participant loan interest rate

Currently prime rate is 8.50%.  Moodys Bond rate is 6.17%.  We have a new plan that wants to allow for loans and was questioning whether they could base the plan loan interest rate off of Moodys.  Any thoughts whether that would be acceptable, given the disparity between Moodys and Prime?

Thanks

It's facts and circumstances. The IRS has informally said they are good with Prime +2% but if you can justify Moody Bond Rate as reasonable based on rates commercially available by banks in the Plan Sponsor area then that's might be OK. As far as I know there is no stated safe harbor interest rate but some rates are less likely to be challenged by IRS or DOL than others.

For a participant loan to get its prohibited-transaction exemption, the loan must “[b]ear a reasonable rate of interest[.]” 29 C.F.R. § 2550.408b-1(a)(1)(iv).

The same rule provides: “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.”

29 C.F.R. § 2550.408b-1(e) https://www.ecfr.gov/current/title-29/part-2550/section-2550.408b-1#p-2550.408b-1(e).

That standard is nonsense. Among a few reasons, there is no loan a commercial lender makes under terms similar to a typical participant loan.

None of -1(e)’s three examples describes a loan that meets the rule.

Plans’ fiduciaries, often with little or no advice (because many service providers deny providing tax or legal advice), have specified ways to set an interest rate for a participant loan.

The prime-plus-two setting many plans use is not in any administrative-law document. IRS employees described it in a telephone forum. (You can read the nonliteral transcript: https://www.irs.gov/pub/irs-tege/loans_phoneforum_transcript.pdf.) Whatever was spoken was preceded by a warning that a speaker’s remarks “should not be considered official guidance[.]” (A Treasury rule excludes the remarks from even the nonprecedential authorities one may use to support a tax position.) Further, the IRS employees did not say they spoke, even unofficially, for anything of the US Labor department.

A value of the prime-plus-two setting might be that, because so many plans use it, it might be impractical for either government agency to enforce against it.

Before looking to the Moody’s measure, a fiduciary might consider whether loan-taking participants are as creditworthy as the corporate borrowers the Moody’s measure refers to.

On 8/24/2023 at 3:44 PM, Peter Gulia said:

Before looking to the Moody’s measure, a fiduciary might consider whether loan-taking participants are as creditworthy as the corporate borrowers the Moody’s measure refers to.

Yes, but also consider that the loan (if executed properly) has better security than an AAA Moody's bond. The employer gets to withhold the loan repayments and if there is a default it has the loan itself as security. Participant defaults, you 1099 the loan, and "poof" you've been repaid.

12 hours ago, Luke Bailey said:

Yes, but also consider that the loan (if executed properly) has better security than an AAA Moody's bond. The employer gets to withhold the loan repayments and if there is a default it has the loan itself as security. Participant defaults, you 1099 the loan, and "poof" you've been repaid.

Yup, Luke has a good point. 

You need to find a loan that looks like what is going on here.

The credit union I use offers loans secured by one of your own CDs (why you take this out baffles me but they have offered it for decades so someone must do it) is CD rate +2%.  The 60 month CD rate is currently 5.99% so plus 2% you get 7.99%. 

You have as a baseline a fully secured loan by your own assets being offered by a local lending institution.  It is lower than prime+2 higher than Moody's.  Although a lot closer to prime+2

Maybe the client of the person who asked original question should see if they can find that and document it if they really want to forge their own path.  But given how small the gap between prime+2 and what I got in my area it might not be worth the work and risk. 

FWIW, while Peter is right that retirement plan loans are unique in their characteristics, it doesn't hurt to contact local banks and ask them what they are charging for secured loans these days to get some sense of the market.  I don't know if anyone does this nowadays, but in the olden days, people used to secure bank loans with accounts at the same bank so-called "passbook" loans) and that always seemed to me like a reasonable facsimile of plan loans. 

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Geeze, I remember those "good old days", less regulation, etc.  I have seen many plan documents with prime +1 lately.

I second PG.  The idea of setting a plan loan rate as a "reasonable" rate by comparison with what a commercial lender would charge makes no sense because plan loans are unique.  That having been said, keep in mind that the plan is making an investment on behalf of the borrowing employee, not conferring a benefit to the employee via a low interest rate.  Thinking about it this way, would not a relatively higher rate be more reasonable?  I'd also ask this of the treehouse.  What do you see, if anything, about how the IRS looks a loan rates in plan audits?  I have zero experience in that respect.  Finally, no matter what your decision is, the relevant lending fiduciary should carefully document their decision with reasoning on what's reasonable.  Fiduciary decision making is a process, and it's the process that should count the most.

The Labor department’s interpretation about an interest rate for a participant loan has been constant since at least 1981. ERISA Advisory Opinion 81-12A (Jan. 15, 1981). Further, Labor proposed its notice-and-comment rule in 1988 and made it final in 1989.

The Treasury department’s prevailing-rate standard is even older, no later than 1960, than the Labor department’s 1981 advice.

One thing to consider when documenting the loan provision is that Moody's publishes lots of "bond rates".  It would be best to precise about which rate will be used.

I would argue that Aaa is the appropriate rate and you want to look at 5-year term for most loans, but obviously that can vary. Today the 5-year Aaa rate is 4.95%.

I remember calling banks back in the late 80's/early 90's. They got very annoyed with the calls after the first 10-12.

Labor’s rule does not preclude that a participant “loan provides the plan with a return [greater than] the interest rates charged by persons in the business of lending money for loans which would be made under similar circumstances.”

See 29 C.F.R. § 2550.408b-1(e) https://www.ecfr.gov/current/title-29/part-2550/section-2550.408b-1#p-2550.408b-1(e).

Some fiduciaries might set for participant loans an interest rate a little higher than prevailing rates.

4 hours ago, Bill Presson said:

I remember calling banks back in the late 80's/early 90's. They got very annoyed with the calls after the first 10-12.

Why do we still have to work so much now that we have the inernet, Bill?

4 hours ago, Luke Bailey said:

Why do we still have to work so much now that we have the inernet, Bill?

Luke, the internet hasn't made things easier, it's just allowed for more things to be piled on.