"Unintended consequences” are generally a bad thing. But not always. The 401(k), for example.
This week we celebrated 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, 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 40
thbirthday, 401(k). And here’s to 40 more!
Nevin E. Adams, JD
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.
