IRC Section 401(k) “Revolution”

For the most part, very few Americans can recognize a specific Internal Revenue Code (IRC) section by chapter and verse, but that is clearly not the case when comes to Section 401(k), a provision added by Congress in the Revenue Act of 1978 that allows employees to defer current taxation on deferred compensation.

Shortly after the passage of the provision, Ted Benna, a consultant and co-owner of The Johnson Companies, was working in his office in suburban Philadelphia “on a quiet Saturday afternoon during September 1979.”1 He devised a new plan design allowing “each employee to put into the plan whatever portion of the cash bonus he or she wanted.”¹ In order to assist the company in satisfying the nondiscrimination requirements, he envisioned the concept of a matching contribution to entice lower earners to fund their accounts.

Benna’s plan design has revolutionized the American retirement savings landscape. In a 2021 interview conducted by Forbes,² Benna addressed the negative perception that the 401(k) was a replacement for the defined benefit (DB) pension. He countered that coverage in pensions was never universal—even when pensions were much more ubiquitous. The 401(k) revolution allowed smaller companies to get into the game, which can largely be seen as a positive.

Prior to the advent of the 401(k), the retirement benefits for workers largely relied on the three-legged stool of: (1) Social Security, (2) private pensions, and (3) individual savings. With the popularity of the 401(k), many employers over the past decades have shifted their funding of retirement benefits toward 401(k) contributions, most commonly a “matching” contribution. This coincided with changes promulgated by Financial Accounting Standards Board (FASB), which required different (more market-based) accounting of the defined benefit pension plans, which exposed many employers to more volatility on their balance sheets.

Moving to the 401(k) design takes one of the legs of the three-legged stool away, focusing more of the emphasis on individual savings (supplemented by a company match). This burdens the employee in a couple key respects. First, the investment risks would now be fully borne by the employee. Second, the longevity risks that can be pooled with a group of annuities to reduce risk is now an individual risk of outliving one’s savings.

These individual risks (along with inadequate levels of savings in many cases), now shouldered by a generation entering their retirement years with diminishing access to a private pension, have combined to create a retirement crisis in the country. One question is beginning to emerge: Could “next” generation defined benefit plans make a comeback and help resolve the looming crisis?

The efficiency of the defined benefit plan

Some employers are beginning to see the potential value in bringing back their private pension plans. Most notably, IBM announced that it will be shifting its current 401(k) matching contributions into its pension plan and reopening it to new entrants. IBM’s plan had been closed to new entrants for nearly 20 years.

For employers considering thawing their frozen and closed plans, it is important to consider the reasons they were put on ice in the first place. One of the most common cited concerns is the cost volatility of the traditional plans. Traditional pensions generally provided for an annuity at retirement, based on final average earnings. This design has substantial leverage, with costs for a participant ballooning in the later years of their employment. These designs also have long durations, exposing the company to interest rate risk. Notwithstanding recent increases in interest rates, over a decade-long period of low interest rates had resulted in high plan liabilities on company balance sheets.

A common alternative to the traditional plan that has gained in popularity over the last decade is the cash balance plan.³ These types of plans provide employees with an annual contribution and a guaranteed rate of return. In many ways, these plans have the “look and feel” of the matching contributions in 401(k) plans. The guaranteed rate of interest is what makes these plans different from a 401(k) design. The plan sponsor gets to set this rate, and they can select a flat rate (hoping to outperform it with the plan assets, reducing future costs) or a variable return (tied to indices of the yields on corporate bonds, for example). Recent changes in law and clarifications provided in IRS regulations even allow a sponsor to provide a variable return tied to the plan’s actual return on assets (subject to certain requirements), which directly connects the sponsor’s liability to the assets held.

While the so-called “market return” cash balance plan still exposes participants to investment risk, placing their accounts within the defined benefit plan enables participants to cost-effectively convert their balance to an annuity at retirement, providing lifetime income. Participants of course generally have the option of portability—and they can choose to manage their lump sum in retirement.

Use of pension surplus to fund benefits

Given substantial increases in interest rates over the past two years, many plans have current surpluses. In a recent article from Milliman, 28% of those surveyed in the Milliman 100 index fell within this category.⁴

While this may be a welcome sign for some employers considering full plan terminations, others may not want to incur the time and expense of terminating their plans at this time. Even plan sponsors with overfunded plans may find themselves with unrecognized losses parked in accumulated other comprehensive income (AOCI) that would need to be immediately recognized as an accounting income statement expense if they elected a full plan termination. Plan termination is a lengthy process that can stretch over several years and involve the expertise and fees of a host of professionals: attorneys, administrators, actuaries, and investment advisors, among others.

Companies wishing to punt on a plan termination process may be well advised to position their assets in a “liability hedging” strategy—working with their advisor and actuary to immunize their interest rate risk with existing assets. Any remaining surplus could become a problem in the event of plan termination (where surplus assets can be taxed at high levels unless corrective actions are taken)⁵—however, if the company were to reopen its pension, it could use existing surplus to pay for the new cash balance credits that would be offered in lieu of a company match.

Best of both

One of the outstanding benefits of the 401(k) revolution has been to provide employees with a tax-advantaged way to save for their retirement. That said, many participants only save enough to obtain the company match. What would happen to the retirement system if these matching contributions suddenly vanished?

Consider a company that was providing a 5% company match (where the employer matched employee contributions dollar for dollar on the first 5% of an employee’s wages). To receive this match, an employee would have to contribute 5% of their own wages, making up a total annual contribution of 10% of pay (5% employee contribution plus 5% employer match). If the company decided to shift its contribution into a cash balance plan and eliminate the match, there likely would be a group among its employees that would also take their 5% contribution off the table, because it would no longer be needed to get the “free money” offered by the company. This would have a detrimental effect on their overall retirement savings.

An alternative approach would be to split the company contribution (currently at 5%) into two pieces. As an example, a 3% of pay cash balance contribution and a 2% matching contribution. The company could change the structure of its match to condition its 2% matching contribution on the employee deferring the original 5% under the previous arrangement. That is, the company would match 40% of each dollar the employee contributes up to their first 5% of pay. This is sometimes referred to as “stretching” the match. Note that, in this example, assuming an employee continues to fund their account to receive the full matching contribution, the overall annual contribution is unchanged, a total of 10%. In this example, the employee’s overall retirement benefit would not be harmed, but a plan sponsor with an overfunded pension plan could realize cost savings through using its surplus pension assets to fund a portion of the current costs, rather than funding new cash contributions into the 401(k) plan.

Retaining some exposure to the company match (and therefore hopefully continuing to encourage savings across the rank and file) is also likely important to allow highly compensated employees to take full advantage of the maximum 401(k) deferral. Each year there are certain tests that 401(k) plans must pass to demonstrate that the plan is benefiting an adequate cross-section. Having high earners defer at the maximum permitted by law puts strains on these nondiscrimination tests and may not be permissible if other employees reduce their contributions.

Companies may also want to consider taking advantage of recent changes to the tax code to benefit younger workers who may be paying off student loans and otherwise unable to save. In these instances, the company could continue to provide its matching contribution, subject to the employee making the required 5% contribution (as in our example above, to get the full match) in the form of a student loan payment.

Conclusion

Companies have a lot of difficult choices regarding how they spend their benefit dollars. Market-based cash balance plans can provide companies with flexibility to provide “account balance” type benefits (which employees tend to appreciate due to their ease of understanding and portability) while taking advantage of the efficiencies of a defined benefit plan (providing some potential cost reductions as well as granting access to an affordable option to annuitize retirement savings and pool longevity risk across a peer group).

¹ Benna401k LLC. A Brief History of 401K. Retrieved December 27, 2023, from http://benna401k.com/401k-history.html.

² Tepper, T. (December 22, 2021). Ted Benna, Father of the 401(k), on the State of Retirement Savings Today. Forbes Advisor. Retrieved December 27, 2023, from https://www.forbes.com/advisor/retirement/ted-benna-interview/.

³ Peatrowsky, M.J. & Townsend, L. (April 20, 2022). Cash Balance Plans: Frequently Asked Questions. Milliman. Retrieved December 27, 2023, from https://www.milliman.com/en/insight/cash-balance-plans-faq.

⁴ Cook R. (December 28,2023). IBM saves billions by reopening its pension plan – Could other companies do the same?. Retrieved December 28, 2023 from https://www.milliman.com/en/insight/ibm-saves-billions-by-reopening-pension-plan.

⁵ Murray, S. (October 24, 2023). Options for Excess Assets in a Pension Plan Termination. Milliman. Retrieved December 27, 2023, from https://www.milliman.com/en/insight/frozen-pension-plans-options-for-excess-assets-pension-plan-termination.