In 401(k) We Trust How the creators of the modern DC plan transformed America s retirement landscape

Transcription

1 REPRINTED FROM DC DIMENSIONS SUMMER 2014 In 401(k) We Trust How the creators of the modern DC plan transformed America s retirement landscape By Jim Miller, Senior Associate, Dimensional Fund Advisors Thirty-five years ago, the Revenue Act of 1978 created a new generation of retirement savers. Enacted that November, the law was instrumental in launching the modern 401(k) plan. This savings experiment has survived for more than three decades and remains a uniquely American experience. Here, some of the key stakeholders involved in the birth of the 401(k) reflect on the development of today s defined contribution system. TED BENNA, founder and president of the 401(k) Association, gained IRS approval to form the first 401(k) savings plans in 1982 for The Johnson Companies. WARREN CORMIER 1 is CEO and co-founder and Boston Research Technologies. Cormier and Dr. Shlomo Benartzi founded the RAND Behavioral Finance Forum in DALLAS SALISBURY is president and CEO of the Employee Benefit Research Institute (EBRI). RICHARD STANGER, a former member of the congressional Joint Committee on Taxation, was the principal author of the Revenue Act of 1978, the basis for today s 401(k). DAVID WRAY, former president of the Plan Sponsor Council of America ( PSCA ), is a nationally recognized authority on the 401(k).

2 : BIRTH AND ACCEPTANCE OF NEW RETIREMENT SYSTEM Although today s 401(k) plans now contain over $5 trillion in retirement assets, they evolved into America s primary retirement savings vehicle as much by a confluence of economic events as by refinement and intelligent design. The code itself simply described a provision under which employees would not be taxed on the portion of income they chose to receive as deferred compensation (rather than as direct cash payment). It is inaccurate to say the 401(k) started as a savings plan for the rich. Richard Stanger, the principal author of the legislation, says, We were confident that assets would flow into the system in a reasonable way, not just from the highly compensated, but from the entire workforce. He was right: It became a savings plan for the masses. By 1984, over 17,000 retirement plans offered a 401(k), with 7.5 million participants and $91.75 billion in assets. 2 The mid-1980s soon made clear that the 401(k) had long-term viability Section 401(k) of the Internal Revenue Code was introduced as part of the Revenue Act of 1978, signed by President Carter in November of that year

3 DC DIMENSIONS Summer 2014 Essentially, the movement to cash balance combined with the 401(k) and the growing mutual fund element made it feasible for new ventures such as Microsoft and other companies born in the 80s to immediately adopt a defined contribution retirement program and never go down the defined benefit road. DALLAS SALISBURY 53 In 1979, Johnson & Johnson began the process of adopting a 401(k) plan. McDonald s Corp. became the first company to implement automatic enrollment for plan participants when it started its 401(k) plan in In 1981, the IRS issued proposed regulations sanctioning the use of employee salary reductions for retirement plan contributions. Xerox, Eastman Kodak, PepsiCo, and Ford Motor Co. all took steps to establish the nation s first DC Plans. THIS WAS A REALLY GOOD EXAMPLE OF SOMETHING DONE WELL; THE GOVERNMENT ENABLED IT AND THEN GOT OUT OF ITS WAY. IT WAS AND IS A VERY AMERI- CAN EXPERIENCE. RICHARD STANGER

4 : PLAN PARTICIPANTS BECOME CHIEF INVESTMENT OFFICERS 64 With bipartisan support, Congress passed the Tax Reform Act of 1986, which simplified the income tax code and eliminated tax shelters. It would also have a profound impact on the 401(k). Contributions to 401(k) plans were curtailed to make profit sharing equitable for all employees. Prior to 1986, plan participants were able to contribute the lesser of 25% of compensation or $30,000 annually. The new law reduced the 401(k) deferral limit to $7,000 and indexed it to inflation. IN THE 80S WE SAW EMPLOYERS ADDING FUNDS TO THEIR INVESTMENT MENUS, SOMETIMES 10 OR EVEN 15 OPTIONS. WITH THE PASSAGE OF ERISA S 404(C) REGULATIONS IN 1992, PLANS WERE AIMING TO REDUCE THEIR FIDUCIARY EXPOSURE BY MAKING STABLE VALUE AND MONEY MARKET FUNDS THE DEFAULT INVESTMENT VEHICLE. THE RISE OF THE FIRST LIFECYCLE FUNDS WAS JUST A FEW YEARS AWAY. DALLAS SALISBURY By 1990, the number of plans offering a 401(k) feature grew to 97,614, with nearly 20 million active participants and $385 billion in assets. 2 The bull market of the 90s then fueled investors enthusiasm for do it yourself investing as equity markets rallied and tech stocks boomed. At the same time, many investors found their portfolios heavily (and, in some cases, solely) concentrated in employer stock. As the confidence of participants grew, so did the number of fund options available on their employer-sponsored plans. It was not uncommon for a plan lineup to consist of funds, and many were redundant and inappropriate for retirement savings. This era of participant as chief investment officer would be short-lived. It gave way to regulatory oversight, increased scrutiny of fund lineups, and the implementation of choice architecture in plan design. A period when the plan sponsor acted in a more paternalistic fashion would arrive soon THE TAX REFORM ACT OF 1986 REGULATORY ENDORSES THE 401(K) SYSTEM AS THE PREDOMINANT RETIREMENT SAVINGS VEHICLE. DALLAS SALISBURY The Tax Reform Act of 1986, signed by President Reagan in October, reduced the maximum allowable annual 401(k) deferrals by employees. Bipartisan congressional support was largely based on a more mobile US labor force and Congress desire to provide meaningful benefits to all employees, not just long service career employees. The first commingled Mutual fund trust-based target- target-date date funds were funds were created in created in With the passage of the Tax Reform Act of 1986, the supplemental DC plan became a full-fledged retirement program, thus sealing the fate and preordering the dominance of the DC system as the primary retirement program for the private sector. Dallas Salisbury The IRS issued Revenue Ruling in June 1998, which gave employers a stamp of approval to make negative elections (i.e., automatic enrollment) into 401(k) plans for newly eligible employees.

5 DC DIMENSIONS Summer : INNOVATION ENDORSED BY REGULATION By 2002, the number of plans with a 401(k) feature grew to 423,000, with over 42 million participants and $1.9 trillion in assets. 2 As many investors made misguided investment decisions and were overwhelmed by an abundance of fund choices, investment managers began to offer target-date funds (TDFs) as a solution. The objective was to increase the possibility of a successful retirement savings outcome without requiring continual rebalancing and review (or the requisite investment knowledge, interest, and time). The prevalence of TDFs in 401(k) plans increased dramatically with the passage of the Pension Protection Act of 2006 (PPA). The law s overarching purpose was to provide guidance and safe harbors for plan sponsors that were implementing auto-enrollment and auto-escalation. The PPA approved three investment choices as Qualified Default Investment Alternatives (QDIAs): managed accounts, balanced funds, and TDFs. This landmark legislation was the catalyst for massive growth in the TDF space, as plan sponsors added TDFs as QDIAs and fund managers scrambled to assemble funds to meet demand $ $480.7 Total Assets in Target-Date Funds (in $ billions) Source: Investment Company Institute, 2013 Investment Company Fact Book $ $ $ $ $ $ $ AS AN INDUSTRY, WE WERE STARTING TO UNDERSTAND THE POWER OF PARTICIPANT INERTIA AND HOW USING OPT-OUT AND AUTOMATIC PROVISIONS COULD IMPROVE OUTCOMES. HOWEVER, WE ARE NOT THERE YET. HOW WE IMPLEMENT AUTOMATIC SOLUTIONS MATTERS. WARREN CORMIER The Pension Protection Act of 2006, signed by President Bush in August, enacted numerous changes to the tax law provisions affecting tax-exempt organizations and made permanent some provisions of the Economic Growth and Tax Relief Reconciliation Act of For the DC industry, it allowed employers to automatically enroll employees and granted safe harbor status to plans using Qualified Default Investment Alternatives ( QDIAs ). Considered by many economists as the worst calamity since the Great Depression, the 2008 financial crisis led to a bailout of banks by national governments and a global downturn in stock markets. Unemployment within the US soared and retirement savings account balances plunged. The first of the Baby Boom generation hit age 65 in For the next 18 years, boomers will be turning 65 at a rate of about 8,000 per day. 3

6 : GENERATION 401(k) 86 By the end of 2013, 88 million Americans in over 638,000 DC plans had amassed $4.2 trillion in retirement assets. 2 The DC plan is now the most popular US retirement savings vehicle. Nearly 80% of full-time workers have access to one, and 90% of employees at large companies participate in a DC plan. 4 For America s workforce, there can be no more important question than, is it working? According to the Employee Benefit Research Institute s 24th Annual Retirement Confidence Survey, 67% of retirees are at least somewhat confident that they have saved enough money to live comfortably throughout their retirement years. Unfortunately, this finding means 33% of retirees lack some level of retirement confidence. Before we can determine if these statistics reflect success or failure, we should offer a caveat. According to Warren Cormier, The average person retiring today has been in the system for about 20 years and that is not enough time to determine if the program is working. We need to evaluate those who started saving in their 20s and retire at age 65; that s over 40 years. Once we see those results, only then can we determine if the system truly worked. David Wray also reminds us that evaluating the experiment needs to account for assets held in Individual Retirement Accounts (IRAs). You must include IRAs because the bulk of the assets in IRAs come from DC rollovers, he says. When you look at the wealth created by the entire system, it is truly remarkable. We have over $11 trillion in DC and IRAs the good ole days are today! Most experts, including our assembled panel, agree that the system in not perfect. Critics argue for greater plan participation, implementation of goals-based savings rates, reduction of leaked assets when participants change jobs, compression of recordkeeping and investment management fees, more robust advice and guidance, greater integration of DC assets with household assets, improved automatic features, and a greater focus on retirement income. It is an ambitious list of priorities THE EMPLOYER-EMPLOYEE PARTNERSHIP IS PARAMOUNT FOR THE CONTINUED SUCCESS OF THE AMERICAN RETIREMENT SYSTEM. INNOVATION AND CUSTOMIZATION SHOULD BE FAVORED OVER MANDATES AND REGULATION. DAVID WRAY If we think about retirement readiness, we must address the decumulation phase this is where participants need the most advice and guidance. Warren Cormier The Employee Benefit Research Institute s 24th Annual Retirement Confidence Survey found that 67% of retirees are at least somewhat confident they have saved enough money to live comfortably throughout their retirement years. Net assets in target-date funds hit $618 billion as of December 31,

7 DC DIMENSIONS Summer 2014 WHAT THE FUTURE MAY BRING Predicting the future of America s defined contribution system is exceptionally difficult, especially when the regulatory process and breadth of stakeholders are considered. Yet there is a good chance the following issues will be addressed over the next few years: Regulation Harmonization of the Securities and Exchange Commission s and Department of Labor s definitions of fiduciary. 5 Safe harbor criteria for making annuities available as a DC distribution option. Plan Design A greater use of automatic features. 6 A greater focus on savings rates and targeting appropriate cohort savings rates through automatic deferral increases. 7 A rethinking of traditional communication and education. 8 More appropriate DC plan design metrics. We could (and should) see more plans targeting income replacement rates and/or participant savings goals as plan design evolution criteria. Investments More robust target-date funds. They will continue to become more customized and should begin to focus on cohort-based savings goals. A greater focus on lifetime income. Pending greater regulatory safe harbor provisions, we hope to see a greater integration of lifetime income programs. Institutional funds. Based on the DOL s 2012 enhanced fee disclosure rules, we anticipate more institutionally priced, transparent fund lineups. Greater focus on short-term and global fixed income options, often missing pieces for DC plans. We anticipate more alternatives to money market funds. Far from perfect and far from failure, America s post-erisa voluntary employer-sponsored retirement system approaches its 40th anniversary with millions of participants and trillions of dollars saved for the future. According to the system s first architect, Richard Stanger, The DC system is a really good example of something done well; the government enabled it and let the private market innovate and compete. This same framework will address future shortcomings and ensure continued success. 97 Growth of 401(k) Assets and Participants $1.7T 2005 $2.4T 2006 $2.8T 2007 $3.0T 2008 $2.2T 2009 $2.7T 2010 $3.1T 2011 $3.1T 2012 $3.5T 2013 $4.2T 2014 $5.1T 1980 $0 USD 1985 $144B 1990 $385B 42MM 53MM 67MM 74MM 88MM 7.5MM 20MM Sources: Investment Company Institute, US Department of Labor, Cerulli Associates.

8 1. Warren Cormier occasionally speaks at events sponsored by Dimensional Fund Advisors LP and receives honoraria for this service. 2. Source: Employee Benefits Research Institute. 3. Source: AARP, Boomers Turning 65, 4. Source: US Department of Labor, Bureau of Labor Statistics, Employee Bene its in the United States, Table 1, Civilian Population, As of the reprint date, the Department of Labor has issued new proposed regulations on the definition of "fiduciary" that are expected to be finalized in For more information, see the Defined Contribution Institutional Investment Association (DCIIA) research paper Best Practices When Implementing Auto Features in DC Plans, dropdown menu. 7. For more information, see the Dimensional research paper How Much Should I Save for Retirement? media/31539/how_much_should_i_save.pdf. 8. More information, see DCIAA research paper Rethinking Defined Contribution Communication and Education, dropdown menu. 9. Source: Investment Company Institute Dimensional Fund Advisors. Reprinted from DC Dimensions Winter The views and opinions of the third-party authors do not necessarily represent the views of Dimensional Fund Advisors. The articles are distributed for informational purposes only and should not be considered investment, tax, or legal advice or an offer of any security for sale. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. To read other articles from the magazine or for more information about Dimensional s DC services, please visit us at us.dimensional.com/services/dc-services.