The savings model certainly has its detractors, but was Ted Benna really saying he regretted finding an Internal Revenue Service (IRS) code that led to the formation of the very first 401 (k), a discovery that spawned an industry and transformed the way workers, primarily in the private sector, save for retirement?
As it turns out, it’s not the actual model he’d blow up. Rather, it’s the investment practices that morphed into multiple and confusing choices for plan participants, and the fees associated with them.
“There are millions of people who have benefited from putting money into a 401 (k) and accumulating probably $15 trillion when you take what has been rolled over into IRAs, so no, I’m not disappointed in that. I don’t grieve over the fact I had a role in that,” he said.
“When I said I would blow this thing up and start over, what I am really talking about is the way they are being managed investment-wise today, not necessarily the whole thing. I regret that I played a role here in helping Wall Street make ridiculous amounts of money … the investment structure is broken and it needs to change, and I am going to push hard to do whatever I can to fix that.”
When it comes to the formation of the 401 (k), there is myth and reality, he explains. The myth would have one believe Benna was sitting in his office one Saturday in 1979 reading the tax code, when he stumbled on the related section and had a eureka moment.
In fact, he says, many people were aware of that particular section that had been added for an entirely different reason. The discovery was when he realized it could be used for a purpose no one else had considered.
Going through the code wasn’t an exercise in light reading. Rather, he was working on an assignment for a client – a bank – that wanted to redesign its retirement program. The bank was offering employees a cash bonus plan but wanted a tax deferred profit sharing plan in which workers couldn’t access the savings until they left the bank’s employ.
The plan worked for higher-paid executives who could shelter their income and get the related tax break. However, he says, to make it work lower-paid employees would have to participate, and to encourage them to do that he came up with the idea of a matching employer contribution – a nudge so to speak.
“What I did and what no one else had done, to my knowledge, was to come up with the idea of a matching employer contribution, and the other was for employees to be able to make pre-tax contributions themselves,” says Benna.
“The myth is that I discovered this paragraph in the IRS code, but I’ve never said that. It wasn’t a mystery. This had been passed into law. Anyone who followed retirement legislation knew this had been added in the fall of 1978 … but it had a delayed effect to Jan. 1, 1980.”
As it turns out, the concept had an added bonus for the employer. The matching contribution was covered by salary reduction.
“When employees put their money into these plans pre-tax, they are legally authorizing their employers to reduce their salary, and that reduced amount legally becomes an employer contribution rather than an employee contribution under the tax code.
“Any participant in a 401 (k) plan, without even realizing what they are doing, is signing a salary reduction agreement.”
The model was introduced to the market in the fall of 1980, and the 401 (k) was born.
“I was looking to successfully complete an assignment … it wasn’t to turn the world upside down.”
However, turn the retirement world upside down it did, to the consternation of many pension experts and policymakers. Concerns about the model include the related fees and an absence of decumulation solutions; essentially members of DC-type plans receive a lump-sum payment when they leave the plan, and it’s their job to figure out how to turn the money into retirement income that lasts an increasingly longer life.
Solutions being considered include letting members remain in their plan following retirement, benefiting from lower fees and internal management expertise. Annuities, including late-life annuities, are also being proposed as solutions to decumulation risks, including longevity.
Critics of DC-type plans like the 401 (k) maintain they are tied to the reduction of DB plans, mostly in the private sector. While the majority of those employers now offer new hires a DC plan, with many closing DB plans, regulations had more to do with the trend than a fondness for the newer model, says Benna, who adds he once “made his living selling DB plans.”
The Employment Retirement Income Security Act of 1974 (ERISA) “made it impossible” for him to continue” doing that, he says.
Before the introduction of ERISA, employers who maintained a DB plan simply had an annual funding requirement, and if the plan became unaffordable, it could be terminated, with whatever money existing being used to provide benefits. ERISA, he continues, contained a provision that allowed the Pension Benefit Guaranty Corp. (PBGC), for underfunded plans, to claim 20 per cent of corporate assets.
“Accountants began to tell their clients not to go near DB plans because of this … once that happened, you began to get a decline in new plans, and existing plans started to terminate.”
Other changes introduced by the legislation included a revision of the accounting rules, “which made financial reporting a crapshoot … before the accounting rules changed, it was pretty easy to know what your pension liability and impact on earnings would be.”
So if regulations contributed to the demise of DB plans in the United States, could a reworking of the regulations help revise them? Many say yes, but Benna is not optimistic that will happen. For one thing, employers like the predictability of the DC formula.
“The point is that regardless of whether 401 (k) existed or not, moving away from DB pensions was going to happen.”
Originally, there were only two investment options for the 401 (k): a guaranteed and an equity fund. Employees didn’t need to be financial experts to understand what they were getting into, and employers didn’t need a team of advisors, says Benna, who adds that began to change when the investment options ballooned.
“As the number of funds began to expand, you had asset consultants to monitor the funds. And now all of a sudden you needed professional help to do that … and participants were being charge as much as 250 basis points.”
He would solve that problem by simplifying the process once again. Rather than participants choosing from a slew of investment options, they could be moved to targeted maturity funds, or pre-packaged allocation models.
A plan he moved to this new structure now runs at a cost of under 20 basis points, and participants have a “proper allocating mix, widely diversified” without needing additional financial advice, at a cost.
Members who wanted more control over their investments had the opportunity to do so, but more than 90 per cent stuck with the pre-allocation mix. This type of model, says Benna, changes investment behaviour and drives a plan to a less expensive arrangement.
He also likes the idea of letting savers invest their money in established plans, like the Thrift Savings Plan, a 401 (k) scheme for federal employees. It’s well designed, has an independent board and the fees are extremely favourable, he says.
“I’m proposing that the program be opened up to allow individual retirement savers in the U.S. to be able to have the option of investing their money into that program, and to create some real competition for the private sector.”
If he were in a position to legislate changes to the retirement system, they would include auto enrolment with an opt-out option, and automatic increases of employee contributions to 10 per cent of earnings.
“The most valuable benefit of a 401 (k) is that it helps people become savers who never would otherwise … you need to be saving for retirement, no one will argue with that. That’s basically what a 401 (k) does.”