The Unintended Consequences of 401(k)

In a comment to March 1’s post, Chris from California observed that 401(k) plans have effectively shifted the burden of building up a retirement fund from the employer to the employee. I gotta’ go along with Chris on that one.

I question whether that was the intent of 401(k), but it sure has been the effect. Here’s a little history.

401(k) was added to the Tax Code in 1978. But it had its roots long before that. Over the years, it had become popular for companies to adopt profit sharing plans; they served as a tax-favored environment in which to reward employees with bonuses when the company had a good year. Some companies had wanted to give employees a choice of getting their profit sharing bonuses paid outright to them or saved inside the profit sharing plan. Fearing that only the higher paid employees would opt for the plan contribution—and the rank-and-file employees would all take cash—in the 1950’s and 1960’s the IRS came up a couple of guidelines for when this kind of choice would be allowed. These guidelines were designed to assure that at least some decent percentage of lower-paid employees were getting contributions to the tax-favored plan. In 1978, Congress decided to codify the principles behind these older IRS rulings by enacting 401(k).

401(k) lay there like a lump in the Tax Code for a few years until the IRS finally issued interpretive regulations in 1981. Those regulations included an innocuous-seeming technical feature which would eventually lead to the wholesale adoption of 401(k) plans. The 1981 regulations made it clear that the employee’s choice of cash-or-tax-deferral was not limited to ad hoc bonuses. To run a 401(k) plan, a company did not have to go through the steps of offering the employee a bonus and asking, “Will you take that in cash, sir, or shall I deposit in your tax-sheltered account?” The employee could be allowed to make that choice by electing to reduce his regular weekly wages by some amount, and have that amount added to his 401(k) account. So beginning in 1981, 401(k) plans could be adopted by any company, whether or not they paid bonuses.

It became common for companies to offer a matching contribution of some kind—both to reward employee thrift and to encourage lower-paid employees to participate so the plan would meet the tests imposed by 401(k).

But then, as now, the match was usually modest rather than overwhelming. Perhaps 25% or 50% of your own dollars. Everyone, it turns out, loved 401(k). The employee loved it because, unlike her future benefit under the company’s traditional defined benefit pension plan, the employee could sink her teeth into her 401(k) account. She could watch her account grow with each quarterly statement. You can relate to a growing account with six digits much better than some pie-in-the-sky future monthly benefit with only four. It helped that the effective invention of 401(k) in 1981 coincided with the beginning of the biggest, baddest bull market in history.

And boy did employers love 401(k)! They saw that they could get their employees to pick up 2/3 or 80% of the cost of their own retirement—and even smile about it.

I think profit sharing plans generally, and 401(k) plans in particular, had been thought of—by policy makers and human resources professionals—as adjuncts to the traditional defined benefit pension plans; as a tax-efficient aid for employees to build up the third leg of retirement’s three-legged stool. But over the years, many employers have dropped their traditional pension plans altogether. To soften the blow, they could tell their employees, “We’re not taking away your retirement funding; we’re just putting the dollars into a generous (e.g., two-for-one) matching contribution, rather than a pension plan which few of you appreciate anyway.” But after some time (and forgetfulness) intervened, that two-for-one match gave way to the “industry standard” 50% match. The second leg of the stool was gettin’ kind of wobbly.

That was then. This is now. In current hard times, if you listen carefully you can hear the thudding sound of companies dropping their matching contributions. And their employees—or those who still have jobs anyway—are left to shoulder the retirement funding burden on their own. It remains to be seen whether those companies who have discontinued their matching contributions will reinstitute them once they return to profitability.

I've got two more posts on this subject, and then I'll get back to planning. I promise.