An ‘Unintended’ Consequence

"Unintended consequences" are often a euphemism for something bad. But not always. Take the 401(k), for example.

While the nation turns its attention to Election Day, Nov. 6 happens to be the “birthday” of the 401(k). Well, kind of. It’s actually the anniversary of the day on which the Revenue Act of 1978 — which included a provision that became Internal Revenue Code (IRC) Section 401(k) — was signed into law by then-President Jimmy Carter.?

That wasn’t the “point” of the legislation of course — it was about tax cuts (some things never change). It reduced individual and corporate tax rates (pulling the top rate down to 46% from 48%), increased personal exemptions and standard deductions, made some adjustments to capital gains and created flexible spending accounts.

But it did, of course, also add Section 401(k) to the Internal Revenue Code. That said, so-called “cash or deferred arrangements” had already been around for a long time — basically predicated on the notion that if you don’t actually receive compensation (frequently an annual bonus or profit-sharing contribution in those times/employers), you don’t have to pay taxes on the compensation you hadn’t (yet) received.

That approach was not without its challengers (notably the IRS) and,?according to the Employee Benefit Research Institute?(EBRI), this culminated in IRS guidance in 1956 (Rev. Rul. 56?497), which was subsequently revised (seven years later) as Rev. Rul. 63?180 in response to a federal court ruling (Hicks v. U.S.) on the deferral of profit-sharing contributions.

Enter the Employee Retirement Income Security Act of 1974 (ERISA), which — among other things — barred the issuance of Treasury regulations prior to 1977 that would impact plans in place on June 27, 1974. That, in turn, put on hold a regulation proposed by the IRS in December 1972 that would have severely restricted the tax-deferred status of such plans. But ERISA also mandated a study of salary reduction plans — which, in turn, influenced the legislation that ultimately gave birth to the 401(k).

So, how did something that became America’s retirement plan get added to a tax reform package? Rep. Barber Conable, top Republican on the House Ways & Means Committee at the time, whose constituents included firms like Xerox and Eastman Kodak (which were interested in the deferral option for their executives), promoted the inclusion which added permanent provisions to “the Code,” sanctioning the use of salary reductions as a source of plan contributions. The law went into effect on Jan. 1, 1980, and regulations were issued Nov. 10, 1981 (which has, at other times, also been cited as a “birthday” of the 401(k), since that was what allowed/encouraged employers to act on it).

The ‘Fathers’ of the 401(k)

Now, it’s said that success has many fathers, while failure is an orphan. The most commonly repeated story is that Ted Benna saw an opportunity in this new provision, recommended it to a client (which, ironically, rejected the notion), but then promoted it to a consulting firm (The Johnson Companies), which then embraced it for their own workers. The reality is almost certainly more nuanced than that, though Mr. Benna (who?has in recent times derided what he ostensibly created) has managed to be deemed the “father” of the 401(k) by just about every media outlet in existence.

What we do know is that in the years between 1978 and 1982, a number of firms (EBRI cites not only The Johnson Companies, but FMC, PepsiCo, JC Penney, Honeywell, Savannah Foods & Industries, Hughes Aircraft Company and a San Francisco-based consulting firm called Coates, Herfurth, & England) began to develop 401(k) plan proposals, many of which officially began operation in January 1982.

Now, it’s long been said that 401(k)s were never intended (nor designed) to replace defined benefit pensions — true enough.

But consider that in 1979 only 28% of private-sector workers participated in a traditional defined benefit (DB) plan, with another 10% participating in both a DB and a DC plan. In contrast, the Bureau of Labor Statistics reports that 70% of private industry workers had access to a defined contribution plan in 2024. As of December 2023, American workers have set aside nearly $11 trillion in defined contribution plans — and there’s another $11.4 trillion in traditional IRAs, nearly three-quarters of which were opened with rollovers (likely from DC/401(k) plans).?

The reality is that the nation’s baseline retirement program is, and remains, Social Security. But for those who hope to do better, for those of even modest incomes who would like to carry their current standard of living into post-employment, the nation’s retirement plan is, and has long been, the 401(k). And despite a plethora of media coverage and academic hand-wringing that suggests they are wasting their time, the American public has, through thick and thin, largely hung in there — when they are given the opportunity to do so.

That may not have been the intent of the architects of the 401(k), or its assorted foster “parents” over the years. But these days it’s hard to imagine retirement without it.

So, happy birthday, 401(k). And here’s to many more!