Inerest rate for pension loans

Hi,

The current prime rate appears to be 5.25 (WSJ). What are plans using currently as the interest rate for plan loans?

Thank you.

We use prime + 1. Most of our clients are good with that.

Thank you very much.  We will use 6.25% (I just hope they will be ok with this as prime has gone up considerably).

13 minutes ago, SSRRS said:

Thank you very much.  We will use 6.25% (I just hope they will be ok with this as prime has gone up considerably).

You're welcome! Yes it has. I suppose the consolation is that participants are paying back themselves.

The interest rate is supposed to be commensurate with a rate that would be charged by a local (regoinal?) bank for a similar loan.  In some places of the country, the cost of borrowing may be higher or lower.

But instead of calling around to banks in the area, ERs have been using the prime rate +1 or +2 as a shortcut.

The IRS said in a phone forum a bunch or years back, that prime +1 may be too low and that +2 is better.

Anecdotally, I have not heard of any auditor questioning +1, so many people go with that.  We use prime +2.

21 minutes ago, SSRRS said:

Thank you very much.  We will use 6.25% (I just hope they will be ok with this as prime has gone up considerably).

If they dont like it, then no loans from the plan.  Now that would be heaven...

Less than prime +1 would probably be an issue on audit.  At least they would would ask you to justify the rate, and "the client wanted it" wont cut it.

*EDIT loans not land...

Has anyone had an EBSA or IRS examiner question a plan’s interest rate for a participant loan?

(Despite 34 years’ experience working with retirement plans, I’ve never seen such a challenge.)

If an examiner suggested an interest rate was too low (or too high), what reasoning did the examiner give?

Oddly, my local credit union I use will give you a loan that is secured by a CD for 4.75% (their 5 year CD rate plus 2%) which would be the closest commercial loan to a 401(k) loan.  After all a 4k loan is fully secured by the account balance.  Yet, I doubt anyone would advocate that rate.  

It has been years since I did 4k loans but back when I did them I never had an IRS and DOL auditor question it and the most common our clients used was prime plus 1% or prime. 

7 hours ago, Karoline Curran said:

You're welcome! Yes it has. I suppose the consolation is that participants are paying back themselves.

We use prime plus 1; no IRS agent will ever challenge that because it is much too complicated an issue and subjective; they would have enormous difficulty justifying any time spent on that issue to their superiors.  That is the practical side of it.

As to pay back themselves, no they are not.  They are paying back the plan.  If it is pooled accounts (as many of our plans are), they are simply producing an asset that is earning (in this example) 6.25% for everyone in the plan. Whether that is good or bad depends on what they are losing/gaining vs the other assets in the plan.  If the plan return was 8%, they are losing money and would be better borrowing from the bank.  If the plan return was 4%, then the higher rate of return is a positive in their account.  If it's a directed account, the same is true except that the numbers apply to their account only.  But "paying back themselves" is a completely misleading "advantage" and should be dropped from any discussion of loan positives/negatives.  Rate of return is the real issue vs opportunity costs.

9 hours ago, Larry Starr said:

 Rate of return is the real issue vs opportunity costs.

As implied above, the other issue is whether the sponsor wants to "discourage" loans by using a higher rate.

9 hours ago, Larry Starr said:

We use prime plus 1; no IRS agent will ever challenge that because it is much too complicated an issue and subjective; they would have enormous difficulty justifying any time spent on that issue to their superiors.  That is the practical side of it.

As to pay back themselves, no they are not.  They are paying back the plan.  If it is pooled accounts (as many of our plans are), they are simply producing an asset that is earning (in this example) 6.25% for everyone in the plan. Whether that is good or bad depends on what they are losing/gaining vs the other assets in the plan.  If the plan return was 8%, they are losing money and would be better borrowing from the bank.  If the plan return was 4%, then the higher rate of return is a positive in their account.  If it's a directed account, the same is true except that the numbers apply to their account only.  But "paying back themselves" is a completely misleading "advantage" and should be dropped from any discussion of loan positives/negatives.  Rate of return is the real issue vs opportunity costs.

I still maintain you are paying back the interest to yourself (I don't have any pooled accounts)  as opposed to a bank or credit card, so I disagree that this advantage should be dropped from discussions. :)

10 hours ago, Larry Starr said:

We use prime plus 1; no IRS agent will ever challenge that because it is much too complicated an issue and subjective; they would have enormous difficulty justifying any time spent on that issue to their superiors.  That is the practical side of it.

As to pay back themselves, no they are not.  They are paying back the plan.  If it is pooled accounts (as many of our plans are), they are simply producing an asset that is earning (in this example) 6.25% for everyone in the plan. Whether that is good or bad depends on what they are losing/gaining vs the other assets in the plan.  If the plan return was 8%, they are losing money and would be better borrowing from the bank.  If the plan return was 4%, then the higher rate of return is a positive in their account.  If it's a directed account, the same is true except that the numbers apply to their account only.  But "paying back themselves" is a completely misleading "advantage" and should be dropped from any discussion of loan positives/negatives.  Rate of return is the real issue vs opportunity costs.

While  it is true the real question is opportunity costs I would contend your listing of them MIGHT be incomplete.  You have to look at this cost of credit vs other credit costs.

If this person's other choice is a 15% credit card giving up even an 8% rate of return might still be a good choice it would seem.   This actually can be a complex calculation with many assumptions that may or may not come true. 

I am not a huge fan of 401(k) loans mostly because if you lose or change your job  you have to pay the loan back at a time it might be very hard to do so and that harms your retirement.  However, I have taken them a few times in my life when things were tough and my other choice was very expensive other credit. 

1 hour ago, Karoline Curran said:

I still maintain you are paying back the interest to yourself (I don't have any pooled accounts)  as opposed to a bank or credit card, so I disagree that this advantage should be dropped from discussions. :)

Even back when I did pooled balance forward 4ks and PSP plans I think I had one plan that made the plan loans part of the "bond fund".  All the other balance forward plans the loans were the one thing where the earnings/loan interest went back to the person taking out the loan.  So in my experience at least seeing loan interest going back to the whole group was rare.  It sounds like Larry sees something different. 

1 hour ago, ESOP Guy said:

So in my experience at least seeing loan interest going back to the whole group was rare.  It sounds like Larry sees something different. 

Many of my pooled plans treat loans as an pooled investment rather than a directed investment.  Its certainly not rare, but overall it is less common.

https://www.tdbank.com/personal/collateral.html?state=NJ&city=913

I checked the rates for fully secured personal loans at TD bank in NJ and FL and it was prime plus 2%.  I tried to find rates at PNC, Chase, CapitalOne and Bank of America but they were all a PITA.  I just wanted a number, I didn't want to fill out an app.

Makes me think, though, that prime plus 1 is below market.

10 hours ago, david rigby said:

As implied above, the other issue is whether the sponsor wants to "discourage" loans by using a higher rate.

We discourage loans by having NO LOANS in the plan.  I'd say over 95% of our plans do not allow loans.  Want to borrow money: go to the bank!  My employers don't want to be in the banking business with their employees.

14 hours ago, Larry Starr said:

We discourage loans by having NO LOANS in the plan.  I'd say over 95% of our plans do not allow loans.  Want to borrow money: go to the bank!  My employers don't want to be in the banking business with their employees.

Unfortunately, most of our plans do allow for loans.  Some for more than one. I'm  not a huge fan, but sometimes circumstances are such that they are necessary. All our loans are managed by whatever investment house the money is in so minimal involvement by the employer other than okaying the loan online. I only have one that I have to reconcile manually and that is a pain!

16 hours ago, K2 said:

Makes me think, though, that prime plus 1 is below market.

Maybe.  But, again, I've yet to hear about an auditor question +1.

Side question:  what is the penalty for having loan rates too high or too low?  Is it a prohibited transaction?  Some sort of fiduciary breach?  What would the remedy be?

4 hours ago, BG5150 said:

Side question:  what is the penalty for having loan rates too high or too low?  Is it a prohibited transaction?  Some sort of fiduciary breach?  What would the remedy be?

Isn't the requirement to use a commercially reasonable rate part of 72(p)? I thought it was but I can't seem to find the reference at the moment.

If it is, then a loan made with a non-compliant interest rate wouldn't be compliant with 72(p) and would therefore be treated as a distribution. If the participant wasn't eligible for a distribution, then it is an operational failure, and the remedy is EPCRS.

Edit: As far as I can tell, the requirement that the loan bear a "reasonable" rate of interest only appears in 4975(d)(1). So using an "unreasonable" rate would not result in the loan being treated as a distribution, but would result in it being a prohibited transaction. To correct the PT, I would think you would have to re-amortize the outstanding balance of the loan at a reasonable interest rate, and repay to the plan any additional interest that would have been paid if it had been amortized at a reasonable rate from the beginning.

I'm a financial guy and will leave the question of loan rate to the ERISA pros. But let me weigh in on the relative financial merits of Plan vs. commercial loans, and maybe dispel some common myths about the former.

Smith needs a $10K loan. She can take it from her 401(k) or the bank. In either case the

interest rate will be 6% and the loan will be amortized in 260 level weekly repayments.

The base case is that her Plan investments are expected to grow at 6% as well.

If she borrows from the bank her $10K in the Plan will grow to approx. $13,500 in 5 years

If she borrows from the Plan, her repayments will grow to the same (approx.)  $13,500 in 5 years.

Her out of pocket is the same either way, so it’s a wash. And incidentally that disproves the myth that interest on a Plan loan is double taxed. Plan loan interest is not double taxed but could be disadvantaged relative to a commercial loan if interest on the latter is deductible (qualifying HELOC perhaps?). Nor is one paying oneself back rather than the bank or credit card company. You can’t pull  yourself out of the quicksand by tugging on your own hair.

But in the real world a commercial loan, particularly for someone who needs a loan, is likely be substantially more expensive than an account secured Plan loan.  Let’s say by even a modest 2% a year. That difference, if contributed to the Plan, effectively increases the Plan’s investment

rate of return by 2% a year.  In our example the $10K Plan loan results in a Plan balance of approx. $14,900. And that's without any consideration of the possible tax benefits associated with the marginal additional contribution.

It doesn’t matter for purposes of this analysis whether the Plan loan is from a traditional or

Roth bucket. It may matter if the commercial loan interest is deductible And, of course, assumptions about Plan investment return are assumptions.

Actually, from a tax perspective, the merits of the loan would depend partly on whether it is a roth or regular 401(k).  Why?  Because a higher rate of interest (i.e. a higher rate of return on 401(k) plan assets) means more money in the plan growing tax free.  If it is a regular 401(k), there is a small tax deferral advantage that attaches to future earnings on the interest once paid back into the plan (even though the interest repayment is coming from after-tax dollars and the earnings on the interest will be fully taxable at retirement -- this is the same tax deferral advantage that the tax code gives people who just purchase stock or some other capital asset and hold it for a long time before ever recognizing the built in gain). 

If it is a roth 401(k), however, then earnings on the repaid interest will never be taxed.  Thus, it actually may be in the interest of the participant to have a 401(k) plan charging them the highest permissible rate of interest that will satisfy the commercial reasonableness standard, so that the participant can maximize their tax-advantaged retirement savings.  Of course, this is only really applicable to participants that can afford to try to maximize their tax-advantaged retirement savings. 

On a side note, I find it difficult to believe that ANY 401(k) plans are giving out loans to participants that are ultimately secured by anyone else's account balance.

Even when you take a loan out of your own 401(k) account, the plan is supposed to first determine that you meet some baseline standard of credit-worthiness and then to charge a commercially-reasonable rate of interest.  But if you have an ERISA plan giving out loans to a participant from communal assets, then my understanding is that the ERISA plan has a full fiduciary duty to ensure that that is the best available investment option for the plan (and it probably isn't, at least unless the participant has undergone a thorough, commercial credit check just like they would at a bank, and unless the participant is being charged an individualized interest rate that is clearly based on the results of that credit check).  

I also note that typically, 401(k) plans allow participants to choose where their funds are invested (at least within certain broad categories).  It's a lot easier to deal with the situation where the participant is essentially directing that some of their money be invested in a loan to themselves than it is to think about the utter mess that would result from participants having access to loans secured by other participants' 401(k) balances.   

Am I missing something big? 

On ‎10‎/‎24‎/‎2018 at 9:13 PM, Larry Starr said:

As to pay back themselves, no they are not.  They are paying back the plan.  If it is pooled accounts (as many of our plans are), they are simply producing an asset that is earning (in this example) 6.25% for everyone in the plan.

Whether that is good or bad depends on what they are losing/gaining vs the other assets in the plan.  If the plan return was 8%, they are losing money and would be better borrowing from the bank.  If the plan return was 4%, then the higher rate of return is a positive in their account.  If it's a directed account, the same is true except that the numbers apply to their account only. 

But "paying back themselves" is a completely misleading "advantage" and should be dropped from any discussion of loan positives/negatives.  Rate of return is the real issue vs opportunity costs. 

Even where all participants in the plan are getting the 6% return if/when the loan is actually paid back, I would expect there to be a provision in the 401(k) plan saying that if the loan is defaulted on, then the plan can recover by doing some kind of deemed distribution and offset against the loanee/participant's 401(k) balance.  

If the plan expects an 8% average return from its other investments, then it better not be investing in a 6% loan unless that loan is significantly lower-risk than the other assets that the plan invests in (e.g. because it is secured by that participant's 401(k) balance, which is literally under the control of the plan), otherwise it would be breaching its fiduciary duties to invest prudently. 

Separately, it seems to me that to the extent interest is being paid directly into a participant's individual 401(k) account, rates of return are all but meaningless (except for tax considerations), because a person is literally borrowing from themselves.  

4 hours ago, AKowalski said:

On a side note, I find it difficult to believe that ANY 401(k) plans are giving out loans to participants that are ultimately secured by anyone else's account balance.

Even when you take a loan out of your own 401(k) account, the plan is supposed to first determine that you meet some baseline standard of credit-worthiness and then to charge a commercially-reasonable rate of interest.  But if you have an ERISA plan giving out loans to a participant from communal assets, then my understanding is that the ERISA plan has a full fiduciary duty to ensure that that is the best available investment option for the plan (and it probably isn't, at least unless the participant has undergone a thorough, commercial credit check just like they would at a bank, and unless the participant is being charged an individualized interest rate that is clearly based on the results of that credit check).  

I also note that typically, 401(k) plans allow participants to choose where their funds are invested (at least within certain broad categories).  It's a lot easier to deal with the situation where the participant is essentially directing that some of their money be invested in a loan to themselves than it is to think about the utter mess that would result from participants having access to loans secured by other participants' 401(k) balances.   

Am I missing something big? 

Yea you are missing something big.  I don't know where you get the idea that the loans are secured by other participants balances.  That is not how it works, and that is not what was discussed above...

20 hours ago, AKowalski said:

Even where all participants in the plan are getting the 6% return if/when the loan is actually paid back, I would expect there to be a provision in the 401(k) plan saying that if the loan is defaulted on, then the plan can recover by doing some kind of deemed distribution and offset against the loanee/participant's 401(k) balance.  

If the plan expects an 8% average return from its other investments, then it better not be investing in a 6% loan unless that loan is significantly lower-risk than the other assets that the plan invests in (e.g. because it is secured by that participant's 401(k) balance, which is literally under the control of the plan), otherwise it would be breaching its fiduciary duties to invest prudently. 

Separately, it seems to me that to the extent interest is being paid directly into a participant's individual 401(k) account, rates of return are all but meaningless (except for tax considerations), because a person is literally borrowing from themselves.  

Both of your postings show that you really don't understand what is going on with participant loans and plan returns, and the issue of diversified investments. Also, there appears to be a lack of understanding of the plan provisions that are REQUIRED to be in a plan with regard to participant loans and defaults.  RatherBeGolfing's response is correct; you clearly are confused about how pooled assets work. But there are so many other issues you raise that would require reams of discussion to correct, that this is not the place to do it. But just one: a plan loan is 100% collateralized with at least a 50% cushion on the value of the collateral, and payback secured by payroll deduction make the participant an excellent credit risk that requires no additional determination of credit worthiness; it is automatic.

On 10/25/2018 at 4:27 PM, K2 said:

https://www.tdbank.com/personal/collateral.html?state=NJ&city=913

I checked the rates for fully secured personal loans at TD bank in NJ and FL and it was prime plus 2%.  I tried to find rates at PNC, Chase, CapitalOne and Bank of America but they were all a PITA.  I just wanted a number, I didn't want to fill out an app.

Makes me think, though, that prime plus 1 is below market.

Remember that the fully secured PLAN loans are secured by 200% (or more) of the value of the loan, whereas no such requirement is applied to the loan you are checking.  That alone can be used to justify the prime plus 1.