Prepayment not allowed on loans?

[Belgarath]

Never seen this one... client wants to NOT allow prepayment on participant loans. Not seeing anything in 1.72(p) or 2550.408(b)-1 specifically prohibiting this, but it seems wrong on so many levels that I've got to assume this has been addressed somehow before.

First, it doesn't seem like ERISA would pre-empt state law on this question, so if state law doesn't allow for such a provision on loans, then that nixes it, perhaps. Then I start thinking about fiduciary issues - if a participant wants to pay it off early, and the plan/fiduciary won't allow it, then the participant is, in essence, being forced into an investment that is perhaps "underperforming." Etc., etc., - anyone ever heard of this question coming up?

[Bill Presson]

Most documents have an option on this. We typically allow for prepayment but ONLY to pay it off entirely. No extra principal payments to deal with.

[QDROphile]

You might be concerned with something that is usually overlooked, including by the IRS and DOL.  Loans have to have commercially reasonable terms.  At least some commercial loans are regulated and are required to allow prepayment of some sort.  In the environment, I would venture that it is very common, if not universal to allow prepayment, although the specific terms probably vary, e.g. there may be a permissible prepayment penalty under some loans to protect the expected profit of the lender.  It may be commercially unreasonable to deny prepayment altogether, and it may be unreasonable to have prepayment penalties for plan loans.  Denying partial prepayment is common, as an administrative burden, and should be allowed.

[Peter Gulia]

If the plan’s governing document, summary plan description, 404a-5/404c-1 information, and loan agreement were carefully written (and the administrator has evidence that the disclosures were delivered), a claim that a fiduciary breached its responsibility by allowing a participant loan that was an imprudent investment might be negated by the fiduciary’s ERISA § 404(c) defense that the loan, including the lack of a right to prepay, resulted from the participant’s investment direction and exercise of control.

If a loan was a non-exempt prohibited transaction, the plan’s equitable relief might include that the borrower disgorges the ill-gotten proceeds (with any profits made from using the proceeds) and restores the plan to no less than the result the plan would have obtained by keeping the loaned amount and prudently or properly investing the amount.

But it’s unclear whether the participant loan Belgarath inquires about was or would be a prohibited transaction.

Although 29 C.F.R. § 2550.408b-1 might preclude some participant loan terms that are less favorable to the plan than terms that would obtained “by persons in the business of lending money”, I don’t read the rule to preclude terms that might be more favorable than terms a commercial lender would get.

https://ecfr.federalregister.gov/current/title-29/subtitle-B/chapter-XXV/subchapter-F/part-2550/section-2550.408b-1

And unless the plan itself is in the business of banking (or the plan is not the lender), ERISA ought to preempt States’ laws.

[Belgarath]

Interesting. Thank you all for the input. 

[C. B. Zeller]

One more thing to consider - the plan administrator has a duty to ensure that the loan is repaid, as any amount that remains outstanding is at risk of default. If the plan administrator chooses not to allow prepayment, they are increasing the risk to the plan, perhaps imprudently so. If the plan is participant-directed then this may be less of a concern though.

[Peter Gulia]

C.B. Zeller brings us an important point.  If not everything about the loan is participant-directed, a fiduciary must consider prudence.

If a provision not to allow prepayment is only in a procedure that is not a governing document, a fiduciary must do what is prudent.

And if the no-prepayment provision is in the plan’s governing documents, ERISA § 404(a)(1)(D) might call a fiduciary to consider whether, in the particular circumstances, obeying the documents is imprudent.

[MoJo]

What C.B. and Peter bring up has been my concern for decades.  I would argue that there is a presumption that a prudent fiduciary would not turn away a plan debtor bearing money to reduce that debt.  The problem is, is that the way a prepayment works on OMNI is that it simply is applied to the next payment (or more) and does NOT adjust the interest payable over the life of the loan (as a prepayment on a mortgage or auto loan would do).  That means simply that when the loan is issued, the total amount due (principle and interest) is set in stone and doesn't change.  If a participant wants to pay off the loan in it's entirety, the "payoff amount" is the total of all future payments, which include interest not yet "earned."

I do not understand why the programmers of OMNI (and other r/k systems I seen) can't handle loans like a bank does.  After all, the purveyor of OMNI is FIS, which is a large fintech company that provides bank software for virtually every banking need - including loans.

Around our shop. we simply say "loans are evil."  'nuff said.

[C. B. Zeller]

1 hour ago, MoJo said:

The problem is, is that the way a prepayment works on OMNI is that it simply is applied to the next payment (or more) and does NOT adjust the interest payable over the life of the loan (as a prepayment on a mortgage or auto loan would do).  That means simply that when the loan is issued, the total amount due (principle and interest) is set in stone and doesn't change.  If a participant wants to pay off the loan in it's entirety, the "payoff amount" is the total of all future payments, which include interest not yet "earned."

In other words, if a participant repays a substantial amount (but not the entire amount) of their loan in advance, they will be charged the amount of interest that was due on the original amount of principal? There is no way that this would result in a commercially reasonable rate of interest. The loan would immediately become a prohibited transaction.

[Peter Gulia]

A general principle for a prohibited-transaction exemption is that an employee-benefit plan should pay no more, or get no less, than what would result from even-handed dealing.

Under the rule to interpret and implement the ERISA § 408(b)(1) exemption [hyperlink above], “[a] loan will be considered to bear a reasonable rate of interest if such loan provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.”

While this requires that a lender plan get no less than an imaginary bank lender would get, some might read this text not to preclude a plan getting more interest.

Beyond the rule’s text, the Labor department’s explanation of its rulemaking supports such a reading.  Loans to Plan Participants and Beneficiaries Who Are Parties in Interest With Respect to the Plan, 54 Federal Register 30520, 30524-30525 (July 20, 1989).

Tax law might treat a loan with more interest than is “commercially reasonable” as a deemed distribution.  See 26 C.F.R. § 1.72(p)-1 (flush language before the Q&As).

https://ecfr.federalregister.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFRac15f73ecf59a99/section-1.72(p)-1

But I have never seen the Internal Revenue Service assert this.  And my experience includes working inside what then was the #2 recordkeeper with tens of thousands of plans, many of which had situations of the kind MoJo describes.

485073054_participantloanexemptionexplanation30515-30531.pdf

[C. B. Zeller]

The prohibited transaction exemption under IRC 4975(d)(1) also requires that the loan bear a "reasonable" rate of interest.

A rate of interest that is too high opens the door for abuse. It could be used as an avoidance of the annual contribution limits. If the IRS are not enforcing this then they are failing to do their jobs, in my opinion.

For example, consider a loan of $50,000, amortized into monthly payments over 5 years at an annual interest rate of 5%. The amount of each monthly payment is $943.56. The sum of the scheduled repayments is 60 x 943.56 = 56,613.70. Under the recordkeeping system that MoJo described, the participant could immediately repay the loan by making a single payment of $56,613.70. That would have the same effect as allowing the participant to make an additional contribution of $6,613.70 without regard to any applicable limits. The rate of interest in this case would be 6,613.70 / 50,000 = 13.23%. If the loan were paid back the next day, the equivalent nominal interest rate on an annual basis would be 13.23 x 365 = 4,828%.

[Peter Gulia]

Under Reorganization Plan No. 4 of 1978, the Labor department’s rule to interpret ERISA § 408(b)(1) also controls the interpretation of Internal Revenue Code of 1986 § 4975(d)(1).  And until the Supreme Court changes the Chevron precedent, a Federal court must defer to the rule if it is a permissible interpretation of the statute.

If a participant loan is a non-exempt prohibited transaction, the § 4975 excise tax is imposed only on a disqualified person, such as the participant.  The excise tax never is imposed on a plan, and is not imposed on a fiduciary that acted only as a fiduciary.

The IRS could show that a loan with too-generous interest is a deemed distribution, with whatever consequences that brings.

Also, the IRS might, in some circumstances, show that a loan with too-generous interest allowed the participant to evade deferral or contribution limits, or otherwise get more tax deferral than was proper.

Executive agencies make difficult choices about how much law enforcement to pursue.  The IRS is no stranger to those choices (and often describes them in government reports).

[MoJo]

4 hours ago, C. B. Zeller said:

The prohibited transaction exemption under IRC 4975(d)(1) also requires that the loan bear a "reasonable" rate of interest.

A rate of interest that is too high opens the door for abuse. It could be used as an avoidance of the annual contribution limits. If the IRS are not enforcing this then they are failing to do their jobs, in my opinion.

For example, consider a loan of $50,000, amortized into monthly payments over 5 years at an annual interest rate of 5%. The amount of each monthly payment is $943.56. The sum of the scheduled repayments is 60 x 943.56 = 56,613.70. Under the recordkeeping system that MoJo described, the participant could immediately repay the loan by making a single payment of $56,613.70. That would have the same effect as allowing the participant to make an additional contribution of $6,613.70 without regard to any applicable limits. The rate of interest in this case would be 6,613.70 / 50,000 = 13.23%. If the loan were paid back the next day, the equivalent nominal interest rate on an annual basis would be 13.23 x 365 = 4,828%.

Start from the premise that the rate is reasonable at inception.  I don't think this becomes a "springing" PT simply because of this issue.  It must be commercially reasonable when issued.  But then again, when I worked for a bank, and we went to the lenders to determine "commercially reasonable" terms, the lender laughed, and said there was no way to make it commercially reasonable given ERISA's rules, and other factors....

I agree, it can result in an additional contribution to the plan under some circumstances.  I've never seen that happen (and usually the complaint goes the other way - "you're charging me too much interest.")

But, it is what it is, and that's the way OMNI (and others) work.

[amethbrilliant]

As far as I know, in most cases (and in my case, too), prepayment is allowed only when you want to repay the entire loan. Otherwise, it’s prohibited, and that’s convenient. It helps me ensure I paid as much as I should have.
I am a regular bank customer and don’t know all the peculiarities of this case. I just did some reading on https://www.youngandthrifty.ca/, and it seems to me that I read this about prepayment. It is not often used because it would lead to a constant re-evaluation of the loan or something like that.
Also, thanks for the answers. It makes things clearer for me.