The 401(k) Revolution Was a Victory for Retirement Savers
A parade of news stories tell Americans they face a crisis of insufficient retirement saving, with “retirement savings gaps” in the trillions of dollars. Many commentators look back fondly on the days of traditional “defined benefit” pensions, lamenting the shift to 401(k) and IRA plans. Some advocates propose big changes to our retirement system, such as expanding Social Security, repealing tax preferences for 401(k)s, and setting up retirement plans run by state governments.
But here’s the reality: in our 401(k) world, more Americans are saving larger amounts for retirement than ever before. Retirement savings are at record levels, retirement incomes are rising, and Americans are less dependent on the financially-troubled Social Security program. Turning back the clock on pensions wouldn't make sense, even if it were possible.
Traditional “defined benefit” (DB) pensions offered workers a fixed monthly benefit that lasted for life. That sounds great. But to promise a decent, guaranteed benefit to all employees is an expensive and risky proposition for employers. Just ask state and local governments, whose required pension contributions have tripled since 2001.
Those costs and risks explain why private sector employers never really offered a decent DB pension benefit to all employees. To begin, DB pension coverage never exceeded 38% of the workforce. Even if you did participate in a DB plan, it didn’t mean you’d get a solid benefit. Many employers required that employees retire with at least 15 years of job tenure before they could qualify for a pension. If you were forced to leave your job mid-career, you potentially lost hundreds of thousands of dollars in future retirement benefits.
Those factors help explain why even in 1980 – near the peak of DB pension coverage – barely half of the richest quarter of new retirees received any sort of private pension benefits, according to Social Security Administration data. In the poorer half of the population, almost no one received any private pension benefits.
Worse, many employers didn’t fund their pensions adequately, so if the corporation went out of business employees lost benefits. If you worked for companies from Bethlehem Steel to Lehman Brothers, from Polaroid to Pan Am, you found out that a “guaranteed” DB pension benefit isn’t always guaranteed.
In 1974 the federal government passed legislation requiring employers to lower DB pension vesting requirements and to improve their funding of benefits. But once employers had to offer DB plan benefits to most employees, not just the longest-servings ones, and had to fund the benefits they promised, employers stopped offering DB pensions. In other words, these plans weren’t scalable to provide decent benefits to the whole working population. Today, DB plans are common only in state and local governments, which aren’t subject to the federal government’s vesting and funding rules. For most private sector workers, 401(k)s are the main retirement saving vehicle.
On paper, 401(k) plans don’t look nearly so great. While DB pensions were funded by employers alone, 401(k)s usually involve both employer and employee contributions. And while employers bear the market risk with a DB plan, with a 401(k) employees must choose their investments and accept the ups and downs of the market.
But 401(k)s have some important upsides. For one, employers are actually willing to offer 401(k)s. Today, 61% of all employees are actively participating in an employer-sponsored retirement plan, far higher than during the DB pension era. And more savers means more saving: retirement plan contributions are also up, from less than 6% of employee wages in the 1970s to 8% today. That’s a more than one-third increase in the amounts that Americans are setting aside for retirement.
Americans’ retirement savings are now at record levels. U.S. retirement assets are over twice the average in other developed countries and our total retirement incomes match up well with our OECD peers. But retirees in other developed countries rely far more heavily on pay-as-you-go pensions similar to Social Security, which are costly to sustain as their populations grow older. Given how difficult it has proven for politicians to fix Social Security, it’s reassuring that Americans are diversifying their sources of retirement income.
More workers participating in retirement plans helps increase incomes once they retire. Since 1984, the percentage of new retiree households receiving private retirement plan benefits has nearly doubled, according to a new Census Bureau analysis of tax data. Since 1989, total retirement incomes have risen by at least 50% above inflation for poor, middle class and higher-income retiree households alike.
But what about claims that 401(k)s have high fees, or that ordinary Americans don’t know how to invest? Those claims once may have been true, but no longer. The typical large 401(k) plan has a per participant fee of about $62, versus $108 for large state government employee pensions. Likewise, economist Josh McGee of the Manhattan Institute has shown that over the last decade 401(k) investment returns have matched those of traditional pensions, as 401(k) investors embrace low-cost index funds and automatic investment strategies.
But won’t workers who retire with a big lump of cash in their 401(k) spend it too fast and run out of money late in life? In fact, numerous studies show that even well-off retirees reduce their spending as they age, even after counting healthcare costs. Instead of running out of money, retirees’ financial assets commonly rise as they get older.
Compared to DB pensions, 401(k)s have one final important advantage: human nature. We’re creatures of habit, and once we sign up for a 401(k) and decide how much to contribute, most of us will keep on contributing through good times and bad. DB pensions, by contrast, require complex annual calculations of how much the employer must contribute, calculations that depend upon assumptions regarding employment growth, longevity, interest rates and other factors. DB pension sponsors, whether they’re governments or private employers, often don’t want to make their full annual contributions. And by tweaking these actuarial assumptions DB plan sponsors can get away with paying less – at least, until the plan runs short of cash. You will be very hard pressed to find a DB pension – especially in the public sector – that’s close to fully-funded.
Our retirement system isn’t perfect and there’s much that policymakers can do to improve it. We need to spread access to 401(k)s, particularly among small employers. Multi-employer 401(k) plans could lower the fixed costs and regulatory burdens that prevent small businesses from offering plans. Likewise, about half of 401(k) sponsors now automatically enroll their employees, a policy which greatly increases participation. That should be made a universal best-practice, if necessary by tying automatic enrollment to the federal tax preference for retirement saving. And, of course, Social Security reform is needed to keep the program solvent and to improve the safety net for the truly poor.
The two most important questions regarding our retirement system are “How many Americans are saving?” and “How much are they saving?” More Americans are saving larger amounts for retirement than ever before. More can be done, but we should recognize that the 401(k) revolution has largely been a successful one.
