From Here to Security: How Workplace Savings Can Keep America’s Promise

CHAPTER 3 HOW DID WE GET HERE? THE RISE OF DEFINED CONTRIBUTION SAVINGS

From tiny seeds a mighty tree may grow.

—AESCHYLUS

To understand how we evolved the workplace savings systems that Americans rely on today, we need to look back more than 40 years. It also helps to recall how “the law of unintended consequences” plays out.

All legislation and regulations have consequences. The intended ones are typically immediate and foreseen; the unintended ones are often totally unforeseen, but may have powerful, even revolutionary, long-term effects. This is very much the case with two 1970s laws that helped set off an unplanned, almost accidental transformation in American retirement finance.

The first was The Employee Retirement Income Security Act of 1974 (ERISA), which was adopted to address a wave of private pension failures, notably the 1963 bankruptcy of the Studebaker Corporation that cost thousands of workers and retirees their pension incomes. ERISA aimed to set high standards and practices for traditional defined benefit pension plans. It also created the federal government’s Pension Benefit Guaranty Corporation (PBGC) to insure and backstop pension payments. But its long-term unintended effect, as we’ll see, was to start a lasting decline in traditional pensions.

The second law that seeded change was the Revenue Act of 1978, a seemingly routine adjustment of tax brackets and rates. But this 1978 law included an obscure provision, barely noticed at the time, but now world-famous: section 401(k) of the Internal Revenue Code. This allowed employees to defer taxes on a portion of income provided they set that money aside for their retirement. Ultimately, this 401(k) tweak in the tax code gave birth to a whole new defined contribution industry. In short, two laws designed to protect and extend the defined benefit pension status quo actually launched a revolution.

Intended to bolster traditional pensions, ERISA inadvertently sped up a transition away from them. It created new and sometimes expensive mandates for plan sponsors, raising minimum standards for participation, vesting, and funding. By establishing the Pension Benefit Guaranty Corporation, it added some reliability to traditional plans, but at a cost of higher and rising insurance payments and compliance costs. The unintended effect was to encourage many plan sponsors to seek other ways to offer retirement coverage to their workers. And a viable alternative came quite soon, embedded in the Revenue Act of 1978.

By providing a personally owned, tax-advantaged alternative to traditional pensions, section 401(k) planted the seed for the multitrillion-dollar defined contribution savings that have grown up over the past two generations and reshaped retirement finance in the United States and, increasingly, around the world.

The availability of personal payroll-deduction retirement savings options did not spur an immediate gold rush into these new 401(k) accounts. At first, just a handful of large companies began offering K-plans as supplements to their traditional pensions, offering them at first mostly to senior executives. Looking back, it’s comical to recall the clunky, off-putting name that most early sponsors gave to these savings options: “salary reduction plans.” Not much marketing genius in that name!

Yet by the early 1980s, thousands of employers across America had begun to realize the potential of 401(k) plans and individual workers’ accounts to become a mass-investing retirement savings vehicle for almost all workers, not just executives. Better still, and unlike traditional pensions, the costs of these plans would be entirely predictable.

That’s because K-plans, by definition, shift investment risk from the plan sponsor to the individual participant. They promise no more than the potential income that can be drawn from participants’ accumulated balances. This means that they are, again by definition, fully funded by the contributions of employees along with any matching funds an employer may choose to offer.

The benefits of such plans to employers seem crystal clear: total predictability and limited liability. But 401(k)s and defined contribution plans like 403(b)s and 457s also proved immensely appealing to millions of workers who saw their personal wealth begin to grow in their regular plan statements. The 18-year boom in equity markets that ran, with a few sharp breaks, from 1982 to 2000 provided a powerful tailwind to the rapid growth of a defined contribution industry that included plan sponsors, record keepers, investment managers, consultants, and advisors.

And this surge was further stimulated by legislation that established nondiscrimination rules that required plan sponsors to share the benefits of workplace savings plans with nearly all employees, not just the highly compensated.

The Rise of Workplace Savings 1.0

From the mid-1980s straight through to the century’s end, a steadily increasing share of America’s leading companies moved to convert their retirement benefit offerings from traditional pensions to defined contribution savings plans.

What started as a trickle soon swelled to a flood. This first generation of payroll deduction plans—what we’ll call Workplace Savings 1.0—was well underway, and it grew explosively. Thousands of companies adopted the new plans, and a growing array of service providers started to compete for their business by offering an ever-growing range of investment choices, options, and customer services.

The transition from traditional pensions to defined contribution plans was driven by market pressures to control costs, and by demand from employees themselves. Increasingly mobile workers liked the fact that these new plans offered rapid or immediate vesting. Others appreciated the strong sense of personal ownership these plans provided. As of 1990, more American workers were enrolled in DC plans than in traditional final-pay pensions.

By the mid-decade of the 1990s more than 40 million workers owned over $1.3 trillion in workplace retirement savings accounts and IRAs. Most new cash flowing into IRAs came in the form of substantial rollovers into these accounts from workplace savings plans, at retirement or at the time of job changes, not from individual contributions that people actively chose to deposit in small increments.

Regulatory oversight of the emerging defined contribution plan system took another big step with the passage of the Economic Growth and Tax Reconciliation Act of 2001 (EGTRA), which allowed for additional catch-up savings for employees over 50 years old and created Roth 401(k)s, which enabled employees to make after-tax contributions that are taxed upon withdrawal the way ordinary 401(k) funds are. This offered another strategic option for savers and financial planners to consider.

More recently, the Pension Protection Act of 2006 (PPA) capped 20 years of retirement policy evolution by endorsing a series of best practices in workplace savings plans that had been inspired by behavioral finance research and experiments by a handful of progressive plan sponsors. The PPA, in effect, marked the first time that Congress and top policy makers recognized defined contribution plans as the primary source of future retirement income and acted to treat these plans as a system. (We’ll learn more about why PPA marks such a remarkable leap forward in retirement policy in the next chapter.)

Today, traditional pension plans and defined contribution savings continue to coexist. Some large companies continue to fund and sustain defined benefit plans, but they are a shrinking minority. By contrast, the flood of assets fueling America’s defined contribution savings engine shows no sign of abating. Both types of plan continue to evolve, but in very different ways, as we’ll see.

FIGURE 3.1 Private sector workers participating in an employment-based retirement plan, by plan type, 1979-2013, among all workers

Source: U.S. Department of Labor Form 5500 Summaries 1979–1998, Pension Guaranty Corporation, EBRI.

Traditional Defined Benefit Pensions

Some analysts, and especially critics of America’s retirement system, claim that until quite recently, this country enjoyed a “Golden Age” of defined benefit pensions. To hear them tell it, most American workers enjoyed turnkey financial security for life; then, the self-seeking leadership of corporate America threw these workers to the wolves of the financial services world, leaving them to fend for themselves and manage their own retirement through risky, high-cost 401(k) plans. This is nonsense on steroids, the academic and journalistic equivalent of an urban legend.

Let me say that I have nothing against defined benefit pension plans, provided they are well run, have fair rules, and are fully funded. All through my career, I have worked for companies that serve such plans. Many traditional pensions are rock solid and offer great benefits to long-serving workers.

But the notion that DB plans were ever near-universal is a myth. And nostalgia for that myth distracts us from acting to improve the DC plans that have replaced them. Here are the facts.

At their high-water mark in the early 1990s, traditional pensions, which deliver retirement benefits based on salary and years of service, only covered 35 percent of private sector American workers, mostly at large, national scale Fortune 500 firms. Most companies that offered these DB plans required years, sometimes as long as a decade or more, to vest the ownership of retirement assets and future income for any individual worker. Income benefits in retirement were usually calculated in a way that provided huge gains based on the last decade or so of a worker’s career, typically from age 50 to 65. Younger workers’ vested income rights grew slowly for many years and would most often be cashed out, or even forfeited, if they left before full retirement age.

Tens of millions of workers who changed jobs prior to vesting never received a penny’s worth of benefits. Contributions made on their behalf to the DB pension pool wound up sweetening the pensions of long-serving “lifers.” What’s more, most of these traditional pensions were tied to a single employer. They weren’t portable; you couldn’t take them with you when you changed jobs.

Those who cling to the notion that our retirees were better off in the age of defined benefit need to face up to actual real-world data. Virtually all the key indicators of elders’ welfare today are superior to those seen a generation ago. Well along into the defined contribution era, we have less elderly poverty, better elderly health, longer life expectancy, and even superior measures of happiness among elders than we had a generation ago when defined benefit pensions were at their peak.

Over recent decades, the U.S. economy has grown increasingly dynamic. We routinely see companies and even entire economic sectors expanding, contracting, and even disappearing. Fast-growing upstarts regularly eclipse markets and roll out new technologies. Workers themselves hold 8 to 10 jobs over a typical career. In this new reality, the limitations of DB plans with their multidecade vesting provisions are striking.

That’s why virtually all of the fastest-growing companies that have emerged over the past generation—in information technology, mobile broadband, finance, life sciences, digital networks, renewable energy, and the like—haven’t chosen to offer defined benefit pensions. Facebook, Apple, Microsoft, Amazon, Netflix, and Google have only ever offered defined contribution plans.

Most remaining DB plans today are concentrated in a dwindling number of long-established incumbent firms in mature industries with a high proportion of union membership (oil, autos, airlines) and in the public sector (also, in many states, a union mainstay). Even in these areas, the future of defined benefit plans is not promising.

While there is great disparity among DB plans in terms of their relative levels of funding and viability, taken as a whole, U.S. defined benefit pension plans are saddled with unfunded liabilities that measure in the trillions of dollars. That simply means that companies or government agencies in too many cases have not set aside enough money to reliably pay the benefits to retirees that these plans promise on paper.

Private sector DB plans face chronic underfunding of some $300 billion. In fact, the Pension Benefit Guaranty Corporation established by ERISA to insure and backstop such plans may itself soon face insolvency unless Congress acts to provide it with more funding.

In the public sector, while many DB plans are healthy and on track to match liabilities, many others—notably the massive state plans in New Jersey, Illinois, and California—will almost certainly be unable to deliver benefits that those states’ political leaders (many now retired) promised these government workers. Several states’ pension systems are underfunded by 50 percent or more. In aggregate, public sector DB plans face unfunded liabilities of nearly $5 trillion, and highly predictable crises loom in the near future.

Public DB plans are being weighed down by a classic “support ratio” challenge. Rising numbers of retirees depend on contributions from fewer active workers. Underfunded pension pools face liabilities owed to growing numbers of retirees, often against a backdrop of flat or declining tax bases. An aging demographic is the primary culprit, driving serious and intractable municipal and state debts and deficits.

Even current monetary policy threatens DB plans’ prospects. The zero-interest-rate environment that has prevailed in the wake of the global financial crisis is severely stressing traditional pension plans’ liability models. Historically low interest rates create a powerful drag on public pension plans that invest heavily in fixed-income instruments. The lower the interest rate, the lower the returns and therefore the greater the difficulty in matching liabilities.

These trends combine to create a perfect storm with potentially tragic consequences for millions of private and public sector workers whose defined benefit retirement income may not be forthcoming. For governments and corporations, the costs of continuing to provide secure defined benefit pensions can threaten their ability to invest in innovation and crowd out essential services. The choice can even boil down to current staffing or current pensions, a choice between keeping police and firefighters on the job today versus paying full benefits to those who served their communities in the past.

Defined benefit pensions may have been suited to a slower changing, less volatile economy in which workers were accustomed to job tenure measured in decades. Today, they often seem like an artifact from another time. By contrast, defined contribution savings are robust and surging.

The Defined Contribution Tsunami

From the perspective of a career largely dedicated since the mid-1980s to spurring the growth of defined contribution retirement savings, my timing was extremely lucky. I caught a wave.

In 1985, defined contribution savings plans accounted for only $427 billion—less than half the assets to be found in defined benefit pension plans. Over the next 10 years, DC assets under management soared by about 12 percent a year, quadrupling to $1.3 trillion by 1995, while traditional pension assets grew about 5 percent, still healthy, but losing overall market share.

The explosion of DC assets continued unabated, despite the dot.com boom and bust at the turn of our century. As this transition gathered steam, it became obvious that a fundamental shift was taking place in American retirement finance. Individual workers, for the first time in history, were accruing substantial wealth of their own despite periodic bouts of market volatility that did little to set back the inexorable rise in individually held assets.

By 2005, DC and IRA assets were at parity with DB, at $7.4 trillion each. Only a dozen years later, in 2017, and again, despite the ravages of the 2008–2009 global financial crisis, defined contribution workplace savings plans and IRAs topped $15 trillion, over 75 percent more than the $8 trillion managed by traditional DB plans (Figure 3.2).

FIGURE 3.2 U.S. total retirement market assets

Source: ICI Total Retirement Assets, Fourth Quarter 2016.

It is true that individual 401(k) savers’ behavior can be more volatile than that of professional pension plan managers. Some individual investors have made serious mistakes in responding to market setbacks such as selling at the bottom during a stock market correction. But if we look at the behavior of defined contribution savers as a group, it’s clear that workforce savers in aggregate manage periods of volatility nearly as well as those in traditional DB pension plans.

We’ve had several real-life stress tests in recent years, notably the historically unprecedented retreat of asset prices during the 2008–2009 global financial crisis. The market reversals of that period were unique, not only because of their severity, but because nearly every asset class—stocks, bonds, and even real estate—all retreated together in a massive “risk-off” trade, something that traditional risk models had not anticipated.

But even as that gut-wrenching volatility stressed markets worldwide, 401(k)-type plans actually held up better than traditional DB pensions. And as markets recovered from 2009 onward, defined contribution plan assets grew at nearly twice the rate of DB assets.

Between 2007 and 2008, when markets bore the full brunt of the crash, total DC plan assets fell by 12 percent, while DB plan valuations retreated by 14 percent. And over the first five years of recovery, from 2008 to 2013, traditional pension plan valuations increased by 41 percent, but DC workplace savings and IRA valuations soared by fully 78 percent due to both the market recovery and continuing flows of new contributions by workers and employers.

Calling a Draw on the Pensions vs. 401(k) Debate

Capstone evidence that the transition from defined benefits pension to 401(k)-type savings plans has not eroded retirement security in America came in late 2015. Two of America’s leading retirement research institutions effectively called a draw in the long-running debate over the outcomes of traditional pensions and the emerging DC savings system.

Boston College’s Center for Retirement Research (CRR), in a 2015 report entitled “Investment Returns: Defined Benefit vs. Defined Contribution Plans,” found that between 1990 and 2012, professionally managed DB plans outperformed DC plans by just 0.7 percent—with the differential accounted for mainly by higher fees on the DC side. But as we know, economies of scale and competitive market forces are steadily bringing down 401(k) fees, as total assets in these plans grow and competition to manage them becomes more intense.

While most traditional pensions are found in larger, often multibillion-dollar funds, the defined contribution market is mostly made up by tens of thousands of small and medium-sized workplace savings plans. The cost differential is real and challenging. But it is diminishing rapidly. New technologies, market competition, and the increasing use of index funds are all driving down the cost of defined contribution plans of all sizes. The BC Center’s report also noted that more defined contribution savings tend to be allocated to equities, which means that they encounter both more risk and higher returns than the DB plans that lean more heavily on fixed-income investments.

The report marked a sharp course change for CRR, which, like many other academic analysts, had long believed that defined benefit plans provided markedly superior retirement readiness. As its authors concluded: “Our reading of the data . . . is that the accumulation of retirement assets has not declined as a result of the shift to defined contribution plans. We are going to have to change our story!”

Another 2015 report, from the Employee Benefit Research Institute (EBRI), went a major step further. EBRI assessed the likelihood that workers currently ages 25 to 29 would be able to replace at least 70 percent of their preretirement income through traditional final-pay defined benefit pensions or, alternatively, through 401(k) plans.

The findings were strikingly positive for those like me who have long been convinced that well-designed workplace savings plans can successfully deliver retirement readiness for most people. EBRI found, for example, that workers in the third and fourth income quartiles have a much higher probability of success with 401(k) plans than with DB plans. And if we raise the target replacement ratio to 80 percent, payroll savings plans have a much higher probability of success than DB plans for all workers except those in the lowest-income quartile, where results are a virtual tie. EBRI’s report further found that workers in plans that applied automatic savings escalation would earn even higher rates of replacement.

EBRI’s findings confirm my view that well-designed defined contribution plans can do at least as well, and very often much better, for workers’ retirement readiness than traditional pensions. As I mentioned earlier: “There’s nothing wrong with 401(k) plans that can’t be fixed by what’s right about 401(k)s.”

America’s Primary Retirement Savings Plan

Today, we are far along in the transition from traditional pensions, which served a minority well, to a system of individual payroll savings that can potentially enable almost all working Americas to reach retirement readiness. There’s no going back. Defined benefit pensions will almost surely continue to flatline as their plan participants age and leave the workforce. Defined contribution plans will likely continue their expansion and, we hope, extend coverage to more workers and workplaces.

In a little over 30 years, we have already spread defined contribution retirement savings to a much larger share of American workers than traditional pensions ever touched. And by many measures, these plans are providing superior benefits—more sustainable, fully funded, and immune to many of the demographic pressures faced by traditional pension plans. These are amazing achievements.

But as 401(k)s and other payroll savings plans have become America’s primary source of future retirement income, the deficits and flaws that affect far too many of these plans have become a major source of controversy and political vulnerability—some of it based on real failings.

Academics, theorists, and the financial media pore over the shortfalls and failings that pockmark the defined contribution landscape. But too few of these critics bother to note the successes and positive trends in the evolution of DC savings, even though these elements are equally visible and suggest proven pathways to improving the whole workplace saving system.

Here’s what we know: Roughly half of American workers now enjoy access to 401(k)-type plans. Multiple polls tell us that these workers are very happy with their plans. Actuarial data tell us that millions of them are on track to be able to replace much, or even all, of their working life income once they retire.

A Job Half Done

Clearly, we face a challenge. Many of the defined benefit pensions still available today are sorely strained. Collectively, they face wrenching adjustments as funding shortfalls measured in the trillions of dollars stress many of these plans to the breaking point. Among private businesses, traditional pensions are disappearing fast. In the public sector, they present an enormous fiscal issue for many state and local governments. Indeed, some cities have actually declared bankruptcy largely as a result of unsustainable pension obligations.

In stark contrast, defined contribution savings plans do very well by middle- and upper-income workers. But they don’t reach nearly as deeply as they could to serve low-income, part-time, or “contingent” workers or those in small firms that lack on-the-job payroll savings plans entirely.

The fact that roughly 35 percent of all American workers don’t have such savings options is tragic. I would even say it’s a scandal, a failure of imagination and empathy on the part of policy makers in this country. But that gap in coverage doesn’t mean that the 401(k) workplace savings concept is broken or failing. What it means is that we need to extend coverage to all.

The job of fleshing out a workplace savings system for all Americans is only half done. But we are, to be fair, just about 30 years along in the great migration from defined benefit pensions to defined contribution models. Today’s surviving DB plans reflect nineteenth-century designs. By contrast, the fast-evolving defined contribution system was pretty much invented from scratch—beginning in the 1980s—just as I was beginning my career.

To keep evolving, and improving, workplace savings in America, we surely do need to admit the flaws. But much more importantly—and constructively—we need to focus like a laser on the success stories and the structures, behaviors, and ideas that account for these successes. To lift America’s workplace savings plans to a new level of efficiency and effectiveness, we should follow the advice that Alex Haley, the author of Roots, took as his motto: “Find the good and praise it.”

As it happens, there is a shining example of wise thinking and bipartisan political compromise to guide us. Sadly, almost no one outside the retirement industry has ever heard of this legislative landmark. But 11 years after its adoption, this law is helping tens of millions of working families build a more solid financial foundation. Despite the dysfunction of Congress in recent years, the process that led to this law’s passage offers us hope that our elected officials can sometimes work across party lines to improve all Americans’ futures. So, in the next chapter, let’s take a deeper look at this remarkable law, the Pension Protection Act of 2006.