How 401(k) Plans Changed the Way Americans Save for Retirement
Happy birthday, 401(k)! A few lines in the tax code 40 years ago dramatically changed the way Americans save for retirement.
The 401(k) plan may be as integral to retirement in America as Social Security and Medicare, but it wasn’t conceived as a cornerstone of retirees’ financial security. In 1978, the provision was inserted into the Internal Revenue Code to clarify that employees who invested a portion of their salary in company profit-sharing plans could defer taxes on the money. That led a handful of large companies to offer 401(k) plans to senior executives who wanted to supplement their pensions.
By the mid 1980s, companies began to see the advantages of abandoning traditional pensions entirely and replacing them with 401(k) plans. Even with a company match, 401(k) plans were less expensive than traditional pensions. Companies no longer had to put aside enough money to cover lifetime payments to retired employees. And 401(k) plans shifted investment risk from employers to plan participants. By 2015, only 5% of Fortune 500 companies offered pensions to most of their new employees, down from about 50% in 1998, according to benefits consultant Towers Watson. The more than 54 million participants in 401(k) plans today hold about $5.1 trillion in assets, according to the Investment Company Institute. The plans cost the government more than $115 billion a year in tax revenues, but a proposal by Republican lawmakers to cap pretax contributions at $2,400 a year was shelved following objections from the financial services industry.
A learning curve
At first, employees embraced 401(k) plans, too. The 18-year bull market that began in 1982 led to healthy growth in their portfolios. And unlike traditional pensions, which are typically based on an employee’s salary and years of service, 401(k)s give participants more flexibility to choose how much to save starting a year or less after they join a company. Plus, employees can change jobs and take the money with them.
But as 401(k) plans became the primary source of retirement savings for millions of people, problems began to emerge. Some plans were riddled with high fees and subpar investment options. Forced to manage their own portfolios, many novice investors made poor investment decisions. Many workers contributed far too little to ever have a nest egg big enough to ensure a secure retirement. More troubling, many workers didn’t bother to sign up, or they cashed out when they changed jobs.
The financial services industry, which has reaped a windfall from the growth of 401(k) plans, says many of those problems have been solved. Average expenses fell from 1.02% of 401(k) assets in 2009 to 0.97% in 2014, according to a 2016 study by the Investment Company Institute and Brightscope, which rates 401(k) plans. Automatic enrollment has led to an increase in participation, particularly among millennials. For example, more than two-thirds of new participants in Vanguard-managed plans were automatically enrolled in 2016. According to an analysis of 401(k) plans managed by Wells Fargo, when young workers are automatically enrolled, 85% stay in the plan and the rest opt out; when auto enrollment isn’t offered, only 38% of new employees sign up.
Meanwhile, the rapid growth of target-date funds has simplified investing choices. These funds allocate investments in stocks and bonds based on your expected retirement date. The investment mix gradually becomes more conservative as you get closer to retirement. At the end of 2016, 72% of participants in 401(k) plans managed by Vanguard had all or part of their accounts invested in a target-date fund, up from 18% in 2007.
Target-date funds eliminate the paralysis that often sets in when investors are faced with too many choices, says Leon LaBrecque, a certified financial planner in Troy, Mich. Portfolios invested in target-date funds are on autopilot, which helps workers avoid costly investment mistakes, such as selling during market downturns.
Automatic enrollment has increased participation in 401(k) plans, but average contribution rates actually declined slightly between 2015 and 2016, according to a study by Alicia Munnell and Anqi Chen, of the Center for Retirement Research at Boston College. The reason: Once employees are automatically enrolled at a 3% contribution rate, most remain at that level.
Even so, the number of auto-enrolled workers who are contributing less than they would have if they had signed up voluntarily “is overwhelmed by the number of people who would have been putting in zero and are now putting in 3%,” says Jack VanDerhei, research director for the Employee Benefit Research Institute, a nonprofit research organization.
One way around the low-rate problem is to increase the amount workers contribute every year automatically (unless the employee specifically blocks it). Two-thirds of 401(k) plans managed by Vanguard automatically increase employee contributions by one percentage point a year up to a specific cap, which ranges from 6% to 20%.
Some plans are setting the initial contribution rate for auto-enrolled workers above 3%. For example, one-fifth of Vanguard-managed plans enroll new employees at a contribution rate of 6% or more. Companies that have increased their default contribution rates haven’t seen a decrease in the number of workers who participate in their plans, says Diana Awed, vice president for retirement services at T. Rowe Price. A recent study sponsored by the Voya Behavioral Finance Institute for Innovation found that companies can set their default rate as high as 10% without affecting enrollment.
The haves and have-nots
Laurette Dearden, a certified financial planner in Laurel, Md., says her husband started contributing to his company’s 401(k) plan in the early 1990s. At first, he contributed only about $60 a paycheck. “It was not a lot of money, but it was a lot to us because we had little kids, and it was a stretch to put anything away,” Laurette says. Over the years, her husband increased his contribution every time he got a raise or a bonus, and the account grew. The Deardens, now in their mid fifties, have more than $1 million in their retirement accounts and are confident they can afford a comfortable retirement. Laurette’s husband plans to stop working at 65; Laurette isn’t sure when she’ll retire, but she knows she can afford to do it on her own terms. “The amazing thing is how those small, earlier dollars really added up,” Laurette says.
Such success stories are much more difficult to find among people who don’t have access to a 401(k) or similar workplace retirement savings plan. Most large companies offer 401(k) plans, but only about half of small and midsize companies do. One-fourth of private-sector employees work for companies that don’t offer a retirement savings plan at all, according to a survey by the Pew Charitable Trusts.
The impact on savings is stark. Nearly one-fourth of U.S. households have saved less than $1,000 for retirement, according to EBRI’s 2017 Retirement Confidence Survey. More than two-thirds of workers who have saved less than $1,000 said they don’t have a workplace retirement plan.
Several states have proposed requiring employers that don’t offer a retirement plan to automatically enroll workers in a state-run IRA. The initiatives have been stalled by legal challenges from industry groups representing employers. They argue that the state-run plans would create regulatory headaches for companies with employees in multiple states and could even discourage some companies from offering 401(k) plans. Last spring, Congress repealed Obama-era regulations that would have made it easier for states to require employers to enroll their workers in IRAs automatically. A proposal that has more support from employers would allow small businesses to band together to form multiple-employer plans, or MEPs.
Ted Benna, a benefits consultant, is widely credited with creating the 401(k) plan features most companies use today (he came up with the idea for a match). But Benna now believes 401(k) plans are too expensive and cumbersome for many small employers. He has developed model savings plans that provide a way for employers to offer IRAs, with the added benefit of payroll deduction and a company match.
Benna has developed another model for employers with 100 or fewer employees using a SIMPLE IRA, which allows for pretax contributions of up to $12,500, or $15,500 for those over 50. (The maximum an individual can contribute to an IRA is $5,500, or $6,500 if you’re 50 or older.) To keep costs down, Benna’s models use low-cost funds from Vanguard and Schwab. “You can get the benefits of a 401(k) without using Section 401(k) of the Internal Revenue Code,” he says.