want to enable additional borrowing where the consequences of default include both a significant reduction of savings levels plus major tax penalties?

I have one other concern about this plan that I haven't seen addressed yet. As the plan is written, borrowers may spend no more than 40% of the total asset value of their 401k via this new VISA card. Obviously there is a necessity for a spending cap, since the idea is to try and prevent people from spending too much of their retirement money. However, what happens in a case like Enron, where the value of employees' retirement plans plunged to zero in a matter of weeks? People who have borrowed against their 401k have suddenly seen the collateral for their loans disappear. Not only did they just lose their entire retirement, but now they also owe a significant amount of money to their credit card, which most likely will no longer be constrained by the low interest rates built into the current program. As the loan is no longer collateralized, the banks will probably be able to raise interest rates on these loans to market rates - in some cases over 20%. Further, the IRS will, presumably, still be able to charge penalties for early withdrawal, even though the 401k is now worthless!

Proponents of the plan argue that, if people are allowed to borrow against their 401k, they're more likely to contribute to the plans. While I agree that people should be encouraged to save for retirement as much as possible, I'm wary of any method that involves borrowing against savings. The idea behind retirement savings accounts, and all the tax benefits that come with them, is that they are supposed to be untouchable savings. There are penalties against early withdrawal because this money is supposed to grow, untouched, until retirement, when it may be the only viable source of income for most people.

Allowing loans against 401k plans that can so easily become permanent withdrawals flies in the face of the underlying concept of the retirement account. The upcoming pilot program for this plan will show whether people actually use this plan properly or, as I suspect, drain their retirement accounts without considering the consequences. I hope I'm wrong.