When the Chancellor announced the Lifetime Isa he said he would be looking to see if introducing a loan facility similar to that available under the US 401k retirement plan would be a good idea. The thinking is that giving people access to their savings before retirement could increase take-up.
By way of background, 401k plans are workplace retirement savings plans and are the US equivalent of our workplace defined contribution schemes. Not all 401k plans offer loans but most do and generally participants can borrow the maximum of $50,000 or 50 per cent of their account value under the plan. Repayments are made according to a fixed schedule and deducted directly from salary. The term of the loan is usually no more than five years but can be longer where the money is being used for house purchase. The repayment schedule is calculated at a commercial interest rate usually between 0.5 per cent and 1.5 per cent over the US prime rate, which is currently 3.5 per cent.
While I had some long-held opinions on the subject, I realised I did not know a lot about the facts, so I did some research. In particular, I tapped into the database on 401k participant behaviour from US-based Fidelity Investments.
The first question I wanted to answer was whether loans are popular. They certainly seem to be, with around 10 per cent of 401k participants initiating a new loan last year. Overall, around 21 per cent of participants have a loan outstanding. Over half of those with a loan have more than one. So it seems there are a reasonable proportion of people who rely very heavily on loans.
But surely it is better to borrow from yourself than from a bank? In theory, this is true. The rate of interest you pay is likely to be lower, you will not get credit scored and any interest that is paid goes back into your account. However, when you borrow from a 401k plan, what you are actually doing is redeeming investments in your account and then repurchasing them using the loan repayments. So while you are earning interest on the amount withdrawn, you are foregoing investment returns. In the long run this is likely to drag on overall investment growth, therefore impacting on the potential future benefits from the plan.
I have often heard people in the UK claim that many of those taking 401k loans never pay the money back and end up defaulting, putting a hole in their retirement savings. In fact, default rates are relatively low, largely because repayments are made via payroll and deducted automatically. Where defaults do often occur is where an individual leaves employment with a loan. They then have 90 days to repay the loan, which may be difficult, especially if they are not leaving by choice. If the loan is not repaid, the outstanding balance is treated as a withdrawal, is taxed and has a 10 per cent penalty applied, putting an even bigger hole in the participant’s retirement plans.
What does happen is that people taking loans will often reduce their normal pension contributions. In fact, 25 per cent of those taking out a loan reduced contributions in the following five years, with 15 per cent stopping contributions altogether. Combined with having assets out of the market, this can have a significant impact on retirement preparedness.
So what does this mean for the Lifetime Isa? We have to be very cautious about implementing a loan facility where there is no existing collection mechanism such as payroll deduction. What would stop individuals from simply contributing then borrowing the money back and repaying through existing contributions? That does not seem like something that should be supported by the Government subsidy.
It is interesting to note the Individual Retirement Account (the US personal pension) does not offer loans. Even if we could be certain loans would be repaid, a model similar to that used in the US could result in those that take loans seriously undermining their retirement prospects.
Overall, the benefits of early access through loans seem questionable and their introduction would certainly create significant additional complexity. The Lifetime Isa does offer the prospect for early access, albeit with loss of the Government’s uplift and a modest penalty. I would suggest we see whether this is enough flexibility to encourage people to save before we start looking to add more bells and whistles to what should be a reasonably simple product.
Richard Parkin is head of pensions at Fidelity International