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401(k) Creator Rebuts Critics of the Plans

By Ted Benna Creator of the first 401(k) plan

It had to happen sooner or later -- the unbridled enthusiasm that surrounded 401(k)s for two decades has been adversely impacted by Enron and the recent general stock market funk. Critics say 401(k)s are not working, and that they have replaced more guaranteed forms of "defined-benefit" pensions, to the employers' advantage. The authors of one book even claim that the 401(k) is a hoax.

If there is a 401(k) hoax, it's the unrealistic expectation, fueled by the bull market of the 1990s, that 401(k)s could be a way to get rich fast. This was never the intent behind the 401(k) plan. I created the first 401(k) as a way to help the average worker save more for retirement over the long term. In effect, I discovered a way for workers to automatically save a portion of salary each month and get an immediate tax break. These benefits are still alive and well, as is the ability to move your vested account balance with you from job to job.

Of course, 401(k)s aren't perfect. Very few things are -- if any. Problems exist, particularly because of the patchwork of regulations that rule these plans, and because of the latitude employers have in applying the rules. Congress may impose new requirements, but the system will still have imperfections.

I think it's time for a reality check on 401(k)s and how they should be viewed and utilized.

The Great Debate (DB vs. DC)

The most adamant opponents of 401(k)s claim that these plans are responsible for the death of defined-benefit pension plans. They claim that employers have dumped defined-benefit plans in favor of 401(k)s in order to reduce costs, and that this has meant reduced retirement benefits for affected workers. (Defined-benefit plans are traditional pension plans in which retirees who qualify receive a predetermined amount each year in retirement. With a defined-contribution plan such as a 401(k), the amount of the benefit in retirement depends on how much is contributed to the plan and how well the investments -- generally selected by the employee -- perform.)

	If there is a 401(k) hoax, it's the unrealistic expectation, fueled by the bull market of the 1990s, that 401(k)s could be a way to get rich fast. Ted Benna

Critics claim that employers switch from a defined-benefit plan to a 401(k) to reduce costs -- all eligible employees will get a benefit with a defined-benefit plan, whereas with a 401(k), only employees who contribute can receive a matching employer contribution. However, this argument ignores the fact that when a company replaces a defined-benefit plan with a defined-contribution plan, the company typically makes an automatic employer contribution to the new plan comparable to the total amount historically contributed to the pension plan. For example, if the annual defined-benefit plan cost to the employer has been 5 percent of pay for eligible employees, the defined-contribution plan will include an automatic annual employer contribution for all eligible employees equal to 5 percent of pay. Most companies don't change retirement plans to reduce the benefit they give to their employees. They do it because year-to-year costs are more predictable with a defined-contribution plan. Of course, there are exceptions. Companies that are struggling to survive may provide a lower-cost replacement benefit, or none at all.

The outrage at pension plans being replaced by 401(k)s is greatly exaggerated. Recent analysis by Watson Wyatt Worldwide shows that 83 percent of Fortune 100 companies still have defined-benefit plans, compared to 89 percent in 1985. The number dropped partly because companies have entered this group that never had defined-benefit plans. The common perception that most companies have replaced their defined-benefit plans with 401(k)s is wrong.

The total number of defined-benefit plans in the United States has decreased substantially since 1985. The decrease is mostly due to smaller employers dropping defined-benefit plans because the tax benefits to the owners were reduced through legislation. I used to work with such plans. The primary goal of the owners (commonly professionals) was to get a large tax break for themselves while giving as a little as possible to their employees. These plans were primarily tax-avoidance schemes, and we shouldn't regret their demise, nor should we attempt to draw broad conclusions about national retirement policy from their elimination. Most defined-benefit plans that were established to provide retirement benefits to employees, rather than tax breaks to owners, are still around.

Pluses and Minuses

I have been asked to defend 401(k)s against defined-benefit plans on several occasions, including the 25th anniversary of the Employee Retirement Income Security Act (ERISA) in 1999. My position is that each type of plan has its pluses and minuses.

Defined-benefit plans are great for employees who spend most of their careers at one place, but they are horrible if you move from job to job. Why? Because you build very little value during the first five to 10 years of eligibility at each job, and the benefit that you do earn is frozen.

401(k) plans let you take your money with you when you change jobs, but they also have potential drawbacks. Perhaps the biggest weaknesses are that you have to contribute to get any benefits, unless your employer makes an automatic contribution, and you must assume responsibility for the investment results.

Bottom line: it isn't a matter of one type of plan being inherently good and the other evil. Each has pros and cons, and what's best for any person depends on individual circumstances. The ideal is to work for an employer that has both types of plans, which is the case for most Fortune 500 companies.

Semi-forced Savings

401(k) plans number more than 400,000, and over 90 percent have fewer than 100 participants. Most of these smaller employers never had, and never would have, a defined-benefit plan, even if 401(k) didn't exist. Why? Because a defined-benefit plan costs at least 5 percent of pay per employee, and few employers of this size are able or willing to commit to this.

	Semi-forced savings ... is by far the greatest benefit of a 401(k). The tax breaks and employer matching contribution are a big plus, but the convenience of automatic saving is what converts spenders into savers. Ted Benna

The primary reason why the 401(k) is so popular among smaller businesses is because it is the only plan that will work with an employer contribution equal to 1 percent or less of employees' pay. Most of these employers wouldn't have any plan if 401(k)s didn't exist. So the question is whether a 401(k), despite its imperfections, is better than no plan at all. Participants who contribute to these plans would agree that the answer is "yes."

Over the years I have met many participants of different races, job levels and ages. Without fail, each has thanked me for starting the first 401(k) savings plan because their own 401(k)s have helped them save thousands of dollars that they would have blown otherwise. This has convinced me that semi-forced savings, when money is regularly deducted from a worker's paycheck, is by far the greatest benefit of a 401(k). The tax breaks and employer matching contribution are a big plus, but the convenience of automatic saving is what converts spenders into savers. Most employees would never achieve a similar level of savings without a 401(k).

Culprit: Lack of Investment Understanding

401(k) participants are required to take investment risks, which can provide both rewards and punishment. When the stock market produced double-digit returns during the 1990s, rewards were high and the system appeared to be wonderful. Articles about 401(k) millionaires appeared regularly. More recently, articles have focused on participants who suffered substantial losses during the prolonged stock market slump. Unfortunately, many participants had excessive stock holdings entering this market decline, and many were heavily invested in technology stocks or their own employer's stock. Participants who were planning to retire soon incurred particularly painful losses. A 30 percent or greater drop in the value of your investments isn't a big deal when you're in your 30s and have time to recover financially, but is likely to require a change in your retirement plans if you're in your late 50s or 60s.

	The 401(k) as a retirement-saving vehicle is no hoax. But ... building a nest egg sufficient to maintain your lifestyle when you retire is a long-term endeavor that requires an adequate level of contributions and intelligent investing Ted Benna

The assets in 401(k)s are estimated to exceed $1.5 trillion dollars. IRA assets are even greater, because participants have transferred substantial amounts out of 401(k)s into IRAs during the past five years, and this trend will continue. Most of the money that is in 401(k)s or has been transferred into IRAs belongs to middle-income workers earning between $20,000 and $100,000.

Our strong middle class is what makes America different from most other countries. Years ago, Soviet Premier Nikita Khruschev told the United States that the Soviet Union would bury us -- we would be taken over by communism and our factories would be owned by the workers. He was partly wrong -- our capitalistic society is alive and well despite the recent stock market turmoil. But some of what Khruschev said came true. By some estimates, approximately 50 percent of the total value of the U.S. companies listed on the various stock exchanges is owned by workers through pension plans, 401(k)s, 403(b)s, 457s and IRAs. Private retirement plans, including 401(k)s, have enabled workers to gain substantial ownership of corporate America.

Make the System Work for You

The 401(k) as a retirement-saving vehicle is no hoax. But it's essential to realize that building a nest egg sufficient to maintain your lifestyle when you retire is a long-term endeavor that requires an adequate level of contributions and intelligent investing. A few participants built huge sums in shorter periods during the 1990s bull market by being in the "right" investments at the right time, but this was more a function of luck than skill.

Retirement planning requires discipline and hard work. It would be great to have someone take this burden from us and assume the responsibility for providing total retirement income security, but no organization can do that. The government can and does help, by providing basic retirement benefits through Social Security, but it's having trouble managing the existing system. Your employer can help too, but the ultimate responsibility is yours.

The system isn't perfect, but there's no such thing as a perfect system. Learn enough about investing to take full advantage of your 401(k). Do your part to make the system we have work for you.

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The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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