Executive Summary
The employer pension plan has been a part of the employee benefits landscape for nearly 140 years. Yet the reality is that after a tremendous rise in the decades after World War II, the availability of the defined benefit plan has been in decline for over 30 years, as the defined contribution plan has risen to take its place.
Yet unlike a pension plan that was paid in addition to an employee’s salary, the defined contribution plan often amounts to little more than an employee saving his/her own money in the first place, perhaps plus a moderate match that is losing its purpose as a behavior incentive when more and more plans include automatic enrollment and automatic escalation of contributions in future years.
All of which raises the fundamental question: if employers simply paid a greater salary (with a raise equivalent to what the match would have been) and let employees choose whether to save, is there really any need for a 401(k) plan at all? And with the MyRA coming soon – which once in place, could be easily modified in the future to include automatic enrollment, and higher contribution limits similar to what 401(k)s allow today – could we be witnessing the beginning of the end of the 401(k) plan altogether?
History Of Employer Retirement Plan Benefits
The first private pension plan was established by the American Express Company in 1875, though pensions were relatively rare through the late 1800s and early 1900s, due in large part to the fact that few employers were large enough and stable enough to even offer them in the first place. By 1940, only about 15% of private-sector workers were covered by a pension plan.
However, as pensions became increasingly popular in the decades that followed, especially on the back of the post-World-War-II economic boom, a growing disparity emerged between those working for large companies that were able to offer pensions, and smaller businesses that could not. By 1960, 41% of all private-sector workers were covered by pension plans, but almost exclusively those working for larger firms. To address this gap, a series of laws were passed, creating everything from Keogh plans in 1962 (the predecessor to today’s small business and self-employed individual retirement accounts), to the Individual Retirement Account (IRA) established in 1973 (as a part of ERISA, though the first accounts weren’t available until 1975) for those who were not covered by an employer pension plan at all.
At the same time, through the booming 1950s and 1960s, some employers also allowed additional after-tax contributions to retirement plans for employees who wished to supplement their pensions, and a number of employees sought out various “deferred compensation” arrangements that would allow them to make such contributions on a pre-tax basis. However, the tax deductions were often challenged by the IRS as tax avoidance schemes. To resolve the issue – and actually to prevent even more aggressive perceived abuses – Congress passed the Revenue Act of 1978, which created the first 401(k) plan to limit such employee salary deferral tactics. Upon realization that the 401(k) rules would actually make it relatively easy for employers to offer a supplemental savings plan to employees on a tax-preferenced basis, 401(k) plans quickly grew popular. The movement towards defined contribution plans had begun.
However, as it turns out the introduction of the 401(k) – with the new rules first taking effect in 1980 – also essentially marked the peak percentage of private sector employees covered by pension plans at 46% of private-sector workers. While there is much debate about whether the availability of defined contribution plans itself led to the decline of pension plans, whether long-term employers found their base of prior employees so large the pension plan became difficult to manage relative to the current size of the business (i.e., GM’s $134B in total global pension obligations with a $25B shortfall in 2012 when it only had $5.3B of income in 2013!), or the simple fact that it takes a lot more to provide pension coverage now that life expectancies are so much longer than they used to be, the end point is the same: there has been an incredible shift from defined benefit pension plans to defined contribution plans. In today’s marketplace, only about 18% of private-sector workers are still covered by a pension plan (some industries far more than others), while 401(k) plans are widely available from employers large and small.
Do Retirement Plans Really Need To Be Employer-Based?
With employer retirement plans being offered for nearly 140 years, it’s difficult to imagine a world where the employer does not offer such a plan. Yet the reality is that while it’s clearly necessary in an environment where a pension plan is offered by an employer and funded by an employer – in addition to any compensation the employee already receives –the case is less clear in the context of defined contribution plans like 401(k) plans, which in the end represent an employee’s own contribution of their own money to the plan in the first place. In other words, if an employee is going to be paid some amount (e.g., $80,000), and wishes to defer some portion (e.g., $10,000) of that income for future retirement use, does it really actually matter if the money goes to an employer-based retirement plan or one the individual controls directly? Either way, the employer’s “cost” is the same $80,000 salary, and the only thing that changes is where the employee decides to have the money deposited.
Historically, there have been two primary reasons that it’s preferable for employees to have access to and participate in an employer-based retirement plan. The first is that many employers offer a match to employee contributions as a form of incentive to participate and an additional employee benefit, which simply isn’t available if employees contribute to a retirement account of their own. The second is the fact that the current contribution limits for defined contribution plans like 401(k)s are significantly larger (at $17,500 plus a $5,500 “catch-up contribution” for those over age 50, in 2014) than for individual retirement accounts (where the IRA limit is only $5,500 plus a $1,000 catch-up).
However, the landscape is beginning to shift. In 2006, the Pension Protection Act established the opportunity for employers to begin to automatically enroll employees in pension plans, and by 2011 it was estimated that 56% of employers automatically enrolled employees; in addition, a whopping 51% also included automatic escalation features that lead employees to save a portion of their future raises, thereby further increasing their contribution rate in the long-term as they commit to “saving more tomorrow” (even if they can’t today). While these shifts to take advantage of our behavioral tendencies have the benefit of helping us to save, they are having an unintended side effect: there are some indications that employers are beginning to reduce how much matching they offer. After all, if the point of matching is to encourage savings behavior or to encourage employees to save more, but automatic enrollment and automatic escalation are already defaulting them to do so, there’s not much reason to have a match. At that point, there may be a perception difference between “matching” the employee and simply giving the employee a higher salary (which they can choose to save or not), but there’s no action financial distinction anymore.
Of course, the one remaining caveat is that “just” getting paid more and deciding to save it may be limited by the relatively “modest” (at least compared to 401(k) plans) contribution limits attached to IRAs. Yet arguably if the only reason that employer-based plans retain an advantage over individual plans is the contribution limit, that is something Congress could theoretically “fix” by simply increasing IRA contribution limits to align with (or fully coordinate with) 401(k) plans. Which leaves the potential for payroll-deduction-based automatic enrollment as the last distinguishing feature of the 401(k)…
Introducing the MyRA
During his State of the Union address earlier this year, President Obama announced that the Treasury would soon be rolling out a new “MyRA” program, with a pilot program targeted by the end of 2014 (implying wider rollout someone in 2015). The MyRA offering is intended as an “easy-to-use” starter retirement account, primarily for workers who do not have access to an employer retirement plan.
In practice, the MyRA will simply be a Roth IRA – with the same income and contribution limits – that can be funded directly through payroll contributions with amounts as low as $25 initially and $5/paycheck, with no fees to set up and use the accounts. Contributions will be invested in a government bond offering comparable to the Thrift Saving Plan’s “G Fund” (which provides a variable interest rate that trends with government bonds but a principal guarantee that the account value will never decline, even if rates rise). And while the proposal was nominally explained as being for those who don’t have access to an employer retirement plan, the reality is that as a Roth IRA, it could be available to anyone.
What’s significant about the MyRA is that it provides the mechanism for employees to someday be defaulted into automatic enrollment (or controversially, potentially even mandatory enrollment) and automatic escalation of future contributions, just as is now available with 401(k) plans. While such an approach would arguably be quite burdensome for small businesses, it’s far more feasible when it’s routed centrally through the existing administrative mechanisms that already exist to handle payroll taxes via the Treasury. And although it would require an Act of Congress to do so, once the MyRA structure is established and available, the question may soon become “why not” provide automatic enrollment for those participating in the workplace, if only to provide more parity with those who actually do have access to a 401(k) plan (especially if the Treasury is already absorbing most of the administrative burden from small businesses).
Yet the end point of such a path would put IRAs and 401(k) plans on their most equal footing yet – automatic enrollment, payroll deduction from the workplace, default investments with the option to change in the future – yet the IRA/MyRA version would be more easily portable (as it’s not tied to the employer in the first place), and the only material difference would be the contribution limits (which can be changed).
In other words, just as may soon be the case with health insurance as well, employers may simply be able to pay their employees a full salary, and let the employee decide whether and how much to allocate to everything from health insurance to retirement contributions and anything else. The point is not that employers would pay their employees less; it’s simply that employers would pay the same total amount to employees and let them decide where to direct it (or not), perhaps with some helpful nudges (like automatic enrollment as a default) along the way.
Which raises the question: if employers really did simply pay the equivalent of a match as additional salary, and individuals were defaulted into a MyRA with automatic enrollment, reasonable low-cost investment options, full portability, and the same contribution limits as a 401(k) plan, do we really need 401(k) plans at all? And if the MyRA plan is coming soon – with the potential for the rest to follow not long thereafter – could we be witnessing the beginning of the end of the 401(k) plan?
Let’s hope so. Self savings and health insurance should in no way be attached to employment. Can’t think of one good reason for either, in the current (and future) environment, where we are all becoming more self-directed in terms of generating an income.
Michael,
Great point which should be heeded for its wisdom..
The portability of retirement plans from one employer to another to include self employment is an idea whose time has come. It has been envisioned for several decades by informed industry leadership who advance the often inconvenient truth which makes so much sense.. All upside, very little downside. Faster, better, cheaper expert solutions with superior results. Thank you for your contribution in moving things forward.
SCW
Michael, since ultimately the employee is truly responsible for his/her own retirement lifestyle, shouldn’t the employee be the ultimate decider on the issue? I see fewer and fewer matches, or perhaps significant matches and what the current 401k has become is simply the employer acting as a benevolent “holder” of the money. I write tons of IRAs for self employed professionals and they are easily as competent as an HR person in managing their own program.
One interesting question that I get frequently is not “Can I get my money when I want?”, or “How are my deposits invested?”, the question I get whenever MyRAs come up is WHO holds my money? My clients suspect that if it is in any way held by a federal authority (ala Social Security) they won’t play. And I can’t say I blame them.
PS…..Love your work, Michael. I read it every day.
John,
It’s already been announced that the Treasury will contract with a private-sector firm to handle the actual administrative implementation of the MyRA. See http://www.freerepublic.com/focus/news/3117166/posts
– Michael
Heh. Then MyRA is DOA.
My employer matches 50% of my $23,000 401k contribution. I love it the way it is.
And how would you feel if your employer simply paid you another $11,500/year, your IRA had contribution limits high enough to contribute the entire amount on a pre-tax basis anyway, and you ended out getting the same money but had the choice about whether/how to save it?
Michael,
If MyRA could supersede 401(k), why hasn’t IRA done it? With my 401(k), I have excellent investment choices, such as institutional DFA funds, to which I wouldn’t have access from any IRA (traditional, Roth, or MyRA). My employer also provide salary-only, commission-free advisers who are well-trained to be knowledgeable about all of our specific employee benefits, including 401(k) and health insurance plans. I’m happy investing with my employer under the protection of ERISA.
Employers will pay full salary? What employers will do is pay the little people a little more and keep part of what they were paying and save the cost of administration. They will not (most of them) deal straight with the employees.
What will the employees do with the extra cash? Buy snowmobiles or fishing boats.
MyRA is a great idea for funding government giveaway programs while paying a return guaranteed to be less than the rate of inflation. Sounds a lot like Social Security, and see how well that has worked out.
1. I’m OK with the government expanding the size and scope of IRA’s (or MyRA’s, or whatever they want to call them). But I don’t like them having control over the investment options (really, the G-Fund? NOW? Not the best timing for that).
2. While it would be great if employers simply paid you more in salary and you invested the equivalent into your “MyRA”, who is going to dictate that employers do that? And what if employees decide NOT to invest the money, but simply pocket it? The further we get away from the pension system, the worse off we are as a nation in terms of retirement safety. 401K matches at least guarantee that the employer money is going in there.
Of course people will spend the extra money. Government bailed out the people who wasted their money in the last crash. The people who saved and were responsible ended up paying their own bills plus those of the bailouts.
Michael,
Great discussion, as usual. What about the different creditor protections offered by 401(k)s vs. IRAs, as well as the (hated by planners, loved by clients!) ability to borrow from 401(k)s?
You didn’t mention that employers gets a tax deduction for contributing to retirement plans. Would that be the case with the MyRA? I don’t thik so.
JBH,
Employers get a tax deduction for paying salary to employees. Whether the employer puts $1,000 into your 401(k) plan, or pays you $1,000 of salary that you contribute to a MyRA, the tax consequences are identical for the employer. Both provide the employer a $1,000 business deduction for a $1,000 payment.
– Michael
The employer has to pay 7.65% payroll tax on additional salary paid. Seems it is “cheaper” for the employer to make a matching contribution than paying more salary.
A bit of perspective. Back in 1976, I joined a consulting firm with an enlightened dictatorial approach. It offered “GAC,” an acronym for Guaranteed Annual Compensation. Each year 20% of your GAC went into a defined contribution plan – with 100% vesting. Various investment options were given through Fidelity.
The selling pitch was, it’s really your money, all of it, now. But – you couldn’t access it (at least without penalties and taxes).
Now, every single one of us complained that really it was a dodge to pay us lower salaries, and why didn’t the company trust us (buncha smart MBAs) to decide how to invest our own money, and just give us the whole amount without forcing it through a DC plan.
Fast forward to five years later. Every one of us had to acknowledge that our forced investment plan had been the best possible thing for us; that each of us would have vastly squandered the money, and that none of us would have made investments that outperformed what we had available to us in qualified plans, much less overcome the tax advantaged version of it.
The lesson: if we’re going to give portability, equality of payments, etc., do NOT fall for the frequent-fellow-traveler of giving people tons of choice about what to do with it. Individual human beings are terrible financial planners. Left to our own devices, we need some strcuture that forces us to sock some away.
Choice over “how” to save it is, to a limited extent, a good thing. Please don’t throw options funds and ETFs into the mix.
But choice over “whether” to save it gives me the chills. Sorry – the vast majority of people behave stupidly towards money planning, and I hope we don’t mess up a good move by extending it to “whether.”
It’s not stupid to plan for government to pay your bills. They have consistently used that to buy votes.
What is stupid, is to plan for lower taxes in the future.
The 401k matching I think is a much stronger incentive to save than the “default enroll”.
Maybe you could have the government give some kind of a tax credit “match” for the first 5% of your income that you put into an IRA? That to me would serve the same purpose as the employer match, yet it wouldn’t be tied to an employers whim.
I MUCH prefer to have my money in an IRA where I can invest it how I like, rather than in a 401k with a few crappy funds with high expense ratios.
And PLEASE don’t make us put our money into some govt bond thing. Please, anything but that.
401k and “myiras” will be simply be confiscated when we go the way of Argentina.
No? OK, then they will be used to means test you out of everything else. Either way,
don’t think the government is here to help.
That’s goofy. Of course employers will pay people less. Government stands by ready to pay the bills and buy the votes. A 7th grader can see that.
Obama’s goal is to control every expect of the American people. That’s what you call socialism…
The problem in this country is so many people are completely lost on how to fund an IRA etc and how really easy it is. Personal finance should be taught in all levels of school but is not. People have no understanding of risk/reward, asset allocation, re-balancing etc. Shoot just go to bogleheads.com and you can learn all that needs to be. 1 mutual fund can cover all your needs.
Also any IRA in which the government has control over or control over the options I would completely stay away from. Open an account at Vanguard, invest in a Life Strategy fund that fits you and keep pumping as much money into it and 30/40 years later you will have saved a lot of money.
Boy, what rubes are we? Here we go again.