Tapping the 401K and unrealized gains

I just picked up on a MarketWatch article about 401(k) debit cards through Tim Iacono’s blog. It marks a pretty astounding trend in financial innovation.

Debit cards are straightforward. You use them for purchases and money is deducted from your bank account. But when the debited account is your 401(k) retirement plan, critics angrily line up to take a swipe at that piece of plastic.

It’s not hard to see why. The 401(k) debit card lets you borrow from retirement savings and pay yourself back with interest over time, much as you would with a typical 401(k) loan. Only the card makes it much easier to crack your retirement nest egg; all you do is shop, swipe and sign.

Let’s cut to the chase here. A debit card used to draw down your 401(k) is a very bad idea and should be banned by regulators of the industry. Leave it to the financial services industry to come up with some innovative deal to get consumers to go out and spend money the don’t have. Hats off to the innovative genius who thought this one up. This is just the latest in a line of credit products used to tap unrealized gains — a great way to keep the party going.

The problem I have with these instruments is they represent the end game in a slippery slope of excessive credit. Credit is the basic mechanism we consumers use to tap into unrealized gains in income and wealth.

For example, a mortgage is a credit taken on under the assumption that one will have enough future income at each mortgage payment due date to pay off the mortgage over time in full. Essentially, it is borrowing against future income.

Likewise, credit cards allow people to borrow today ostensibly under the assumption that they will earn enough in future income to pay off the credit balance in full at some point in the future.

In a very real sense, we are consuming our future income by taking on these credits. Therefore, credit at its core allows one to ‘consume’ one’s future income before it is realized. Credit is like a short sale — borrowing against your future income before you earn the money or have legitimate access to it. That’s the purpose of credit and there is nothing inherently wrong with it as long as the agreement between lender and borrower is entered into prudently (which is not the case in predatory lending).

Unrealized gains
Where credit has become excessive is where it is has become like margin lending — borrowing against unrealized gains in wealth. The oldest form of lending on the margin is the stock market, where one owns shares and borrows against the value of those shares in order to consume the unrealized paper gains without having to sell the shares.

This is all fine and good while the asset is appreciating. But, if the asset falls in value, the owner faces the potential of negative equity where the loan is worth more than the asset. Margin loans are often seen as a contributing factor in the stock market crash which heralded the coming of the Great Depression.

Now, we have more financial innovations that allow us to lend on the margin against our assets. First, it was residential property and home equity lines of credit (HELOCs). This produced the famous housing ATM during the housing bubble and has left Americans with far less equity in their homes. In many cases, ‘homeowners’ are suffering from negative equity due to their having extracted unrealized gains using their HELOC.

With 401(k) debit cards here, we have people setting aside pre-tax dollars to use upon retirement. In this sense, those dollars don’t legitimately exist before retirement — at least as far as the future pensioner is concerned. So this is an asset supposedly accumulating unrealized gains until one hits retirement. Instead the 401(k) debit card allows consumers borrow on the margin against future wealth and consume those pre-tax dollars to the detriment of their future living standards.

What is clear to me is that human nature fixes most of our mental energy on the here and now. We aren’t thinking long-term enough to resist the temptations of margin lending. Allowing people to tap into unrealized gains in wealth this way is allowing us to collectively mortgage our future. I can offer only two solutions to the problem.

  1. In the case of HELOCs and 401(k) debit cards, allow people to draw down only a certain percentage of their equity, say 20%.
  2. Ban the instruments outright. We can’t handle the enticement.

Do we really want people borrowing against their 401(k) with a debit card?

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