How (not) to deal with 401k loan defaults

Read the article "Loan defaults drain $37 billion from 401(k)s each year" on CNN Money. The last paragraph made me so angry I had to go read the study in its entirety. If you care here it is:

401(k) Loan Defaults: How Big Is the Leakage and What Can Policymakers Do to Preserve Americans' Nest Eggs? Robert Litan (Brookings Institution) and Hal Singer (Navigant Economics)

First of all, I have no complaints about the quality of the research done here. The facts themselves seem reasonable. My problem is with the policy suggestions. If these suggestions make it to Congress, I'll go back to writing letters to my representatives. That's a big deal; currently I only write letters when Wikipedia asks me to help save the internet.

Let's start with some assumptions that the study presents that I agree with (assume if it needs to be backed up with data, that the citation is in the study).

1. Many 401(k) borrowers have been denied other forms of credit and are using the 401(k) as a last resort
2. People have 60 days to repay the loan in full if they lose their job, or even just switch to a different job.
3. People are less likely to put money into a retirement account if they believe that the money will for inaccessible in the event of an emergency.

Here's what happens if a person defaults on his 401(k) loan.

1. He loses that portion of his retirement savings
2. He must pay income taxes on the loan amount
3. He must pay "penalties" (in some cases)

The story points out some proposed solutions that I summarize below. These ideas attempt to balance restricting using these funds for purposes other than retirement with preserving liquidity in the event of an emergency.

1. Limit borrowers to one loan at a time or limiting the size and scope of loans
2. Easing the repayment terms to reduce default.
3. Extending the time to pay back the loan in the event of job loss
4. Allowing a grace period if the person is currently collecting unemployment.
5. Making loans portable from one employer to the next.

Some of these seems quite reasonable to me (2-5, say), and the researchers claim to "largely agree". However, they also seem to think these proposals ignore the "welfare of the borrower". What this means is that none of these solutions help a borrower who has been forced to default on their 401(k) loan. They propose signing people up for loan insurance by default. They also point out that the policy administrators won't tinker with the average 401k plan on their own so policymakers need to come to the rescue.

"In particular, the law should be amended so that plans may choose to allow 401(k) borrowers to be automatically enrolled into insurance coverage unless they opt to decline such protection."

This is a horrible solution. The study points out that the average 401(k) loan borrower is 

• liquidity-contrained
• earning a lower income
• generally less wealthy
• less financially literate

So the answer to dealing with a poor, cash-tight, financially illiterate customer is to offer them an additional financial product? Actually, it's to offer them the right to refuse it, should they read all the paperwork and decide to do so. On top of this, lets charge them for this.

I understand why people need to be encouraged to keep their money in their retirement plans. But lets not forgot that this is, essentially, money that people have earned. They are borrowing from themselves. The primary beneficiaries of this policy change would be the insurance companies and that bothers me.

I confess that the actuarial math behind their proposal almost convinced me. I believe that insurance, in general, has a place in the overall solution. What I would like to see is a policy change that makes it easier to carry a loan from one employer to another and to allow for grace periods. Yes, people still forego the return on investment (what are they really making in the market anyway...), but at least this way we have made it as easy as possible for borrowers to repay themselves.

Along with this, I would like to see a stronger market for 401(k) loan insurance. I dread the idea of borrowing against my 401(k) (I'm considering it to buy a house) because it seems complicated and full of paperwork. If I can navigate this process, I can surely be presented with my options - including loan insurance. The problem, as the researchers point out, is that there is no incentive to create these policies such that they are affordable. There is no market. Then propose a solution that encourages a market without taking advantage of ignorance. That is something I would love to read.