Feature Articles

401(k) Perspective: Where Did the 401(k) Plan Come From?

By Ted Benna
Creator of the 401(k); Author of Ted's Table

In the first of three exclusive articles for mPower about the development of the 401(k), Ted explains what led up to the creation of the first 401(k) plan. The next two articles will look at how the plan has developed over two decades, and where it is headed. Ted Benna is a member of the board of directors of mPower, which publishes this Web site.

Almost everybody has heard the term "401(k)," but few actually know much about section 401(k) of the tax code. Tell us a bit about it.

The Internal Revenue Code (IRC) is structured in sections, with Section 401 covering tax-qualified retirement plans. Section 401 begins with paragraph (a) and ultimately goes to paragraph (k), which was added when the Tax Reform Act (TRA) of 1978 was enacted by Congress. Like many tax bills, this one was passed during the final hours before Congress adjourned for the legislative session. It is common in such bills to have paragraphs added which are of special interest to certain entities.

"Launching 401(k) restored my enthusiasm for the retirement business because it is a plan that primarily benefits middle-class workers who earn between $20,000 and $100,000. Our strong middle class makes the United States unique." — Ted Benna, creator of the 401(k).

I have been told that paragraph (k) was added to the TRA at the last minute by a New York State congressman who was encouraged to do so by a bank that was located in his district. I have never learned who was actually responsible for writing this provision of TRA.

The original version of Section 401(k) ties the amount that the highest paid one-third of employees at a company can put into the plan directly to the amount that the bottom two-thirds puts into the plan. The top one-third is permitted to put in up to 3 percent more than the average percentage of the bottom two-thirds, but no more than twice the average percentage of the bottom two-thirds. For example, if the bottom two-thirds puts in 2 percent of pay, the top one-third could put in 4 percent.

What was the retirement savings climate leading up to the first 401(k) savings plan?

Many of the major banks had cash-bonus plans during the '60s and '70s. Typically, eligible employees received one to two weeks of base pay as a cash bonus at the end of the year. These bonuses were intended to be performance-based compensation tied to the bank's financial results. Employees were told they should not expect these bonuses in the future. After receiving them for a few years, however, most employees did in fact expect these bonuses. As a result, the intended flexibility and incentive factors largely disappeared.

At some point, someone came up with a better idea: a cash-deferred plan. The cash-bonus plans were replaced at many large banks by plans where half of the bonus amount was contributed into a tax-qualified retirement plan. This portion wasn't taxable until the employee left the bank and received a benefit distribution. Each employee could elect to take the other half as a taxable cash payment or contribute it to the tax-deferred retirement plan. Assume an employee received a $400 contribution to this type of plan. Half, or $200, was automatically deposited into the plan. The employee could take the other $200 as a taxable cash payment or also deposit this amount into the plan.

These plans were approved by the Treasury Department even though there wasn't any provision for them in our tax laws at this time. Treasury eventually became disenchanted with these plans because a disproportionate share of the tax benefits were going to the higher-paid employees. This led Treasury to prohibit the establishment of new cash-deferred plans during 1972. Existing plans were permitted to continue, but new plans could not be adopted. Treasury's goal was to examine these plans more closely and to ultimately decide their future fate.

Congress prevented Treasury from taking further action when it passed the Employee Retirement Income Security Act (ERISA) during 1974. Congress didn't know what to do with these plans at the time but they wanted to make sure they decided their future rather than Treasury. Congress provided an answer when it passed the TRA of 1978, adding paragraph (k) to Section 401 of the IRC. Congress' intent was merely to resolve the future of these cash-deferred plans, which were of interest primarily to banks. Congress never suspected they were setting the stage for the emergence of 401(k)s as we know them today.

So, the atmosphere was right for the type of change that Section 401(k) would ultimately allow. How did you come to figure out how to use Section 401(k) as you did?

There was a myth that I discovered a section of the IRC that no one knew about. Everyone who followed changes in the tax laws was aware that paragraph (k) had been added to the IRC. My reaction when Congress added paragraph (k) to Section 401 was that we finally had an answer for the future operation of these cash-deferred plans, but I did not expect it to be a big deal because I was focused, like everyone else, on the limited usage of these particular plans. It should be noted that this change in the law had a delayed effective date of January 1, 1980. This date came and went as a nonevent — employers weren't lined up waiting to take advantage of this change in the law.

During the fall of 1980, I was a benefit consultant and co-owner of The Johnson Companies, an employee-benefits consulting firm in suburban Philadelphia. I was helping Cheltenham National redesign its defined-benefit pension plan. The bank also had a cash-bonus plan which the president wanted to eliminate because it was no longer an effective compensation tool.

A couple of years earlier, I helped another bank client make this type of change. Many of the employees of this bank were not thrilled to have the cash bonus replaced by a contribution to a retirement plan. I was convinced that many of the employees at Cheltenham National would feel the same way, so I wanted to use what I had learned to do something better. At this point, I was drawn back to Section 401(k) as a potential answer. This change in the law occurred between these two consulting assignments. I could use this new Section of the IRC to design a plan that could make all employees happy. I could replace the cash-bonus plan with a cash-deferred plan in which each employee could defer as little or as much as he or she wanted.

I knew replacing the cash-bonus plan with a cash-deferred plan would work only if we could get the lower-paid two-thirds to contribute a meaningful amount into the plan. Many of the lower-paid employees were tellers who earned $5,000 to $7,000 annually. It was at this point that I thought of adding an employer-matching contribution to produce an additional incentive. The specific match I recommended was $0.25 for each $1.00 an employee put into the plan. I felt the combined incentive produced by tax savings and the employer match would be sufficient to get many of the lower-paid two-thirds to put money into the plan.

Was the employer-matching contribution included in the law?

There wasn't a specific provision in the tax code at the time for employer-matching contributions. There also wasn't a provision enabling employees to take a portion of their pay each pay period and make pretax contributions. Such contributions are known as a salary reduction. When you contribute to a 401(k), technically you are authorizing your employer to reduce your pay and to contribute this amount to the plan as an employer contribution.

Yet, because there wasn't anything prohibiting either of these possibilities, I took the position that they should be permitted since they weren't prohibited.

Most large employers, at this time, had after-tax savings plans in which employee contributions were matched by the employer. We had such a plan at The Johnson Companies where the matching contribution ranged between $0.25 and $0.50 depending upon an employee's years of service. I came to the realization one quiet Saturday afternoon in my study that all these after-tax savings plans could be converted to plans in which employees put their money into the plan from their pretax rather than their after-tax incomes.

How did you feel when you realized you were really on to something?

The day after I made this discovery, I flew to Colorado to meet with a study group of men who were in the same business as I. We met once a year to exchange ideas. I was of course all pumped up about this new idea which I was still formulating. These guys were the first to hear about my new idea.

Most of my work prior to 401(k) involved helping professionals and small business owners establish retirement plans. The primary motivation in most instances was to get as big a tax break as possible for the owners while providing as little as possible to the other employees. I had reached a point by age 39 where I was no longer enjoying this work because I was helping those who needed it the least. I was prayerfully considering alternatives, including becoming involved in some type of full-time ministry. It was during this period of searching that the 401(k) ideas came to me. I am convinced that the ideas were not solely my own. Launching 401(k) restored my enthusiasm for the retirement business because it is a plan that primarily benefits middle-class workers who earn between $20,000 and $100,000. Our strong middle class makes the United States unique.

What was the reaction of your associates at The Johnson Companies?

The senior technical people agreed that my ideas should work, but my senior partner, Ed Johnson, was skeptical. His first question was, "Why haven't the top tax attorneys and consultants come up with this idea if it was legal?" I told him I couldn't answer that question. Ed insisted that we obtain a legal opinion from an independent attorney, who agreed that what I was proposing was potentially workable.

The Johnson Companies used an outside advisory board of businessmen to help guide the company. When I presented this idea to this group, their advice was to sell the idea for a significant sum and to start working on the next idea because it was too big for our small company to take to market. We accepted their advice and offered to sell the idea, including technical support, to two large insurance companies for $1 million. We were turned down by both. We then decided to take 401(k) to market on our own.

So, the bank, Cheltenham National, was the first to use a 401(k) plan?

No. They decided not to proceed with my solution because their attorney did no want them pioneering something. We actually installed a 401(k) plan for their employees two or three years later.

Read More Read the story of the first three 401(k) contributors.

The first 401(k) savings plan was for our employees at The Johnson Companies. We required pretax contributions for the 6 percent that was matched by the employer when we made the change. The employer match was $0.25 per $1.00 to $0.50 per $1.00, tied to years of service according to the following schedule — $0.25 for up to two years of service, $0.35 for three to five years of service and $0.50 for five or more years of service.

How did your employees react to this new type of plan?

Being able to make pretax contributions was a big plus for employees, but there also was a negative. The Johnson Companies' after-tax savings plan gave employees ready access to their contributions even while they were still active employees. Employees could withdraw these contributions for any reason, and they didn't have to pay any taxes because their contributions were taxed before going into the plan. Pretax contributions to a 401(k) could be withdrawn only for a financial hardship. We knew employees would like making pretax rather than after-tax contributions, but we didn't have any idea how they would react to the more restrictive withdrawal provisions.

We presented the change to our employees without hard-selling the advantages. We gave them the pros and cons and then waited for the results. We were surprised when all the enrollment forms were returned to find that the bottom two-thirds had decided to contribute a slightly higher percentage than the top one-third. When we reviewed the results, we realized that many of our lower-paid two-thirds were women who were part of a two-income household, and that many of our top one-third were men who were sole wage earners. Many of the higher-paid employees had a lower savings capacity due to mortgage and tuition payments. This result with our own employees helped us to realize that this idea would work: The combination of tax savings and an employer-matching contribution would in fact provide a sufficient incentive to achieve a high level of participation among both higher- and lower-paid employees.

The idea of reducing taxable income through contributing it to a 401(k) must have caused some consternation for Uncle Sam. Were you concerned about how the Treasury Department would react to your new idea?

Ed Johnson, my senior partner, was much more concerned than I was. Drew Lewis, who became Secretary of Transportation in early 1981, was a friend of Ed's. Ed arranged a meeting with Drew. We asked him to introduce us to the top people at Treasury because we knew the fate of 401(k) would ultimately be determined by them.

This resulted in several conversations with Mike Melton, who was the person drafting the proposed 401(k) regulations. He did not give me any insight to the proposed regulations prior to their release, but I drew some comfort from the fact that he realized we could achieve similar results even if contributions via salary reductions were not permitted. This was of much more concern to me than the employer-matching contributions because most large companies already had plans with matching contributions. I had a bit of anxiety until the proposed regulations were issued, during November 1981, supporting both the matching contributions and employee pretax contributions via salary reduction.

So, you had the first plan up and running and it looked as though the Treasury wasn't going to nix it. It was time to start selling the plan, right?

The biggest challenge we had was getting media attention for this new idea. The first newspaper story appeared in The Philadelphia Inquirer and it was written by Craig Stock. We also worked hard to get either The Wall Street Journal or The New York Times to do a story. The New York Times finally did a 401(k) article. Both the Inquirer and Times articles were picked up by the wire services resulting in national exposure. This generated several hundred telephone calls and letters seeking more information. By late 1981, I was receiving calls from virtually every major publication to do a 401(k) story.

Craig Stock told me he received several hundred telephone calls from tax attorneys and human resource executives claiming this wasn't legal. This was the typical initial response. Next came skepticism that the lower-paid employees wouldn't contribute. The skeptics were convinced lower-paid employees would never contribute enough money to make the plan work if it would be tied up until retirement age. One reason why they were wrong is the fact that many of the employees who were included among the lowest-paid two-thirds were married women whose children were beyond the college tuition draining years. Typically, these employees contributed the maximum amount that was allowed.

It is somewhat hard to understand today, but the 401(k) was totally unknown, so the entire concept had to gain broad-based acceptance. Employees saving for their own retirement was also a strange concept. Bethlehem Steel was one of the first large employers that I helped establish a 401(k). When I mentioned during a meeting there that it was time to get employees saving for retirement, I was told that didn't fit Bethlehem's culture because employees who spent their careers at Bethlehem were taken care of for life. We were about to move from an era in which employees looked primarily to the government and their employers to provide retirement income to an era in which employees would begin to assume much of this responsibility.