401(k) World: The Piggy Bank

The first story in a new quarterly series, PLANADVISER In-Depth, considers the tax code that underpins America’s pension system and the challenges and opportunities for its future.

In Shlomo Benartzi’s influential 2012 work, “Save More Tomorrow,” the behavioral economist wrote that, “in the realm of financial preparation for retirement, we are now essentially in a 401(k) world.”

He went on to argue that this world has many flaws. Built on IRS tax Section 401, item (k), the initial idea of the code was to help people save “a little extra on the side.” Benartzi goes on to point out shortcomings in the system, including: lack of access for many private-sector workers; resistance to participation; relatively low deferral rates; and little to no investment know-how among participants.

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“In short,” Benartzi wrote, “the 401(k) world is in crisis.”

The professor emeritus and retirement industry entrepreneur laid out a plan to solve this crisis through what he called 90-10-90 goals for plan sponsors and advisers:

  • Get 90% of workers to enroll in a 401(k);
  • Have them defer at least 10% of their salary, augmented by a company match; and
  • Have 90% invested in a target-date fund or other “one-stop,” professionally managed portfolio.

More than a decade has passed since Benartzi’s book and have, as of 2024, the U.S. has reached “Peak 65,” when more people than ever will hit the traditional retirement. How far, then, have we come since Benartzi laid out a way to guide America’s 401(k) retirement system experiment?

“Getting one size fits all was a great starting point,” Benartzi says of that past work. “Fast forward to today: We learned how to do it better. In fact, I don’t think it should be 90% [participation]. I think it should be 98%. We know how to get there.”

A Successful Fluke

Ted Benna, known as the father of the 401(k), likes to bust myths. One important one, in his view, is that there was no “heyday” of retirement savings in America. The defined benefit pension system that dominated in the 1950s and 60s did not cover the majority of people, and those that were covered often had to remain with their employer until retirement to recoup the benefits.

Another myth: He found the 401(k) by scouring the Internal Revenue Code in search of a replacement to those DB plans.

“The 401(k) was a fluke,” Benna says. “It was never intended as the primary means of retirement savings.”

In his 2018 book, “401k – Forty Years Later,” he describes how a business problem prompted him to dig into Section 401 of the tax code. In his work as a retirement benefits consultant, he had a bank client seeking to redesign its offering to attract senior executives with a cash/deferred profit-sharing plan. Benna wanted to find a solution that did not involve having employees choose between getting a cash bonus or putting all their earnings into a retirement plan.

When digging into Section 401(k), he saw a better solution: a deferral program through which employees could put aside as little or as much as they wanted. Benna knew he had something good on his hands and recalls how he excitedly told his wife when he returned home that day.

The public relations push didn’t take that long. By the early 1980s, 401(k)s were getting attention in the financial press, and, eventually, among employers. Benna, however, does not attribute the usefulness of the tax code itself to the boom that followed. Rather, he says the Employee Retirement Income Security Act of 1974, designed to protect worker pensions, underpinned the 401(k) growth.

ERISA, he says, changed accounting rules for offering a company-sponsored pension plan, making profit and loss statements and quarterly earnings less predictable. It also put a maximum limit on pension benefits, which, by Benna’s estimation, created “a decoupling of the people at the top and rank-and-file” workers. Senior level executives didn’t see the benefit of managing a DB plan, particularly as their own compensation had become more tied to company stock and nonqualified savings vehicles.

“ERISA is the reason for the death of the DB plan,” Benna says. “I couldn’t sell a pension plan after ERISA.”

Liftoff

Although the 401(k) became active in the 1980s, employers shying away from DB plans also focused on individual retirement accounts as a self-directed savings program. It was not until the early to mid-1990s, says Craig Copeland, director of wealth benefits research at the Employee Benefit Research Institute, when 401(k)s really took off.

In 1992, there were $93 billion in assets held in U.S. defined contribution retirement plans. By 2001, that figure had jumped to $2.25 trillion—outpacing the $1.97 trillion in DB plans, and just below the $2.62 trillion in IRAs. Copeland attributes the DC growth primarily to the basic system of automatically deferring paychecks and the creation of employer matching.

“The first initial drivers were the automatic payroll deduction and getting that with an employer match; that is and still will continue to be the driver of contributions overall,” he says. “Auto-enrollment built upon that, as did auto-escalation in terms of building up the savings further.”

These tools have been so powerful that, even in the latest SECURE 2.0 Act of 2022, auto-enrollment mandates for new plans and auto-escalation are key provisions.

The other area that started to explode was IRAs, which, as the beneficiary of 401(k) rollovers, have grown to hold more assets than DC and DB private sector accounts combined. IRAs now hold $11.95 trillion in savings, and, according to Copeland may be set to grow further in coming years as retirees roll out of workplace plans and after-tax Roth savings grow in popularity.

U.S. Private Sector Retirement Plan and IRA Assets

Defined Benefit
Defined Contribution
IRA
1992
$1.23T
$0.93T
$0.87T
2001
$1.97T
$2.25T
$2.62T
2010
$2.87T
$3.77T
$5.03T
2015
$3.44T
$5.25T
$7.48T
2020
$3.67T
$8.41T
$12.66T
Source: Board of Governors of the Federal Reserve System as compiled by Employee Benefit Resource Institute.

Coverage Gap

According to the Bureau of Labor Statistics, 66% of private industry workers had access to a DC plan in 2022, and of those, 48% participated.

But participation does not necessarily mean strong enough savings for retirement. In the Vanguard Group’s analysis of 5 million participants in its recordkeeper system, the average balance in 2022 was $112,572, but the median was just $27,376, indicating that many workers are not building a significant stash.

Auto-enrollment, auto-escalation, matching and various other plan design elements made the 401(k) more than just an individual’s tax-deferred savings account. But, by Benna’s estimation, those changes did not go far enough.

“The 401(k) works well only for middle-income workers,” Benna says. “It’s not working for the low-end, and the very wealthy don’t care about it.”

To move savings forward for more people, Benna would like to see a mandate that all employers have to offer a savings plan of some kind—though it could be an IRA. He also advocates for a mandate that employees, when they change jobs, cannot just cash out, but must keep assets in the plan or move them to a new plan. Finally, he would like to see a tax break for retirees on the “first $1,000 or $2,000” that they put toward a guaranteed income option to help protect savings and add a guaranteed paycheck to Social Security.

Benna, who wrote “401(k)s & IRAs For Dummies,” notes that he included there the best options for small business owners, and although he is seen as the 401(k)’s creator, he advocates for IRA options for those earning less than $150,000.

“For many small companies, 401(k)s are the wrong plan,” Benna says. “Unfortunately, advisers are selling [401(k)s] when they shouldn’t be, because that is what [advisers] are trained to do.”

Save Less Today, More Tomorrow

For behavioral economist Benartzi, a combination of learnings, technology and innovation can improve retirement outcomes.

To get there, he points to three key areas:

  • First, the industry needs to make “the nudges better” to get participants to save. For instance, when someone opts out of a retirement plan, they shouldn’t be treated as a “bad person,” but communicated with in a respectful way. “You should virtually ask them, ‘Would you like to start saving next year? We understand now is not the right time.’ 80% would do it.” Plans should also auto-escalate semi-annually, instead of just annually, he says.
  • Second, technology can help push beyond the “one-size-fits-all model.” From now on, plans can have “smart defaults” that account for Social Security as an income replacement option for those who don’t make enough to save much beyond the government program.
  • Third, he hopes to see more holistic thinking about the average U.S. consumer’s financial situation. “Right now in the U.S., roughly, for every dollar in retirement savings in 401(k) plans, there is $2 in consumer debt [including mortgages]. … You can’t manage the assets without managing the liability.” Benartzi wants to see more holistic advice for workers, such as paying down debt before saving. For example, if a worker has maxed out credit cards, no employer match and a family to care for, then “I would argue: Save less today and even more tomorrow.”

In Benartzi’s view, artificial intelligence will enable further personalization. It’s an area of interest he is actively working on, with technology he says “will leapfrog” other personalized programs out there today.

Future

Despite ‘Peak 65,” researcher Copeland notes that there should not be a mass withdrawal from 401(k) assets via required minimum distributions right now, as many of this cohort is still relatively young.

“We’re still just starting to get the generation that has their full career under their 401(k),” he says. “It’s another 15 to 20 years [until] the Baby Boomers retiring now start getting into their mid-80s.”

Even then, he notes, the movement toward Roth IRAs, which are taxed ahead of time and do not require withdrawals, may in large part be transferred to heirs without money being withdrawn. Due to these factors, 20 years from now, “I think we’re having a different conversation than we are now,” he says.

Copeland believes decumulation is the biggest challenge facing retirees and near-retirees as they manage finances in a post-employer pension age.

“We don’t have anything that we see that people are doing [around retirement income] other than taking RMDs,” he says. “Many of the financial companies have come up with great ideas for withdrawal strategies … there just isn’t the take-up.”

For Benartzi, the problem of how to manage retirement goes back to personalization and management—it’s about process, not products.

“You go to the doctor, we don’t start with medicine. We start with: What are the symptoms?” he says. “Let’s identify the disease, and let’s then figure out the product. Whether it’s medicine A, Y, Z, or whether it’s physical therapy, or whether it’s drink less wine, or whatever the thing is that will get you to the solution … to me, you have to start with the process.”

This is the first installment of PLANADVISER In-Depth, a new quarterly series that will delve into the world of 401(k) plan advisement and the future of retirement savings. The next article will focus on retirement plan advisers and the industry’s convergence with wealth management.

 

More on this topic:

401(k) World: Retirement Plan and Wealth Advisement
401(k) World: Recordkeepers, Advisers and ‘Coopetition’
401(k) World: DCIO Managers Adjust to Fee Pressures
401(k) World: Cyber Thieves
401(k) World: The Litigators

Industry Asks IRS to Limit Automatic Features in Merged Plans

Specifically, commenters request that single-employer plans not required to have automatic features, should retain that status when joining a MEP or PEP.

The Internal Revenue Service’s comment period for an interpretative notice related to several provisions of the SECURE 2.0 Act of 2022 resulted in responses that included requests for further clarification ahead of Tuesday’s deadline.

The “grab bag” notice, issued in FAQ format, sought to clarify various provisions including: automatic features, de minimis incentives, tax credits, Roth matching contributions, and distributions to the terminally ill.

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Automatic Provisions

SECURE 2.0 requires plans created on or after December 29, 2022, to automatically enroll participants at a contribution rate of 3% to 10% starting in 2025. Plans started prior to December 29, 2022, are not subject to this requirement and are “grandfathered” in.

The IRS notice explained that a single-employer plan that is grandfathered under this provision and later joins a multi-employer plan or pooled employer plan that is not granfathered, loses its grandfathered status.

The American Benefits Council argued in its letter that this contradicts the statute and reduces the access that single-employer plans have to MEPs and PEPs. This interpretation could disincentivize single-employer plans from joining MEPs that are otherwise in the interest of their participants, especially if plan sponsors are worried about the increased cost of matching contributions that could result, the ABC wrote.

ABC recommends instead that the IRS should allow the single-employer plan to keep its pre-enactment status within the MEP or PEP. The ERISA Industry Committee made the same request in its letter to the IRS.

ERIC pointed out to the IRS that employers who will be subject to automatic features in 2025 already have participants in their plans. ERIC asked the IRS to clarify that participants already in a plan at a rate below what is described in the law need not be automatically enrolled in a plan in which they are already enrolled. In the event the IRS decides previously enrolled participants must be automatically enrolled at contribution levels of between 3% and 10%, ERIC asked for guidance on the legal status of their previous contribution level and if a participant’s enrollment a rate outside the law’s range can be considered opting out.

De Minimis

SECURE 2.0 permits the use of de minimis incentives to encourage workers to join a plan sponsored by their employer. The IRS notice states that these incentives can only be used to encourage joining a plan and continued participation, and the total incentive cannot exceed $250.

On this issue, ERIC asked the IRS to clarify the value of a speculative award, such as a raffle. Does $250 refer to the maximum award that can be granted, or does it refer to the expected value? A $500 raffle that someone only has a 1% chance of winning actually has an expected value of $5, not $500.

The IRS explained in its notice that any incentive under this section of SECURE 2.0 is considered to be taxable income. ERIC asked if a sponsor can “gross up” the award such that it is $250 in post-tax income, and therefore over $250 in total.

Terminally Ill Distributions

SECURE 2.0 permits terminally ill participants to withdraw from their retirement accounts early without being subject to a 10% penalty. The IRS explained that a participant must provide an attestation from a physician that the participant has a condition that is “reasonably expected to result in death in 84 months or less,” and “a narrative description of the evidence that was used to support the statement of illness or physical condition.”

ERIC’s letter asked the IRS to eliminate the narrative description element of the notice, saying that “such a description is not required by the statute.” ERIC also wrote that there is no real purpose to a narrative requirement since “the physician’s justification or analysis does not appear to be subject to second-guessing or appeal.”

Roth Matching

Section 604 of SECURE 2.0 permits plans to allow participants to receive employer contributions on an after-tax or Roth basis. This means that a worker would pay income taxes on the plan sponsor’s matching contribution in order to receive it post-tax.

The IRS clarified in the December notice that in order to elect this, a participant must first be fully vested in employer contributions. This was intended to avoid a situation in which a participant pays income tax on Roth matching contributions, and then ends their employment with that plan’s sponsor before being fully vested, and then having those contributions revoked on which they already paid taxes.

ERIC noted that many participants on gradual vesting schedules are partially vested and they should be able to receive contributions on a pro-rated basis that equals their vested status into a Roth account. For example, a participant that is 40% vested after 2 years of service ought to be able to receive that 40% as Roth if they chose to, though the IRS’s release would not permit that.

Lastly, ERIC asked that the IRS clarify that a participant may take part of a plan sponsor’s match as a Roth, instead of being forced to make an all-or-nothing choice. An employee with a 6% match, should be allowed to take half as a traditional, pre-tax contribution and half as a Roth if their plan permits it and they elect it. The IRS’s release does not explicitly forbid or permit this.

Comments from ABC, ERIC and the other commenters did not address the tax credits’ section of the IRS’s release.

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