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An Historical Perspective on the 401(k): The Inspiration Behind Mass-Market Retirement Savings

What inspired me to find a tremendous investing opportunity in the Internal Revenue Service's tax code?

Back in the 1960s and the 1970s, Most Fortune 500 companies had traditional defined benefit pension plans and thrift/savings plans. Mid-sized to smaller employers had either a profit-sharing plan or no plan.

There were exceptions, but this was the most common retirement plan scenario pre-401(k).

The typical thrift/savings plans had very liberal withdrawal provisions; therefore, the focus for most of these plans was short-term rather than retirement.

Most of these plans were converted into 401(k) plans during the early 1980s, by adding a pre-tax employee deferral feature. This started a shift from short-term to longer-term savings for many employees at these companies, increasing the prospects for a financially secure retirement.

Employees working for an employer that offered only an employer-funded profit sharing plan were totally dependent on the profitability and generosity of their employers for retirement-income security. At that time, employees of these companies were not permitted to contribute to an IRA, even if the employer didn?ft make any contribution to the plan. There were examples of wildly generous profit sharing plans, but annual contributions to the more typical plan were below 5% of compensation - considerably less than what was needed to provide an adequate level of retirement income.

These profit-sharing plans were redesigned during the early years of 401(k) to add employee deferrals and perhaps an employer matching contribution in addition to the employer profit-sharing contribution. Enabling employees to make pre-tax contributions (in addition to the employer contributions) increased the potential of having an adequate level of retirement income.

The third category of employers that joined the 401(k) party included those who never had any retirement plan. Most were businesses with less than 100 employees. The 401(k) was and, still is, appealing to many of these smaller businesses because there isn't any required employer contribution. An employer could offer a plan with an attractive matching contribution at a cost of 1% of payroll or less. This was the only type of retirement plan many of these smalleremployers could afford to adopt.

The First 25 Years

The advent of the 401(k) added to the retirement income security of our nation during the next 25 years. Employees of the Fortune 500 companies accumulated substantial account balances, which, when combined with Social Security and their traditional pension benefits, enabled many of them to retire more comfortably than if 401(k) never happened.

Retirement income security also improved for employees who had been covered by employer-funded profit-sharing plans if they contributed to the plan when pre-tax contributions were permitted.

Offering a 401(k) plan has also enabled hundreds of thousands of small businesses help their employees save for retirement during the first 25 years that these plans have been on the market. Employees who have participated in these plans have accumulated retirement savings that otherwise would not have been possible.

The Next 25 Years

The demise of traditional defined benefit plans among larger employers began with the passage of the Employee Retirement Income Security Act (ERISA).

I know, because I used to sell defined benefit plans before ERISA. I knew nothing about defined contribution plans at that time. The market for defined benefit plans, other than for small professional organizations, died because ERISA gave the Pension Benefit Guaranty Corp. a claim to a portion of corporate assets. As news of this fact spread, employers were warned by their professional advisers to stay away from defined benefit plans. I had to shift to selling defined contribution plans because there was no longer any interest in defined benefit plans.

The reasons for avoiding defined benefits have increased dramatically since ERISA was enacted. The situation is so bad, in my opinion, that companies with defined benefit plans (traditional or hybrid) will continue to be under great pressure to eliminate them. As employers continue to shed their defined benefit plans, 401(k)s and other defined contribution plans will be the sole vehicles for accumulating assets for retirement among non-union employees.

The result will be to place an even greater burden on employees to plan for their future. The awareness of these facts is what led Congress to address some of the major weaknesses of 401(k)s when it passed the Pension Protection Act (PPA). PPA removed barriers and added incentives to encourage employers to automatically enroll employees, to automatically increase contributions, and to structure investments in a manner that would increase the likelihood for success. Helping employers add these features will improve the system during the years ahead, but there is a huge challenge.