Commentary & Opinion

The 401(k) Turns 40

It has come a long way… but what’s next?

by Lori Lucas

Ms. Lucas is CEO, Employee Benefit Research Institute ( Republished with permission from her ebri blog.

NOVEMBER 5, 2018 — The 40th anniversary of the introduction of Sec. 401(k) to the Internal Revenue Code is particularly significant to me on several levels. As a retirement professional, I have seen my career closely track the ups and downs of 401(k) plans. I’ve watched them evolve from tiny supplemental savings plans, to useful benefits for attracting and retaining workers, to the primary employer-sponsored retirement plan of corporate America. But now as 401(k) plans turn 40, plan sponsors, policy makers, and the industry must decide how they fit into the decumulation phase of workers’ lives.40years

I started saving in my own 401(k) around 1990. It was a brand-new offering by my employer, and I had previously only had an IRA for my retirement planning. At that time, there were just under 98,000 401(k) plans and about 20 million active plan participants. Total assets in these plans at the time were $385 billion.

In the early 1990s, Sec. 404(c) was written into the Employee Retirement Income Security Act of 1974 (ERISA). This new safe harbor allowed plan fiduciaries to not be liable for investment losses suffered by plan participants who self-direct their investments, provided that the plan sponsor met certain conditions. One was offering basic information about plan investment options. Nonetheless, in 1993, when I was still a pretty new investment consultant, a plan sponsor nearly hung up the phone on me when I suggested he offer help to participants on selecting their investments. Like many back then, he feared this would be construed as fiduciary investment advice — for which he could be held responsible.

Safe Harbor for Advice?

The Department of Labor (DOL) then issued Interpretive Bulletin 96-1, giving plan sponsors much more latitude to educate participants. However, there was still no safe harbor for advice. I experienced the challenge of this every time I conducted a participant meeting. For example: Standing in front of a refrigerator in a break room at 7 a.m. at a manufacturing plant, I was trying to teach a room full of women (for whom English was a second language) asset allocation. At the end of the presentation, one of the women raised her hand and asked me if I could just tell her which investments to select. Of course, I could not. (Actually, before I could answer to tell her that, her supervisor instructed her to ask her husband. But that is another story.)

The dawn of automatic enrollment came in the year 2000, when the IRS issued guidance on “negative elections.” People like the woman in the break room at the manufacturing plant now could be enrolled into a 401(k) plan without having to figure out their own investment elections. This seemed like a pretty big deal to me, and now that I was director of retirement research at 401(k) recordkeeper Hewitt Associates, I could examine the impact of automatic enrollment on 401(k) participation. Working with David Laibson and James Choi at Harvard University, we found that few people opted out under automatic enrollment. At the same time, few people also increased their contribution rate, even if it was a very low rate such as 2 or 3 percent of pay. I presented this research at various conferences, and invariably someone in the audience explained how they would never offer automatic enrollment because of concerns about state wage garnishment laws. So, adoption remained low.

401(k) plans received a big boost with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which increased the amount participants could contribute to their plans and created catch-up contributions, among many other provisions. That same year, the SunAmerica Advisory Opinion was issued by the DOL, permitting asset allocation services to be provided to participants in ERISA-covered plans under certain conditions. This launched managed accounts, a type of early robo-advice for 401(k) participants.

Of course, 9/11 also happened that year, and with it, a market collapse. Plan participants generally stood firm: I was in charge of the Hewitt 401(k) index at the time, which saw net transfers of just 1.4 percent of balances in the month of September 2001.

In 2004, the number of plans with a 401(k) feature clocked in at 418,553. There were 44,407,000 active participants in 401(k) plans with total assets of $2.19 trillion. There was also a new type of investment option available: target-date funds. These allowed plan participants to invest in professionally managed portfolios tied to their retirement time horizon. However, few sponsors used them as the plan’s default investment. Again, there was no safe harbor protection around defaults, and many sponsors were counseled that stable-value funds were a more prudent option because the possibility of loss was remote.

Enter TheThe Pension Protection Act of 2006

Originally named Save More Tomorrow™, automatic contribution escalation—like automatic enrollment—leveraged behavioral finance. In this case, it recognized that the same people who are reluctant to increase savings today may allow their contributions to be automatically increased over time...

The Pension Protection Act of 2006 (PPA) changed many things. It created a safe harbor for automatic enrollment and sanctioned the use of automatic contribution escalation. The latter was the brainchild of Richard Thaler of University of Chicago and Shlomo Benartzi of UCLA. Originally named Save More Tomorrow™, automatic contribution escalation—like automatic enrollment—leveraged behavioral finance. In this case, it recognized that the same people who are reluctant to increase savings today may allow their contributions to be automatically increased over time. (Note: Research shows they generally do.) Under the final regulations issued by the DOL in 2007, target-date funds were deemed to be a qualified default investment alternative within the PPA’s automatic enrollment safe harbor. The PPA also provided ERISA pre-emption of state wage garnishment laws. Use of automatic enrollment, automatic contribution escalation, and target-date funds subsequently soared.

The year 2006 saw another milestone as well: Schlichter Bogard & Denton filed its first lawsuits alleging excessive fees in 401(k) plans. As the DC practice leader at Callan Associates, I saw requests for fee analysis by plan sponsors skyrocket. Many wanted to understand how they could eliminate the practice of revenue sharing. A once-popular way to pay for plan administration, revenue sharing allocates an agreed-upon portion of an investment fund’s expense ratio back to the plan’s recordkeeper. The fee lawsuits took issue with this approach.

The market collapse of 2008 was as tough on 401(k) plans as it was on everything else. During the market decline of 2001–2002, people had joked that their plan was now a 201(k). No one joked about the 2008–2009 collapse. Times were so hard that some plan sponsors were forced to eliminate their employer matching contributions. One plan sponsor’s comment summarized the angst of that period: “I just want to know what is going to blow up in my plan next.” Although the number of plans with a 401(k) feature was now up to 511,583 and the number of active participants was 59,976,000, total assets slumped from nearly $3 trillion in 2007 to $2.23 trillion at the end of 2008.

The markets — and 401(k) plans — have since bounced back with a vengeance. In 2016, a Department of Labor survey found that 62 percent of workers had access to some type of defined contribution plan, most likely a 401(k) plan. Of those with access, 72 percent were participating. Assets in 401(k) plans as of the end of 2017 stand at $5.28 trillion.

40th Anniversary

My personal journey with 401(k) plans finds me celebrating their 40th anniversary as president and CEO of the Employee Benefit Research Institute. And we are celebrating our own 40th anniversary. EBRI was conceived in 1978 for the purpose of researching not only 401(k) plans, but all employee benefits. Today, the EBRI/ICI 401(k) database is the largest of its kind in existence, housing 27 million participants’ data on balances, investments, and activities. The database shows that workers with the greatest proportion of assets in 401(k) plans are those in their 50s. Forty-three percent of assets reside with workers who are mostly in the final stretch of their career before retirement. These workers are likely to rely on their 401(k) assets as their primary, or potentially their only, retirement nest egg. They face the daunting challenge of figuring out how to draw down their assets so that their nest egg lasts their full retirement. They don’t know how long that retirement will be, what health care costs they will face, or how the markets will perform.

Many do not use their 401(k) plan as their drawdown vehicle. EBRI finds that in 2016, the amount of dollars moved to IRAs through rollovers was more than 16 times the amount contributed directly to IRAs. And for the most part, retirees’ drawdown strategy is simply to take the required minimum distribution. Our research shows that, depending on the size of the nest egg, only between about 12–27 percent of assets are drawn down over the course of the typical retirement. When asked, retirees say they would rather preserve assets for a rainy day rather than spend them, even if it means living well below their ability.

As the 401(k) celebrates its 40th anniversary, the question arises: Ultimately how useful is a retirement account that people are afraid to spend? And does the 401(k) need to do more to benefit the huge new wave of retirees that will depend upon it?

EBRI has catalogued these changes and their implications in its new Fast Facts. Also, see our timeline: The Rise of the 401(k) Plan – Zero to $5.28 trillion in 40 years.