Five Moments that Shaped the 401(k)

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The way preparing for retirement once worked for most Americans was they had their pensions, their private savings and income from Social Security. Indeed, for much of the 20th century, the system was thought of as a three-legged stool.

Beginning in the 1980s, that calculation began to change. The 401(k), also known as a defined-contribution plan, entered the scene, reshaping the way most of us now save for retirement. Instead of counting on a company pension, workers could use their 401(k) to determine how much of their money to save, where in the market to invest it, and how to make their gains last in retirement.

The change didn’t happen overnight, though. It took a series of developments to turn the nation away from pensions, or defined benefit plans, toward the 401(k). Here are five of the most important:

Studebaker spurs reform

One of the earliest chapters in the decline of the corporate pension plan came in December 1963 with the closing of the Studebaker production plant in South Bend, Ind. When the plant shut down, the liability of the company’s pension plan exceeded its assets by $15 million.

The shortfall did not affect retirees or retirement-eligible employees over the age of 60, each of whom received their full pension. For younger workers, though, the closing was a serious blow for their retirement plans. Employees younger than 60, including some who had clocked 40 years of service with the firm, received a lump-sum payment worth about 15 percent of the value of their pension. Employees younger than 40 got nothing.

In time, the closing would serve as a catalyst for legislation designed to better protect corporate pension plans. That effort culminated with the Employee Retirement Income Security Act of 1974.

ERISA changes the game 

The law, known as ERISA, sought to correct a major flaw in defined benefit plans exposed by Studebaker’s plant closing: that an employer’s pension promises to employees were not necessarily bound by law. If a firm could not afford the payout, as was the case with Studebaker, it was not bound to provide them.

ERISA set out to correct that by pushing employers to protect workers’ accrued pension benefits.  The law also established a safety net for employees by ensuring they could keep a minimum slice of their pension in the event that a firm could not meet its obligations. That came through the Pension Benefit Guaranty Corporation, modeled after the protection given to bank deposits through the Federal Deposit Insurance Corporation.

The law marked a watershed moment for the nation’s labor laws, but it also meant employers had to set aside more money to fund their pensions, as well as take on new insurance costs. For many firms, the burden became too great, leading many to eventually search of an alternative to the defined benefit.

The 401(k) is born

Four years after ERISA became law, a new section of the IRS tax code, section 401(k) was introduced as a way to offer taxpayers a break on their deferred income. The provision went largely unnoticed until 1980, when Ted Benna, a suburban Philadelphia benefits consultant, found it could also be used to allow employers to count a salary reduction as a tax-deferred contribution to employee retirement plans.

Benna proposed the idea to the client he was then consulting, but the client declined to take his advice. Soon enough, though, others would jump at the idea.

The 401(k) was especially popular at first with companies looking to offer managers and executives a path to supplement their savings.

“It starts as a supplemental savings program, and the initial contributors into that program … were managers and executives of the firms that had the time and money and inclination to even put them in,” Michael Falcon, head of retirement at JPMorgan Asset Management explained to FRONTLINE. “They weren’t widely recognized or known or available or accessible, let alone did people have the impetus or the money to contribute to them. Over time, through the ’80s and into the ’90s, there were increasingly efforts to engage the broader population to participate in those plans, and that’s the advent of the company match.”

As the 401(k) spread throughout the labor force, it also became increasingly complex. “I am not convinced we have added value by getting more complicated,” Ted Benna told Marketwatch in 2011. “I would blow up the system and restart with something totally different.”

The Bull Market

For much of the 1980s and 1990s, however, that complexity didn’t seem to dissuade employers from moving toward the 401(k), nor did it dampen enthusiasm for the plans. From 1982 through 1999, the S&P 500 earned annualized returns of 19 percent. The bull market coincided with a massive shift away from corporate pension plans: In 1980, the 401(k) had yet to enter the lexicon, but by 1990, the number of active participants in 401(k) plans had skyrocketed to 19 million, according to the Investment Company Institute. Five years later, the number of active participants in 401(k) plans had grown to 28 million, eclipsing the number with private-sector pensions by 5 million. Of course, when the market crashed in 2000, and then again in 2008, investors were reminded of the risks or relying on the market to save for retirement.

The Pension Protection Act

The dot-com crash did little to help corporate pensions. From 2001 to 2006, more than 700 pension plans collapsed in the U.S., taking the Pension Benefit Guaranty Corporation (PBGC) from a $10 billion surplus to a $23 billion deficit along the way.

The trouble gave way to the Pension Protection Act of 2006, a law that critics argue have undercut pensions by simplifying the 401(k). The law made 401(k)’s more efficient by removing obstacles to automatic enrollment for employees, encouraging plan sponsors to increase default contribution rates and providing workers with a broader array of investment options.

At the same time, the law placed more stringent standards on defined-benefit pension plans. It required firms to have their plans fully funded over seven years, closed loopholes that allowed underfunded plans to skip payments and forced companies that underfund their plans to pay higher premiums to the PBGC.

“The Pension Protection Act is a lovely sounding name of a law, but it in fact did the opposite of what the name implies,” Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at the The New School for Social Research, told FRONTLINE. “The Pension Protection Act really put the final nail in the coffin of defined benefit plans.”

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