When the coronavirus outbreak turned into a COVID epidemic followed by lockdowns in many states, Congress stepped in to help by passing the Coronavirus Aid, Relief and Economic Security Act with broad support. Provisions first in the CARES Act (and now similarly included in the Consolidated Appropriations Act) directing payments to individuals, as well as those allowing the sponsors of 401(k) workplace retirement plans to temporarily increase loan and withdrawal limits, were widely covered at the time, but it is the rules permitting qualified individuals to delay their retirement loan payments that may generate the lasting impact for plan sponsors.
Plan sponsors have historically treated loans as an administrative program, outside the boundaries of fiduciary standards and review. The Department of Labor (DOL) takes the position, however, that a participant loan is a plan investment, and requires the same fiduciary oversight as any other investment in the plan. And loan administration, an area most plan sponsors spend little time on, just became more complex.
Passing the test
Why worry? The auditors from the Department of Labor seemed friendly enough and were straightforward about the information they needed to start the audit. The Retirement Director at a large industrial services company would simply share the request with his recordkeeping Account Manager and have the information together in a few days. After all, his employer had hired a large financial services firm for work just like this, and they must have been through this thousands of times. The auditor might not even need to visit.
However, things did not quite work out that way. Several months later the auditors were still at work; by the time they finished the Retirement Director understood a lot more about his loan program. His employer had to address several deficiencies to close the audit along with making a hefty payment.
What happened? It is best to start at the beginning.
The administration of 401(k) plans and their assets is chiefly governed by The Employee Retirement Income Security Act . But ERISA is written in a way that leaves room for interpretation, leading many challenges involving plan investments to be resolved through high profile and costly litigation. In what is seemingly an acknowledgement of this, DOL uses its own resources to focus more broadly on plan administration and enforcement, where popular features like plan loans can prove quite challenging.
Loans a ripe environment
Loans provide an especially fertile testing ground for several reasons, according to attorneys familiar with these matters. For one thing, loans themselves are only permitted as an exemption to the rules governing the use of a plan’s investments, making them a natural area of focus. In fact, the DOL actually classifies its loan rules as part of a “prohibited transaction exemption.” Exemptions, as a matter of law, must be administered carefully.
Loan administration can be complex. The DOL and the Internal Revenue Service (IRS) both adhere to the “form and operation” mantra: that not only must the plan documents be written correctly, but the plan must operate in accordance with those terms. Loan administration can be rife with errors because loans touch so many areas, and several important data points generally fall outside the scope of standard recordkeeping services. These areas, including the verification of employment status, details related to the default of the loan, job classification, and the direction to offset must be maintained by the plan sponsor themselves to establish compliance.
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There is also the matter of loan defaults, which is often a specific focus of IRS examinations. A loan is a formal plan investment evidenced by an actual contract between the plan and the participants who borrow, and the expectation is for these loans to either be repaid or to be timely taxed. But loan defaults can be difficult to properly document and administer, a fact that has been further heightened by rules that now require plan sponsors to separately report “loan offsets” on Form 1099-R. Regulators have the information to target their resources.
Approaches for plan sponsors
Most plan sponsors may feel comfortable that their plan administrator is doing everything that needs to be done. But it is the plan sponsor, not its administrator, who the IRS and DOL will hold accountable for proper loan administration, and it can serve the plan sponsor well to step up its own oversight. Although loan approval and administration have largely been outsourced for years, these remain fiduciary responsibilities.
Plan sponsors interested in an objective third party review of their loan programs can hire consultants or their own auditors to conduct a regulatory style examination. An independent audit can provide plan sponsors a point in time review. These services can be costly, however, and limited in value if they are not completed regularly.
Another option for plan sponsors is to establish a loan insurance program that repays all or a portion of the outstanding loan balance of any worker that loses their job. This program by itself substantially lowers loan related risks by automatically reducing the level of loan defaults, supporting the financial wellness objectives many plan sponsors are pursuing. And because a loan insurance program organizes a plan’s loan data - including those areas that often fall between a plan sponsor and its third party recordkeeper – it has the added benefit of creating and documenting the type of enhanced compliance procedures and loan data that can serve the sponsor well during an audit.
Looking ahead
The CARES Act and the Consolidated Appropriations Act both leverage 401(k) plans to free up funds for workers impacted by COVID and other federally declared disasters. But once these special provisions have ended, any loan that falls behind will be subject to default. It is up to plan sponsors to make sense of it all.
The added safeguard of loan insurance can help demonstrate to regulators that the plan sponsor has established compliant procedures and regularly assesses its own performance. Loan insurance provides plan fiduciaries - who have the responsibility to monitor, assess and act where necessary - a means to fulfill these important obligations.
