(/Illustration by Dadu Shin…)
When lawmakers added a subsection to the tax code called the 401(k) more than three decades ago, they could not have imagined that this string of three numbers and a letter would become a fixture in the financial lexicon.
Nor could they imagine the stress it would unleash.
A poll by Gallup last year showed that for two-thirds of Americans, not having enough money for retirement topped seven other financial worries, including medical bills, mortgage payments and their children’s college tuitions.
Worrying about having enough money for retirement is not a new phenomenon. But the rise of the 401(k), dating to the early 1980s, has steadily shifted more financial responsibility onto the shoulders of many Americans who are — let’s face it — clueless.
The number of people who are unprepared is growing. In 1983, researchers now at the Center for Retirement Research at Boston College calculated that 31 percent of working-age households were “at risk” of not being able to maintain their standard of living after they retired. By 2009, it was 51 percent.
“I don’t know how you feel, but managing your own money is just horrible,” said Alicia Munnell, director of the center. “We just don’t know how to do it.”
Consider the hurdles between every American with a 401(k) and a decent retirement: First, wade through your HR department’s paperwork to enroll in a plan at your company. Second, save enough. (Imagine what you think is enough. Then save more.) Next, manage your investments intelligently through stock market highs and lows, tending to your portfolio every year to make sure you have the right balance of stocks and bonds, and avoid withdrawing any money early. And not least, when you retire, ration your money at just the right rate: not so little that you live uncomfortably but not so much that you run out.
The result has been a system that works well for people who know how to use it. For many others, it’s better than nothing, but it still may not be enough.
“Does the system work or not? It’s really a ‘compared to what’ question,” said Eric Toder of the Urban Institute. “One side emphasizes the glass is half-full and the other emphasizes the glass is half-empty. The real question is, how do we make the system work better for the people for whom it’s not working while not destroying the benefits?”
As company pension plans peter out, Munnell estimates that it will be another decade before people rely almost entirely on their 401(k)s.
That means 10 more years before a system — once imagined to be only supplementary to Social Security and pension plans — is fully tested. That’s 10 years in which bigger waves of workers sign up for a savings vehicle that they expect will see them through old age.
For the past several years, there’s been a movement to fix the 401(k), or at least make it work better for average people — that is to say, almost all of us — who are bound to make some mistakes along the way.
Reformers want the 401(k) of the future to look very different. But even the program’s biggest critics concede that the system that was unwittingly launched in 1978 is here to stay.
Retirement plans, defined
Broadly speaking, companies help workers plan for retirement in two ways.
Defined benefits, often called pension plans, guarantee workers a certain amount annually when they retire based on earnings in their final years and how long they’ve worked at the company. The employer must set aside the money, invest the funds and pay employees, regardless of what happens in the market.
In a defined-contribution plan, which includes 401(k)s, the employer diverts money from the employee’s paycheck — while perhaps chipping in some to an account owned by the employee, effectively creating a savings account. There are restrictions on when the money can be drawn. The employee owns the account, though, and can move the money from employer to employer.
The 401(k) was created by the Revenue Act of 1978, which also reduced individual income tax rates and the corporate tax rate and created flexible spending accounts.
But years before the law, companies had defined-contribution plans that were precursors to the 401(k). Firms — banks in particular — created accounts in which employees could put their bonuses rather than collect the money in cash. The accounts allowed employees to defer the taxes they would owe immediately with a cash payout.
The IRS was wary of this setup, but Congress gave it the rubber stamp. In the 1978 law, Congress added 401(k)s to the tax code, formally allowing employees to put a portion of their salary in these tax-deferred accounts. Three years later, the government issued official regulations, and companies including Johnson & Johnson and PepsiCo were among the first to adopt the new 401(k).
The number of companies offering the plan exploded in the 1980s and 1990s.