How did the 401(k) start?

You may wonder how did the 401(k) come to be, and why has it become the de facto standard for most Americans?

In building for a healthy retirement, the concept of the three-legged stool has been the aspirational approach since 1949. It includes:

1. Social Security to help keep any American out of poverty but not much more

2. Employer benefits such as a 401(k) or pension – the key for most

3. Personal Savings – those that get ahead of the game with emergency plus savings

Some people may not have all three legs, as they don’t have access to retirement benefits or don’t do a particularly great job of building personal savings; and will have to rely on the one or two legs they have.

Retirement Benefits in the United States and How it Started

Before we dive into the evolution of the 401(k), it’s important to understand where we began. When we became a country, there was no such thing as retirement benefits. We were a very agrarian society at the time, people often worked until they died, and of course, most people did not live as long. Consider that in 1900, the average American lived to 47 years of age.

What is a pension plan?

Pensions started in the US after the revolutionary war for veterans and were approved and funded by the US government. Yet, the first private sector pension plan did not start until 1875. For the private sector, the employer fully funded the pension for the employee, which sounds desirable to most all of us. Early adopters of pensions in the late 1800s and early 1900s were in more “dangerous and physically hard” industries such as railroad and mining. As more pensions came to be, there were significant qualifiers such as 10- to 20-year tenure requirements, age restrictions, and more.

And while there is a perception that most Americans had access to pensions prior to the 401(k) that is far from the case. As the industrial revolution came into full swing, more well-paying jobs developed in cities. The Great Depression drove the beginning of Social Security in 1935 legislation, since it became apparent the U.S. had no backstop with the development of a more modern work life. As our country and businesses grew, many large businesses adopted pensions and by 1980, it is estimated 38% of Americans had access to a pension.

With the advancements in medical care, wealth, and living standards, we began living longer. By 1950, the average American was living to be 68 years old. Today, the average is around 80. Longer lifespans mean longer retirements, and that creates very significant business liabilities for pension plans. This was a core driver that helped cause the decline of pensions benefits over the last 40 years or so. Before, a pension planning to cover 3-8 years for a retired employee was a manageable liability for a business. When this changed to 15-30 years for most retired employees, pensions became a large liability for companies to manage.

In fact, pension liability not only impacted in a business investing for growth, but it could also impact the very survival of a business if the liability grew too large. Before there was pension insurance, if a company failed most, if not all, the pension benefits were gone for that company and its employees. Basically, managing market risks and aligning payouts with the growing length of retirement grew more and more complex and costly. Ensuring jobs and business growth are obviously the first priorities of a company; not finding a means to fund pensions. And perhaps a little by accident, the solution to make retirement benefits more widespread and less a burden for a business was about to present itself.

How did a 401(k) start?

In the Revenue of Act of 1978, section 401(k) created what has evolved to be America’s most popular retirement solution. At first, it wasn’t situated to take on what is needed to truly be the third leg of the retirement savings stool. The 401(k) was initially designed to be a suitable replacement for executive profit sharing plans and ensure more employees were included. The 401(k) provides tax advantages for both employees and employers to contribute to the retirement plan. But as regulations better supported the 401(k) solution to be a flexible retirement plan that could cover employees without all the pension liabilities, companies started preferring 401(k)s.

A Lot of New Features Enabled 401(k)s to Be a Strong Retirement Benefit

401(k) plans needed to evolve to really be an effective means for Americans to be retirement ready, and they really have. Most of the key legislative changes over the last 40+ years are providing more Americans access to a 401(k), enabling more small businesses to offer a plan, making it simpler to enroll employees, and allowing tax-deferred and Roth contributions to help more Americans build meaningful nest eggs. Some of the highlights include:

• As 401(k) plans are meant to benefit all employees, not just high earners, IRS tests were instilled in 1986 to help ensure this was the case.

• Yet, testing could make it difficult for small businesses to offer a plan, so the Safe Harbor 401(k) feature was added in 1996 as part of the Small Business Job Protection Act. This plan design automatically satisfies IRS testing needs of the business.

• Getting participants to enroll could be an issue, and in 2000, automatic enrollment was enabled and further enhanced in future legislation. This feature automatically opts employees into the plan and has proven effective in getting more Americans to start saving in their 401(k) plan.

• In 2001, The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) enabled:

  • Catch up contributions for those 50 and older.

  • Introduction of the Roth 401(k) feature that became effective in 2006.

• Most recently, Secure Act 2.0 of 2022 enables:

  • More tax credits for small business to cover the cost of 401(k) benefits.

  • Employers to match Roth contributions vs. just tax deferred contributions. (Roth was only available for employee contributions previously).

  • Automatic enrollment for 401(k) plans as of 2025.

  • More part-time workers access to 401(k) – 500 hours of work for two consecutive years will be provided access to their company plan as of 2024.

  • Employers to provide gift cards as an added incentive to participate.

401(k)s are now estimated to cover more than 2/3rds of Americans. Compared to pensions, that is a big increase. Automatic enrollment and automatic paycheck deductions have helped many Americans build a nest egg. The evolution of model portfolios and target date funds have helped more Americans who are inexperienced in investing to get off on the right foot. While more can be done – especially in growing access to 401(k)s as close to 100% as possible -- to further improve 401(k)s, you can see how 401(k)s have evolved to be the preferred retirement savings solution for Americans.

Takeaways:

• Beyond some public sector coverage typically for veterans, retirement benefits were not available in America until 1875 with the first private pension plan. There were only a little over 300 companies offering pension plans in 1919. Social Security did not come into being until 1935.

• The concept of three-legged stool for retirement came to be in the mid 1900s. It consists of Social Security, Retirement Benefits, and Personal Savings. However, many people did not have access to retirement benefits even with the growth of pensions.

• With the advent of the Industrial Revolution, better medical advances and diets, Americans began living longer, and our thinking about retirement solutions started to evolve.

• With longer life spans, pension plans became a large liability for companies to manage.

• The 401(k) was part of legislation that was enacted in 1978 to help create incentive to cover more employees receiving tax-advantage profit sharing.

• Over the last four decades, numerous changes to the 401(k) features and rules have enabled it to be a robust, flexible retirement solution. 401(k)s became more and more popular for businesses to offer and have increased coverage of retirement benefits in America.

• Key enhancements to 401(k)s include the Roth 401(k), catch-up contributions, a Safe Harbor 401(k) design to make it simple to administer for small businesses, and generous tax credits for small businesses to start a 401(k).

• Automatic enrollment, automatic contributions via payroll, target date funds, and model portfolios have helped make it simpler and better for employees to contribute and build for a comfortable retirement.