FiduciaryNews

Exclusive Interview: Treasury Senior Advisor Mark Iwry Explains the Early History of the 401k and Where We Might be Heading

February 19
00:03 2014

J. Mark Iwry is Senior Advisor to the Secretary of the Treasury and is the Deputy Assistant Secretary for Retirement and Health Policy at the U.S. Treasury Department. In that role, he is centrally involved in retirement and savings policy as Mark_Iwry_300well as related rulemaking and regulatory activity. From 1995 to 2001, he was the Treasury Department’s Benefits Tax Counsel, serving as the principal official directly responsible for tax policy and regulation relating to the United States’ qualified pension and 401k plans, IRAs, employer health plans, deferred compensation, and other employee benefits.

In recent years Mark has been recognized as one of the “30 top financial players” (Smart Money magazine), “100 Most Influential People in Finance” (Treasury and Risk magazine) (one of five in the field of Retirement and Benefits), “Investment News 20” (20 individuals expected to have a major influence on the financial services industry), “100 Most Influential People in the 401(k) Industry” (401(k) Wire), etc. Mark’s books and articles include the co-edited volume (with William Gale and Peter Orszag), Aging Gracefully: Ideas to Improve Retirement Security in America (Century Fdn. Press, 2006).  

Mark is an honors graduate of Harvard College and Harvard Law School, received a Masters in Public Policy from Harvard’s Kennedy School, and is listed in Who’s Who, Best Lawyers in America, Washington DC Super Lawyers, etc.  He is a Fellow of the American College of Employee Benefits Counsel and a member of the bar of the U.S. Supreme Court.

FN: Most people associate 401k plans with the DOL from a regulatory standpoint, but, as many veterans know, the real origin of this retirement savings vehicle is the IRS. Can you explain to those who are not familiar with the story how the IRS actually “birthed” the 401k plan?

Iwry: Yes, as you know, “401(k)” refers to a subsection of the tax code, reflecting the origin of these programs and their regulation by Treasury and IRS as a condition of their favorable tax treatment.  401(k)s  grew out of employer-sponsored profit-sharing and thrift savings plans that traditionally supplemented the basic employer-funded pension plan.

At one point, a number of the money center banks wanted to allow executives the choice to defer tax on their bonuses, by having the bonuses contributed to their accounts in the profit-sharing plan on a pretax basis instead of being paid to the executive in cash. My friend and law partner, the late Ed Cohen, a distinguished tax professor at the University of Virginia law school and leader in the tax bar, advised one of these plan sponsors as outside tax counsel. In his memoir, Deep in the Heart of Taxes (which I recommend to your readers), Ed recounts how he worked with the IRS and Treasury to sketch out a preliminary regulatory regime to make employee-elected, tax-favored retirement saving possible.

My friend, Dan Halperin, now a professor at Harvard Law School, who served as Deputy Assistant Secretary of the Treasury for Tax Policy in the late 1970s, was heavily involved as well. Treasury naturally had policy concerns about taxpayers’ potential use of elections – both in tax-qualified plans and on a nonqualified basis – to defer tax and more generally manipulate the timing of the taxation of their compensation income. So Treasury and the IRS tried to constrain these “cash or deferred” compensation elections. A related policy concern was practices that could be unduly preferential to executives, leaving out the rank and file employees. That’s why Treasury and IRS developed a preliminary regulatory structure to limit this activity, then codified a version in the tax code through the Revenue Act of 1978.

In 1980, a consultant named Ted Benna importantly expanded the 401(k). He came up with the idea of letting employees elect to have a portion of their regular salary or wages, as opposed to bonuses, (which tended to be a larger share of compensation for executives than for most workers) contributed to the retirement savings plan on a tax-deferred basis. Salary reduction made it possible to democratize the 401(k) because it provided an easy way for millions of workers to save modest amounts on a regular basis without having to take initiative on a continual basis. In the early 1980s, Treasury and IRS also proposed 401(k) nondiscrimination rules and related regulations, and with that, 401(k)s took off.

As the plans expanded, Congress, in the Tax Reform Act of 1986, replaced the rudimentary 1978 statutory scheme with a far more systematic and elaborated statutory regime, which Treasury implemented through final rules in 1988. The legislation and rules were largely designed to limit 401(k) discrimination in favor of higher-paid workers. We implemented these polices because executives’ higher tax brackets and greater resources gave them far greater incentive to postpone a portion of their compensation in order to defer tax on it (and on associated earnings) until retirement, when their tax rates were expected to be lower.

Now, some three decades and $4 trillion dollars later, the 401(k) has developed into what many view as the principal point of access to diversified participation in the stock market for the American middle class.

FN: How would you describe the differences between what the Treasury and IRS regulate versus what the DOL regulates with respect to 401(k)s?

Iwry: Both jurisdictions are very important. The DOL focuses on the various fiduciary and investment issues, which are so critical, including fee disclosure as well as other reporting and disclosure.

The role of Treasury and the IRS starts with the very creation of the plan – the official name of which is “Cash or Deferred Arrangement” – which resides in section 401(k) of the Internal Revenue Code.  Their remit includes the rules regarding favorable tax treatment, how to defer employees’ salaries, the nature of the cash or deferred elections, nondiscrimination standards, the plan sponsor’s choice of plan, withdrawals (including hardships and loans), and other matters.

In particular, Treasury has taken the lead since the late 1990s in nudging the 401(k) system away from the earlier “do it yourself” model that it followed during the first 15 years of the 401(k). Starting in 1998, Treasury and IRS issued a series of rulings and regulations defining, approving, and promoting automatic enrollment (also known as “opt out” enrollment) in 401(k) plans, as well as 403(b)s, 457 plans, and SIMPLEs.  The use of automatic enrollment and other automatic or similar features is intended to make these plans more effective in promoting saving, more inclusive, a bit more helpful to employees, and a little more like pension plans.

FN: What are the types of errors the IRS catches and generally what is done to remediate those errors?

Iwry: The basic sanction under the tax code for errors or violations under a tax-qualified plan is that the plan loses its favorable tax treatment. This means employees would lose their favorable tax treatment because of the employer’s failure to comply. In reality, most violations or errors are of a sort that disqualification of the plan would be far too extreme a penalty. Therefore, as a practical matter, Treasury and the IRS have worked out a set of intermediate sanctions over the years that generally are payable by the plan sponsor and are proportional to the nature and extent of the compliance failure. Small mistakes give rise to small penalties, larger mistakes to larger penalties. This is designed to protect employees and also to allow employers to self-correct whenever possible. This “Employee Plans Compliance Resolution System” (EPCRS) has been quite well-received.

FN: The future of the 401(k) seems to be evolving away from the dominance of investments and more towards saving. What are some of the evolutionary changes you see coming to 401k plans?

Iwry: The investment industry emerged in recent years as the dominant influence on and driver of 401(k)s. It was not always this way. In fact, self-directed investment – putting the employee in charge of determining how to invest, choosing among a considerable number of investment funds or options – is not an inherent attribute of the 401(k). The core feature of the 401(k) is the employee’s ability to choose how much to contribute, not necessarily how to invest. And 401(k) investment returns have traditionally lagged behind the returns on defined benefit pensions or other professionally managed portfolios. This is largely because the 401(k)s traditionally were invested by individuals, most of whom lacked the knowledge and discipline of investment professionals. These individual investors also traditionally have been subject to essentially retail investment fees and expenses rather than wholesale institutional cost structures.

It does not need to be this way. We’re getting more advice, lower-cost target date funds and other diversified options, and managed accounts. In fact, 401(k) plans could evolve toward the use of professionally selected collective investments determined and regularly rebalanced by investment managers or fiduciaries in accordance with ERISA’s fiduciary standards involving more limited participant choice, at least in most instances – like pension or traditional profit-sharing plans. Whether this eliminated or (as is more common) just limited the scope of employee investment choice (perhaps to those participants who affirmatively choose choice), it would reduce expenses and provide professional discipline and more systematic asset allocation, diversification and rebalancing, including less overconcentration in employer stock.

Over the last 15 years, Treasury has tried to strengthen the 401(k) and bring in more moderate and low income individuals. Our focus is both on increasing participation in existing plans – primarily through the automatic enrollment initiative which Treasury first approved in 1998 – and making plans available to more employees.

These efforts have made considerable progress. Automatic enrollment has increased participation from 2 out of 3 or 3 out of 4 (under traditional, opt-in enrollment) to as high as 9 out of 10 of those eligible.

The DOL also has advanced the ball by identifying qualifying default investment alternatives consistent with the Pension Protection Act of 2006. The whole idea of “automatic” represents an evolutionary step in the 401k concept away from the early “do-it-yourself” model (which might be viewed as 401(k) “1.0”). There’s still free choice – employees can always opt out – but automatic enrollment overcomes the inertia that favors not doing anything. We’ve since started to give employees more guidance using behavioral strategies, beginning with simple auto-enrollment (call this “401k 2.0”).

In recent years, looking to bring about a stronger 401(k) – a “401(k) 3.0” model – we’ve been working to encourage employers to automatically enroll not only new hires, but existing employees too, to use an initial default contribution rate of 5 or 6 percent rather than a rate around 3 percent, to implement automatic escalation of contribution levels with each year of employment, to increase employer matching and nonmatching contributions if possible, and strengthen the plan in other ways.

FN: As you know, 401k plan fees have been a big issue, especially for smaller plans. There’s a trend to consider using Multiple Employer Plans (i.e., “MEPs”) to create economies of scale in order to reduce fees. From an IRS standpoint, is there any interest in the possibilities of MEPs?

Iwry: Yes, as part of our effort to promote more retirement security and saving, Treasury has been interested in encouraging and supporting all types of retirement plans, including defined benefit and profit sharing plans.  This includes expanding options such as multiple employer plans, consistent with appropriate safeguards, to bring more smaller employers and their employees into the system.

FN: Do you have anything else you’d like to add for our readers’ benefit?

Iwry: The 401(k) plan is a key tool for American workers to help save for retirement and other long-term purposes that are fundamental to economic prosperity. The 401(k) glass is half-empty in the sense that a large portion of the workforce is not eligible for a plan. But the 401(k) glass is half-full in the sense that 401(k)s reach a large portion of the middle class – over 50 million employees. Yet many employers still haven’t sponsored a plan, especially smaller employers that might lack the confidence that they can continue to maintain and fund retirement plans.

We need to do more, and the President has therefore proposed legislation to provide for a breakthrough in retirement coverage by automatically enrolling in payroll deduction IRAs tens of millions of workers who currently have no access to an employer-sponsored plan. We continue to urge Congress to enact this legislation, which would provide a tax credit to participating employers and is supported by many organizations in the private and nonprofit sectors. In the meanwhile, as the President announced in his 2014 State of the Union address, Treasury is moving to offer payroll deduction Roth IRAs – called the myRA program – invested in safe, simple retirement bonds backed by the full faith and credit of the United States. These are intended for individuals who are not eligible for any 401(k) or other employer-sponsored plan, if their employers are simply willing to allow the payroll deduction.

FN: Mark, we’re especially grateful for you taking the time during this busy portion of the year to share your thoughts with FiduciaryNews.com readers. I’m sure they appreciate it and I encourage to attend those conferences where you’re speaking so they can hear firsthand your insights, knowledge and experience.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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2 Comments

  1. Mike Smith
    Mike Smith February 19, 17:23

    Chris,

    Thank you for this excellent piece!

    Sincerely,

    Mike

  2. Steve Mueller,,,ERISA COUNSEL
    Steve Mueller,,,ERISA COUNSEL February 19, 20:23

    Actually long before Ted Benna and the Revenue Act of 1978, Hand and Associates developed salary reduction money purchase pension plans. Affectionately referred to as “before tax bite plans” , these plans were submitted to and issued FDLs by the IRS. I testified in 1975, right out of law school before the House ERiSA oversight committee regarding then “freeze” of these arrangements courtesy of ERISA Sec, 2006 that these plans someday would supplant traditional pension plans and should be condoned by Congress, Hence the grandfathering of pre-ERISA salary reduction money purchase pension plans under IRC Sec. 401k. Now you have the whole story, And the grandfather of the 401k plan. These plans were also crafted in the form of basic documents with adoption agreement containing plan variables and through the IRS regional office at the time in Austin, Tx, working with George McQuiston were the forerunner of regional prototype plans which soon matriculated into the array of prototype plans now on display by vendors,

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