When you rang in the New Year, did you remember to lift a glass of bubbly to toast the Internal Revenue Code 401(k)? That’s the section of U.S. tax law that forever changed the way we save for retirement.
The 40th anniversary for this key section of the tax code is 2018. When Congress approved the Revenue Act of 1978, it gave employees a tax-free way to defer their compensation. Unbeknownst to lawmakers at the time, this change would pave the way for the launch of company-sponsored 401(k) plans just a couple of years later.
Back then, 401(k)s were far more basic than they are now. Originally seen as supplements to pension plans, they were often invested in company stock, and employer matches were not yet the norm. Investment options later expanded amid the dot-com boom in the ’90s, says Nathan Voris, managing director of strategy for Schwab Retirement Plan Services.
[See: The 10 Best ETFs to Buy for 2018.]
“401(k)s became a bit more front-and-center as more Americans become investors,” he says. “The 401(k) grew up during that same era as the explosion of mutual funds.”
For better or worst, the rise of 401(k)s accelerated a major shift for both employers and employees. Under pensions (also known as defined-benefit plans), longtime workers would be granted lifetime payouts in retirement, but the rise of 401(k)s shifted the burden onto workers to save and manage their own money for their golden years.
The upside: The rise of the 401(k) also coincided with workers becoming more mobile. They were no longer chained to one employer for decades at a time, and because 401(k)s are portable, workers could take their nest eggs with them as they switched jobs. Pensions, on the other hand, often required long tenures with the same company, and workers who left short of 20 or 30 years could be faced with little or nothing in retirement.
“A hallmark of the 401(k) is its flexibility,” says Sarah Holden, senior director for retirement and investor research at the Investment Company Institute. “This is a plan that’s great for a mobile workforce, and workers who move in and out of jobs.”
The downside: Once savings decisions are left up to individuals, it takes some financial savvy, not to mention access to a company plan in the first place, to maximize their value. As of March 2017, only 59 percent of U.S. workers had access to a defined contribution plan like a 401(k), and of them, roughly a third declined to participate in those plans, according to the Department of Labor.
While some public services workers, like government employees, teachers and police officers still have access to pensions, about 30 percent of American workers have no retirement benefits through their employer. They come from a mix of backgrounds, Voris says, including freelancers, gig workers, employees of small businesses and seasonal workers.
Workers with lower wages or limited investing knowledge also tend to vastly underprepare for retirement. In a 2016 report, Economic Policy Institute economist Monique Morrissey found that the rise of 401(k)s has exacerbated inequality, benefiting already rich workers and leaving the majority of employees unprepared for retirement.
[See: 7 Things That Can Derail Your Retirement Investing.]
“Our retirement system used to reduce inequality, but since the shift to 401(k)s, it has only served to magnify it,” she writes in a blog post. “These accounts are accidents of history that were never designed to replace pensions, and it should come as no surprise that they have not worked for the majority of people.”
Whether you love them or hate them, 401(k)s are here to stay, though. As of 2015, about 55 million participants held these plans, totaling $5.1 trillion in assets, according to the Investment Company Institute. That’s up from just 7.5 million participants and $92 billion in assets in 1984, the earliest data available from the Department of Labor.
Average balances vary widely, depending on the age and career span of participants. Participants in their 40s with more than two to five years of tenure had an average 401(k) plan balance close to $35,000, compared with an average balance of more than $280,000 for participants in their 60s with more than 30 years of tenure, according to ICI.
Perhaps the biggest change to 401(k)s over the last decade has come from the influence of behavioral economists like Richard Thaler, who won the Nobel Prize in economics earlier this year. His research supported the idea that employers should “nudge” their workers to participate more fully in their retirement plans. Using automatic enrollment and escalation features, companies could initially enroll new hires in 401(k)s and gradually increase their contributions over time. Workers would be given the ability to opt out or change their contributions if they preferred not to follow their employer’s defaults.
In 2016, the Pension Protection Act cleared the way for companies to set these defaults and opened a new era in which employers could play a more paternalistic role in retirement savings.
The other major milestone for 401(k)s came with the rise of the target-date fund, a product that invests in a diversified portfolio and automatically rebalances over time as the account holder nears retirement. These funds have become particularly popular among young investors, with 60 percent of 401(k) participants in their twenties holding target-date funds as of 2014, according to ICI.
“The target-date fund really changed the face, and almost institutionalized and professionalized the 401(k),” Voris says. “That was a turning point that made it a powerful vehicle for the average American to invest in.”
[See: 7 Tips for Finding the Best Target-Date Retirement Funds to Buy.]
For 2018, the contribution limit for 401(k)s increases from $18,000 to $18,500, with an additional $6,000 in catch-up contributions for savers age 50 and older.
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Happy 40th Anniversary to the 401(k) originally appeared on usnews.com
