Loan Default

[Guest andmik]

Hello,

With the change in the bankruptcy laws to allow a participant to continue to repay a plan loan to himself while undertaking a bankruptcy, is there any circumstance where a participant, while still gainfully employed with the employer, can unilaterally request that his loan repayments be stopped in payroll and be honored by the employer?

There is nothing that I can see that otherwise prevents the employer from allowing this "stoppage of payments" or on the other hand something that requires that such a participant request must be denied in all circumstances.

I realize this will result in a default, and deemed distribution taxation/penalty are likely to result.

Any insight will be appreciated.

Sincerely,

andmik

[QDROphile]

The the loan was made on the assumption that it would be repaid. It could be a breach of fiduciary duty to allow the loan to fail to be repaid when repayment is otherwise provided for. Also, fail to enforce terms of the loan, which includes the repayment facility, could be an improper in-sevice distribution.

[austin3515]

I agree w/ QDRO 100%.

[Bird]

I disagree.

The the loan was made on the assumption that it would be repaid. It could be a breach of fiduciary duty to allow the loan to fail to be repaid when repayment is otherwise provided for.

The first statement is not unique to payroll deduction repayments. And I don't know how the second statement can be backed up.

IMO, the payroll deduction nature of the loan repayments is an administrative convenience, so the sponsor doesn't have to process checks from participants. I don't think it has anything to do with forcing payments to be continued, unless the election was irrevocable.

I'm not saying it's ok to process a loan with the understanding that payments will be stopped. But I don't see how you can prevent someone from making a change to a voluntary payroll election.

[austin3515]

If its incorporated into the promissory note (which is at least where we have it in our loan paperwork), than it ceases to be voluntary when they sign the note. It's not an administrative convenience at that point--it's a contractual obligation.

[QDROphile]

If the account loaned money to General Motors, would it be a fiduciary breach if the fiduciary decided not to enforce the loan against Genreal Motors? We sometimes forget that participant loans loan are investments and plan assets, and the manangement of the plan for the benefit of participants does not look to the participant's immmediate personal needs or convenience. It is a retirement plan, not a payday lender, and that is why we have prohibited trnasaction rules, with only limited exceptions for plan loans.

[Bird]

If its incorporated into the promissory note (which is at least where we have it in our loan paperwork), than it ceases to be voluntary when they sign the note. It's not an administrative convenience at that point--it's a contractual obligation.

I don't know what your documents say, but I imagine they say "I will make these payments by payroll deduction." I don't think that means "I will make these payments by payroll deduction forever." I think it means "any payments I make will be by payroll deduction."

If the account loaned money to General Motors, would it be a fiduciary breach if the fiduciary decided not to enforce the loan against Genreal Motors?

I guess, but how is such a loan enforced? By asking for it, or seizing collateral, right? In the case of a participant loan, there is a mechanism to enforce the loan if it is not paid, and that is to default it. Have you considered that the Plan Administrator is not necessarily the Plan Sponsor? That is, the PA doesn't necessarily have control over the payroll function.

Try this: a participant has a loan that is being repaid by payroll deduction. The participant runs into trouble, and cannot afford those payments - if they are continued, the participant will be evicted from their house. Are you going to advise the employer to continue to withhold loan payments?

[austin3515]

Though its difficult, imagine if your bank said, "oh forget it, I know you're down on your luck so just forget about the loan I gave you."

I know it stinks, but what are you going to do? Who decides whose tale of woe is bad enough?

[Guest andmik]

Thanks to everyone so far who has taken the time to provide feedback.

I see that there are clearly two camps on this. One says you can never allow stopping payroll deduction loan repayments, while the other recognizes that certain situations where a participant may come under a "hardship" and need to stop the payments (not necessarily on a whim).

It would seem to me that if the loan was issued in good faith and a situation later arises that changes the ability of someone to repay the loan and they make the request to stop the payroll deductions, then if the loan repayments are stopped the fallout is default and taxation. In a plan that allows only one loan, the person will not be able to take another loan since the defaulted loan will remain an obligation of the participant until an offset can occur.

I did not mean to indicate that the loan would just be forgiven with no negative result. To Austin's point, the bank will not say "just forget about it" if you fail to repay your mortgage, but rather they will default your mortgage and take your home consistent with what will happen on a plan loan default with relatively costly taxation/penalty consequences being the end result.

Still not sure where to come down on this but thank you for your insight.

[Bird]

An employer allowing an employee to stop plan loan payments through payroll deduction is not forgiving the loan.

I hesitated before posting the sob story, because I don't think that this decision has anything to do with facts and circumstances. But as an employer who refused to stop withholding loan payments, I wouldn't want to be sued by someone in that circumstance (I think I'd lose). I suppose if your loan agreement language is so strong that it says you must continue loan payments under any and all conditions, then you're ok, but again, I doubt it says that. (Mine says "Payroll Deduction. Payments will be made through payroll deduction from each regular paycheck.") But why should it be that strong (that you can never stop)? Who cares? Loan defaults happen. As long as the Plan Administrator makes a reasonable effort to collect, that should be good enough.

[masteff]

My former boss was of the opinion that, in spite of a loan agreement stating payments will be made by payroll deduction, payroll laws can sometimes require employers to stop the loan deduction if the employee requests it in writing.

[austin3515]

Except that ERISA trumps those laws.

Another example of an incredible lack of guidance in a situation that arises quite frequently.

Also, TAGData indicated in a Q&A on their site that QDRO and I are correct (though admittedly as someone who is not an employer, it is very easy for me to say this).

LAstly, I should point out that if a participant is eligible for a hardship distribution, they can request this in the form of a loan offset, thus potentially solving the problem.

[masteff]

Except that ERISA trumps those laws.

Past comment from abanet.org made w/ respect to proposed "enforceable payroll withholding arrangement" for a plan loan...

Many state statutes which address procedures for payroll withholding make employer non-compliance a criminal act (typically, a misdemeanor). The extent of ERISA preemption over state criminal laws is questionable.

My personal opinion is run directly to ERISA counsel and make them put in writing which way to go w/ a given employee's request... but I do think it's not entirely cut and dried.

[austin3515]

At the Northeast Benefits Conference I asked Scott Falwell (or something like that, he runs the EPCRS program), and asked "If a participant can no longer afford loan payments and forbids the employer in writing from continuing payroll deductions, may the employer stop the deductions?"

His response was yest "but blah blah blah" (the blah blah blah being all of the obvious issues regarding taxes, max loan calc on future loans, etc.).

It has since occured to me as well that the act of disccontinuing loan payments simply puts the loan into default as a violation of the terms of the promissory note. Just because you have an agreement doesn't mean both parties are necessarily required to follow its terms--however, the terms of the agreement have implications for the failure of either party to abide by the terms (in this case, it would be the Plan's eventual loan offset upon a distributable event--of course taxation occurs "immediately"). I think further that it would be an abuse of the employer's position to disregard the aforementioned request.

So I think you could say I have turned a complete 180 on this one. Of course, I now have justification for what I wanted to do all along. So that's a good thing

But I do like the requirement of a written letter from the participant forbidding future loan payments.

[masteff]

But I do like the requirement of a written letter from the participant forbidding future loan payments.

And to get the full CYA effect, I'd propose the employer respond to the written request w/ a letter acknowledging the request and explicitly stating the consequences of default, as well as providing a copy of the special tax notice.

P.S. - after reading a few DOL Advisory Opinions that were only halfway related (dealt w/ not allowing loan deductions at all vs stopping deductions), I do think the DOL would be the more likely to have a problem w/ it. Of course, I just had my "duh" moment... it would be the DOL because it's ERISA preemption and not IRC preemption.

[austin3515]

There was a big DOL official (Kristen Zarwinski??) right next to Scott, and she did not say a word re his answer.

I too agree though that its primarily a DOL issue, regarding protection of assets, etc. But I still feel pretty good about the answer nonetheless. After-all, the Plan is adequately protected via the security agreement.

[BG5150]

If this happens to one person, then another, and then another, it would show a pattern of defaults of loans in the plan. Isn't that a qualification issue?

Also, if a participant defaults on the loan voluntarily, shouldn't the plan administrator report that to the credit agencies?

Theoretically, the PA should be verifying the credit-worthiness of the applicant even before the loan is made. The PA shouldn't just say, Mr. X makes such and such a month, and since it's coming out of his paycheck, we are guaranteed to get the payments. A bank could do that: Mr. X makes such and such, so we should be guaranteed to get our money. But they don't. Why should plan administrators?