401(k) 101: The Rise of the 401(k)

February 15, 2018

If we had to guess one retirement plan you’re probably familiar with at this point, it would be the 401(k) (a.k.a. a type of defined contribution plan—not to be confused with a defined benefit plan, which we covered in some detail last month). We’ll be getting into the specifics of what a 401(k) actually is in next week’s blog post, but for today, let’s take a look back at its history, and the reasons why it is one of the most widely adopted retirement plans—particularly in the private sector.

As we touched upon in our first blog for January’s month-long series on pensions, the concept of the pension is reaaally old (we’re talking Ancient Rome old). By comparison, the concept of the 401(k), just shy of 40 years in age, is kind of the new kid on the block (NKOTB…*swoon*).

The impetus for the establishment of the 401(k) was Congress’ passing of the Revenue Act of 1978, which included in it a provision—Section 401(k), shocker—that gave employees a tax-free way to defer compensation from bonuses or stock options. Ted Benna, regarded as the “Father” of the 401(k), was a benefits consultant for Johnson Companies at the time of the bill’s passing, and saw the law as an opportunity for employers to create a tax-advantaged savings account for their employees.

It turns out this was a genius idea, because within just a few years, a number of “mammoth” companies—think Johnson & Johnson, PepsiCo, JCPenney, and Honeywell, to name a few—had 401(k) plan proposals in the works.

By 1981, the IRS had issued rules that allowed employees to contribute to their 401(k) through salary deductions, a move that officially jump-started the plan’s widespread adoption throughout the early ‘80s. Companies liked the plan because they felt it was cheaper and more predictable to fund than a pension, and employees were excited about having a new savings option that, they were told, could help put them in a better position to retire.

The “bull” markets of the 1980s and 1990s certainly made it seem that way.

Quick sidebar: A “bull” market is a term used in the stock trading and investing world; it means the market is showing confidence in the form of prices and market indices like the NASDAQ going up. Yes, it’s a good thing.

Plus, legislation like the Economic Growth and Tax Relief Reconciliation Act of 2001 increased the amount that individuals and companies could contribute to their accounts, further cementing the idea.

But, the good-and-bad aspect of the 401(k) is that it’s subject to the rise and fall of financial markets. This makes it less safe than a defined benefit plan, and particularly susceptible to, well, the opposite of a “bull” market (known as a “bear” market—are you seeing a theme here?). So, those awesome financial gains people’s accounts experienced in the ‘80s/’90s? Yeah…two recessions in the 2000s pretty much erased them, and have since led some early 401(k) champions to have second thoughts about the retirement revolution they started in the first place. It turns out that they never intended for the plan to replace the pension system, although that’s what it’s done, for the most part, in the private sector: just 13% of workers there still have access to a traditional pension.

Misgivings about 401(k) plans are part of a larger debate over how to help all Americans save more for retirement. With people living longer (hey, we talked about that, too), there’s a very real possibility that those who don’t receive a lifetime monthly payout through a pension plan could actually outlive their retirement savings. Not good.

At the end of the day, though, the 401(k) is here to stay. And, since we here at The Dime live and breathe all things retirement savings, we for one are grateful that the plan provides those who don’t have access to a defined benefit plan through their employer a viable way to save. If you have access to a 401(k) through work, that’s great! Believe it or not, that’s not the case for many. But, be sure you take full advantage of that benefit; as we discussed in last week’s blog post on the “retirement stool” concept, if you don’t have access to one of the “legs” (in this case, a defined benefit plan), you should really be doubling down on the other two. After all, your future self depends on it.