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Looking Into the 401(k) Future

The 30th anniversary of the first 401(k) savings plan which I designed is rapidly approaching on Jan. 1, 2011, making this an appropriate time to briefly consider how 401(k) has impacted our retirement system.

Most Fortune 500 companies offered their employees a defined benefit plan, plus a thrift/savings plan, when 401(k) savings plans began in 1981. The thrift plans featured after-tax employee contributions, plus matching employer contributions. The most common retirement plan available to employees of small to mid-size companies was an employer-funded profit sharing plan.

Thrift plans contained very liberal withdrawal provisions, resulting in the maximum permissible annual in-service withdrawals by most participants. Employer contributions to most profit sharing plans (other than professional corporations) averaged less than 5% of compensation. As a result, most thrift and profit sharing plans did not provide much retirement income. The introduction of the 401(k) savings plan substantially changed this situation.

Large employers with thrift plans added a pre-tax employee contribution option within a few years after Jan. 1, 1981. Many participants shifted from after-tax to pre-tax savings. These participants became long-term rather than short-term savers, trading the tax break offered by 401(k) for much tougher in-service withdrawal restrictions.

Cruise Control

Most employees in large companies who made this shift during the early days of the 401(k) have retired and are receiving Social Security, monthly pensions and withdrawals from significant 401(k) accounts. Most are doing well in retirement, despite the market upheaval during 2008. Retirees from such companies are typically the most financially secure group in our nation's retirement population. They are the seniors most often seen in restaurants and on cruises.

Smaller employers with employer-funded profit sharing plans also added employee pre-tax contributions to their plans during the first few years, once such contributions became available. The combination of employee deferrals and employer contributions increased the average annual contribution level from less than 5% to around 10% of compensation. Recent retirees from these employers are generally not as well off as employees who have retired from large employers and who are receiving Social Security, monthly pensions and withdrawals from their 401(k) accounts.

However, they are financially much better off than they would have been had their contributions not been added to these employer-funded profit sharing plans.

Over the past 30 years, more than 300,000 employers who never offered any other retirement plan also adopted 401(k) plans. Most of these employers would have adopted employer-funded profit sharing plans, with contributions averaging less than 5% of compensation, if 401(k)s didn't exist. Accumulating sufficient account balances and converting them into an adequate stream of retirement income is a daunting task for most employees of such employers, but they are generally doing better than would have been the case if 401(k) did not exist.

The next 30 years will be much different from the past 30 years because an ever-shrinking number of non-union, private sector employees will receive monthly pension benefits. Defined contribution plans, such as the 401(k), will increasingly become the primary vehicle for delivering retirement benefits.

Having started my career on the defined benefit side of the business, I am not thrilled that defined benefit plans are losing their role. Future workers who will face retirement without a monthly pension check will be required to plan much more carefully for their retirement than employees who receive a monthly pension.

We have 30 years of experience from which to draw in order to make 401(k) a more useful retirement vehicle. The following are my recommendations for doing so:

* Continue to encourage automatic enrollment and automatic contribution increases.

* Prohibit employees from investing any of their contributions in employer stock to prevent future Enrons.

* Require all lump-sum benefit distributions, including plan terminations, to be transferred to a special IRA account that cannot be accessed prior to age 55.

* Continue to shift from participant-selected investment portfolios to design-based investment solutions, such as target maturity funds and managed accounts.

* Require universal and workable fee disclosure to plan sponsors and to participants.

* Exclude 50% of the first $1,000 of monthly income that is taken after age 55 from a defined contribution plan or an IRA rollover account as an annuity from taxable income.

Ted Benna, president of the 401(k) Association and chief operating officer of Malvern Benefits Corporation, is commonly referred to as the "Father of 401(k)" because he created and gained IRS approval of the first 401(k) savings plan.

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