Highway 401 Traffic. Click highlighted cities for local traffic conditions. 7 hours ago - Using a 401(k) plan to save for retirement is an attractive option: You get tax advantages, the funds are automatically taken out of your. Conveniently access your workplace benefits such as 401(k)s and other savings plans, stock options, health savings accounts, and health insurance.
401(a) vs. 401(k): An Overview
Traditionally, American workers relied on what was called the three-legged stool of retirement income (workplace pension plan, Social Security payments, and personal retirement savings). But employers have largely abandoned pension plans, replacing them with workplace-sponsored retirement savings plans like 401(k)s and 401(a)s, to name two examples.
Both of these savings plans are workplace retirement plans, included in the 401 section of the Internal Revenue Code. They are, in essence, tax codes. The difference between a 401(a) plan and a 401(k) plan is first in the type of employer offering them and then in certain details and provisions.
401(a) Plan
A 401(a) plan is a money-purchase retirement plan normally offered by government agencies, educational institutions, and non-profit organizations rather than by corporations. These plans are usually custom-designed and can be offered to key employees as an added incentive to stay with the organization. The employee contribution amounts are normally set by the employer. The employer has a mandate to contribute to the plan as well. Contributions can be pre- or post-tax.
The sponsoring employer establishes the contribution and vesting schedules, and these can be set up in a way to encourage employees to stay with the organization. If employees leave, they can often withdraw money by rolling it over into a qualified retirement savings plan or by purchasing an annuity. Participation is often mandatory, as are employer contributions. Investment options are easily limited by the employer, and government-sponsored 401(a) plans often offer only the safest investment options. Education employers are sometimes offered a related plan called a 403(b) plan.
401(k) Plan
A 401(k) plan is usually offered by private-sector employers. It allows an employee to invest pre-tax dollars from his or her paycheck into retirement savings account funds. The contribution amount is determined by the employee and, while some employers provide a matching program, this is not a requirement and many do not.
The employer offering the 401(k) plan selects which investment options are available to the participants, though as a function of their fiduciary duty, they need to be careful to offer participants a wider range of options than sponsors of 401(a) plans often do. Employers typically offer around 15–30 investment options, though that number has trended down in recent years, as research has indicated that too many options confuse participants. Assets in a 401(k) plan accrue on a tax-deferred basis, though they are taxed at regular rates when they are withdrawn.
Key Takeaways
- 401(a) plans are generally offered by public employers and non-profit institutions. 401(k) plans are usually offered by private sector employers.
- While participation in a 401(k) plan is not mandatory, with a 401(a) plan, it often is.
- While a 401(k) plan allows for the employee to decide how much he wants to contribute, the contribution amounts and levels of a 401(a) plan are set by the employer.
- A 401(k) plan offers the employee a range of investment products, while a 401(a) plan gives more control to the employer regarding investment options, which may be more limited in terms of risk.
Forty years ago, Congress passed the Revenue Act of 1978 and added a single paragraph marked (k) to Section 401 of the Internal Revenue Code. The primary intention was to put more parameters around pretax contributions made to cash-deferred plans. Yet, in fewer than 900 words, Congress inadvertently created what is now a major part of the backbone of retirement in America.
Today, 55 million people are active 401(k) plan participants, according to the Investment Company Institute. More than $5 trillion sits in these accounts—and at least as much has moved through these plans if you include funds rolled over to individual retirement accounts or annuities, or cashed out for retirement.
By many counts, the 401(k) has been a huge success. “In terms of a very large nation with many retirees, we look awfully good, and it has really to do with what has happened over the past 40 years with the 401(k) system,” says Paul Schott Stevens, president and CEO of the Investment Company Institute, or ICI, the fund industry’s trade association.
We can, however, do better.
More on the 401(k)
Without a doubt, the 401(k) has hastened or improved retirement for a large segment of the population, namely people with full-time jobs and matching benefits. But it’s far from perfect.
Among other issues, it puts the onus of making smart investment decisions on individuals. “It’s like going to the doctor, being told to go educate yourself on your anatomy, and then to pick one of these three drugs to take,” says Mitch Tuchman, managing director of Rebalance IRA, an investment advisor that uses low-cost exchange-traded funds in its clients’ portfolios. “You are making people do what they aren’t supposed to do.”
Moreover, despite being the go-to national savings system, it isn’t available to a large and expanding portion of the working population.
“The big failure with the 401(k) is that it was supposed to be easy and popular, and we were supposed to expand coverage from 50% to nearly 95%,” says Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at the New School, in New York. “Instead, we’ve gone from 50% coverage down to under 50% coverage.”
Listen to a conversation between Beverly Goodman and Alex Eule about whether the 40th birthday of the 401(k) is a time to celebrate or rethink our retirement policies. in a recent episode of The Readback. You can sign up for the podcast in iTunes or wherever you listen to podcasts.
One thing is certain: The 401(k) was a boon for asset managers. What was once a niche segment for mutual fund companies and benefits consultants has ballooned into the largest part of the financial-services business.
Roughly a third of all U.S. mutual fund assets reside in 401(k)s, and half of all fund assets are in some sort of retirement option, including individual retirement accounts, or IRAs.
“Without question, this made the mutual fund industry,” observes Ted Benna, a former benefits consultant who is widely credited with creating the first 401(k). “Pre-401(k), you had Fidelity, Vanguard, American, and some others, but they were pretty small operations. The 401(k) turned them into financial giants,” Benna adds.
Pivotal Moments in the 401(k)'s History
Like most people, the 401(k) plan took 20 years to hit its stride. There have been many changes to these employer-sponsored retirement plans over the years, many of which have encouraged workers to contribute more. But it's the bull market that has been the biggest boon, helping assets in 401(k) plans reach $5.3 trillion today.
3
5
$0 trillion
6
The Revenue Act of
1978, which includes
a new Section 401(k),
goes into effect.
1984
1986
The Tax Reform Act of
1986 reduces pretax
employee contributions
from $30,000 to $7,000.
1990
401(k) plans
exceed 97,600.
’94
Small Business Job
Protection Act of 1996
creates Simple plans
for employers with fewer
than 100 employees.
401(k) plans exceed
230,800.
1998
IRS approves automatic
enrollment into 401(k)
plans for newly eligible
employees. Number of
401(k) plans exceeds
300,500.
2000
Economic Growth and
Tax Relief Reconciliation
Act of 2001 makes
substantial changes,
including increasing
deferral limits and
introducing “catch up”
provision for people 50
and older.
’04
’06
2008
Accounts with more than
$200,000 decline an
average of 25%.**
2012
Department of Labor
introduces new fee
disclosure rule
requiring administrators
to give participants an
explanation of all fees
deducted from
their accounts.
401 K Log In
’14
2018
Department of Labour
Fiduciary Rule (or 'Best
Interests Rule') is overturned.
4
2
5
6
1984
1986
The Tax Reform Act of
1986 reduces pretax
employee contributions
from $30,000 to $7,000.
1990
401(k) plans
exceed 97,600.
1996
Small Business Job
Protection Act of
1996 creates Simple
plans for employers
with fewer than 100
employees. 401(k)
plans exceed 230,800.
’96
1998
401 Area Code
IRS approves automatic
enrollment into 401(k)
plans for newly eligible
employees. Number of
401(k) plans exceeds
300,500.
’02
2006
Roth 401(k)
makes its
debut.
’08
Accounts with
more than
$200,000
decline an
average of
25%.**
’12
2018
Department of Labour
Fiduciary Rule (or 'Best
Interests Rule') is
overturned.
*Total 401(k) plans and Other private-sector DC plans asset data through 2015 are from ICI tabulations of Form 5500 data from the US Department of Labor. **Between January 1, 2008 and January 20, 2009
Sources: Investment Company Institute; Federal Reserve Board; Department of Labor; EBRI/ICI
A Wrinkle in the Tax Code
In 1978, Benna was a 36-year-old partner in a small Philadelphia-area benefit consulting firm, the Johnson Cos., where his main focus was selling defined-benefit pension plans to employers. Like many of his peers, he took note of the new wrinkle in the tax law because he was interested in what it meant for the cash-deferred plans that were popular among his banking clients.
The new provision, which went into effect in 1980, meant that, in order to make pretax contributions, employees would have to commit to keeping their savings in place until they turned 59½, except for certain hardship withdrawals. What’s more, Section 401(k) included a nondiscrimination rule that limited what the highest-paid employees of a company could contribute, based on what other employees put in as a percentage of their pay.
Benna is the first to say that when he came up with the idea for a 401(k) plan, he wasn’t trying to reinvent the U.S. retirement system. Rather, he was trying to reconcile the interests of highly paid executives with other employees. The solution: create a plan that would allow employees to defer their bonuses and deduct pretax contributions from their paychecks, and sweeten the deal—and satisfy nondiscrimination testing—with matching employer contributions.
Incidentally, the maximum employee contribution allowed by the Internal Revenue Service at the time was $45,475; it dropped to $30,000 in 1982 and to $7,000 in 1986. For this year, it’s $18,500.
Benna’s proposal to his client was ultimately nixed by the bank’s lawyers, but Benna was inspired to convert his firm’s own thrift savings plan into a 401(k). The Johnson Cos.’ 401(k) became the first such retirement account when it went into effect on Jan. 1, 1981.
“It didn’t take a rocket scientist to know these would take off,” says Benna. “We were dealing with marginal federal income tax rates above 50%, and when higher-paid executives became aware that they could put away money pretax, they were gonna have a lot of interest in this thing.”
That they did, and according to an account by Herbert Whitehouse and published by the Employee Benefit Research Institute, or EBRI, in 2003, many benefits experts had clued into Section 401(k) and were working on creating their own programs, independent of what Benna was doing. “Of course, the real ‘fathers’ of America’s new 401(k) baby were the members of Congress who passed the Tax Reform Act of 1978,” wrote Whitehouse, who managed executive compensation at Johnson & Johnson, which introduced its plan to employees on Valentine’s Day 1982.
The plans still had critics. Some people questioned whether they were even legal or whether employees would be willing to “take a pay cut” in order to make contributions.
In one memorable moment, when Benna met with executives of Bethlehem Steel, a human-resources manager politely dismissed his suggestion that they add a 401(k), noting that the company took care of its employees. The steel maker went bankrupt in 2001, and the U.S. Pension Benefit Guaranty Corp. took over Bethlehem’s retirement obligations, with many employees getting a cut in expected benefits.
An Industry Is Born
In 1981, the IRS sanctioned the use of employee salary reductions as a source of contributions, greenlighting large companies’ plans to roll out 401(k)s. Within two years, according to the Employee Benefit Research Institute’s telling of history, roughly half of all large companies had introduced, or were in the process of introducing, 401(k) programs.
401k Companies
Initially, these supplemented traditional pension plans. Then, through a series of events, including new accounting rules, “defined-benefit plans no longer made sense for many employers, and so what else do we have left? Well, there’s these 401(k) plans,” says Jack VanDerhei, EBRI’s research director.
By the late 1980s, many large companies had 401(k)s, and employees loved them. “HR managers were hearing, especially from younger employees, that people appreciated the 401(k) plan much more than the defined-benefit plan,” he says. “Whether or not it was in the employees’ best financial interest, that was how it was perceived because they could see these account balances building up. And what’s the defined-benefit plan to anybody under age of 50? It’s a formula that they don’t understand.”
As 401(k)s grew in popularity, so did their complexity. What Benna imagined as a relatively simple way to save took on a life of its own. The first systems typically had two options: a guaranteed investment contract and an equity choice, which employees could split up a handful of ways. In 2015, the average large 401(k) offered 29 investment options, according to the latest data from the ICI and BrightScope.
That increase in potential investments led to higher fees, Benna observes. The shift also gave rise to an army of consultants and advisors needed to create and monitor the growing menu of choices. “That’s when the investment community took over the 401(k) business,” says Benna, who adds that total costs increased from roughly 0.1% for the earliest plans to 1% to 2.5% today. “The bottom line is there was money to be made.”
Competition and price wars throughout the industry eventually worked in investors’ favor, and fees have dropped. According to the most recent ICI and BrightScope data, 401(k) participants paid an average expense ratio of 0.48% for stock mutual funds in 2016, versus 1.28% for the average equity fund, and down from 0.77% in 2000.
Meanwhile, the rise of target-date funds—which base asset allocations on expected retirement dates and automatically adjust their holdings as a date approaches—have helped solve the do-it-yourself investor problem.
Eight out of 10 401(k) programs offer target-date funds, according to the ICI, and they’ve been widely embraced, particularly by young investors. This might be in part because more employers are automatically enrolling investors into target-date funds.
Target-date funds take away the guesswork of where to invest, and auto-enrollment and auto-escalation provisions nudge employees to start saving and gradually increase their contributions. However, the retirement plans still leave room for other poor choices.
A Persistent Problem
401k Fidelity
Take early withdrawals, for instance. The estimates of these vary greatly by source. The Employee Benefit Research Institute’s database indicates that fewer than 5% of active 401(k) participants have taken early withdrawals in a given year.
The key word here is “active.” It’s when employees leave a company that plans are most vulnerable to leaking savings. Research from E*Trade Financial found that nearly 60% of investors 18 to 34 years old—ages when job mobility is high—indicated that they had taken money from their retirement accounts.
The Center for Retirement Research at Boston College found that 401(k) plan leakage causes a 25% reduction in aggregate retirement wealth, according to a 2015 analysis. The study looked at cash-outs, as well as in-service withdrawals, such as a hardship distributions. That’s why many people, including Benna, argue that employees shouldn’t be able to touch their plans until retirement, except in hardship situations. But the ICI’s Schott Stevens cites research showing that participants contribute less when a loan isn’t an option.
Another way to reduce savings leakage: auto-portability—automatically rolling 401(k) balances from a previous employer’s 401(k) program into a new employer’s. This idea has been proposed under the Automatic Retirement Plan Act of 2017, or ARPA. In addition to mandating auto-enrollment and contribution increases, auto-portability would roll former employers’ plans to their new accounts.
“ The system, which of course was never built to be a replacement for pensions, was built in a time and place when people worked very differently. ”
Solving the Access Problem
That’s all well and good, says the New School’s Ghilarducci, but it doesn’t take care of the estimated 50% of working Americans who don’t have access to a 401(k). “I used to be all for making the 401(k) a lot like a defined-benefit plan; I was in favor of auto sweeps, auto everything,” says Ghilarducci. “The economic reality is that these tweaks are still more favorable for people who have stable jobs and stable lives.”
In other words, 401(k)s don’t solve what she and others consider a big problem—the need to make retirement plans more widely available, including for part-time employees, freelancers, and employees of smaller firms. Just over half, 53%, of companies with five to 250 employees have retirement savings plans, according to Pew Charitable Trusts.
On this point, critics and fans of the 401(k) agree. Whether through a 401(k) or other offering, access to retirement saving must be improved.
(Ghilarducci has come up with one alternative. In collaboration with the Blackstone Group’s Executive Vice Chairman Tony James, she has proposed Guaranteed Retirement Accounts, which is effectively a self-funded pension to augment Social Security.)
True, anyone is free to contribute to an IRA, but people are 15 times more likely to save for retirement if a program is offered through their employer, says Laurie Rowley, co-founder and president of the National Association of Retirement Plan Participants, a nonprofit organization aimed at making information transparent and accessible for all working Americans saving for retirement.
“The system, which of course was never built to be a replacement for pensions, was built in a time and place when people worked very differently,” observes Rowley, whose organization has its own proposal, called Icon, to simplify and expand retirement savings for nontraditional employees. “People are going in and out of jobs at a much more frequent rate, and, on top of that, we have new forms of employment. Almost 100% of job creation in the past decade has come from non-traditional employment arrangements, not from full-time jobs.”
Among millennials, 66% say they have nothing saved for retirement, owing to a lack of access or ineligibility, according to the Schwartz Center for Economic Policy Analysis. This is particularly problematic, given how much starting early affects saving success. Even so, this isn’t the number that Ghilarducci worries about most: If nothing is done to change the system, she says, 40% of middle-class Americans will fall in or near poverty by the time they reach age 65.
Perhaps the biggest problem with the 401(k) isn’t what it does or doesn’t do, Ghilarducci says, but that its arrival precluded other programs. “If the 401(k) had not come about, we would’ve had companies keep their defined-benefit plans, because it was a valuable benefit for their employees, and we might have had a national kind of public option to a 401(k), where people could voluntarily save more in their Social Security,” she observes.
Fixing 401(k)s for the Future
For his part, Benna’s only regret about the 401(k) is that the plans have made a small segment very rich, at the expense of too much complexity and unnecessarily high fees paid by participants. At the same time, the 401(k) helped him save for his own comfortable retirement, he says, and people regularly stop him and thank him for inventing the plans.
Fixing 401(k)s might not require blowing them up and starting over, as he was once quoted as recommending. The basic structure is fine, but he would make some changes, including requiring all employers to offer a 401(k) or IRA funded through payroll deductions, with auto-enrollment and auto-escalation—and rules that wouldn’t let participants touch their savings until their golden years.
Finally, when retirement does come, he’d cap the percentage of assets that can be taken as a lump sum. The bulk of participants’ savings, he says, should be annuitized for a steady stream of retirement income.
To be sure, managing retirement assets for the long haul is arguably harder than accumulating them. While people save for retirement over decades, giving them time to recover from investment missteps, if a person fouls up in the relatively short span of retirement, it might be impossible to recover.
In part, Social Security is based on employee payroll deductions that can be considered a form of forced savings. The ICI’s Schott Stevens notes that Uncle Sam already pays this out to retirees as steady income.
People should have an annuity option, he maintains, but he wouldn’t require it. “I think it’s important to be neutral, from a regulatory and policy point of view, about what tools are made available and what choices people make with respect to using those tools,” he says.
Over at the Employee Benefit Research Institute, VanDerhei offers a compromise: auto-annuitize. Studies have shown the impact of automating decisions about when, where, and how much to save, he notes. So why not make converting retirement assets into an annuity the default option?
“I’m not saying everybody’s going to do it, but some people will want something other than Social Security as a base of guaranteed retirement income,” he comments. “I think that’s the single biggest change you’re going to see going forward.”
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