The Birth of a Notion

“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 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!

Footnote

  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.

Add Your Comments

5 Comments

  1. John McGowan
    Posted November 6, 2018 at 1:33 pm | Permalink

    Just a couple observations, from an old lawyer who was “there” at the time (and hates glory-grabbers like Benna).

    For the record, the real father of the 401(k) was Donald C. Alexander (who was the IRS Commissioner until 1977, and had just left for private practice, with I think either Morgan Lewis or Miller & Chevalier). Alexander lobbied key members of Congress in 1977 and 1978 (Conable likely was one of them) to put into effect a provision that “gave” private sector employees the same deferral right that public school teachers already enjoyed in/with 403(b) plans.

    I was with Owens-Corning at the time, as their in-house ERISA guy, when the 1978 Revenue Act introduced the 401(k)/cash or deferred arrangement concept. I put a 401(k)/CODA feature in the Owens Corning Fiberglas Corp. savings plan in 1981, before the regulations came out, because the consultants were out there selling it relentlessly. A good 2/3 of the Fortune 150 put 401(k)s in their plans between 1979 and about 1982 or 1983. We all talked about them, and how to troubleshoot the issues, at ERIC (ERISA Industry Committee)meetings.

    The big sell, made by the consultants (ours was Hewitt Associates at the time), was to give employees the choice between cash and benefits, which would help the employees avoid federal, state and local income AND employment taxes by deferring potentially a lot of their income. The pitch to the employer is that the FICA saving (401(k) deferrals were excluded from FICA wages until the 1983 Social Security Reform Act changed the rule, as part of the Reagan-era deal to “save” Social Security. Senator Bob Dole was the one who threw the 401(k) CODA under the FICA bus.

    That’s why Ted Benna, who tries to take credit for everything (as you point out in your piece) is full of h.s. on this one, like so many others.

  2. John McGowan
    Posted November 6, 2018 at 1:38 pm | Permalink

    Clarification:

    The consultants’ “sell” was that a plan sponsor could pay for the cost of putting the 401(k) feature in place from the savings the sponsor would realize from its not having to pay its half (i.e., the employer’s half) of the FICA taxes that plan-covered employees would be able to exclude from their incomes by deferring part of their pay. Again, that only lasted until 1984, when the 1983 Social Security Reform Act took effect.

  3. Nevin E. Adams, JD
    Posted November 7, 2018 at 7:34 am | Permalink

    Mr. McGowan – thank you, both for your perspective, and for taking the time to share it with the rest of us.

  4. url url'>Conny Saab
    Posted November 9, 2018 at 3:01 pm | Permalink

    Hi Nevin, nice post. Interestingly, i was in a study group session of TPA’s in 1981 when Bill Johnson brought this issue to us for discussion. We immediately saw the importance of what had been created because as Mr. McGowan pointed out that it gave the American worker the same opportunity that teachers had as well as some government workers. Originally the concept was to give the choice to the participant, take the cash or save it. it has involved into no choice but has spawned an industry initially for the insurance companies now investment companies to manage the hundreds of thousands of small plans and i cannot forget the TPA firms.

    Frankly as an Adviser of DB’s, I saw lots of plans that really had little substance for the participant unless long term. as you state, 401(k) plans while pushing the responsibility of retirement to the participant at the very least the money belongs to them forgetting sponsor contributions. it has helped more people prepare for retirement and today we are focused on education of those in retirement and approaching retirement. I think that helps most Americans right there. now let’s see what we can do to strengthen our Social Security since it does remain the foundation for the majority.

    Keep up the good work Nevin.

  5. Nevin E. Adams, JD
    Posted November 10, 2018 at 8:27 am | Permalink

    Thanks, Conny. Much appreciated.

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