Setting interest rate on plan loans to participants

[Guest JVH]

How do you typically set the interest rate for plan loans to participants secured by a right of offset against the participant's account balance, and that requires payroll deduction payback. Assume a five year payback, level amortization each pay period.

It seems like prime plus one percent is the most common I have seen.

Have you seen any guidance from the DOL or IRS on how to determine a reasonable rate of interest, other than it must a rate that basically a commercial lender would charge on a similar loan.

[FundeK]

Prime plus one is definately the most common one I have seen.

We recently had an IRS auditor inform us that prime plus one "did not appear" to be a reasonable rate of interest, so apparantely they have issues with it.

As you stated, the interest rate must a rate that a commercial lender would charge on a similar loan. The only loans issued that are secured by a participant retirement plan balance (similar loan) are issued from a retirement plan. If the majority of retirement plans use prime + 1% how can that not be a reasonable rate of interest?

We responded to the auditor that at the TPA firms who recordkeeps the plan, 90% of the plans use prime plus one. Since there are no specific guidelines for determining a reasonable rate of interest, a Plan Sponsor must make the determination based on all relevant facts. Using a benchmark survey, if it contains this information would be helpful.

Basically it is up to the Plan Sponsor to determine how they will define a reasonable rate of interest, and stick to it. I would recommend putting this policy in writing in case the big bad auditors come knocking on your door.

[Guest PensionAdministrator]

It is our policy to call three local banks and get the rates for comparable loans and then take the average of these three comps to determine the loan rate. It is usually hard to explain to the banker exactly what type of loan we are looking at but generally we tell them to give us the rate for 5 year loan secured by cash or a CD.

Hope this helps.

[rcline46]

PensionAdministrator - since you go through all of that - how do the rates compare to prime plus 1?

What if your client is not in the same city you are - do you call 3 banks in the nearest city to your client? Otherwise - what justification do you have for charging the rates used in Des Moines, Iowa with the rates charged in Los Angeles, CA - or South Los Angeles? Or Harlem in NYC vs Bronx?

Or credit unions vs local banks vs large banks? Or small towns with only 1 bank!

You will get widely different rates under these conditions.

While admiring your persistance in getting rates, it is a luxury most TPA firms just don't have. That is why prime or prime plus 1 is so popular.

[MWeddell]

Whether the loan interest rate is reasonable is a DOL issue not an IRS issue.

There are a fair number of surveys on the issue that will indicate that (i) prime + 1% is the most common interest rate, and (ii) prime +/- an increment is used by a large majority (2/3rds?) of retirement plans that offer loans to participants and that this has been true ever since the 1989 DOL loan regulations were final. Given those circumstances, if the DOL ever wanted to challenge the practice of using the prime rate, realistically they will have to issue less ambiguous guidance given that commercial lenders don't make loans fully secured by retirement plan accounts.

[FundeK]

MWeddell - Have you ever had an IRS auditor question this? I was really confused by some of the auditors request because they were DOL regulations he was questioning and he is an IRS auditor!

Would a DOL auditor even bother asking you to prove how you determined a reasonable rate of interest?