It’s been 40 years since Congress passed the Revenue Act of 1978. Why is this obscure piece of legislation significant? Because the Revenue Act created Section 401(k) of the federal tax code. Over the past 40 years, the 401(k) provision has helped to transform the way working Americans save for retirement. Unfortunately, this transformation may not be as great as people think.
Defined contribution plans existed before the creation of the 401(k), but they were much less common. Among workers who had a retirement plan through their employer, most had a defined benefit pension. The 401(k) provision was created to allow workers to defer some of their compensation into tax-advantaged savings accounts. This primarily benefited highly-paid corporate executives who now had a shelter to stash part of their high salaries.
For the first few years of its existence, the 401(k) was little-known. In the early 1980s, however, the Reagan administration changed the legal interpretation of the provision and allowed for it to be more widely adopted. Originally, the 401(k) was intended to be a supplement to Social Security and defined benefit pensions; a way for workers to save a little extra toward their retirement. Companies, however, began to offer defined contribution 401(k) plans instead of defined benefit pension plans. There were other reasons that private companies moved away from pensions, but the availability of the new 401(k) plan gave them something else to offer.
Since this shift in the early ‘80s, the number of Americans participating in 401(k)s has increased dramatically, just as the number participating in pension plans has fallen. In 1983, 62 percent of workers participated in a pension plan and only 12 percent participated in a defined contribution plan (26 percent participated in both). By 2016, however, the number participating only in a pension plan had plummeted to 17 percent, while the number participating only in a defined contribution plan had shot up to 73 percent (only 10 percent were in both types of plans in 2016). These numbers demonstrate how dramatic the shift has been in favor of 401(k)s and other defined contribution plans.
What is the result of this dramatic shift? 401(k)s have failed to provide adequate retirement security for working families. Despite the rosy promises of early 401(k) supporters, these defined contribution plans do not offer the same level of retirement security as defined benefit pensions. According to the 2016 Survey of Consumer Finances, the typical household approaching retirement had $135,000 in combined 401(k)/IRA assets. This will only provide around $600/month in retirement, hardly enough to support a dignified and secure retirement. Also, unlike pensions, 401(k)s do not offer annuities. Retirees can purchase annuities, but few do. Instead, retirees must decide how to use their accumulated savings and risk either spending it too quickly and outliving their savings or spending too little and having to accept a lower standard of living in retirement.
It’s important that throughout 2018 we remember the 40th anniversary of the creation of the 401(k). This once minor provision of the tax code has completely changed the way many Americans save for retirement, but has failed to live up to the promises of its creators. As anti-pension ideologues continue to attack pensions for librarians, nurses, EMTs, and other public sector employees, we must keep in mind that 401(k)s are not a good alternative.