Boon or Bane?: 401(K) Loans and Loan Provisions

Abstract

Traditional life-cycle models unambiguously predict that having the ability to borrow from defined contribution (DC) plans is utility enhancing since lower liquidity constraints will increase contemporaneous contributions. Behavioral finance, on the other hand, indicates that workers with dynamically inconsistent preferences may enjoy higher lifetime consumption than otherwise if they have no loan option. The lack of loan option acts as a commitment device to preserve savings for future consumption. Absent the commitment device contributions may be lower than otherwise. We study DC plan contributions for those with standard and with dynamically inconsistent preferences and find that a loan option raises current savings, but does so more for households with standard discounting than for those with dynamically inconsistent preferences. The effects on lifetime savings may differ, depending on the actual loans taken out and when the loan option exists. We simulate retirement account balances, using our parameter estimates for contributions and loan amounts, for households with standard and dynamically inconsistent preferences. The simulations show that the net effect is positive for standard discounters, but not necessarily for dynamically inconsistent discounters, depending on the impact of the borrowing option on employee contribution rates to DC plans.

Keywords: defined contribution, retirement savings, 401(k) loans