I love my 401(k). Think it sounds weird to profess love for a financial account? Let me explain.
- Every dollar that I put into my 401(k) reduces my tax bill because all contributions are income tax deferred. That allows me to invest even more and get to FI faster.
- Every dollar that I put into my 401(k) goes straight into low-cost index funds where they will grow at higher returns than most active funds, and with no work required from me. FI here I come!
- Every dollar that I put into my 401(k) grows tax-free. Over the long term, this will allow my 401(k) funds to grow leaps and bounds ahead of money invested in a taxable brokerage account. Stoking the FIRE, baby.
- Every dollar that I put into my 401(k) also gets a portion matched by my employer. Free money = faster FI!
So, yeah. I love my 401(k). It’s a pretty great tool for financial independence and early retirement. But the 401(k) hasn’t always been here. For decades, retirees relied on an entirely different method to gain financial freedom: pension funds.
How it all began
That got me wondering how my own beloved 401(k) came to be, and why pensions are so uncommon now. While I love my 401(k), and I think most people in the FIRE-sphere do too, is everyone really better off with a 401(k) than they would be with a pension?
The emergence of the 401(k) marked a shift in responsibility for funding retirement from employers to employees. 401(k)’s and IRA’s are perfect fits for aspiring early retirees who already have a relatively high savings rate. But the vast majority of Americans do not save 50%+ of their incomes.
So today I would like to briefly discuss how the 401(k) evolved over the years, and how you can take full advantage of it to achieve financial independence.
The pre-401(k) era: Pensions
Back in the old days (the 1970’s and earlier), employees relied on defined-benefit pension plans provided by their employers.
When you reached a certain number of years at a company, you would be eligible to receive a check every month in retirement. The amount you received depended on the time you spent at the company and somehow incorporated your salary (usually the average of the last few years of service).
Actually, defined-benefit pension plans aren’t as uncommon today as you might think. Government employees and teachers are likely to have access to defined benefit pension plans, and Social Security is one itself.
What was wrong with pensions?
Not much, really. If you were willing to stay an extended period at your employer, your pension payout could get pretty sizeable.
But for those employees who wanted to beef up their retirement through a high savings rate, their only options were – you might want to cover your children’s eyes for this one – old school brokerage accounts!
Not the no-hassle, low-fee, Internet-driven Godsend that is Vanguard. No…you had to actually talk to a stockbroker everytime you wanted to make an investment. Scary.
In fact, the 401(k) wasn’t designed specifically to replace the pension – its rise as the cornerstone of America’s retirement was mostly accidental.
The first 401(k)
The namesake for our beloved retirement account comes from Section 401(k) of the Revenue Act of 1978. High earning employees wanted a way to save on taxes and invest their cash bonuses. So, a bunch of politicians got together and decided to throw in a way for employees to save on taxes for those bonuses and stock options, and voila, the 401(k) was born.
The first 401(k) plan was created by Ted Benna. He understood that higher income earners at the company would benefit the most from the tax savings, so in order to attract lower income earners (and make the plan’s total fees lower), he incentivized it with an employer match.
In 1981, the IRS had allowed employees to contribute a portion of their regular salary to their 401(k) plan. By 1983, half of all large companies offered a 401(k) plan. They sold the 401(k) to employees as a better way to save for retirement than pensions.
So which is better: pension or 401(k)?
The stock market boom of the 1980’s and 1990’s certainly made the 401(k) seem like a good deal, but was it really? Today the average American saves only around 5% of their income. With a pension, the decision for how much to save is made for you. Your money is automatically invested for you, effectively putting your savings on autopilot.
And that’s the main point. The 401(k) gave employees much greater control on their retirement savings, and depending on your savings rate, you could end up much better than you would with a pension, or much worse.
Let’s hit some of the pro’s of the 401(k) compared to the pension.
- You have the ability to save a large portion of your income. Obviously, the definition of “a large portion” is different for everyone, but the 2017 contribution limit of $18,000 is a significant cut of the average American’s salary.
- You choose what to invest in. With a 401(k), you can tweak your investments to meet your own risk comfort level. Those who invest aggressively in stock and are willing to see some short term drops in their account values will probably benefit greatly over the long term.
- The money in your 401(k) becomes vested quickly. With a pension, you usually have to stay at your company for over 5 years in order to ever see the benefits. But with a 401(k), every dollar you put in is yours, and your employer’s match will likely become accessible to you in less than 5 years.
- It’s your money. If you ever need to take the money out of your 401(k), you can either withdraw the assets entirely or borrow against your balance. Both options come at a price, namely in the form of unrealized income tax, penalties, and the opportunity cost of not being invested in the stock market. (I generally don’t recommend that you do either, but hey, you can if you want to.)
- You can control how much you withdraw. In retirement, you have the option to withdraw a little, or a lot from your 401(k). This allows you control how much you pay in taxes each year. Pension funds pay a set amount each year.
The 401(k)’s future
Will the 401(k) always be here? I think so, at least for the foreseeable future.
There were rumors with the recent tax reform legislation that contributions would be reduced substantially from $18,000 to $2,400, but that didn’t make the final cut of the bill. I think that proves that any changes to the 401(k) that hurt participants is wildly unpopular. Politicians don’t like being unpopular.
Many 401(k) plans are plagued by high fees. This might keep some people from contributing to their 401(k), but even then it is probably worth contributing at least up to the employer match.
Increased visibility of plan fees may drive them down in the future. Options for low fee investment option such as index funds are a step in the right direction, and the rise of robo-advisors may eventually become helpful in 401(k) plans.
As the future of Social Security becomes less certain, investment accounts such as the 401(k), HSA, and the IRA will become more important for retirement savings. These plans give the responsibility for saving to the individual, rather than the government or the employer. As long as you accept that responsibility and save a majority of your income, that’s a good thing.
What do you think of the 401(k)? Do you agree that shifting the responsibility for saving for retirement from the employer to the employee is a good thing? Let me know in the comments!