Coming Up Short The Challenge of 401(k) Plans
By Alicia H. Munnell Annika Sunden
Brookings Institution Press Copyright © 2004 Brookings Institution Press
All right reserved. ISBN: 0-8157-5888-X
Chapter One Introduction
Even before the collapse of Enron, the protracted bear market, and the mutual fund scandals, questions about how to provide people with an adequate retirement income were high on the national policy agenda. The number of Americans over age sixty-five will double by 2030. With a life expectancy at age sixty-five of roughly twenty years, these individuals will spend more time in retirement than individuals before them. To ensure that today's workers will have a secure retirement, we need to understand what sources of income retirees have available now and what they are likely to have in the future.
The public debate about retirement income has focused on the future of Social Security, the basic tier in the U.S. retirement system. The second tier, employer-sponsored pensions, has received considerably less attention. These programs, however, are a crucial source of retirement income for middle-income families. This book explores the fastest-growing type of employer-sponsored pension, namely 401(k) plans. These plans merit serious attention in their own right, as 58 percent of households with pension coverage rely solely on 401(k)s and similar plans to supplement Social Security. Yet the median combined balance of a 401(k) and an individual retirement account (IRA) for household heads in their late forties and early fifties is only $37,000. In addition, some troublesome features of 401(k)s and defined contribution plans generally, such as lump-sum distributions upon job change and at retirement, are increasingly common in the rest of the pension system.
The emergence of 401(k) plans is a phenomenon of the last twenty or so years. In 1980 most workers covered by a pension had a defined benefit plan. These plans typically provide employees lifelong monthly retirement benefits based on years of service and final salary. For employees who remain with one firm throughout their working lives, defined benefit plans can offer a predictable and substantial stream of monthly benefits. Mobile employees, however, forfeit some pension income when they change employers.
From the employer's perspective, defined benefit plans help manage the work force by encouraging longer tenure and efficient retirement. Since pension benefits based on final earnings increase rapidly as job tenures lengthen, these plans motivate workers to remain with the firm. Defined benefit plans also encourage workers to retire when their productivity begins to decline. But for employers, these plans also have two disadvantages: exposure to financial market risk and lack of employee turnover even when desired.
For a variety of reasons, the nature of pension coverage has changed. It has become a 401(k) world. The 401(k) plan is essentially a savings account. The employee and, most often, the employer contribute a percentage of earnings into the account. These contributions are invested, generally at the direction of the employee, mostly in mutual funds of stocks and bonds. When the worker retires, the balance in the account determines the retirement benefit, which is almost always paid in a lump sum.
It is easy to understand the popularity of 401(k) plans. They are portable, which means that mobile workers can take their balances with them. Employees get statements several times a year, and many have daily access to pension benefit data through the World Wide Web, which makes their benefits seem more tangible. As the plans allow employees to choose investments that match their tolerance for risk, it also gives them a sense of control over their retirement funds. Rapidly rising account balances greatly enhanced the popularity of these plans during the stock market boom of the 1990s. With the sharp decline in the stock market that began in 2000, workers may have become somewhat less enthusiastic about investing their own retirement funds.
Employers also like 401(k)s. These plans are a tangible benefit, which employees appreciate. Employers can use 401(k) plans to attract workers who value saving and who, some economists argue, are presumably more conscientious and productive. And employers' contributions are controllable and do not hinge on stock market and interest rate swings. This means that when the stock market plummets, the employee, not the employer, loses money. And when interest rates fall, rather than the employer paying more for an annuity, the employee realizes a lower retirement income. Moreover, 401(k) plans are fully funded by definition, eliminating the work and expense associated with funding requirements and pension insurance. Generally, they are also less costly for the employer to administer than defined benefit plans.
In view of their appeal to both employees and employers, 401(k)s and similar defined contribution plans are now the dominant form of private pensions in the United States. Of those with pension coverage, 58 percent of households now rely exclusively on 401(k) or similar defined contribution plans; another 23 percent have a defined benefit plan in addition to a defined contribution plan; and only 19 percent rely solely on a defined benefit plan. The shift in pension coverage occurred primarily through the stagnation of defined benefit plans and the establishment of 401(k)s; defined benefit plans were rarely converted to 401(k)s. Many defined benefit plans are starting to look like 401(k)s, however, through conversions to cash balance plans or some other hybrid form. Although 401(k) and similar plans emerged only in 1981, they will determine the economic security of a significant portion of the baby boom generation. To set the stage for the discussion of 401(k) plans, the next two sections put 401(k)s in perspective by reviewing the evolution of private pension plans and the regulations that govern them.
The Origins of Section 401(k)
The Internal Revenue Code (IRC) treats employer-sponsored benefits more favorably than benefits that individual employees purchase on their own. The rationale is that benefits provided by the employer will be broadly distributed, particularly to lower paid employees who are unlikely to respond to tax incentives. This treatment puts employers in a bind. On the one hand, providing the benefit to all employees lowers costs because of favorable tax treatment. On the other hand, universal provision means that benefits go to some employees who do not value them. Therefore, employers have an incentive to fit their compensation program to their employees' needs but to disguise employee choice in order to retain the tax advantage. (Giving employees choice risks running afoul of the doctrine of constructive receipt.)
If employees can opt for cash, the Internal Revenue Service (IRS) could say that they "constructively received" the cash, and the contribution to the plan would then be subject to tax. In the 1950s several employers offered employees a choice between receiving a year-end bonus and having the same amount deposited in a tax-favored plan. The IRS was asked to determine whether such an option affected a plan's tax status. In 1956 the IRS approved a profit-sharing plan that offered choice, thus indicating that elective contributions were not inconsistent with qualified plan status. Later rulings suggest that the IRS did not view constructive receipt as a problem in the 1956 case because the election of cash had to be made during the year before the actual amount of the bonus was known. This view, however, was somewhat at odds with the treatment of other arrangements. So tax experts were not surprised when the IRS, in 1972, proposed regulations to tax those amounts that employees could choose to receive in cash even if they were ultimately contributed to a plan.
Congress appeared supportive of the 1972 regulation. But in passing the Employee Retirement Income Security Act (ERISA) in 1974 it delayed its implementation for previously existing arrangements until January 1977 and then until January 1978. In considering the Revenue Act of 1978, the House voted to extend the freeze, implicitly allowing elective contributions. The U.S. Treasury Department, however, wanted a more permanent solution.
Section 401(k) of the IRC was the compromise. Section 401(k) says that if plans with elective contributions meet a special nondiscrimination test-so that excessive benefits do not go to the higher paid employees-then constructive receipt does not apply. The need for broad participation explains why matching contributions are a common feature of 401(k) plans. To ensure that the funds are retained until retirement, section 401(k) also prohibits distributions before age fifty-nine-and-a-half or separation from employment (including death and disability), except in the case of hardship.
The law went into effect in January 1980. In 1981 the IRS issued proposed regulations that sanctioned the use of employee salary reduction for retirement plan contributions. And the rest is history.
401(k) Plans in Perspective
Pension plans are large and complex institutions. They arise naturally from real business needs, bump along on their own for a while, falter here and there, and then require some government oversight and involvement to set them right. That certainly was the case with traditional defined benefit plans.
During the last quarter of the nineteenth century, the large, prosperous, and heavily regulated transportation industry, which employed many workers in hazardous jobs, pioneered the establishment of private plans. In 1875 American Express set up the first pension plan to provide disability benefits to workers with twenty years of service. In 1880 the Baltimore and Ohio Railroad, noted for its enlightened labor policies, organized a plan based on employee contributions. In 1900 the Pennsylvania Railroad established a plan financed by the employer, which served as a model for other railways. By the end of the 1920s the railway industry had extended pension coverage to 80 percent of its workers. In addition, most large banks, utility, mining, and petroleum companies, as well as a sprinkling of manufacturers, had formal plans. While large industrial employers were establishing pension plans, a small number of trade unions were instituting their own schemes for retirement benefits. By 1928 about 40 percent of union members belonged to unions that offered some form of old age and disability benefits.
The Great Depression had a profound effect on both the industrial and union plans. Many railways were operating in the red and did not have pension reserves to help pay benefits to their retired employees. Because so many people were involved, Congress passed the Railroad Retirement Act of 1935 to nationalize the much-stressed plans. Employees covered by other industry plans were often not so fortunate. As business activity declined, many companies could not meet both operating expenses and rising pension payments. In response they made substantial cutbacks, ranging from suspending the accumulation of pension credits to trimming or even terminating the benefits of retired employees. Union plans also were affected by high unemployment, which depleted union treasuries.
After the Great Depression, industry and labor had to recreate the pension system. Although World War II consumed many of the nation's resources that might have been directed toward improved provisions for old age, wartime wage controls provided some support for the expansion of private plans. The War Labor Board, which had set legal limitations on cash wages, attempted to relieve the pressure on management and labor by permitting employers to bid for workers by offering attractive fringe benefits. Pension benefits cost firms little in view of the wartime excess profits tax and the ability to deduct pension contributions.
In the immediate postwar period, employees focused on cash wages to recover ground lost during the period of wartime wage stabilization. But in 1949 pension benefits became a major issue of labor negotiation because of increased employer resistance to further wage hikes, a weak economy, and the obvious inadequacy of Social Security, which averaged only $26 a month at the time. Labor's drive for pension benefits was aided when the Supreme Court confirmed the National Labor Relations Board's 1948 ruling that employers had a legal obligation to negotiate the terms of pension plans. The United Steelworkers of America and the United Automobile Workers then launched successful drives for pension benefits, and other unions soon followed.
The main expansion of today's private pension system, then, actually began during the 1950s. Although growth continued in the 1960s, it was due primarily to expansion of employment in firms that already had pension plans as opposed to the establishment of new plans. Pension coverage continued to expand until the end of the 1970s but has been virtually stagnant since then. Currently, less than half of the private sector work force participates in a pension plan (figure 1-1); a somewhat larger percentage has some coverage at some point in their lifetime. It is definitely better to have a pension than not to have one, regardless of the strengths and weaknesses of one type versus another.
As pensions became an important institution, workers began to rely on employer-provided benefits as a major source of retirement income. Government also had a stake in the pension system, because the favorable tax treatment accorded these plans reduces federal income tax revenue. Employer contributions to a pension plan are deductible as a business expense when made, investment income earned by pension funds is tax exempt, and the employee is not taxed until receipt of pension benefits. As a result, employees pay significantly less tax on compensation received in the form of deferred pension benefits than in the form of cash wages. The cost of these favorable tax provisions is enormous. After the present value of future tax payments on benefits is deducted, the revenue loss to the Treasury Department is an estimated $172 billion for 2002. This amounted to 20 percent of federal income tax revenues of $858 billion in that year and 42 percent of the $455 billion in payroll taxes collected to support the old age portion of Social Security.
The government's large tax expenditure on the employer-sponsored pension system requires that employees be treated fairly along a number of dimensions. As far back as the 1940s federal regulations insisted that tax-favored plans provide retirement benefits to the rank and file as well as to highly compensated employees. In the 1950s and 1960s it became clear that such plans had other serious problems. Some employers imposed such stringent vesting and participation standards that many workers reached retirement age only to discover that they failed to qualify for a pension because of a layoff or a merger.
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