Participant Loans as "Pooled Investment"

[Guest wolfman]

401(k) Plan has made participant loans as a "pooled investment" rather than "earmarking" the loans as part of the borrower's account balance.The loans are secured by participant's vested account balance, however, the participant's account balance does not reflect the loan balance. The loans are taken from and paid back to a bond fund option. All participants invested in this fund share in the loan interest payments. One of the basic concerns is the potential for paying out a participant their entire vested balance forgetting to offset by the outstanding loan balance. Another concern is that participants with outstanding loans are able to direct the investment of their entire account balance. Should they be mandated to invest an amount equal to their loan balance in the bond (loan) fund or is that a fiduciary decision?

If possible the client would like to convert the loans to earmarked loans as part of the participant account balance. Any thoughts, comments, recommendations about the conversion and potential problems would be appreciated. I have not been able to find much guidance in this area. Thanks.

[Guest PAUL DUGAN]

We have taken over a number of plans where loans are treated as a part of the general investments but all of these plans are plans with no investment elections. I think you have a fiduciary problem. If participant A elects to invest 100% in the stock account and participant B elects to take a loan participant A then has part of his account is now invested in the loan and/or the bond account. How do you justify this.

My first question is what does the document say. If it requires this method amend if not change your procedures now. I see no problem with the change if its not required by the document just explain it as a correction. If it is required by the document I would give the current participants with loans an option. The loan interest if it is an arm length transaction is probly better the return on the bond fund.

[Guest wolfman]

Thanks for the response Paul. I agree with your fiduciary concerns. However, in your example Participant A will still be invested in the stock fund. The loans are taken from the bond fund, and all interest payments are allocated to the bond fund. Therefore, only those participants in the bond fund share in the loan interest payments. The plan document, which is a prototype, does not address these details, nor does the loan agreement. The loans are secured by up to 50% of the participant's vested account balance. However, the participant taking the loan is not required to be invested in the bond fund. The plan has a healthy amount invested in the bond fund so the participants invested there should be secure. However, if there was not a lot invested in the fund, the fiduciary should mandate that the participant maintain an investment in the fund at least equal to their outstanding loan balance (this should probably be done anyway). Otherwise, there may not be enough cash to enable tranfers to other funds or distributions.

[M R Bernardin]

What you are describing is a normal arrangement for a plan that treats loans as a general plan investment. I do not believe it is necessary from a fiduciary perspective to have the borrower invest an equal amount in the bond fund; all that is necessary is that the responsible fiduciary determine that the loan is a prudent plan investment. Of course, there are lots of reasons why earmarked loans are less risky and a better idea.

In converting these loans from general asset to earmarked, consider the following: (1) since participants apparently have the authority to direct their plan accounts, should they be notified and given an opportunity to affirmatively choose to have a portion of their plan accounts prospectively invested in their loans, (2) the participants invested in the bond fund will be receiving cash in exchange for their interest in the loan notes, so it will be necessary to assign a value to the loans, and this will be complicated if any of the loans are past due, (3) should participants be given an opportunity to pay off their loans before this "conversion" since the return on this money will be changed, and (4) do the loan documents (application, promissory note, etc.) have any language in them that would prevent you from converting to earmarked loans, such as language regarding how loan payments will be applied?