IRS Says Prime is NOT Reasonable

[austin3515]

I just listended to the IRS phone forum where they went over their questionnaire and the results. They said they are getting a lot of questions on interest rates for participant loans but:

1) They referened the DOL's rules. (commerically reasonable, etc)

2) BUT Prime was NOT reasonable, because only the bestest borrowers can borrow at prime.

3) Prime +1 and Prime +2 was "probably reasonable"

We've always used and always seen prime plus 1 so I'm happy they have backed off the statement of "anything less than prime +2 is suspect." I can see their point on prime anyway.

[ESOP Guy]

I can't see any reason to NOT use prime. The loan is 100% secure. The plan can never have a loan loss from a plan loan. It is a risk free (from default) loan. You could make a case it is as safe as a gov't bond of the same length. In short a 1 year or less loan in my mind could reasonablely have a <1% rate like a T-bill.

Make no mistake I am NOT saying do that because I think the rule makers don't buy my line of thinking, but to say you have to charge above prime makes no sense. The only risk in that loan is interest rate risk. The regulator's are just using their feelings instead of logic in my humble opinion.

Edit is below

Ignore the above.

Prime is more likely. I just double checked my credit union. they will give you a loan secured with a savings account, which pays .2%, for 2.2% (ie rate plus 2%). That is below prime, but above T-bill rate. But prime plus is not what is commerical.

But like I said the IRS makes the rules so do what is safe, not what is right in this case.

[ETA Consulting LLC]

I can't see any reason to NOT use prime. The loan is 100% secure.

I'm pushing the "like" button!

[austin3515]

I wonder if the question of reasonable interest rates has ever gone to the courts?

[Peter Gulia]

Without staking out any particular view, consider that it’s not entirely right to say that the plan can never have a loss on a participant loan.

Although the typical loan terms include repayment through wage deductions, it’s possible for a borrower’s employment to end and for the borrower to be unable or unwilling to repay the loan.

A typical individual-account plan allocates both sets of cash flows and accruals on a participant loan to the account of the participant who borrowed. When the repayments the account has collected are less than the loan’s full loan principal and interest, the participant’s account has at least an opportunity loss on that investment. When the repayments the account has collected are less than the loan’s principal, the participant’s account has a negative return on that investment.

Consider also that a typical participant loan isn’t meaningfully secured. In theory, a plan could collect on an unrepaid loan by redeeming the participant’s other investments. (And keep in mind that those investments might have declined to a current value less than the outstanding loan receivable.) In practice, a plan’s administrator might decide (or be directed) to leave the “real” investments as-is and treat the defaulted loan as having a cash value of zero. A carefully written plan could provide that a participant directs the plan’s fiduciaries on how to handle his or her defaulted loan. See ERISA § 404©(1)(B). (The practices might be different for a loan made by an insurance company, rather than from direct plan assets.) Moreover, with a participant loan, only 50% (or less) of the account is real security for the outstanding loan. With a mortgage loan, 100% of the real property is security for the loan.

ERISA’s rule for what is a reasonable rate of interest – “... commensurate with the interest rates charged by persons in the business of lending money for loans [that] would be made under similar circumstances” – is nonsense. There is no truly similar loan that a commercial lender makes. One might analogize some aspects of a participant loan to a mortgage loan, in which the lender bears some risk that the value of its security interest could have a value lower than the outstanding loan receivable. But what prudent banker should make a loan for which the borrower can, by his or her unwise investment decisions, seriously devalue the lender’s security interest? (There’s a reason why a mortgage lender requires its borrower to maintain fire and homeowner’s insurance.) Besides, what marketplace loan do you know about in which the lender and the borrower are the same person?

Despite those and other inherent difficulties of trying to state a hypothetical fair-market-value for something that doesn’t have a market, one can view both laws’ reasonable-interest conditions as an attempt to provide for the loan a potential income meant to approximate what might have been the account’s investment return had the loan not been allowed and the account remained invested in assets other than a participant loan.

Because both government agencies’ efforts necessarily deal with hypotheticals, intelligent minds could find a wide range of interpretations. But let’s return to the main purpose: the fiduciary who decides the participant loan interest rate must administer the plan “for the exclusive purpose of providing [the retirement plan’s] benefits to participants and their beneficiaries[.]” Why not provide the loan with an interest rate that helps the participant restore his or her retirement savings?

[austin3515]

My mantra is "why not charge prime+1%." just charge prime+1 (not only because there is safey in numbers) and get on with more important things.

[mbozek]

I wonder if the question of reasonable interest rates has ever gone to the courts?

I dont know how such a case would ever get to the courts. Reg 1.72(p)-1(a) states that a valid loan is made with an interest rate and repayment terms which are commercially reasonable. The interest rate used for illustration in the regs was 8.75%. I dont know what benchmark was in effect in 2000 when the regs where published that would generate such a comercially reasonable rate.

For enforcement purposes commercially reasonable is a regulator's nightmare because it is the quantitive equivalent of the old facts and circumstances test. Commercially reasonable has been explained as whatever is offered by banks in the locality for similar loans.

Every time the Q was raised back in the day the response was that 1% over prime was a safe harbor b/c no one could figure how to construct a model of a commercially reasonable rate (and no client want to pay for some lawyer to become a loan officer).

It seems like in the last 20 years the needle has not moved at all in the regulatory playbook to define a comercially reasonable rate.

If the IRS wants to challenge 1% over prime as a reasonable rate then under the rules of practice the IRS would have to provide some authority under the regs for another rate to be the reasonable rate. I dont know where the IRS would find such authority under the 72p regs.

Additional comment on the fulitility of the Q- some plan loans are issued under insurance contracts which are subject to state law regulation of interest rates. For example TIAA provides plan loans to both ERISA and non ERISA plans which charge 2% over what is credited to the participant's account on the borrowed funds. If state law requires that 6% interest must be credited to the participant's account on the outstanding loan balance the participant will be charged 8% for the loan.

[david rigby]

Without staking out any particular view, consider that it’s not entirely right to say that the plan can never have a loss on a participant loan.

In addition, the plan might also incur some administrative expense associated with an unpaid loan.

[movedon]

If I heard the IRS lady on the call right the other day, "prime" as a definition of the rate in the plan document or loan policy is not reasonable. I can agree with that, as long as the IRS lady would agree that the prevailing local commercial rate for a similar loan (as the rate should be described in any decent plan document or loan policy) might be more, less or equal to prime at any point in time. Both the prime rate and a five year secured loan from my bank are currently at 3.25%. I don't see the controversy or difficulty in this. "Prime" is not reasonable. A rate that happens to be the same as or less than prime might be.

If plan sponsors have a problem in regard to rates it is that they don't get credit scores for the participants and so have no idea whether or not the person would qualify for bettter or worse rates in an arms length situation.

[austin3515]

I heard a more broadly sweeping comment on the appropriateness of prime in general. She certainly didn't emphasize a distinction regarding plans that mandate the interest rate in the documents and plans that do not. In my experience, most do not.

[movedon]

I heard a more broadly sweeping comment on the appropriateness of prime in general.

You may have heard right - I wasn't paying very close attention on the call. Wouldn't be the first time an IRS rep said something stupid and wrong on one of those calls.

[mbozek]

If I heard the IRS lady on the call right the other day, "prime" as a definition of the rate in the plan document or loan policy is not reasonable. I can agree with that, as long as the IRS lady would agree that the prevailing local commercial rate for a similar loan (as the rate should be described in any decent plan document or loan policy) might be more, less or equal to prime at any point in time. Both the prime rate and a five year secured loan from my bank are currently at 3.25%. I don't see the controversy or difficulty in this. "Prime" is not reasonable. A rate that happens to be the same as or less than prime might be.

If plan sponsors have a problem in regard to rates it is that they don't get credit scores for the participants and so have no idea whether or not the person would qualify for bettter or worse rates in an arms length situation.

Regardless of whether some IRS official states that the prime rate is not reasonable, her opinion is not an authoritative statement of the IRS which can only act by rulings, regulations or other pronouncements authorized under the IRC. The only legal authority for what interest rate may be charged under a plan loan is reg 1.72(p)-1(a) that the rate must be commercially reasonable. Period. The regulation does not state that the prime rate is not a reasonable interest rate. As previously noted loan interest rates in plan funded by insurance contracts will be set by state insurance law, not bank loan rates. Multi state employers use a single rate that will apply to all plan loans which will not be based on local bank rates in the area where the participant lives. Under the IRS regs using the prevailing interest rate of a particular bank for a commerical loan is no more or less commercially reasonable than using the prime rate or an interest rate set by state insurance law.

[GMK]

I continue to be impressed that there are non-bank plan sponsors who are willing to take on the role of a bank. Maybe they actually do have the skills to prudently and knowledgeably administer loans. Some probably do, but ...

(I am not a banker, and no, we do not offer plan loans.)

[K2retire]

Just to play devil's advocate for a moment, why wouldn't the participant want the highest (rather than lowest) possible interest rate? And in that case, if I wanted to take out a loan today at 7 or 8% interest, would that be considered reasonable?

[BG5150]

Just to play devil's advocate for a moment, why wouldn't the participant want the highest (rather than lowest) possible interest rate? And in that case, if I wanted to take out a loan today at 7 or 8% interest, would that be considered reasonable?

To answer the fist part of your question: I doubt many people who are taking out a loan from their 401(k) plan are really analyzing the precise financial impact for the long run. They need $5,000 now, and want the lowest possible payment. That means the lowest interest rate. That's about it. They are not thinking about the long-term impact on the account balance, be it for better or worse.

[Belgarath]

But do we only have to deal with the IRS regulations? The DOL 2550.408b-1(e) provides the following. FWIW, we actually contact 3 local banks every month to get a rate for such loans, and average the 3. We provide this number to the Plan Administrator, who can then make whatever determination they want!

(e) Reasonable rate of interest. A loan will be considered to bear a

reasonable rate of interest if such loan provides

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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.

Example (1): Plan P makes a participant loan to A at the fixed

interest rate of 8% for 5 years. The trustees, prior to making the loan,

contacted two local banks to determine under what terms the banks would

make a similar loan taking into account A's creditworthiness and the

collateral offered. One bank would charge a variable rate of 10%

adjusted monthly for a similar loan. The other bank would charge a fixed

rate of 12% under similar circumstances. Under these facts, the loan to

A would not bear a reasonable rate of interest because the loan did not

provide P with a return commensurate with interest rates charged by

persons in the business of lending money for loans which would be made

under similar circumstances. As a result, the loan would fail to meet

the requirements of section 408(b)(1)(D) and would not be covered by the

relief provided by section 408(b)(1) of the Act.

Example (2): Pursuant to the provisions of plan P's participant loan

program, T, the trustee of P, approves a loan to M, a participant and

party in interest with respect to P. At the time of execution, the loan

meets all of the requirements of section 408(b)(1) of the Act. The loan

agreement provides that at the end of two years M must pay the remaining

balance in full or the parties may renew for an additional two year

period. At the end of the initial two year period, the parties agree to

renew the loan for an additional two years. At the time of renewal,

however, A fails to adjust the interest rate charged on the loan in

order to reflect current economic conditions. As a result, the interest

rate on the renewal fails to provide a ``reasonable rate of interest''

as required by section 408(b)(1)(D) of the Act. Under such

circumstances, the loan would not be exempt under section 408(b)(1) of

the Act from the time of renewal.

Example (3): The documents governing plan P's participant loan

program provide that loans must bear an interest rate no higher than the

maximum interest rate permitted under State X's usury law. Pursuant to

the loan program, P makes a participant loan to A, a plan participant,

at a time when the interest rates charged by financial institutions in

the community (not subject to the usury limit) for similar loans are

higher than the usury limit. Under these circumstances, the loan would

not bear a reasonable rate of interest because the loan does not provide

P with a return commensurate with the interest rates charged by persons

in the business of lending money under similar circumstances. In

addition, participant loans that are artificially limited to the maximum

usury ceiling then prevailing call into question the status of such

loans under sections 403© and 404(a) where higher yielding comparable

investment opportunities are available to the plan.

[mbozek]

Just to play devil's advocate for a moment, why wouldn't the participant want the highest (rather than lowest) possible interest rate? And in that case, if I wanted to take out a loan today at 7 or 8% interest, would that be considered reasonable?

To answer the first part of your question: I doubt many people who are taking out a loan from their 401(k) plan are really analyzing the precise financial impact for the long run. They need $5,000 now, and want the lowest possible payment. That means the lowest interest rate. That's about it. They are not thinking about the long-term impact on the account balance, be it for better or worse.

Given the current state of the economy most participants want the lowest rates to reduce the amount of each payment, e.g., 4.25%. As a regulatory matter the IRS publicly stated years ago that an interest rate that was above the commercially reasonable rate would be prohibited as a disguised contribution to the plan to avoid the $ limits.

As to whether a 7 or 8% loan would be reasonable I recently saw a post that stated that TIAA was charging 8% which was required by state insurance law for a loan from a 403b plan. I have no idea whether this would be permissible under the 72(p) regs but I dont believe the IRS will disqualify a plan loan that uses an interest rate imposed by state insurance law b/c that would open up another can of worms.

This brings up another Question: does anyone have any knowledge of a plan that was audited by the DOL or IRS for using a specific interest rate?

The DOL regs cited above tilt in favor of using interest rates on the high end b/c the Plan is the lender and lower rates would reduce the amount of income to the plan even though interest on DC plan loans is repaid to the participant's account and has no effect on plan funding. It seems that the DOL and IRS regs are in conflict b/c the DOL wants the plan to impose the highest rate possible whereas the IRS wants the lowest rate to prevent the infusion of amounts that would be regarded as excess contributions.

[Bill Presson]

The thing that I've always loved about these regs is how the DOL & IRS think bankers have time to just sit around all day taking calls from plan sponsors to analyze potential loans that they'll never get.

Brilliant government thought.

[mbozek]

The thing that I've always loved about these regs is how the DOL & IRS think bankers have time to just sit around all day taking calls from plan sponsors to analyze potential loans that they'll never get.

Brilliant government thought.

Or that Plan administrators have the time to call bankers and pay for their attorneys to advise them on what rate of interest to charge on plan loans which is another reason why plan interest rate is prime plus 1%.

[david rigby]

Brilliant government thought.

A triple oxymoron!

[austin3515]

A triple oxymoron!

Brilliant observation.

I think the IRS shouild be ashamed that a group of pension experts can't decide what to charge for interest on a participant loan. Shame shame shame.

[shERPA]

I think the IRS shouild be ashamed that a group of pension experts can't decide what to charge for interest on a participant loan. Shame shame shame.

Exactly. Talk about micro-management. Sheesh!

[Bird]

ASPPA members just got a GAC Alert on this and they linked to a recent IRS newsletter which supposedly shed light on it, but was more of the same about checking vs. commercial rates.

Interestingly, the results of the IRS 401(k) survey show that 46% of plans use prime + 1%. I think there is safety in numbers on this one. Seriously, they just don't have enough to do if they're yammering about this.

[movedon]

IRS phone conference = free CE. And that's about it.

[mbozek]

Just to bring this discussion to a close as to the lack of regulatory guidance of what is a reasonable rate of interest for a plan loan, consider the following:

1. No one has provided any experience of a plan being audited because of the interest rate charged for loans which could mean that plan interest rates are not on the agents radar scope as an audit topic or that agents have no guidelines to determine what is a reasonable rate so they ignore interest rates as an audit issue.

2. I have not found any articles in professional journals and consultants newsletters that discusses how to construct a reasonable rate of interest under 72(p).

3. The IRS 401k plan fix guide's only reference to loan interest rates states under how to fix mistakes:

"4. evaluate loan terms to determine if the loan was based on a reasonable rate of interest (for example, a rate similar to what a participant would have been able to obtain had a similar loan been taken from a financial institution)."

The fix it guide makes no reference to using the prime rate as a benchmark in calculating the plan's interest rate (e.g., P+1 or 2) but does not exclude such use. Presumably a rate of interest set by the financial institution that is holding the assets (insurance co.) would be reasonable.

The only logical conclusion seems to be that there is no way to determine what is a reasonable rate of interest under the current regulations.

[GMK]

Not to be contrary, but it seems to me that a reasonable rate of interest can be determined by finding "a rate similar to what a participant would have been able to obtain had a similar loan been taken from a financial institution."

Examples in this thread show that the interest rate on "similar loans" varies from place to place and from time to time. As pointed out, above, such loans can even be at prime sometimes. In other cases, State law may require a rate for a plan loan that is unreasonably higher than the going rates from financial institutions.

IMO, what cannot be determined under the current regulations is a bright line Safe Harbor rate of interest that the pension experts can simply plug into the plan. It looks like interest rates on loans are a function of too many variables for there to be a simple answer. (Which, on re-reading, is I think in agreement with what Mr. Bozek is saying.)

[mbozek]

Not to be contrary, but it seems to me that a reasonable rate of interest can be determined by finding "a rate similar to what a participant would have been able to obtain had a similar loan been taken from a financial institution."

Examples in this thread show that the interest rate on "similar loans" varies from place to place and from time to time. As pointed out, above, such loans can even be at prime sometimes. In other cases, State law may require a rate for a plan loan that is unreasonably higher than the going rates from financial institutions.

IMO, what cannot be determined under the current regulations is a bright line Safe Harbor rate of interest that the pension experts can simply plug into the plan. It looks like interest rates on loans are a function of too many variables for there to be a simple answer. (Which, on re-reading, is I think in agreement with what Mr. Bozek is saying.)

I thnk we are saying the same thing in two different ways: I am saying that the regs do not provide for a means of identifying how to construct the parameters of a reasonable rate of interest. You are saying that the regs do not define a safe harbor for a reasonable rate of interest which I consider to be a subset design within a reasonable rate of interest. The only empirical evidence I have found for a rate similar to what a participant would have been able to obtain had a similar loan been taken from a financial institution is a loan secured by the participant's account at a commerical bank at a rate of 5 1/2% which corresponds to about 2% above the prime rate in todays WSJ. If the bank is paying 1% interest on the bank account then prime + 1% would be a reasonable rate of interest.

[austin3515]

But can;t the person withdraw all the money from the bank account and then default on the loan? Wouldn't that account for the extra credit risk embedded into the 2nd point above prime?

[ESOP Guy]

Austin;

My understanding is "no". You in effective give them a lien on the account that is securing the loan. So you are borrowiong your own money back. But you can not withdrawal the money unless the loan is paid off.

That is the reason the loan is so cheap. Like I said in my other reply I have a credit union that will give you a 5 year loan secured by a 5 year CD for the CD rate plus 2%.

The only rational reason I can think one would do this is:

1) You don't want to pay the penalty to break a CD.

2) I guess I could give the bank a lien on one of my CDs to let one of my children to have a loan