The 50th anniversary of the enactment of ERISA will occur this September. This landmark anniversary has provided an opportunity for evaluating how successful ERISA has been in providing greater coverage and retirement security to employees. The 401(k) plan hasn’t escaped this scrutiny.
Was the 401(k) Plan a Mistake? Longtime critic of the 401(k), Theresa Ghilarducci, testified before Congress earlier this year in support of the Retirement Savings for Americans Act, which would establish a federal 401(k) plan under which the government would provide low and middle income employees with a 5% contribution. She has described the 401(k) as “an experiment that failed.” More recently, The New York Times Magazine published an article highly critical of 401(k) plans and concluding that reliance on them was a mistake. The article contained many quotes from Prof. Ghilarducci and other critics. It highlighted the disappointment of Ted Benna, widely considered the father of the 401(k), at how 401(k) plans have developed. The Times article didn’t quote anyone defending the system, except for one person who also wanted to end the tax benefits of these plans. The whole thrust of the piece was that most employees can’t rely on their savings in 401(k) plans to fund their retirement.
Do 401(k) plans really deserve a failing grade? An objective answer would be no because the critics haven’t adequately addressed relatively recent developments that, if given a chance to take hold, could substantially improve the existing private employer system. This could be done without creating a new bureaucracy or requiring the federal government to start funding 401(k) plans.
Are Defined Benefit Plans Viable Alternatives? While no one would argue that the 401(k) plan is perfect, 401(k) plans have allowed many employees to accumulate substantial retirement savings on a tax-favored basis. Defined benefit pension plans, which some critics of the 401(k) view as superior retirement vehicles because the investments are managed by employers and the plans offer a fixed annuity for life, have declined since the enactment of ERISA. Reasons for the freezing or termination of many of these plans include stricter funding rules and administrative complexity, as well as the punitive taxes imposed on surpluses when overfunded plans terminate even if the overfunding is a result of superior investment performance.
Despite a recent reactivation of its defined benefit plan by IBM, unless existing law is changed, it is unrealistic to expect that defined benefit plans will again supplant the 401(k) as the main source of a worker’s retirement benefits.
401(k) Plans Are Covering More Employees and Becoming More Like Defined Benefit Plans.
However, changes to the 401(k) market are enabling 401(k) plans to come closer to the defined benefit plan model. These changes make professional investment management available so that employers and workers don’t need to have responsibility for managing investments. They also enable 401(k) plans to more easily offer participants the ability to elect that their account be paid out as a lifetime income stream insuring that they will not outlive their retirement savings.
Here are some relatively recent developments that could make 401(k) plans more accessible and easier for employers to run and employees to navigate while avoiding a new federal program that will crowd out the private pension system:
Automatic Enrollment Will Be Required for New Plans
Studies consistently show that automatic enrollment, which enrolls employees at a fixed contribution rate unless they opt out, increases plan participation. Automatic enrollment is currently voluntary, but beginning in 2025, SECURE 2.0 requires all new plans adopted after December 29, 2023 to have automatic enrollment and auto escalation of automatic contributions.
Long-Term Part-Time Employees Must Now Be Covered. Many plans traditionally excluded part-time employees who didn’t complete 1000 hours of service in a 12 month period. Now all plans must permit employees who complete at least 500 hours in each of three years to contribute, although employers are not required to match those contributions. SECURE 2.0 shortened the number of years from three to two.
“Do It For Me” Investment Options are Becoming More Popular
Plan participants and even many plan sponsors often have difficulty evaluating investment options and making choices. The market has responded to this problem by developing options in which professionals take over the responsibility for managing the investments. Target date funds make investments more conservative as the participant approaches assumed retirement age, but they may be one size fits all. Managed accounts provide more personalized management that may take into account the participant’s risk tolerance and other assets. Some plans now have hybrid investments that convert from target date funds to managed accounts as the participant nears retirement age.
PEPs
Recent federal legislation, SECURE 1.0, created a new type of multiple employer plan called a Pooled Employer Plan (PEP). These are plans in which unrelated employers can pool their assets and adopt a plan run by a Pooled Plan Provider (PPP), a professional who is required to be a Named Fiduciary of the plan and is responsible for administration and usually for investment options. An employer adopting such a plan has limited fiduciary responsibility as provided in the statute and can rely on a professional to run the plan. There are professionals who can assist employers to select the right PEP for them.
After a slow start up period, new PEPs are being created and this has the potential to be a game changer for employers who want to have a 401(k) plan but are too busy or lack the specific expertise to run their own plans.
Outsourced Fiduciary Responsibility
On the plan sponsor side, more sponsors are hiring professional investment managers described in Section 3(38) of ERISA .and outsourced chief investment officers (OCIOs) with delegated responsibility to select and monitor the plan investment options. Plan sponsors can also hire fiduciary administrators and even professionals to quarterback requests for proposals (rfp’s) to find the best professionals for their plans.
Participant Education
More and more plan sponsors are hiring investment advisers to provide investment education to their employees. This will help participants who haven’t selected professional management to make their own choices. But it is unfair to blame the 401(k) system for the failure of our educational system to require that students demonstrate basic financial literacy while they are still in school.
The New Savers’ Credit
SECURE 2.0 created a new savers credit scheduled to begin in 2027 to encourage plan contributions. The current credit is not widely known-I rarely see it described in plan communications- and employees who claim the credit but don’t have tax liability can’t use it to get a refund. Not only is the new credit more user friendly, but qualifying low and middle income employees can receive it as a 50% matching contribution (up to $1000) to an IRA or other retirement plan.
Annuity Options in Defined Contribution Plans. Annuity options in defined contribution plans can insure that employees don’t outlive their retirement savings. Employers who hesitated to include annuity options because they feared being held responsible if the insurer became insolvent now have a statutory safe harbor to protect them so long as they prudently select the insurer. Qualified Long Term Annuity Contracts (QLACs) can now permit participants to apply a portion of their accounts to fund annuities that commence at an age that is later than their required minimum distribution starting age.
Other Reforms Would Help The federal government can further incentivize plan sponsors to adopt new plans with these plan features, or could even impose new requirements as a condition of receiving tax benefits. Just as examples, the law could be changed to require that all 401(k) plans have minimum employer contributions, make low cost index fund options available to participants, or must provide payment options other than lump sums. These would be significant changes to existing law, but they would not throw the baby out with the bath water. They would certainly be less drastic than creating a whole new federally-funded structure with the potential to replace employer-sponsored 401(k) plans.