Where Did We Go Awry With the 401(k)?

Section 401(k) was added to the Internal Revenue Code by the Revenue Act of 1978. It was such a significant part of that act that when I went to www.congress.gov to read the act summary, there was no mention of this new deferral opportunity. It was tossed into the legislation with little fanfare.

Why was that?

401(k) plans were never intended to be the primary retirement vehicle for the masses. In 1978, after the passage of the relatively new landmark law known as ERISA, defined benefit plans (DB) were all the rage and those companies that had chosen not to take the DB route frequently offered profit sharing plans, money purchase plans, or ESOPs, or because of the special tax treatment that they were given at the time, tax credit ESOPs, known back then as TRASOPs (bonus points for anyone who recalled TRASOPs before reading this).

Those were core retirement plans. Combined with Social Security, they were designed to be two legs of the so-called three-legged stool needed for retirement. The third leg was personal savings and the 401(k) plan was supposed to give people a more tax-efficient way to grow that third leg. Read that again; 401(k) plans were designed as savings plans, not as [core] retirement plans.

Somewhere, things went awry. I have written about this many times and blamed virtually everyone who had a voice. As our government and regulators made it more and more cumbersome to sponsor traditional retirement plans and the US economy took several turns for the worse, companies became less comfortable as sponsors of traditional retirement plans. They often placed the blame anywhere that they could. In fact, they placed it everywhere except where it belonged:

• Employees didn't appreciate the other plans (it turned out that the people who didn't have them sure thought their friends who had them had a good deal)
• They could be more competitive without them (don't you get higher productivity and better products and services from happy employees)
• The 401(k) would be enough (of course many of those same companies retained their executive retirement plans)

Now, in a workforce fraught with high turnover, low morale, and lots of part-time jobs, many of us expect employees to save for their own retirement. Projections done by proponents of those plans show that those who do will have a wonderful retirement. Those projections tend to leave out all of these complications:

• You can't defer when you are laid off and most of us seem to face one or more layoffs in our careers these days
• You will have periods in your career when you go through one hardship or another and can't afford to make the deferral you would like
• If you do have a hardship and have to pull money out, those penalties are severe
• You absolutely will not get the 7%-9% annual return on investment, net of expenses, that many of those projections would "promise"

But, companies persist in the belief that the 401(k) is the retirement plan of choice. Potential employees ask about the company's "401 plan." In the meantime, some people retire very early and many will be retiring well after the traditional retirement zone of ages 62 through 65 has passed them by. 

Isn't it time to bring back retirement plans and have more than just savings plans? Any of them can be designed today with the proper administration to show employees their account balance as of that day any day that they choose to look.

You can be an employer of choice.

Despite the Best Efforts of the Government ...

Despite the best efforts of the federal government and of governmental agencies, most Americans in the workforce today really have no idea how they are going to retire or if they are going to be able to retire. Disclosures are much more comprehensive than they were in earlier years. Opportunities for tax-favored savings have grown. Plan designs that truly encourage savings have become common.

So, where did things go wrong?

To consider this, let's look at a brief history of retirement plans -- very brief in this case.

In the beginning (Genesis in this case is known as ERISA), most American workers who were fortunate enough to have company-provided retirement plans were in defined benefit plans. In fact, Section 401(k) had not yet been added to the Internal Revenue Code. So, while some industries tended to favor thrift plans (after-tax savings plans that often also provided for an employer match), university systems and certain other tax-exempt organizations tended to have 403(b)s, and professional corporations often had money purchase and profit sharing combinations, lots of workers had DB plans as their backbones.

And, the workforce model fit with DB plans. Likely, the company that you worked for at age 30 would be the one you would retire from. As a retention device, there were lots of goodies that came with staying with that company until at least age (usually) 55. Another wonderful device known as subsidized early retirement, sometimes combined with early retirement windows, allowed companies to manage their workforces without the need for layoffs. In DB plans, there is no such thing as leakage if you stay with the same company.

So, a worker really didn't have to know all that much. What they did know is that when they retired, they would have a combination of their pension and their Social Security and that between them, that felt like enough to live on.

As the Old Testament evolved, so did the landscape change. Gradually, DB plans were replaced by 401(k) plans until we were faced with the New (world) Testament where the bulk of American workers were no longer accruing defined benefits. And, in a 401(k) plan, as we all know, it's really difficult for a participant to figure out exactly what he can buy for the rest of his life with an account balance.

And then there were disclosures.

Now, we get disclosures about the level of fees being charged against our accounts in a plan. I'm in this business. I can't read them. While the wording is not bad, those disclosures are so boring that even if I try, I am unlikely to make it through the first paragraph.

And, there are proposals that will require my employer (through a TPA) to tell me just what my 401(k) may grow to and how much per year that will be worth in my retirement. But, those all use assumptions.

I can understand those assumptions. If you are reading this, it's likely that you can as well. But, how about the poor participant who doesn't know if 6% annual investment return is reasonable? How about the poor participant who doesn't know whether retiring two years later is worth very much in terms of leading to a more comfortable retirement?

Savings plans are a good supplement, but with the current level of communications, to me, they are not the answer. Computer-based models might help, but even then, they would be dependent upon the assumptions underlying the modeling. If plan sponsors choose them, those assumptions might be reasonable in the aggregate, but very rarely for any given individual. If participants choose them, then they need more education than they can ever expect to get on those selections.

From where I sit, there is no easy answer.

Perhaps it's time to return to Genesis. When plans were funded responsibly, costs were controllable and participants who retired under a DB system with some amount of voluntary savings are generally doing pretty well in retirement.

But, will you?

401(k) Plans Without Matching Contributions Will Not Allow the Masses to Retire

I read an article this morning entitled "Encouraging Savings Without a Match." The article was informative enough and it did discuss the importance of getting workers to save. It discussed how auto features (auto-enrollment and auto-escalation) will have positive effects in allowing workers to accumulate balances large enough to retire someday.

The author and her sources are correct. Auto features will help, but they are not enough.

Why not?

Suppose I am a participant in a 401(k) plan and you are my employer. Suppose that in that plan, you provide me with a fairly measly (by today's standards) match of 25 cents on the dollar for the first 4% of pay that I contribute. That's not much; you're only contributing as much as 1% of my pay, but you are motivating (note the lack of use of the non-word incentivize) me to defer at least 4% of my pay. That means that 5% of my pay will go into my account. It's also a first-year return on my investment of 25% before I have even a bit of positive investment performance.

If instead, you provide me with a more generous match of 50 cents on the dollar for my first 6% of pay, the motivation for me to defer at least that 6% is even greater. And, of course, if you provide me with one of the nice safe harbor matches that are even more generous, I am motivated still further.

Auto-enrollment provides no such motivation. Without that motivation, when I hit a financial crunch (perhaps my new-fangled high-deductible health plan is not providing me with the risk management tools that I really need), the first place I may look to for an extra source of weekly or monthly cash is those 401(k) deferrals. Perhaps stopping them allows me to pay my rent or mortgage on time. Perhaps it allows me to make my car payments. Because I don't have an additional incentive beyond the holy grail of retirement to continue saving, ceasing my 401(k) deferrals sure feels like a good idea. And, once I stop, I probably won't start again.

From where I sit, most people today seem to live at or above their means where their means are characterized by their take-home pay. The old defined benefit-based system allowed people to retire because their take-home pay was perhaps a little bit less in order to pay for their retirement benefit which could be a fair amount more. The discipline in that was not employee-driven, but plan design and ERISA-driven.

Now, the motivation is largely gone and the discipline is largely gone. People are living longer and a lot of them are going to have to work for a long, long time.