plan loan from pooled account

Safe Harbor 401(k) with SH match, Roth and pre-tax deferrals; PS contributions allowed but none made. 
Plan assets are held in a pooled account with annual valuation.

100% owner has 2/3 of plan assets allocated to him as of 12/31/2018; 2019 deferral contributions show roughly same percentage being contributed by owner.
Owner/plan sponsor wants to amend plan document to add plan loans, so that he can take out maximum loan.  He is aware that this opens the door for plan loans to other participants.

My question:  In an account with separate accounts, interest from loan repayments would be allocated to the participant who took out the loan.  In a pooled account, is the loan considered just another plan asset, so that the interest is allocated across all participants?  Or is it allocated only to the participant who took out the loan?

Also, are there fiduciary issues related to the fact that the owner has 2/3 of plan assets allocated to him?

Thanks!

28 minutes ago, M Norton said:

My question:  In an account with separate accounts, interest from loan repayments would be allocated to the participant who took out the loan.  In a pooled account, is the loan considered just another plan asset, so that the interest is allocated across all participants?  Or is it allocated only to the participant who took out the loan?

I'd say generally it is just another plan asset, but sometimes documents allow for loans to be carved out and treated as self-directed.  Handling repayments in that scenario gets ugly and I wouldn't go there.

30 minutes ago, M Norton said:

Also, are there fiduciary issues related to the fact that the owner has 2/3 of plan assets allocated to him?

No.  As you note, everyone has to be given the same opportunity so you might be opening Pandora's box.  At the very least consider restricting the source to deferrals, if that is enough for the owner.

Great idea on limiting loans to deferrals source - thanks, Bird!

I would suggest adding loans as directed investment even if pooled investments, especially with the owner looking to borrow the max. That way, issues that may surface if payments are late, loan default, the interest rate/rate of return, etc. have no impact on other participants.

1 hour ago, CuseFan said:

I would suggest adding loans as directed investment even if pooled investments, especially with the owner looking to borrow the max. That way, issues that may surface if payments are late, loan default, the interest rate/rate of return, etc. have no impact on other participants.

And I would suggest this is problematic. If you are operating a pooled account, then all of a sudden to have an allocated account within the pool could be an administrative complexity that you would not want to deal with.  I see no issue in dealing with the other items listed as that's just part of normal admin. FWIW.

I'm with CuseFan, if given a choice, for the reasons given. 

21 hours ago, CuseFan said:

I would suggest adding loans as directed investment even if pooled investments, especially with the owner looking to borrow the max. That way, issues that may surface if payments are late, loan default, the interest rate/rate of return, etc. have no impact on other participants.

I guess in that scenario every payment has interest and principal credited to the directed account and then the whole payment transferred to pooled?

I agree with Larry, because what happens when you get a bunch or participants taking loans?  

One person is reasonable.  When you have three, five, ten loans, then things get more complicated.

Another vote with CuseFan.

I've been handling loans as CuseFan describes for 26 years now.  It takes a little extra time, but that's why we charge fees for loan administration. I don't see it as being complicated.

Agree with all of above, especially carving out loans as self-directed even if nothing else is, but if you don't do that I think there is fiduciary exposure. First, to be adequately secured under DOL reg. sec. 2550.408b-1(f), the loan must be secured by the participant's account balance. I guess you can do that without also having the loan wholly allocated to that participant's account as an investment, but I have never seen it done that way in the last 35 years. The documents always say that the loan is an investment of the borrowing participant's account for purposes of rate of return (loan interest) and default. Moreover, if the loan is considered to be a pooled investment for purposes of rate of return, this puts a lot of pressure on the interest rate and security to protect the plan as a whole. ERISA 408(b)(1) and regs thereunder protect you from having a PT (ERISA 406), but do not protect on fiduciary duties (ERISA 404).

2 hours ago, Luke Bailey said:

Agree with all of above, especially carving out loans as self-directed even if nothing else is, but if you don't do that I think there is fiduciary exposure. First, to be adequately secured under DOL reg. sec. 2550.408b-1(f), the loan must be secured by the participant's account balance. I guess you can do that without also having the loan wholly allocated to that participant's account as an investment,

Absolutely you can.

but I have never seen it done that way in the last 35 years.

Wow?  Really?  We have done it ONLY that way for over 35 years!

The documents always say that the loan is an investment of the borrowing participant's account for purposes of rate of return (loan interest) and default. Moreover, if the loan is considered to be a pooled investment for purposes of rate of return, this puts a lot of pressure on the interest rate and security to protect the plan as a whole.

The security is automatic, so long as the loan documents are properly prepared.  And the "guaranteed" interest rate return on this investment might be more than some of the bonds in the portfolio.  It is just another part of the total return to the plan, which is shared identically by every account.  Not an issue at all.  And if the plan lost money on the other investments that year (like many plans did last year when the S&P 500 was down slightly), then the loan interest rate of return actually INCREASED everyone's return on their account.  All just normal stuff.

ERISA 408(b)(1) and regs thereunder protect you from having a PT (ERISA 406), but do not protect on fiduciary duties (ERISA 404).

I see absolutely no fiduciary issue here in a pooled account.

To those who feel that there is some problem with allowing participant loans as a pooled investment, remember that participant loans are also permitted in DB plans.

2 hours ago, C. B. Zeller said:

To those who feel that there is some problem with allowing participant loans as a pooled investment, remember that participant loans are also permitted in DB plans.

Sure, but in a DB plan, a low interest rate or default would not impact benefits, just employer funding.

Re Larry's points, are you saying Larry that you set up loans such that for rate of return purposes (other than the negative rate of a return of a default), the loan is a pooled investment of all accounts, but if there is a default, you take the amount of the default out of the borrowing participant's account? Again, I think you can do that, but I think most plans, maybe nearly all, make the borrowing participant's loan an investment of his/her account for all purposes, so that (1) if equities outperform the loan (which they likely will over a five-year period) the "hit" is on the borrowing participant, (2) you can tell the participant that he or she is paying interest to him/herself, and (3) if there is a default, the loss is borne solely by the participant (which I understand is still the case in the system you describe, if I understand it correctly).

And you don't see a fiduciary issue if (1) the owner takes a loan at prime + 1, (2) equities outperform prime + 1 over 5 years, and (3) because all of the investment characteristics of the loan (other than default) are allocated proportionally over all accounts the owner gets some of the equity return on the money he or she has borrowed, and conversely the non-borrowers get some of the loan interest even though some of their mutual funds were cashed out to fund the loan? It doesn't have to be just the owner or a small plan situation. People feel comfortable based on informal guidance and on the security of the loan and market rates in saying that a relatively low interest rate (e.g., prime + 1 or 2%) is OK for participant loans, but no one would want to invest the rest of their plan assets with a hope of just getting prime + 1 or 2% for five years.

17 hours ago, Luke Bailey said:

Sure, but in a DB plan, a low interest rate or default would not impact benefits, just employer funding.

Re Larry's points, are you saying Larry that you set up loans such that for rate of return purposes (other than the negative rate of a return of a default), the loan is a pooled investment of all accounts, but if there is a default, you take the amount of the default out of the borrowing participant's account?

Of course.  There is no other option.  The loan is nothing more than an alternative investment of the plan, just like any other security (think of it like a bond with monthly coupon payments, sort of).  The default is the "seizure" of collateral. 

Again, I think you can do that, but I think most plans, maybe nearly all, make the borrowing participant's loan an investment of his/her account for all purposes,

I doubt that as it applies to pooled accounts, which is what we are talking about; my experience is completely different. 

so that (1) if equities outperform the loan (which they likely will over a five-year period) the "hit" is on the borrowing participant,

When the plan sponsor decided to allow loans, this is just one (minor) result of that process. There is no "hit" ever on a given participant.  It just affects the total return of the assets, which could be positive or negative. So be it.

(2) you can tell the participant that he or she is paying interest to him/herself,

That's NEVER true. The interest is being paid to the plan; it replaces what otherwise the funds would have been invested in.  Could be a worse return or better return. "Where" the interest is being paid (recorded) is completely irrelevant.  This is for another thread..... 

and (3) if there is a default, the loss is borne solely by the participant (which I understand is still the case in the system you describe, if I understand it correctly).

That is always the case; it's the law (part of the loan requirements for the loan not to be a PT).

And you don't see a fiduciary issue if (1) the owner takes a loan at prime + 1, (2) equities outperform prime + 1 over 5 years, and (3) because all of the investment characteristics of the loan (other than default) are allocated proportionally over all accounts the owner gets some of the equity return on the money he or she has borrowed, and conversely the non-borrowers get some of the loan interest even though some of their mutual funds were cashed out to fund the loan?

All the participants have the same opportunity to take a loan and the proceeds are treated the same for all participants.  This is NOT a discrimination issue as you propose above.  There is NO issue there. PERIOD.

It doesn't have to be just the owner or a small plan situation. People feel comfortable based on informal guidance and on the security of the loan and market rates in saying that a relatively low interest rate (e.g., prime + 1 or 2%) is OK for participant loans, but no one would want to invest the rest of their plan assets with a hope of just getting prime + 1 or 2% for five years.

Well, I can borrow from my bank and prime (and lower).  If my plan makes a loan at prime + 1% for all participants, what's the problem?  And I wish your comment about what people would invest in was true, but there are an awful lot of investment idiots out there!  (For those who don't know, I have a presentation on behavioral economics entitled "We are all investment idiots".)

18 minutes ago, Larry Starr said:

Of course.  There is no other option.  The loan is nothing more than an alternative investment of the plan, just like any other security (think of it like a bond with monthly coupon payments, sort of).  The default is the "seizure" of collateral. 

To clarify, if the participant who defaults on the loan payments does not have a distributable event at the time of default, what happens?

45 minutes ago, RatherBeGolfing said:

To clarify, if the participant who defaults on the loan payments does not have a distributable event at the time of default, what happens?

That's a great Q. I think, I say I think because I don't know that it's happened although it seems likely, that we would at that point carve it out as a self-directed account - effectively seizing the collateral of the participant's account.  Of course it has to be maintained "on the books" (but not on the 5500) with additional interest accruing (and then disappearing when it can finally be written off).  Yup, that sounds pretty good now that I write it out...

1 hour ago, Larry Starr said:

Re Larry's points, are you saying Larry that you set up loans such that for rate of return purposes (other than the negative rate of a return of a default), the loan is a pooled investment of all accounts, but if there is a default, you take the amount of the default out of the borrowing participant's account?

Of course.  There is no other option.  The loan is nothing more than an alternative investment of the plan, just like any other security (think of it like a bond with monthly coupon payments, sort of).  The default is the "seizure" of collateral. 

Just to be clear on this, there is no negative rate of return on a default.  Interest on the loan has accrued and the full balance is "seized."  I am absolutely confident that there are no "issues" that the plan should be concerned about with pooled loans - if a sponsor wants to make loans self-directed for reasons of "fairness" or whatever, that's one thing - but for the plan's safety - no.

I found this whole discussion a little humorous.  For us old folks who worked on plans in the days before daily valuation and employees being responsible for self-directing their accounts,  loans were ALWAYS just another investment in the plan and the interest from the loan repayments was part of the overall investment return that was allocated pro-rata to all participants.  When I started in this business, this was everyday plan accounting.

Of course, it is not as common now with daily valuation and self-direction, but it is absolutely permissible.  In a pooled account, the loan is a plan asset, like any other investment, but if the participant defaults, then the defaulted loan amount is only assigned to the borrowing participant, meaning the participant's account is offset and the participant gets a 1099.

Glad to know I'm not one of the "old folks". 

AK, that may have ALWAYS been the way it was done where you worked, but not everyone did it that way.   

Bottom line, I think in a DC plan if a participant borrows, say, $50k from a $100k + account (just as an example), it makes more sense and is safer from a fiduciary perspective to say to the borrowing participant and all the nonborrowing participants that (1) the borrowing participant's account funds 100% of the loan, (2) his/her account's, and only his/her account's, investment in other assets (whether as part of a pooled fund or  individually directed) is diminished by the outstanding amount of the loan at any time, and (3) only his or her account is at risk of default.

7 hours ago, Luke Bailey said:

Bottom line, I think in a DC plan if a participant borrows, say, $50k from a $100k + account (just as an example), it makes more sense and is safer from a fiduciary perspective to say to the borrowing participant and all the nonborrowing participants that (1) the borrowing participant's account funds 100% of the loan, (2) his/her account's, and only his/her account's, investment in other assets (whether as part of a pooled fund or  individually directed) is diminished by the outstanding amount of the loan at any time, and (3) only his or her account is at risk of default.

Luke, I'm a little confused by how you are wording this, particularly the comment that "it makes more sense and is safe from a fiduciary perspective to say....". 

Here's why (referring to your numbered comments so I don't have to repeat them:

(1) That is true; there is no other option. There is nothing else you could say.

(2) That is NOT true; his account is in no way "diminished" because he borrowed money from the plan.  If you have a bank account at the bank but then borrow money from that same bank, I think you recognize that your bank account is in no way changed.

(3) Again, that is true and there is no other option.

So the basic question is why do you think you need to say any of this to the participants (borrowing and non-borrowing) at all? The SPD has all the necessary information about the issues.  If a plan allows loans (BTW, almost all of my plans DON'T allow loans!), it's just a normal part of the operation of the plan.  We don't go out of our way to discuss any other transactions in the trust, why would we single out this one from the standpoint of how it is treated.  Most participants: a) won't care, and b) won't understand!

8 hours ago, Kevin C said:

Glad to know I'm not one of the "old folks". 

AK, that may have ALWAYS been the way it was done where you worked, but not everyone did it that way.   

Well, in the mid to late '70's, I worked for the insurance company that was the largest small plan service provider in the country; I actually set policy on many of the issues we were figuring out back then. And almost all of those plans were pooled in those days (well over 95%), and they were all handled as noted above.

Larry, some of this is terminology, but based on your most recent, we may have misunderstood each other. Example: Plan has two participants, A and B. Each has $100k account. Total $200k invested in mutual funds, whether pooled or self-directed for investment purposes. Plan permits loans. A borrows $50k, B does not borrow. Obviously, immediately after the loan and overlooking daily fluctuations in value, the plan has $150k in mutual funds and holds a $50k note, again whether pooled or self-directed for investment purposes. In the system you are advocating/defending/whatever, does A have $50k in mutual funds and a $50k note allocated to his/her account for investment return purposes, and B still $100k in mutual funds, or do both A and B have $75k in mutual funds and $25k A promissory note for investment purposes?

On 12/7/2019 at 7:05 PM, Luke Bailey said:

In the system you are advocating/defending/whatever, does A have $50k in mutual funds and a $50k note allocated to his/her account for investment return purposes, and B still $100k in mutual funds, or do both A and B have $75k in mutual funds and $25k A promissory note for investment purposes?

I'm not Larry but it's the latter (my bold), and so be it.  The loan is a riskless investment to B, and in today's environment, probably paying 5% +/-.  It's superior to any other riskless investment, which might pay 1-2% at best.  So if you put a loan and mutual funds on a risk/reward spectrum, it could be argued that the loan is actually a better investment than mutual funds (that is not really the point but it is a sound argument).

Bottom line for me remains that this is fine...although we might have a heart to heart talk about the perception of it, in these particular circumstances, which are probably unusual.

I'll take a stab at this since I know Larry will correct me if I'm mistaken ?

1. In a self directed plan, A has $50k mutual funds and a $50k note
2. In a trustee directed plan with loans treated as a segregated investment, A has $50k mutual funds and a $50k note
3. In a trustee directed plan with loans treated as an investment of the trust, A and B both have $100,000 account balances, sharing 50/50 in the investment earnings, which is now $150k mutual funds and a $50k note.

In 1-3 above, the loan is secured by the A's account balance (assuming that the plan does not require additional security).  

Here is where I struggle with 3:  

- If A defaults without a distributable event, does the loan stay on the books until A has a distributable event?  Or does it offset without a distributable event?

- If A does not have enough left in his/her account balance to cover the loan in the event of a default, what happens?  Lets say that distributions and significant investment losses have left A's account balance $10k short of his/her loan obligation at default.

2 minutes ago, Bird said:

I'm not Larry but it's the latter (my bold), and so be it.  The loan is a riskless investment to B, and in today's environment, probably paying 5% +/-.  It's superior to any other riskless investment, which might pay 1-2% at best.  So if you put a loan and mutual funds on a risk/reward spectrum, it could be argued that the loan is actually a better investment than mutual funds (that is not really the point but it is a sound argument).

Bottom line for me remains that this is fine...although we might have a heart to heart talk about the perception of it, in these particular circumstances, which are probably unusual.

Is it really riskless though?  see my questions above on default?

There has to be more than a 0% chance that As account balance will not be able to cover the loan obligation in the event of a default.  Even if A's distributions (in service, since termination would trigger an offset) are limited to amounts that exceed the loan obligation, investment losses to the loan's security are still risk, no?

6 minutes ago, RatherBeGolfing said:

Is it really riskless though?  see my questions above on default?

There has to be more than a 0% chance that As account balance will not be able to cover the loan obligation in the event of a default.  Even if A's distributions (in service, since termination would trigger an offset) are limited to amounts that exceed the loan obligation, investment losses to the loan's security are still risk, no?

Mmm.  Well, my initial rebuttal would be that if an in-service distribution is permitted then that could/would trigger an offset, but I suppose it could be a hardship.  As I said (I think) way back, if the loan defaulted then we would indeed carve it out.  I suppose in a scenario where A takes a loan and does not default, then takes a hardship, there could be risk of loss to B.  Someone would have to work pretty hard to create that scenario and I like to think that at some point we'd say "wait a sec, this loan needs to be carved out" and take action to do so.  

On ‎12‎/‎6‎/‎2019 at 8:23 PM, Larry Starr said:

Well, in the mid to late '70's, I worked for the insurance company that was the largest small plan service provider in the country; I actually set policy on many of the issues we were figuring out back then. And almost all of those plans were pooled in those days (well over 95%), and they were all handled as noted above.

4 out of 5 dentists may prefer loans treated as pooled investments, but that doesn't make the 5th dentist wrong.  I never said your method was wrong. I said it hasn't been done that way anywhere I've worked.  It comes down to a judgment call and there is more than one "right way".

30 minutes ago, Kevin C said:

4 out of 5 dentists may prefer loans treated as pooled investments, but that doesn't make the 5th dentist wrong.  I never said your method was wrong. I said it hasn't been done that way anywhere I've worked.  It comes down to a judgment call and there is more than one "right way".

No disagreement; just pointing out that there is at least one large example of where it was being done "my way" in the '70's.