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In Practice February 21, 2024
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.
Reported by Alex Ortolani
Art by Melinda Beck
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.
“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.
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.
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