The 401(k) savings tool has come a long way since its inception, offering more options and versatility than ever before. The problem is that many plan participants aren’t aware of these changes, and that can result in unproductive plans which are greatly affecting retirement outcomes.
When I speak with folks who have a 401(k) at work, it seems they are just not receiving the proper information on their plans, which may be posted on their employer’s company website or in a long form letter filled with confusing technical jargon.
This has been a problem with 401(k)s from the very beginning. There has been no advice or guidance on what is arguably the largest pool of retirement savings for most individuals.
Let’s take a look back to when 401(k)s began. The term 401(k) is the section of the IRS tax code that created retirement plans. Before the plan’s creation in 1978, the only retirement plan that was available to most individuals was the defined benefit plan. These plans were the opposite of how 401(k)s currently work. A defined benefit pension plan is based on one's salary for a certain period of time. The company then calculated how much of the investment would be required to be put away for the individual's future retirement.
A 401(k) actually defers income, meaning you are putting your own money into the plan. So as 401(k)s began to evolve, companies started to make a small matching contribution as well. This benefit has slowly declined, and even disappeared, at some businesses.
The central idea with the 401(k) was for the employees to take control of their own retirement, and was designed to augment the defined benefit plan. This has changed as well!
Not many options
When the 401(k) began, the plans offered very limited choices. In some plans the only choice was a savings account, offering a certain percentage earning on the employee’s contribution. That was it.
At that time, companies were very hesitant to start 401(k) plans. One of the first organizations to do so was Hughes Aircraft Co. Once employers learned the 401(k) was a great alternative to funding the organization’s massive defined benefit plan liability, they became very popular. Johnson & Johnson, PepsiCo, Honeywell and JC Penney hopped on board the 401(k) train. And as the plan’s popularity grew, companies began to offer different types of investment choices, including the addition of mutual fund selections. But again, the choices were very limited and there really was no guidance or advice offered to early 401(k) participants.
It took employees a longer time to catch on with the 401(k) plan. They were used to seeing a certain deduction in their paychecks for their defined benefit pension plan. Now they were asked to choose how much they wanted to defer and what investments they wanted for their retirement. It was a shock to their system!
Another feature of the 401(k) plan was that pre-taxed dollars were deducted. As participants increased their savings it also lowered their taxable income. The 401(k) offered a lot of benefits to a participant, but still not a lot of features or guidance.
Fast forward to today, where some 94 percent of private employers offer a 401(k) plan, which is incredible progress. In the past 30 years the 401(k) has changed and companies began to customize their respective plans. Some added lots of options to their plan menu. (I have seen companies with more than 200 investment options in their plan. Talk about options overload!) Others did the opposite and subtracted options.
Most never change allocations
It’s very interesting that, with all of this adding and subtracting, close to 80 percent of the folks who enroll in a 401(k) at their workplaces never change the way that their invested dollars are allocated.
I’ve run into the scenario where a participant thought their 401(k) account was growing, only to discover it was earning less than one percent! Most folks really miss this. The growth is due to the contribution of their OWN money and really nothing else.
It’s great having different options available, but you need to know how and when to make changes. Many folks call their plan administrator’s 800 number or go online to seek help. The only information they used to receive was that the questioned mutual fund was a large cap growth fund, or that the fund was a small cap value fund. In other words, just basic information. And the phone representative was prohibited from offering guidance or advice on changing funds or re-allocating money.
So to recap, from its birth in the 1980s until early-2000 the 401(k) plan had become the main retirement vehicle for American workers. The growth has been spectacular, yet there was still no guidance and no advice for participants in the plan.
All this changed in 2006, mainly as a result of the collapse of Enron. As Enron was disintegrating, the organization’s chairman, Kenneth Lay, was exhorting employees to buy more Enron stock through their 401(k) plans. Many followed his ill-conceived advice and lost not only their jobs, but their retirement savings. It was a real mess. So in response, Congress passed the Pension and Protection Act of 2006.
This act created one of the best options available for a 401(k). The “brokerage window” allows 401(k) participants to move a portion (and in some cases all) of their 401(k) dollars over to a self-directed brokerage account, commonly called an “SBDA.” Today, the institutional leaders in this field are Charles Schwab, TD Ameritrade and Fidelity. The SBDA is simply a brokerage account inside your employer’s 401(k). A participant moves money through a “brokerage window” to this self-directed brokerage account.
The event is not taxable because it’s not a withdrawal of funds. You invest some portion of your contributions outside of the mutual funds within the typical 401(k) menu. The feature is also referred to as a “self-directed” 401(k) or “self-directed brokerage account.”
Most important, the Pension and Protection Act of 2006 solved the biggest problem for 401(k) participants, allowing them to work with an investment advisor to finally receive the advice and guidance they needed (and deserved) to preserve and plan for their retirement.