A Brief History of the 401(k)

Why is it even called a 401(k)? If you don’t know where the name comes from, you are not alone. The term 401(k) represents section 401(k) of the Internal Revenue Code written in 1978. So let’s take a look at why the 401(k) was created, the environment in which it was created, and why the fact that it was never designed to be the sole source of retirement planning in the United States is problematic for those of us living in the twenty-first century.

Before we dive in here, I want to properly set your expectations. I’m going to give you just some cursory history here. There are obviously nuances to the evolution of the 401(k), and there are some benefits. But the reality is that the dependency that the US population has today on the 401(k) as a main savings vehicle was never intended to be. Since the early ’80s an entire industry has evolved to exploit a section of IRS code that was originally intended for something completely different.

According to the Investment Company Institute, Federal Reserve Board, and Department of Labor, there is over $7.5 trillion (yes, with a t) tied up in 401(k) plans.

Section 401(k) of the Internal Revenue Code was added primarily as a compromise between the federal government’s desire to tax high-income earners and high-income earners’ desire to decrease their income tax rate as much as possible. The original language of the code allowed employers to decrease profits in a manner that would decrease, or, rather, defer, their tax burden. In 1980, an employee benefits consultant by the name of Ted Benna noticed that the code could potentially allow employees to take a similar advantage. This would incent employers to provide a mechanism for employees to elect to defer some of their income into these newly created plans. On behalf of his employer, Mr. Benna petitioned the IRS to modify 401, section k, to allow such funds to be created. In 1981 the code was amended, and as early as 1983, there were seven million 401(k) participants; as of 2023 (according to the Investment Company Institute, Federal Reserve Board, and Department of Labor), there is over $7.5 trillion (yes, with a t) tied up in 401(k) plans.

LEARN MORE!

So here we are 45 years after the dawn of the 401(k), and the landscape has been radically changed for the average American. In the late ’70s and early ’80s, nearly 80% of all laborers in the United States had a pension plan as part of their entire compensation package. In addition, there was almost no talk about the solvency of the Social Security program. So, in effect, the 401(k) was ADDING on to what had been the established long-term financial plan for nearly everyone across the entire country since World War II. Read that sentence again because it is important. The 401(k) was an addition to the prevailing wisdom of long-term savings at the time.

Fast-forward...and it is a different environment. Many of our political leaders believe that Social Security will be insolvent in the 2030s if nothing is done to address the strains on the system’s current infrastructure. Today, fewer than 10% of employees have any sort of pension plan on which to depend. The 401(k) was the third leg to a retirement savings strategy stool; now, for most people, it is the only leg.

The Stock Market Is Risky

One of the major problems with the ever-increasing dependency on the 401(k) is that at its heart, it is a stock-market-driven approach. Of course, 401(k) investors have options to move their money into safe vehicles, but by doing so, they forfeit any hope of growth. To ensure growth, the average investor believes he or she has no choice but to endure market risk. Accepting this risk is sold by the financial planning industry by telling them, “Don’t worry; over time you’ll perform just fine at about 8%–10%. After all, that is the historical return of the market.”

Sounds fair, right? Stick it out, hold on for the ride, don’t worry about losses, and by the end you’re gonna get yourself 8%–10% on your investment. Seriously, this is how the market is sold to us today: just buy and hold, buy and hold. That is the “strategy” that is going to net you very comfortable growth.

What is true about this? Well, it depends on the time we are examining. It is true that, historically, the market does 8%–10%, BUT that is typically over an 80–90-year window. Eighty years! Who has 80 years to invest? Most people have a 10-, 20-, 30-, or 40-year investment horizon. And there are plenty of 10-, 20-, 30-, or 40-year time frames that the market hasn’t moved.

LEARN MORE!

Let’s put this in perspective. Suppose a 45-year-old woman on the first business day of January 2000 finally reaches the point in her earning life where she can max out her 401(k) and even take advantage of savings in the market that are beyond what the 401(k) allows. During that time, she will have ridden two bubbles and two subsequent busts, the second of the two nearly bringing down the entire US economy. On January 1, 2016, this now 60-year-old woman has earned only about 2.15% (based on the S&P performance from January 1, 2000, to December 31, 2015).

Her window was 16 years. She was told to buy and hold, which she did. She is closer to retirement, and her appetite for risk has most certainly waned. If she even has the patience to continue to hang in there, she certainly is losing sleep when she considers daily that the market has never in its history seen the continual growth that it has currently experienced. Anxious. That is the adjective that best describes this woman, and it is believing in the status quo that led her straight into this state.

Averages Don’t Mean a Thing

Risk. That is what we are focusing on here. Your 401(k) and IRA certainly have the potential for huge upsides, but they come at the price of accepting probably more risk than you’d like. More importantly, the approach is one of timing, and as in that last example in the previous section, our fictional 45-year-old woman who finally maxed out her 401(k) was unfortunate enough to do so when the next 16 years of the market would deliver less than 3%.

Think about that just for a minute. Three percent! This gal worked hard her whole life, probably did all she could to sock away what she could as she raised her children, developed a career, and established her home. What does she get for that hard work? She gets smacked down by the realities of a market that has had a fantastic run since 2009 but over the period that she has invested has delivered an actual return of less than 3%.

It’s a shame, because that gal, and millions like her, deserves better. Everyone deserves an approach that doesn’t insist that he or she just buckle up for the ride because the 80-year track record of the market delivers between 8% and 10%. News flash for you reading this right now: you do not have an 80–90-year investment horizon. Your investment is probably between 5 and 30 years. Why go on about it like that? Because there is one misleading term or phrase used when companies market stock-market-related investments such as the 401(k) and IRA. The term or phrase that needs to be exposed is called “average returns.”

Look at it this way. Let’s assume the market plummets by 50% in one year but then rallies to deliver a 50% gain the very next year. The average return for those two years would be 0%. Not too terrible when you consider that year 1 was a catastrophe. But the actual return on the actual money in the actual accounts that were on the roller coaster ride lost money overall—a 25% loss, for that matter. This is a silly simple example, but let’s not kid ourselves. The math is simple. If we have a dollar and lose 50 cents, a 50% gain on what we have left doesn’t get us back to a dollar, now does it? Of course not, it only gets you back to 75 cents. That’s it. This is why we really shouldn’t pay attention to the average returns over any period of the market. Rather, we should look at the actual performance.

BOOK A CONSULTATION TODAY!

OK, let’s move away from the simple and look at a real example over the course of the 21-year period from 1995 through 2015. See Figure 2.2. This period included the five best consecutive years the market ever had, from 1995 through 1999. But it also includes two brutal stock market corrections.

If a $10,000 annual contribution is made, you can see that the average yield during this time is calculated at about 9.16%. Not too shabby. That being said, if we look at the actual yield over this same period of time, we see it is a much different story. That actual return comes in at a more modest 5.82%. So much for the 8%–10% actual returns you were told you could expect.

This is the reality of what risk means to us. Unless we can somehow predict the movement of the market and have the ability to constantly manipulate our account distributions, this is what recent history tells us about what we can expect. But market timing is impossible; in fact, most of us move money out of the market well into a bear market and don’t put it back in until the bull has been running for a year or so. That compounds the problem here, because any management that we are trying to impose over the risk ends up making matters worse.