Loan Interest - 12%

[52626]

New client. To discourage participants from taking loans, they charge an interest rate of 12%. Why they did not remove the loan provision if they wanted to discourage loans is unclear.

There are several loans outstanding at 12%. No way the Plan Sponsor can support this rate based on the local lending institutions.

To complicate matters, our client has acquired this company under a stock purchase and effective 3/1 our client will be the new Plan Sponsor.

Does the current employer need to redo the loans at an interest commensurate with the lending institutions.

After the stock purchase does our client become responsible for the interest set by the prior Plan Sponsor.

Any guidance would be appreciated.

Happy Friday to all.

[Belgarath]

Well, it'll have to be fixed, but how is another issue! Off the top of my head, without some investigation, I'm not certain if this is a prohibited transaction as a fiduciary breach in addition to an operational violation (the plan certainly must have language/loan procedures for determining a "reasonable" interest rate).

I'm not an attorney, but in most of the situations I've seen where someone is purchasing the stock, there should be some form of due diligence where the sale and purchase agreement addresses who is responsible for what, and whether the price is adjusted accordingly or whatever. This is definitely something that should be addressed by legal counsel if it hasn't been already.

Should be fun.

[ESOP Guy]

It is my understanding that in a stock purchase the company that sponsored the plan never changed so that company is in fact liable for the prior actions. As Belgarath a buy/sell agreement might have something to say beyond that.

This does point to several observations:

1) I know plenty of ERISA attorneys that would say either do an asset purchase because of this liability or have the old plan terminated and start a new one. Yes, I understand since same sponsor there are replacement plan issues.

2) If #1 can't happen a due diligence review before the buy. (I realize that doesn't do anyone much good now in this case.)

[Peter Gulia]

29 C.F.R. 2550.408b-1(e) states: "A loan will be considered to bear a reasonable rate of interest if [the] loan provides the plan with a return commensurate with the interest rates charged by persons in the business of lending money for loans [that] would be made under similar circumstances."

Could the fiduciary 52626 describes have found that a 12% loan meets that condition because the loan provides commensurate interest within the possibly greater interest the 12% rate provides?

[Belgarath]

I'll go out on a limb here and give a flat NO. And I'll be willing to bet that a DOL auditor wouldn't allow the 12% rate either. But, I also predicted that the Patriots would beat Denver in the AFC Championship game, so my predictions aren't worth much...

[Peter Gulia]

Many prohibited-transaction exemptions are worded in terms of making sure the plan receives no less than fair value.

How is a plan harmed if the plan receives more than fair-market value?

[My 2 cents]

Many prohibited-transaction exemptions are worded in terms of making sure the plan receives no less than fair value.

How is a plan harmed if the plan receives more than fair-market value?

In general, the higher-paid employees would be relatively unlikely to seek out a usurious loan from the plan, leaving the 12% rate primarily applying to those non-HCEs desperate enough to take out a plan loan (or otherwise discourage them from trying to do so). Figure that the higher-paid can qualify for reasonably priced commercial loans but the lower paid might not be able to. So the unfavorable rate would probably have the greatest adverse impact on non-highly compensated employees. If the non-HCEs are overcharged for borrowing from their accounts, wouldn't that, by itself, be problematic?

[Belgarath]

As an example for sake of illustration, suppose it is a DB plan. Plan sponsor is required to adequately fund the plan. If Plan Sponsor/Administrator sets a 12% interest rate that cannot be supported by any reasonable standard, the Plan Sponsor's required contribution is reduced. Methinks there is a problem there.

But aside from that, it is a prohibited transaction if the interest rate ain't "commensurate." According to my Webster's, commensurate means "equal in measure or extent" or "corresponding in size, extent, amount, or degree." Would you really want to argue, either in court or with the DOL auditor, that 12% would be "commensurate" and therefore not a PT when by any reasonable sampling of commercial lenders for a loan in "similar circumstances" you would get something like (pick a number) 5%? I sure wouldn't....

[Mike Preston]

Loans are ongoing transactions, so yes, whoever is the Plan Sponsor (at whatever time) has an exposure.

[Peter Gulia]

My 2 cents, thank you for the interesting observation about tax-law nondiscrimination. While it isn't about harm to the plan, at least not the kind that ERISA sections 406 and 408 try to manage, it reveals some of the intellectual challenges of the tax-law nondiscrimination rule.

Belgarath, although 12% interest isn't a participant loan provision I would recommend, a fiduciary might reason that it might not have been so obviously outside what ERISA section 408(b) calls for that past acts must be treated as clear nonexempt prohibited transactions to be undone.

Also, in the comparison to a commercial lender's hypothetical similar loan, what kind of loan does the fiduciary look to as its proxy measure? A participant loan has some attributes of some security, but also several attributes involving a lack of security.

Mike Preston is right that a new fiduciary entering the scene must not ignore a predecessor's acts. After setting new participant-loan provisions "going forward", could there be some room to find that past decisions were not "clearly" imprudent?

[Mike Preston]

My comment is silent on the issue you attribute to it. It goes to the nature of loans. They are considered new "transactions" each year so the new Plan Sponsor doesn't need to find that past decisions were imprudent to repudiate them going forward.

[Belgarath]

Hi Peter:

I suppose a fiduciary might reason almost anything, but that doesn't make it right. I concede that I have made an assumption here that these were loans granted within the last 5 years. If they were principal residence loans granted many, many years ago, perhaps the 12% could be justified, but I still doubt it. If made within the last 5 years, it is unjustifiable. And if a participant complains to the DOL, I think that is exactly what the fiduciary is going to find out.

I'm just having a very hard time concocting any reasonable point of view that allows for a 12% interest rate fitting within the guidelines...and the OP says it was meant to "discourage" loans. That's not allowable!!

I guess I'm just a little cranky on some of these participant loan issues, because participants are getting screwed, and some of them are people without much money.

Whether the new owner decides to take the risk of not correcting is an entirely separate question from the determination of whether it is a PT or not, and on that question, I defer to you attorneys. But I feel pretty confident that upon investigation/audit/participant lawsuit, there would be a determination that there was a PT. Of course, my opinion plus a dollar is worth...probably less than a dollar.

[jpod]

I think I am aligned with FGC in not being convinced that a loan at 12%, even within the past 5 years, is not a PT. I also am not convinced that it is a 401(a)(4) problem just because HCEs might be able to "afford" a super-high rate while NHCEs can't afford it. However, I do believe it is susceptible to being re-characterized as a vehicle for making non-deductible contributions which, presumably, aren't allowed by the plan document and would probably result in an ACP failure.

[jpod]

. . . and perhaps also a 415© failure.

[Belgarath]

Fascinating. So, a couple of ERISA attorneys think that the 12% might be justifiable. I'm not at all trying to be snide or sarcastic here - I'm truly interested in how this might be possible, so can you educate me a bit on situation(s) where it might be deemed reasonable, or, whether "reasonable" or not, that you think the DOL would accept? Thanks.

[Kevin C]

I'm with Belgarath on this one.

Since we are talking about a reasonable rate of interest under the PT Exemption in 2550.408b-1, the definition used might be helpful.

(e)Reasonable Rate of Interest.—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.

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.

[K2retire]

Many prohibited-transaction exemptions are worded in terms of making sure the plan receives no less than fair value.

How is a plan harmed if the plan receives more than fair-market value?

In general, the higher-paid employees would be relatively unlikely to seek out a usurious loan from the plan, leaving the 12% rate primarily applying to those non-HCEs desperate enough to take out a plan loan (or otherwise discourage them from trying to do so). Figure that the higher-paid can qualify for reasonably priced commercial loans but the lower paid might not be able to. So the unfavorable rate would probably have the greatest adverse impact on non-highly compensated employees. If the non-HCEs are overcharged for borrowing from their accounts, wouldn't that, by itself, be problematic?

Actually, when I owned my own business I would have LOVED to take out a loan at 12% -- especially in 2007 or 2008.

Is 12% really over charging compared to the rates a participant might have been paying on their credit card debt?

[GMK]

Shouldn't a plan sponsor understand banking (or hire a banking expert advisor) before offering to administer loans? (Sorry for ranting. I couldn't hold it any longer.)

[My 2 cents]

I think I am aligned with FGC in not being convinced that a loan at 12%, even within the past 5 years, is not a PT. I also am not convinced that it is a 401(a)(4) problem just because HCEs might be able to "afford" a super-high rate while NHCEs can't afford it. However, I do believe it is susceptible to being re-characterized as a vehicle for making non-deductible contributions which, presumably, aren't allowed by the plan document and would probably result in an ACP failure.

I think you may have missed my point. HCEs don't have to take a 12% loan since they surely have access to standard rates through a normal lender. NHCEs may have poor credit, meaning that it's either the plan or another loan shark if they need to borrow.

And I have to agree with Belgarath - the plan either allows loans or it doesn't. The sponsor is not allowed to "want to discourage" anything. If they don't want participants to take loans, the plan should not allow them. Permitting loans is not a required feature, right?

[jpod]

I guess I did miss your point, but now that I understand it I disagree with you even more. How can it be a 401(a)(4) problem if NCHEs are far more likely to take advantage of plan loans than HCEs?

[My 2 cents]

I guess I did miss your point, but now that I understand it I disagree with you even more. How can it be a 401(a)(4) problem if NCHEs are far more likely to take advantage of plan loans than HCEs?

You mean be taken advantage of by plan loans if the rate is so much higher than market. Isn't the whole reason for retirement plans permitting loans to give the opportunity to people with bad credit to obtain reasonably priced loans?

[jpod]

I think the reason for allowing plan loans without it being a PT or a taxable distribution is because a loan feature is viewed as a necessary evil to encourage retirement plan savings, just like hardship distributions.

[ESOP Guy]

My problem with the 12% rate is it in fact looks nothing like what the market would charge for a similar loan. This loan is after all over collateralize. If the person defaults the loan it becomes a distribution and no one has been harmed by the default plus they had to leave 50% of their balance in the plan to "secure" the loan that was already secure. (At least in a daily valued 401(k) plan. A balance forward or DB plan someone might get hurt depending on the exact way the loans are treated. But back when I did many balance forward DC plans a defaulted loan only hurt the participant who defaulted not the whole group.)

What I can tell you is that if I go to my credit union right now and I wanted a 5 year loan secured by a 5 year CD I owned (I guess people do it as they offer these types of loans on their website). I would pay CD rate plus 2%. The 5 year CD is paying 1.45% so plus 2% = 3.45%. Given the loan is secured by a CD the bank holds the website seems to imply (I guess if I was the one advising the sponsor maybe I would talk to my CU and check this) that credit score doesn't matter. The bank is making 2% to loan you your money. I just described a plan loan!

Assuming that is how it works where this plan sponsor is how is any rate above 3.45% "commensurate" at this point?

I don't see commensurate as meaning no lower but meaning equal to if similar situations.

I would add all the legal debate is interesting but my experience with the DOL is it is mostly irrelevant. Most DOL auditors I encounter see themselves (right or wrong) as the guys that need to protect the "little guy" from the "man". As such they simply look skeptical at anything that at first blush hurts the "little guy" and a 12% rate does that. Maybe if you demand to see a manager or go to court and so forth you MIGHT make some of these legal arguments work. If you just want the DOL auditor out of your office as fast as possible a 12% rate isn't going to do it.

[BG5150]

I think I am aligned with FGC in not being convinced that a loan at 12%, even within the past 5 years, is not a PT. I also am not convinced that it is a 401(a)(4) problem just because HCEs might be able to "afford" a super-high rate while NHCEs can't afford it. However, I do believe it is susceptible to being re-characterized as a vehicle for making non-deductible contributions which, presumably, aren't allowed by the plan document and would probably result in an ACP failure.

I think you may have missed my point. HCEs don't have to take a 12% loan since they surely have access to standard rates through a normal lender. NHCEs may have poor credit, meaning that it's either the plan or another loan shark if they need to borrow.

There are plenty of HCEs with bad credit or who have maxed out loans elsewhere.

[BG5150]

I don't see commensurate as meaning no lower but meaning equal to if similar situations.

I've seen discussions where the DOL doesn't want TOO low of a rate either.

[jpod]

There are two examples in the DOL loan regulations that address interest rates that are considered too low to be reasonable. There is no example involving an interest rate deemed to be too high.