“Unintended consequences” are generally a bad thing. But not always. The 401(k), for example.
Today is being celebrated as the birthday of the 401(k) – because it’s the anniversary of the day on which the Revenue Act of 1978 – which included a provision that became Internal Revenue Code (IRC) Sec. 401(k) – was signed into law by then-President Jimmy Carter.
That wasn’t the “point” of the legislation of course – it was about tax cuts (some things never change) – reduced individual and corporate tax rates (pulling the top rate down to 46% from 48%), increased personal exemptions and standard deductions, made some adjustments to capital gains, and – created flexible spending accounts. But it did, of course, also add Section 401(k) to the Internal Revenue Code.
That said, so-called “cash or deferred arrangements” had been around for a long time – basically predicated on the notion that if you don’t actually receive compensation (frequently an annual bonus or profit-sharing contribution in those times/employers), you don’t have to pay taxes on the compensation you hadn’t (yet) received. That approach was not without its challengers (notably the IRS) and, according to the Employee Benefit Research Institute (EBRI), this culminated in IRS guidance in 1956 (Rev. Rul, 56-497), which was subsequently revised (seven years later) as Rev. Rul. 63-180 in response to a federal court ruling (Hicks v. U.S.) on the deferral of profit-sharing contributions. Enter the Employee Retirement Income Security Act of 1974 (ERISA), which – among other things – barred the issuance of Treasury regulations prior to 1977 that would impact plans in place on June 27, 1974. That, in turn, put on hold a regulation proposed by the IRS in December 1972 that would have severely restricted the tax-deferred status of such plans. But ERISA also mandated a study of salary reduction plans – which, in turn, influenced the legislation that ultimately gave birth to the 401(k).
So, how did something that became America’s retirement plan get added to a tax reform package? Rep. Barber Conable, top Republican on the House Ways & Means Committee at the time, whose constituents included firms like Xerox and Eastman Kodak (which were interested in the deferral option for their executives), promoted the inclusion which added permanent provisions to “the Code,” sanctioning the use of salary reductions as a source of plan contributions. The law went into effect on Jan. 1, 1980, and regulations were issued Nov. 10, 1981 (which has, at other times, also been cited as a “birthday” of the 401(k)).
Now, it’s said that success has many fathers, while failure is an orphan. The most commonly repeated story is that Ted Benna saw an opportunity in this new provision, recommended it to a client (which, ironically, rejected the notion), but then promoted it to a consulting firm (Johnson & Johnson), which then embraced it for their own workers. The reality is almost certainly more nuanced than that, though Mr. Benna (who now derides what he ostensibly created) has managed to be deemed the “father” of the 401(k) by just about every media outlet in existence (it may be worth noting that while I am the father of three children, their mother was much more involved in the actual delivery).
What we do know is that in the years between 1978 and 1982, a number of firms (EBRI cites not only Johnson & Johnson, but FMC, PepsiCo, JC Penney, Honeywell, Savannah Foods & Industries, Hughes Aircraft Company and a San Francisco-based consulting firm called Coates, Herfurth, & England) began to develop 401(k) plan proposals, many of which officially began operation in January 1982.
Within two years, surveys showed that nearly half of all large firms were either already offering a 401(k) plan or considering one. Two years later the Tax Reform Act of 1984 (again, among other things) interjected nondiscrimination testing for these plans – and two years after that the Tax Reform Act of 1986 tightened the nondiscrimination rules further, and reduced the maximum annual 401(k) before-tax salary deferrals by employees. And yet, despite those – and a number of other significant changes over the intervening years – employers have continued to offer – and America’s workers have continued to take advantage of these programs.
Now, it’s long been said that 401(k)s were never intended (nor designed) to replace defined benefit pensions – true enough.
However, in 1979, only 28% of private-sector workers participated in a DB plan, with another 10% participating in both a DB and a DC plan. In contrast, the Investment Company Institute notes that, among all workers aged 26 to 64 in 2014, 63% participated in a retirement plan either directly or through a spouse. As of June 2018, Americans have set aside nearly $8 trillion in defined contribution plans, and there’s another $9 trillion in IRAs, much of which likely originated in DC/401(k) plans.
Those who know how defined benefit (DB) plan accrual formulas work understand that the actual benefit is a function of some definition of average pay and years of service. Moreover, prior to the mid-1980s, 10-year cliff vesting schedules were common for DB plans. What that meant was that if you worked for an employer fewer than 10 years (and most did), you’d be entitled to a pension of … $0.00. And, as you might expect, certainly back in 1982, even among the workers who were covered by a traditional pension, many would actually receive little or nothing from that plan design. But then, certainly in the private sector those plans were funded, invested (and paid for) by the employer. Nothing ventured,[1. I know that some would argue that workers effectively bargained for lower wages in return for the pension benefit. Maybe once upon a time, certainly in labor situations where there actually was an active bargaining component. But I suspect that most non-union private sector workers post-ERISA felt no such trade-off.] nothing gained, right?
The reality is that the nation’s baseline retirement program is, and remains, Social Security. But for those who hope to do better, for those of even modest incomes who would like to carry that standard of living into post-employment, the nation’s retirement plan is, and has long been, the 401(k). And – despite a plethora of media coverage and academic hand-wringing that suggests they are wasting their time, the American public has, through thick and thin, largely hung in there – when they are given the opportunity to do so.
That may not have been the intent of the architects of the 401(k), or its assorted foster “parents” over the years. But these days it’s hard to imagine retirement without it.
So, happy 40thbirthday, 401(k). And here’s to 40 more!