IBM Reinvents the 401(k)

Back in January 2008, IBM (IBM) replaced the last of its pensions with a new-and-improved 401(k). The plan came with plenty of enticements, befitting a company that earned more than $10 billion on $99 billion in revenue the previous year. There were generous matching contributions, super-low fees, custom-designed portfolios, free access to financial coaches, and more. Even so, critics hammered IBM's move as one more sign of retreat from the secure retirement benefits of the past.

Today, hardly anyone is complaining about IBM's 401(k), least of all the participants. The plan is sumptuous compared with offerings from most companies. Across the U.S., 401(k)s have been bludgeoned by the financial crisis. Balances have shrunk to a fraction of their former value, and many companies have slashed matching contributions. Yet IBM is sticking with its plan—one of the largest in the U.S., with $27 billion in assets. "In my job, I often hear horror stories," says J. Randall MacDonald, senior vice-president for human resources, who led the shift from pension to 401(k). "I don't hear horror stories about the 401(k)."

IBM's creation isn't revolutionary in design or implementation. But it combines most of the best features of 401(k) plans at other companies, then leverages IBM's size to wrangle cut-rate fees from investment firms that want to manage its retirement assets. With 94% participation among more than 100,000 active U.S. employees, the plan boasts an average employee balance of $127,000, more than double the national average. Fees, which have a bigger impact on long-term results than most people realize, typically are just 10 basis points, or 0.10%. "IBM takes a very paternalistic and serious attitude in terms of the quality and the cost to participants," says Ted Benna, chief operating officer of pension consultant Malvern Benefits and the man considered to be the father of the 401(k).

Having weathered the recession, at least so far, IBM is now toying with some truly radical ideas. MacDonald hopes someday to meld retirement and health benefits into compensation, leading to a performance-based 401(k) through which top performers could be rewarded with better benefits. Given IBM's size and clout, any trail it blazes in this area could alter the retirement landscape dramatically.


The path to IBM's 401(k) epiphany was marred by at least one big blunder. In 1999, IBM redesigned its pension and put in place a hybrid called a cash-balance plan. Legally, this is a defined-benefit plan, but it has more in common with a 401(k). The company contributes money, and employees receive the funds as a "cash balance" in their accounts rather than as lifetime income in retirement.

There was nothing paternalistic about this shift, which was all about costs. Employees fumed over lost benefits, and a class action followed, claiming the change discriminated against older workers. The dispute went all the way to the U.S. Supreme Court, which, in 2007, declined to hear the case and left standing an appeals court ruling in IBM's favor. But by then the case had become one of the biggest human-resources debacles in Big Blue's history.

Against this backdrop, in 2005 CEO Samuel J. Palmisano assembled a team of six top executives, including MacDonald and Karen Salinaro, who was then vice-president for compensation and benefits, to rethink retirement goals and priorities. The team spent two years debating what the new 401(k) would look like—something with more features and benefits than a regular 401(k) but less expensive than the old pension. "They wanted to make a statement," notes Alicia H. Munnell, director of the Center for Retirement Research (CRR) at Boston College.

For IBM, there was no question the pension had to go. Among workers with retirement plans, the percentage covered by pensions fell from 83% to 30% from 1980 to 2006, according to CRR. Meanwhile, those in 401(k) plans, originally meant to be supplementary only, rose from 40% to 92%. The cost savings of the switch were big: IBM said at the time it expected to slash as much as $3 billion over five years from its worldwide retirement revamp.


While the cash-balance switch had been presented as a fait accompli in 1999, this time the management team held employee focus groups. Then, in dozens of town hall meetings, IBM-ers had a simple question: "Why are you doing this?" The answer came in a chart comparing IBM's legacy pensions and new 401(k) with retirement plans offered by its technology rivals. Most tech companies never even offered pensions. Instead they had 401(k)s, profit-sharing, and stock options. In contrast, IBM's plan seemed stuck in a different era. Everyone could see "how out of sync we were," Salinaro says. "They didn't necessarily like it, but they got it right away." Even some people who fought the cash-balance conversion in 1999 accepted the new 401(k). "It seemed there wasn't as much anger," says Tom Midgley, president of Alliance@IBM, the employee group that fought the cash-balance conversion.

Some of the improvements in IBM's plan were obvious. At a time when more than 200 companies have cut matching contributions, and the typical match is 50 cents on the dollar up to 6% of pay, IBM matches dollar for dollar up to 6%. It also gives automatic contributions of 1% to 4%, depending on which pension employees were previously in. Other improvements became clear as stocks tumbled last year, and investors veered between panic and paralysis. The average employee balance is down about 12% since the start of 2008, says IBM. By contrast, 401(k) balances for plans administered by Fidelity dropped 27% last year. The market decline was far worse.

IBM had built into its program two avenues for free financial advice. It provided access to Financial Engines, a company founded by Nobel Prize-winning economist William F. Sharpe that uses software to manage portfolios and runs 20-minute retirement "checkups." It also offered consultations with money coaches at Ayco, a Goldman Sachs (GS) subsidiary that had worked with IBM's top brass for six years. The IBM plan, dubbed MoneySmart, arranged for 25 coaches to be available exclusively to IBM employees for one-on-one advice about any aspect of their financial lives. MacDonald says the programs pay off in lessening financial anxiety that keeps people from performing on the job.

Tim and Tiffany Toomey, who live in Marietta, Ga., and work for IBM, realized they needed help last fall. Their 401(k)s, totaling more than $200,000, were dwindling, and they were not coordinating their asset mix. Tiffany, 42, had a conservative allocation; Tim, 39, was more aggressive, with about 80% in stocks. "I didn't know what to do—get out, or wait it out?" Tim recalls. The MoneySmart advice: Stay the course in a falling market, but change future contributions. The Toomeys took that advice, and scheduled monthly calls with their coach focused on other financial topics, like insurance and college savings. The last was an especially big concern, as they have four kids—a 9-year-old, a 7-year-old, and 4-year-old twins.

The Toomeys are two of more than 21,000 IBM employees who have called the MoneySmart advisers. All that advice doesn't come cheap, which may be why just 12% of large companies offer one-on-one advice, according to the Profit Sharing/401k Council of America. IBM expects to spend $50 million on the program over five years. Margaret M. Keyes, Ayco's head of financial-related services, says Ayco has held "a number of discussions with fairly significant companies" about setting up programs similar to IBM's featuring personalized attention.

Advice is helpful, however, only if the plan is structured right. Studies show that many 401(k) participants make bad decisions, and that defined-contribution plans such as 401(k)s underperform compared with the defined-benefit variety. So IBM leveraged its money-management expertise to assemble the best investments at the best prices. Barclays Global Investors, Neuberger Berman, Pimco, State Street (STT), and Vanguard Group—all are top-notch asset managers in IBM's lineup of core investments. "We try to negotiate as well as we can to wring every penny out of costs," says Ray Kanner, chief investment officer of IBM's retirement funds.

The plan also nudges participants toward better choices than they may have made on their own. Behavioral finance research by academics Richard H. Thaler of the University of Chicago Booth School of Business and Shlomo Benartzi of UCLA Anderson School of Management demonstrated the merits of putting the 401(k) on automatic pilot. One feature, auto-enrollment, pulls workers into retirement plans unless they opt out. Another, auto-escalation, increases contributions along with raises in pay—again, unless they opt out. In studies, these tricks substantially increase 401(k) participation and savings. IBM also offers automatic rebalancing, meaning employees' portfolios are automatically reset to the asset allocation they want over time.


Custom target-date funds are another feature IBM uses to serve employees who don't like to manage their own money. Target-date funds are portfolios that set asset allocation based on how close a participant is to retirement; the funds then ratchet down risk (by decreasing equity exposure, for example) as the retirement date draws nearer. Such funds got a lot of flak after some off-the-shelf products with target dates of 2010 plummeted in the market downturn. IBM, like some other companies with billion-dollar 401(k) plans, has created its own customized target-date funds. Those funds mix indexed portfolios, which are at the core of IBM's plan offerings, and active portfolios. To hedge against inflation, plan managers threw in Treasury Inflation-Protected Securities and alternative assets such as commodities and real estate.

IBM aims to push the envelope further. "Suppose you made a 401(k) plan that was performance-based?" MacDonald asks. "If everybody gets paid on performance, shouldn't there be benefits based on performance? That's what it means to be a performance-based culture."

MacDonald won't go into details about what such a plan might look like and stresses that the concept remains futuristic. It could mean that IBM would take all of its benefits, whether retirement or health, and turn them into defined-contribution plans, so they look more like compensation. Once those benefits could be compared, married and single employees could be treated the same, as could workers with different financial issues. Employees would get more of what they needed—if you didn't need dependent health care, perhaps you could get extra retirement benefits—and top-performing employees could be rewarded with additional benefits.

Although a performance-based 401(k) would be new, it wouldn't be entirely novel. Profit-sharing plans have always had some element of reward for performance, and extra benefits received by highly compensated employees, such as stock options or deferred-compensation plans, are designed to differentiate among workers. Pam Hess, director of retirement research at consultants Hewitt Associates (HEW), notes that some companies have different match structures based on employee tenure. In those cases, employees might get a match up to 6% of pay—or 7% or 8%, depending how long they had been with the firm. "It gets to the question of the whole company and its benefits," Hess says. "How do you spend wisely?"

A thicket of legal, tax, and design complications would need to be sorted through before any such plan could come into being. To maintain a level of financial security for all and not run afoul of anti-discrimination rules required of 401(k)s, there would need to be a floor on benefits for employees—and the extra benefits would need to be spread across top performers, not just handed out to the highly compensated. That might mean comparing workers at similar levels, retirement consultants say, perhaps within salary bands.

IBM is painstaking about due diligence, so whatever design it comes up with is bound to be tested extensively. MacDonald says he knows of no other company that has tried what he envisions for IBM. "That's why I like it," he says. "It's only a matter of figuring out when, why, and how."

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