Once upon a time in America, many employees had defined benefit pension plans. They provided guaranteed retirement income from employers, with benefits often based on a formula factoring in wages and years of service.
Those plans have mostly disappeared. In 2022, just 15% of private sector workers had access to defined benefit plans, according to the Bureau of Labor Statistics.
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They’ve been replaced by defined contribution plans born from the Revenue Act of 1978. The act created a new rule in section 401(k) of the Internal Revenue Code, allowing tax breaks for deferred compensation.
The original goal of section 401(k) was to regulate tax-advantaged profit sharing plans that often benefitted wealthy executives. But a few years after the law was passed, Ted Benna, a retirement benefit consultant at a small Pennsylvania-based firm, began advocating for the 401(k) as a retirement savings vehicle.
Lawmakers and Treasury officials took his advice, Benna became known as “the father of the 401(k),” and the modern retirement savings system was born.
These accounts exploded in popularity in the 1980s, supported by legislation that encouraged employers to offer them as a benefit. They’ve become the default retirement savings strategy for millions.
Unfortunately, there’s a growing body of evidence suggesting this approach may have been a failure.
Here’s what’s wrong with 401(k) plans
Tax breaks are popular, so 401(k)s seem like a great deal. Sadly, they place responsibility for retirement readiness solely on workers, many of whom don’t have the knowledge to make informed choices.
These workers also take on all the risk. If they don’t invest enough, their investments don’t perform well. If they make mistakes such as early withdrawals, they’ll end up with far too little money for a comfortable retirement.
The data is clear on this. The median 401(k) balance among Americans 65 and over with Vanguard defined contribution plans is just $70,620, according to Vanguard’s How America Saves report. Low 401(k) balances and limited Social Security left as many as 8 million seniors in poverty in 2022.
At the same time, the 401(k) industry has become enormously powerful. Retirement industry lobbying groups have increased spending on political action committees (PACs) between six- and eight-fold since the early 2000s, according to Politico. With so much money changing hands, it’s not surprising Congress has repeatedly passed laws expanding 401(k)s.
The SECURE Acts 1.0 and 2.0, in 2019 and 2022, are the most recent examples. Among other things, they increased the amount wealthy individuals can deposit in tax-advantaged accounts. They can now protect as much as $452,000 a year in a tax-advantaged 401(k), while reducing their taxes by as much as $203,600.
Laws favoring 401(k)s enrich financial advisers, brokers, and the wealthy, while leaving poorer workers behind. They also eat up a growing share of government funds, to the tune of $369 billion in tax expenditures in 2023. This is projected to increase to $659 billion by 2027.
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The 401(k) really is failing millions
The reality is 401(k) plans are great for highly educated workers who earn a lot of money. The Economic Policy Institute found these individuals were more likely to:
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Have access to a 401(k)
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Participate in a 401(k) when offered
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Have money to contribute to their 401(k)
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Receive employer matching contributions
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Take on greater investment risks, helping their portfolio balance grow
401(k)s aren’t ideal for almost everyone else, though. Workers earning $150,000 or more have median 401(k) balances of $201,301, compared with $4,033 for those earning under $15,000, and $4,568 for those earning between $30,000 and $49,999, according to Vanguard’s report.
Some argue this is unsustainable. Calls for reform range from eliminating 401(k) tax preferences in favor of funding more generous Social Security benefits, to passing laws incentivizing a switch back to defined benefit plans. However, with the richest and most powerful Americans benefiting from the status quo, the likelihood of major changes in the coming years may seem slim.
Workers who aren’t being well served by a 401(k), or don’t have access to one, do have other options. One could be claiming tax breaks through IRAs, and another could be looking for work in the public sector, as traditional pensions are more likely to be available to government workers.
While these solutions are imperfect, they offer some hope for a secure retirement for those who might otherwise struggle to achieve it.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
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