Will 401(k) Accounts Be Eliminated?

Back in October, some influential members of the House of Representatives held hearings to discuss overhauling the 401(k) retirement plan system. Soon thereafter, talk radio, the blogosphere, and even the generally-sober Wall Street Journal erupted with dark warnings of a plot afoot to “nationalize” or “confiscate” everyone’s 401(k) plans and convert them to accounts managed by the Social Security Administration.

The House Education and Labor Committee interviewed a number of retirees, activists, and others to open discussion on the possibility of altering the nature of 401(k) accounts.  The discussions were partly a response to the realization that 401(k) holders had at that point collectively lost something like 1 trillion dollars in the stock market crash.

The witness whose remarks sparked the most excitement was Theresa Ghilarducci, a professor of economic policy analysis at New York’s New School for Social Research. Among her criticisms of the current 401(k) system were the observations that:

many 401(k) plans contain administrative fees that are not clearly disclosed to employees

401(k) plan investment options are often limited to mutual funds that have relatively costly fee structures

the current 401(k) system, along with IRAs and Keogh plans, receives an indirect tax subsidy projected to approach $76 billion in 2009

the benefits of 401(k) plans tend to accrue disproportionately to high-income earners

During the hearings, Rep. Robert Andrews of New Jersey also criticized the elements of the Pension Protection Act of 2006 that made it easier for investment advisers with direct interests in the sale of financial products to give advice to retirement account holders.

Ghilarducci’s criticisms of 401(k)/IRA retirement savings plans are not without weight, and in her testimony I couldn’t find her advocating forced conversions of existing 401(k) accounts.  The real weakness of her plan, I think, is that it glosses over how her alternative system can be made to succeed.  She proposes a system administered by “a government agency connected to the Thrift Savings Plan and Social Security,” with required worker contributions of at least 5% of salary and a federal pay-in of $600/year per account.  The system is intended to provide workers with a pension-like payout equivalent to a guaranteed return on their funds of of 3% above inflation.

The Thrift Savings Plan is a nice, low-cost defined contribution plan available to federal employees, so that part I like.  What is worrying is that she makes it sound easy to guarantee a return of 3% above inflation for everyone, but this is not so obvious.  Recently Boston College’s Center for Retirement Research released a brief exploring possible ways of supplementing Social Security benefits.  The report notes that a guaranteed return of 3% above inflation is “likely on the high end of what is feasible.” In a footnote, the brief acknowledges that “because interest rates can fluctuate substantially, no private insurer would be able to provide such guaranteed returns.” The government would have to be involved so that it could step in whenever investment returns were inadequate to meet the promised payouts.

The last time I checked my Social Security statement, it contained a polite note warning that by 2041, projected payroll taxes will only cover 75% of the benefits estimated on my statement.  Medicare’s projected shortfalls are even greater.  I’m not comfortable assuming that the government has the capacity to guarantee yet another retirement benefit, especially since it’s already quite busy these days guaranteeing the debts of several of the largest financial institutions in the world.

There’s no indication that Professor Ghilarducci’s plan is being taken up by anyone in Congress.  In response to the excitement generated by a number of less-than-accurate-reports on the hearings, the Financial Planning Association (of which I am a member) quizzed Education and Labor committee chairman George Miller on his intentions regarding 401(k)s.  The FPA issued a press release stating that “FPA’s assistant director of government relations, Phillips Hinch, discussed Rep. Miller’s comments with committee aides last week, who confirmed that there are no plans to abolish 401(k) plans or make changes to their tax status.”

Moreover, Miller has announced on the committee’s website that his goals regarding 401(k)s are not to abolish them, but to reform them by

• Exposing excess fees that Wall Street middle men take from workers’ accounts.

• Bringing young and low-wage workers into the system at a higher rate through automatic enrollment for employers already offering 401(k)s.

• Ensuring that retirement accounts have diversified investment options with low fees.

• Ensuring that workers have access to reliable independent investment advice.

• Reducing vesting periods and improving portability of 401(k) accounts.

All of this seems like good news. However, the sturm und drang over the possibility of 401(k) changes set me thinking about whether some changes would necessarily be such a horrible thing.  It’s helpful to take a moment to remember how the 401(k) came to be such a popular vehicle for retirement savings in the first place.

Prior to 1980, how many people had 401(k) accounts?  Zero. Zip. Bupkiss.  Back then, more than 60% of workers with retirement benefits were covered by company defined-benefit plans. These plans, most familiarly known as pension plans, paid specified benefits based on a worker’s years of service, salary, and age at retirement.  Section 401(k) of the Internal Revenue Code (which took effect in 1980) began as an obscure bit of tax code intended to provide a new retirement savings option for executives – not for the hoi polloi.

Within a relatively short time, however, companies began implementing 401(k) plans widely.  The number of U.S. pension plans peaked at 175,000 in 1983; only about 25,000 remain today. Many of those are expected to be discontinued or reduced in scope in the coming year.  In the last 15 years the number of 401(k) plans has mushroomed from 17,000 to 450,000 or so.  Including other types of defined-contribution plans, there are about 650,000 such plans in existence.

A pension plan pays a promised benefit.  A defined-contribution plan, like a 401(k)/403(b), provides no promise of a specific benefit.  The only promise is that certain amounts will be invested in the plan under certain circumstances.  Why has there been such a decline in the number of pension plans, with a simultaneous leap in the number of 401(k) plans? The attraction of these plans to employers is obvious, and easy for plan providers to sell (to employers): the plans are cheaper to maintain than pension plans and they require fewer commitments on the part of the employer.

Federal rules for pension plans direct employers to make regular additions to the accounts.  Pension laws require additional contributions if a pension plan’s investments go south and the plan becomes seriously under-funded, but in a 401(k) plan, the employer may choose not to make plan contributions when it has a bad year.  General Motors, Frontier Airlines, and Dollar Thrifty Automotive Group have already announced that they are suspending company matches to 401(k) plans, and they surely won’t be alone in doing this.

Something else that makes a 401(k) plan attractive to employers is the aforementioned ability to pass some or all plan administrative expenses on the employees.  Usually this is done in a manner that is invisible to the employee.  From the employee’s point of view, the 401(k)’s virtues include a degree of portability and the ability to direct how the money is invested.  When the stock market is going up, this last feature appeals to our good old American desire for self-sufficiency; when it’s going down, pensions start to look kind of nice.

It seems to me that an interesting bit of sleight-of-hand has been carried out over the last generation or so.  Employers have significantly reduced their retirement obligations and have shifted the burden to their employees, yet the new retirement paradigm has become so firmly entrenched in the American mind that even a discussion of a return to a pension-like system provokes cries of outrage.

Neither pension plans nor 401(k) plans are without difficulties (beyond those already mentioned). Pension plans can fold when employers get into financial trouble.  Several of my former colleagues used to work for Polaroid; they received a fraction of the pension benefits that they were promised.  A real problem with 401(k) plans is that many workers are not financially literate, and many others lack the time, objectivity, or both, needed to properly invest their retirement funds.  A new “guaranteed” plan backstopped by the federal government would have its own shortcomings, to be sure.  What’s needed is some careful analysis to determine the best way to enable/encourage workers to make prudent and successful preparations for the years when they are too old to work.

Will 401(k) accounts be eliminated?  I doubt it.  For one thing, it’s not on anyone’s radar screen.  For another, if this were being considered, it’s likely that the large financial institutions and insurance companies currently administering 401(k) and 403(b) plans would lobby long and hard to avoid losing the fees derived from the trillions that they now manage.

Also, if a plan like Professor Ghilarducci’s is seriously considered, someone will eventually realize that the elimination of 401(k) plans – now the dominant retirement funding vehicle – would take employers off the hook for contributing directly to workers’ retirement funds. Even after the tax savings associated with funding retirement plans, employers collectively spend an enormous amount of money funding and administering retirement plans. If they no longer spend that money, they would have a windfall.  But the money for retirement funds has to come from somewhere; if it doesn’t come directly from corporations, it would either come from them indirectly (through higher taxes) or else the load would be shifted entirely to individual taxpayers.  Oops – a major unintended consequence.  A change of this magnitude will require much more careful analysis than anything that has been offered so far.

I see no reason to change your 401(k) savings habits out of concern that the accounts may be eliminated.  If Representative Miller’s committee succeeds in achieving the goals he has stated, that should be good for 401(k) holders generally.  If a more extensive change in retirement savings comes under serious consideration, we’ve already seen indications that we can expect plenty of lively discussion before anything changes.

About the author

Thomas Fisher, CFP®

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