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5 Dramatic Ways 21st Century 401k Plans Differ from the Original 1980s Version

June 02
01:25 2015

Research in behavioral finance has changed 401k for the better. In many ways, today’s 401k plans may be unrecognizable to the first ones created in the early 1980s. We can list five dramatic differences between modern 401k plans and 143794_8126_1958_Oldsmobile_stock_xchng_royalty_free_300their distant Reagan-era cousins: More Universal Participation; More Investment Choices; Better Investment Choices; Greater Automation; and, Greater Transparency. In what ways have these changes benefited retirement savers and plan sponsors? Have any of these changes done more harm than good. Let’s explore those differences and what was behind them.

In the Beginning
It was early in the Reagan administration that people started questioning the continued viability of the traditional pension plan. It suffered from two practical failures. First, as a result of the long 1970s economic doldrums that culminated in the Great Recessions of 1980 and 1981/82, it failed to deliver on its promise of providing employees with reliable retirement income. Second, it exposed companies to financial liabilities that left them vulnerable to either bankruptcy or takeover. All the while, with Reaganomics poised to launch the greatest post-War bull market in the summer of 1982, smart investors (and these included a majority of younger workers) felt safer being responsible for their own retirement savings plan.

“It wasn’t until late 1981 that the IRS imposed regulations for the 401k plan,” says John M. McArthur, Senior Partner & Chief Investment Officer at Krilogy Financial in St. Louis, Missouri. “At that time it was early in the thought process of shifting the retirement burden more onto the employee, whom had been used to a defined benefit/pension type format that not only provided a specific dollar amount at a specified age in retirement, but that also had taken care of the investment decisions relating to accumulating that benefit, as well.”

While defined contribution plans existed for some time, they were generally funded by the sponsoring company. What set the 401k plan idea apart was the ability for employees to add their own contributions. Susan Conrad, a Director at Plancorp, LLC Retirement Plan Advisors in St. Louis, Missouri says, “401k plans have changed drastically since the 1980s. A ‘401k plan’ is actually a profit sharing plan with a 401k provision. 401k was meant to be a source for employees to contribute if they choose.”

Perhaps the first to notice the benefits of the 401k concept were highly compensated employees (HCEs), who realized this new retirement savings vehicle would not only allow them to defer more taxes, but build up a significant retirement nest egg at the same time. “It seems as if Employers and Plan Sponsors initially created retirement plans solely for the benefit of the owners and highly compensated, at the expense of the rank and file,” says Scott Laue, a financial advisor at Savant Capital Management in Rockford, Illinois.

It wasn’t just plan design that looked different in the 1980s, plan providers also took on a very different appearance. “The 1980s plans were sold primarily by insurance agents who did one on one enrolling, many times with 25% allocated to life insurance to pay for the time involved,” says Joe Gordon, Partner at Gordon Asset Management, LLC in Durham, North Carolina. “The fund industry invaded the space and coupled with the tech revolution, plans started lowering fees and daily valuation became a reality with quarterly statements. Very few plans were sold beginning in the 90s with life insurance any longer. There were no safe harbors for ADP/ACP testing so plan enrollment was crucial for HCEs for testing.”

But we’re getting a little ahead of ourselves…

The Plans They Are a Changin’
It quickly became apparent the popularity of the 401k promise was not shared as enthusiastically by the average worker compared to the highly compensated worker. As a result, the DOL added non-discrimination testing as part of its 401k regulations. This has reduced the occurrence of “top-heavy” plans. “While occasionally that still exists somewhat today,” says Laue, “we more often see plan designs that are really based on helping out all employees. Company profit sharing and matching contributions are shared pro-ratably for the most part, allowing participants to share in the corporates success.”

But the DOL in the 1980s was perhaps more understanding than today, as it realized the ability to save large sums of money made offering a 401k plan too attractive for owners and executives. In came rules that allowed greater savings opportunities – as long as the plan sponsor offered minimum incentives to all employees. “The Safe Harbor provisions were the most beneficial change to the 401k landscape,” says Conrad says. “Previously, the 401k contribution percentage from owners and executives was limited based upon the percentage contributed by their employees. Employers utilizing the Safe Harbor option contribute a 3% of compensation contribution to all employees or one of the approved employer match formulas. In exchange, the owners and executives can contribute the maximum 401k contribution regardless of the percentage contributed by their employees. The ratio tests that resulted in refunds to the owners or executives are eliminated.”

It can be said the young adults of the 1980s were predominantly an entrepreneurial class. Indeed, they not only sought to create their own businesses, but the lure of creating their own retirement savings plan captivated them. The 401k not only provided the venue for this, but it regularly contributions and more frequent reporting (especially after the mutual fund industry captured the product) created a kind of game that compelled employees to contribute more and more as they watched their assets grow faster and faster. A raging bull market only added fuel to this fire. It very quickly became apparent one could fund one’s retirement solely with one’s 401k savings, barring any unforeseen bear market, of course. “Fast forward to today and the 401k source is the primary source for most retirement plans,” says Conrad says. “Employee contributions were a minor part of the equation [in the 1980s] but today they are the primary part.”

This shift significantly hastened the demise of the pension plan, as companies desired to shed this albatross and, younger employees in particular saw no value in a relatively low fixed retirement income. Laue says, “A big change particularly in the larger employer arena is the freezing or elimination of the traditional defined benefit pension plan. While for many, along with social security, that was the retirement source of income, it’s now rare to find those in the private sector who still are accruing benefits in a traditional DB plan.”

The trade-off to employees was simple: In exchange for maintaining the self-discipline to saving regularly and invest wisely, plan sponsors would free them from the vesting shackles of defined benefit plans and incentive them with matching and profit sharing funds in their defined contribution plans. It was an offer the Masters of the Universe could never refuse and it forever altered the retirement savings landscape. “The biggest change today is perhaps the responsibility an employee/participant has to take in understanding and quantifying what a successful transition to and through retirement looks like,” says McArthur says. “The 401k plan has become an increasingly larger part of that equation as in income supplementation benefit pool, with pension plans going away and the longevity of Social Security under some pressure.”

The 401k plan was the classic “if you build it, they will come” scenario. On one hand it attracted retirement savers. On the other hand, it proved equally attractive to those creating investment products for retirement savers. Bringing these two parties together was the growing computer power utilized by plan recordkeepers. This resulted in a dazzling array of investment options. Gone was the simple three-option plan. In was the cavalcade of choices courtesy of your friendly neighborhood TPA. “Technology has led to a far greater array of investment choices,” says Porter L. “Buddy” Ozanne, President at Probity Advisors, Inc. in Dallas, Texas. “Today, an employee/participant can choose from options ranging from a self-directed brokerage account, giving him/her access to almost any marketable security, to the option to turn the investment management over to a professional manager, and all of these choices are now available at a very low cost relative to just the basic plan costs back in the 1980s.”

Not only did we see more investment options, but we also saw better investment options. Laue says, “The mutual fund industry has been fairly quick to respond in offering choices – first it was offering a money market, a bond fund and a stock fund, truly giving the participant some choices, then blended/balanced funds were added to the mix, then the insurance industry created GIC options, then asset allocation became in vogue, then target date funds were all the rage and now the emphasis is on income generation and creating products that are designed so one does not outlive their balance.”

But what good was leading a horse to water if you couldn’t get it to drink. For all the good 401k plans have done for people who have participated, it gnawed at regulators, plan sponsors, and plan service providers that so many employees looked this gift horse in the mouth… and did nothing. Joe Gordon, Partner at Gordon Asset Management, LLC in Durham, North Carolina says, among other things, auto-enrollment is a key change to 401k plans.

But, why did it take so long for auto-enrollment of became as universal as it is today? It wasn’t until the Pension Protection Act of 2006 (PPA) that Congress finally removed the reins from regulators and allowed the use of numerous techniques long proven successful by research in behavioral finance. Katerina D. Egan, Senior Consultant at Chernoff Diamond in New York, New York says, “The incredibly low savings rate amongst those that will need it most triggered the encouragement from the DOL to incorporate auto-enrollment and auto escalation features within a plan design.”

The PPA combined the inertial behavior of an shifting the 401k plan focus from an opt-in to an opt-out action with the availability and use of default investments, allowing employees to set their retirement saving and investing on cruise control. “By far the most helpful change is the automatic opt-in option,” says Nicole M. Boyson, Ph.D. an Associate Professor of Finance at Northeastern University in Boston, Massachusetts. “The default option for 401k participation is ‘YES’ and employees that wish to opt out of participation must make a point to do so.”

Finally, today we see something almost unheard of in the 1980s – fee transparency. Ken Weber, President of Weber Asset Management, Inc. located in Lake Success, New York says, “The key difference is the greater transparency. Now it is possible, in ways not possible in the 80s, to really get a handle on all the fees being charged. But sadly, there does still seem to be plenty of opportunity for obfuscation.”

Ozanne says, “Back in the ’80s, and apart from large company plans, the 401k marketplace was dominated by proprietary product manufacturers… mostly mutual fund companies and insurance carriers. There was precious little fee disclosure, with much of the cost surreptitiously passed on to the employee/participant. As a result, employees were stuck with expensive plans with poor investment options. Today, greater transparency has forced plan costs down, with more costs picked up by plan sponsors, giving the employee a far better deal. Furthermore, technological advances have allowed access to a far greater spectrum of investment choices (including automated, professional asset allocation), empowering employees to achieve a greater degree of success with his/her financial goals.”

“Transparency has become a much greater theme in today’s 401k plan for the benefit of the employee/participant,” says McArthur says. “As the 401k is becoming the key driver to helping supplement the retirement lifestyle that many aspire to achieve, employees of company 401k plans are feeling more pressure and responsibility of having a greater understanding of what they’re owning and investing in and also what they are paying for it. Within the evolution of transparency lies the great importance of employee financial education from the 401k provider to help guide the employees down the proper path at the individual participant level.”

As Shakespeare has said, “Aye, there’s the rub.”

Be Careful What You Wish For
In keeping with our Bardly theme, it appears all these choice may have hoisted retirement savers on their own petard. “The worst change in 401k plans appears to be the combination of more sophisticated investment choices combined with the lack of employee investment education being offered,” says McArthur. “401k Plan Sponsors want to protect themselves from a fiduciary standpoint by offering a diverse enough suite of investment offerings, yet it’s up to the servicing company/adviser of the 401k plan to be willing and able to help provide the resources and educational support needed at the participant level.”

Things go from bad to worse when you mix misplaced expectations with a lack of financial literacy. James Carlson, a Partner at Questis Inc. in Charleston, South Carolina says the “worst change” is “assuming that individuals are smart enough to allocate their own retirement savings. People crave a pension like result but have no idea how to get there without professional assistance. The need for personal management to achieve a pension like result is still there. The worst change is the lack of industry realization of this problem and the unwillingness to fix it. Employees need education and professional management options that adhere to a fiduciary standard.”

In some ways, we still have the classic problem, perhaps a remnant of the market scare of 2008/09, where retirement savers invest too conservatively. “Strangely,” says Ken Weber, President of Weber Asset Management, Inc. located in Lake Success, New York, “many plans now tout the thousands of investment options available to participants. Yet rather than that being a positive development, in reality ‘analysis paralysis’ sets in and many folks freeze; they often just leave their money in money market funds.”

The industry, at the urging of the DOL, has tried to address this problem. Carlson believes that is helps that the investment providers have introduced “target date funds, or solutions that self-adjust as the participant gets closer to retirement age. It’s driven by the fact that most investors do a miserable job of allocating their retirement funds inside the 401k plan. It’s a step in the right direction, but a far cry from what the investor really needs.”

Conrad agrees. He says, “Allowing participants to build their own investment allocation was the worst decision for 401k participants. Most employees are not equipped to select an appropriate investment allocation. History has shown us that most were paralyzed and remained in Money Market which failed to keep up with inflation. Others took the dart approach randomly selecting a number of mutual funds that resulted in investment duplication or participants assuming too much or too little risk. Both options reduced employees’ probability of success. Current participants have numerous risk-based or Target Date solutions offering a diversified allocation with a personalized level of risk. I wonder what the participant experience would have been if plans had moved directly from Trustee direction to asset allocation solutions? They need help understanding how early they should start saving and how much they need to save in order to replace their income at retirement.”

Still, sometimes the cure is worse than the disease. Egan says, “I think it’s the incredible dependency on Target Date solutions and the lack of oversight when selecting Target Date Funds.”

Finally, we circle back to the service provider infrastructure. “Frankly,” says Ozanne, “I can think of only one change that may prove to be less beneficial to the plan participant and plan sponsor over the last thirty years or so, and that is the inability of much of the 401k plan ‘sales force’ to render any meaningful advice to the plan participant. I have been in the industry since its inception, and I have some mixed feelings about whether this change has been poor or a blessing. Our firm, as a registered investment advisory firm, providing ‘3(21) and 3(38)’ investment advisory services to 401k plans can and does render advice to plan participants. However, historically, more 401k plans have been sold and serviced by non-registered brokers, who can no longer render advice to plan participants. While the elimination of the non-registered broker from the ‘advice giving business’ has reduced the possibility that the plan participant may receive bad advice, it has also prevented many employees from receiving any advice at all. Whether this regulatory change is good or bad remains to be seen.

This is Not Your Father’s 401k
How ever you might consider the impact of the changes that have created the 21st Century 401k plan, it’s obvious an employee – or even a plan sponsor for that matter – coming directly from the 1980s to today would not recognize many aspects of the country’s most popular retirement savings vehicle.

To begin with, does anyone still believe they’re not paying for their 401k plan? Weber says, “Well, for the thousands of insurance firm salespeople who pushed their plans as ‘free,’ there would be a huge kick to the gut when they realized that no plans can ever be allowed to say they are ‘free.’”

For the most apparent change, one need look no further than the plan’s menu options. Boyson says the most unfamiliar aspect of today’s 401k plans to a time traveler from the 1980s would “most likely be the very large number of investment options offered by many plans.”

It’s not just the option menu, it’s the entire investment process. “I believe that the access to an incredibly broad variety of investment and administrative options in today’s plans would have been very novel to those of us who participated in the 401k marketplace back in the 1980s,” says Ozanne. “From an investment standpoint, the addition of target date funds and managed models has greatly simplified cost dollar averaging and rebalancing to age appropriate allocations. On the administrative side, the addition of automatic enrollment and automatic contribution escalation have been tremendous aides in increasing participation and satisfaction in plans and have really done a lot to get folks on the right footing for their retirement. This is a far cry from the 1980s when you were handed a number two pencil, an enrollment form, and a bundle of mutual fund prospectus and told to have at it. Today, the fiduciary standard has implications from a compliance standpoint for wirehouses and traditional broker dealers. Today’s movement behind transparency and owing a fiduciary obligation to the participant should absolutely be first and foremost, and the fact is that new industry regulation is often first responded through a strict compliance lens. While these types of changes are generally transitory as the industry alters it delivery model in response to new regulation, in the short term, some participants may actually receive less financial advice than they may have received previously. In this same vein, an area that bears watching due to the potential for far reaching and unintended implications is how the Department of Labor and SEC will ultimately interpret and regulate a plan sponsor’s fiduciary duty related to their providing participants with target date and lifestyle funds.”

Sometimes total control, even for the entrepreneurial 1980s set, might be a bit too much. After all, for most people – and especially busy entrepreneurs – managing a personal retirement plan should not interfere with one’s revenue generating priorities. Conrad says, “A 401k participant from the 1980s would not understand participant directed accounts. In the ‘80s Trustees determine the investment options and the allocation for the entire plan. This included the 401k contributions made by employees. Maybe this was not the best solution because participants regardless of age were invested in the same stock/bond mix and therefore the same risk level. Younger participants might want to carry more risk while older participants might need to reduce their equity exposure. However, the participant directed environment has not turned out well either.”

On the flip side, the incredible ease of automation found in today’s 401k might seem downright alien to an 1980s retirement saver. Under this category, Egan lists “Auto Enrollment, Robo-Advisory Services, and Target Date Asset Allocations.”

Old time plan sponsors might be surprised to see, as Carlson puts it, “A new wave of plans that actually adhere to a fiduciary standard and serve to mitigate fiduciary liability for the plan sponsor.” He says they might not recognize “the outsourced ability to hire and reduce fiduciary liability with ERISA 3(38) or 3(21) service providers. Firms that act as a 3(38) or 3(21) can offer tremendous value to the plan sponsor. Also the flat fee for record keeping or 3(38) duties – the move away from asset based fees would be very unusual to someone 30 years ago.”

McArthur sums things us when he says, “In today’s 401k plan structure, you’ll see a lot more flexibility from a plan design perspective to help meet the needs of not only the adopting company, but also its participants, as today’s 401k plans have become an attractive retention tool for employers. For instance, we’ve seen the evolution of the Safe Harbor benefit, which helps favor the highly compensated employees by allowing them defer the annual allowable maximum regardless of what the group contributes, but also provides either an incentive match or a flat company contribution percentage on all other participating employees behalf. In wasn’t until 1984 that non-discrimination testing was written in to law, so much of the changes you see today are in the spirit of fairness and transparency so that both employers and employees have an opportunity to save in a tax-favorable manner in an effort to materially impact their retirement outcome.”

Who knows what the next thirty-five years will bring.

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s (including information on the new wave of plan designs) every 401k plan sponsor and service provider wants and needs to know. Alternatively, would you like to help plan participants create better savings strategies? You can buy Mr. Carosa’s latest book Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort right now at your favorite on-line or neighborhood book store.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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