The 401(k) Turns Thirty Years Old

The defined-contribution plan revolutionized retirement for U.S. workers. After three decades and the Great Recession, key fixes are needed

Revolutions often begin with drama, a powerful upheaval that seizes everyone's attention. The assault on the Bastille in 1789. The armed insurrection in Petrograd in 1917. Yet sometimes an historic divide is crossed with little fanfare. Only much later is it widely recognized that the world has been fundamentally transformed.

That's the case with the U.S.'s main corporate pension plan, the 401(k). The Revenue Act of 1978 contained a provision that become Section 401(k) of the Internal Revenue Code and it went into effect on Jan. 1, 1980. Subsequent regulations issued by the federal government in 1981 gave benefit specialists the guidance they needed to set up the pension plans. The 401(k) has since evolved into the largest private-sector employer-sponsored retirement plan in the U.S.

The latest comprehensive data (as of the end of 2008) compiled by the Employee Benefits Research Institute and the Investment Company Institute (EBRI) shows that some 50 million U.S. workers are participating in 401(k) plans, with $2.3 trillion salted away—accounting for 16% of all retirement assets.

The impact of the 401(k) goes far beyond a particular pension plan. It changed society and for a long time was closely tied with advancing the American Dream. Like civic associations at the turn of the 20th century and homeownership following the Second World War, investing in the capital markets took on the characteristics of a powerful mass social movement, especially in the '80s and '90s. Millions of people flocked to Wall Street through their 401(k)s, IRAs, and similar retirement savings plans to invest for the future. Nest eggs swelled as equities soared and corporations kicked in matching amounts. (The most common match is 50¢ for every dollar an employee contributes, up to the first 6% of pay.) Stock market twists and interest rate turns became headline news and the media increasingly devoted resources toward helping folks manage their retirement savings.

After Two bear markets: the "201(k)"

The 401(k) is a major reason why the mutual fund industry mushroomed from a sleepy corner of the investing world, with 654 funds and assets totaling $135 billion, into a financial behemoth, with more than 8,000 funds managing about $11 trillion.

Yet 30 years after its official launch, enthusiasm for the 401(k) appears to be waning. The rise of the 401(k) largely coincided with one of the great secular bull markets in history—the years 1982 to 2000. Memories of those halcyon years, which fostered a cult of equity, are fading. Savers have watched their portfolios crumble through two bear markets in less than a decade.

A number of corporations during the recession early in the decade—and many more in the Great Recession—reduced or even eliminated the company match into the 401(k). Morbid jokes among workers about their "201(k)s" highlight how the pension plan has stoked everyday worker insecurity. Although the big-picture 401(k) numbers are impressive, the micro figures are dismayingly small. The average 401(k) account balance, for instance, is almost $46,000 and the median value is a mere $12,655, according to the EBRI. These amounts would certainly not be enough in themselves to carry a person through even a half-decade of retirement.

The biggest problem with the 401(k) itself is how it evolved, with all the responsibility borne by workers. Companies embraced the 401(k) as part of an overall campaign to rein in benefit costs. Management retreated from offering expensive traditional "defined benefit" pension plans in favor of low-cost "defined contribution" plans such as 401(k)s. In essence, with a defined benefit plan, the employer bears all the investment risk and commits to a fixed payout of money, typically based on a salary and years-of-service formula. In sharp contrast, a 401(k) puts all the risk upon employees, who must decide how much to invest and where to invest it.

"I find having it all up to individuals doesn't make sense," says Alicia H. Munnell, professor of management sciences at Boston College's Carroll School of Management and director of the Center for Retirement Research at Boston College.

a changing, mobile workforce

Her sentiment is widely shared. A cottage industry of behavioral economists has chronicled how poor most people are at making sound investment decisions. It's all too easy for employees to get caught up in market enthusiasms, piling in just when prices are peaking and—when mass disillusionment sets in—selling around a perceived market bottom. Few get the hang of the differences between growth stocks and value stocks, let alone the key elements of diversification, asset allocation, beta, and alpha. There's little time to learn modern portfolio money management between the heightened demands on time at work and at home. Yet the investment decisions made at age 30 could determine whether a worker enjoys caviar or corn chips in the average three-decade span of retirement.

That said, the 401(k) is here to stay, flaws and all. For one thing, while corporate penny-pinching was a major factor behind its growth, the defined-contribution plan also reflected the needs of a changing workforce. The 401(k) is portable and it offers faster vesting than traditional pension plans. Its embrace was also driven by the movement of women into and out of the workforce, the inexorable tide of globalization, technological upheavals, and comparable pressures. Indeed, over the past 25 years the median tenure of all wage and salary workers age 30 or over at an employer has stayed at or just below 5 years. Only a small percentage of private sector workers have ever worked at one company long enough to truly reap the full rewards of a defined benefit plan.

"The notion that in the good old days you had a pension and gold watch" is long defunct, says Dallas Salisbury, chief executive of the EBRI.

What can be done to make the 401(k) better? The focus these days is to improve the plans by limiting worker choice. (That may be counterintuitive for a nation that prides itself on an abundance of options for every good and service in its economy.) The recent emphasis on Target Date funds that automatically diversify and rebalance a portfolio is one example. So is the requirement that companies immediately put new workers into the plan unless they choose to "opt out." Similarly, reformers are working on various low-cost annuity plans that could more easily turn the 401(k) savings into a guaranteed stream of income for life in retirement.

Folks may complain about their 401(k)s, but they wouldn't dream of life without them. The revolution is here to stay.

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