401(K) PLANS

A 401(k) plan is a tax-deferred, defined-contribution retirement plan. The name comes from a section of the Internal Revenue Code that permits an employer to create a retirement plan to which employees may contribute a portion of their wages on a pretax basis. This section allows the employer to match employee contributions with tax-deductible company contributions. Earnings on all contributions are allowed to accumulate in a tax-deferred trust. By the late 1990s, 78 percent of employees to whom 401(k) plans were offered elected to participate in them.

HISTORY

The 401(k) provision was created in 1978 as part of that year's Tax Revenue Act, but went largely unnoticed for two years until Ted Benna, a Pennsylvania benefits consultant. devised a creative and rewarding application of the law. Section 401(k) stipulated that cash or deferred bonus plans qualified for tax deferral. Most observers of tax law had assumed that contributions to such plans could be made only after income tax was withheld, but Benna noticed that the clause did not preclude pretax salary-reduction programs.

Then a benefits consultant with the Johnson Cos., Benna came up with his innovative interpretation of the 401(k) provision in 1980 in response to a client's proposal to transfer a cash-bonus plan to a deferred profit-sharing plan. The now-familiar features he sought were an audit-inducing combination then—pretax salary reduction, company matches, and employee contributions. In January 1980, the answer came, according to Benna, literally in response to a prayer. He called his interpretation of the 401(k) rule "Cash-Op," and even tried to patent it, but most clients were wary of the plan, fearing that once the government realized its tax-revenue-reducing implications, legislators would pull the plug on it.

Luckily for Benna and the millions of participants who have made use of his idea, the concept of employee savings was gaining political ascendancy. Ronald Reagan had made personal saving through tax-deferred individual retirement accounts, or IRAs, a component of his first campaign and his presidency. Payroll deductions for IRAs were allowed in 1981 and Benna hoped to extend that feature to his new plan. He convinced his superiors at Johnson Cos. to establish a salary-reducing 401(k) plan even before the Internal Revenue Service (IRS) had finished writing the regulations that would govern it. The IRS surprised many observers when it provisionally approved the plan in spring 1981 and specifically sanctioned Benna's interpretation of the law that fall. The government soon realized the volume of salary reductions it was unable to tax and tried to quash the revolution: the Reagan administration made two attempts to invalidate 401(k)s in 1986, but public outrage prevented their repeal.

401(k)s quickly became a leading factor in the evolving retirement benefits business. Between 1985 and 1994, the value of the 401(k) plans sponsored by the 1,500 large corporations surveyed annually by Greenwich Associates grew from $137 billion to $454.7 billion. The number of employees able to participate in 401 (k) plans rose to more than 48 million by 1991 from only 7 million in 1983, and Benna's prayerful breakthrough earned him the appellation "the grandfather of 401(k)s."

The advent of 401(k) plans helped bring about a philosophical shift among employers, from the provision of defined-benefit pension plans for employees to the administration of defined-contribution retirement plans. In the past, companies had offered true pension plans which guaranteed all individuals a retirement benefit. But after 1981, rather than providing an employer-funded pension, many companies began to give employees the opportunity to save for their own retirement through a cash or deferred arrangement such as a 401(k).

THE BASICS OF 401 (K) PLANS

In benefits parlance, employers offering 401(k)s are sometimes called "plan sponsors" and employees are often known as "participants." Most 401 (k)s are qualified plans, meaning that they conform to criteria established in the Economic Recovery Tax Act of 1981 (ERTA). ERTA expanded upon and refined the Employee Retirement Income Security Act of 1974 (ERISA), which had been enacted to protect participants and beneficiaries from abusive employer practices and created guidelines that were intended to ensure adequate funding of retirement benefits and minimum standards for pension plans.

Basic eligibility standards were set up with this legislation, including a minimum age of 25 years and a predetermined length of service before contributions were made. Some union employees, nonresident aliens, and part-time employees were excluded from participation.

The new 401(k)s incorporated many attractive features for long-term savers, including tax deferral, flexibility, and control. Taxes on both income and interest were delayed until participants began receiving distributions from the plan. Rollovers—direct transfer of a 401(k) account into another qualified plan, such as a new employer's 401(k), an IRA, or a self-employed pension plan—and emergency or hardship loans for medical expenses, higher education tuition, and home purchases, allayed participants' fears about tying up large sums for the long term. While there are restrictions on the availability, terms, and amounts of these loans, the net cost of this type of borrowing may be quite reasonable because the interest cost is partly offset by the investment return. Employees may also receive lump-sum distributions of their accounts upon termination. If an employee elects to take his or her distribution in cash before retirement age, the employer is required by law to withhold 20 percent of the distribution. If the account is rolled over into another qualified plan, nothing is withheld. Employees' self-determination of investments has allowed tailoring of accounts according to individual needs. For example, younger participants may wish to emphasize higher-risk (and potentially higher-return) investments, while employees who are closer to retirement can focus on more secure holdings. These features have been refined over the years through legislation, especially after the government realized the tax revenue losses engendered by the popular plans.

THE EVOLVING 401 (K)

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) reduced maximum contribution limits that had been set by ERISA, introduced the "top heavy" concept, and revised the rules for federal income tax withholding on plan distributions. Most plans allowed employees to defer I percent to 10 percent of current compensation, but such internal limitations have been bound by compensation and contribution ceilings enumerated in TEFRA and subsequent legislation. These limits hindered the ability of senior executives and other highly paid employees to benefit from 401(k) plans. In 1986 the amount an employee could defer annually under such programs was reduced from $30,000 to $7,000. In addition, the compensation that could be considered in determining an employee's deferral was limited to $200,000. The $200,000 limit, which had previously been increasing on an annual basis through a cost of living adjustment, was limited to $150,000 per year under the 1993 tax law. Mandatory "top heavy" tests that prevent 401(k) programs from favoring highly compensated employees restrict the amount that highly paid employees can contribute to 401(k) plans.

Known as "nondiscrimination tests" in the benefits industry, top heavy rules separate employers and employees into two groups: those who are highly compensated and all others. The amounts that the highly paid employees may defer is based upon what the lower-paid employees deferred during the year. For a simplified example, if lower-paid employees on average contributed only 2 percent of their compensation to the corporate 401(k), high-paid employees may divert only 4 percent of their pay. This test adds a second level of limitation on the amount that highly paid employees can defer, often lessening it from legally established limits. Benefits and tax specialists have, of course, devised strategies to circumvent these restrictions, such as 401 (k) wrap-arounds, "rabbi trust arrangements," and other "non-qualified" plans that consciously and legally operate outside the bounds of "qualified" 401(k)s. Furthermore, IRS rule changes arising from the passage of the Small Business Job Protection Act of 1996 allowed highly paid employees to contribute up to 15 percent of their salary into a 401(k) plan, with any amount that turned out to be in excess of top heavy rules merely returned to them at year's end; and established the Simple salary deferral plan, through which employees could channel up to $6,000 in pretax wages directly into an individual retirement account.

The Deficit Reduction Act of 1984 (DEFRA) continued the government's revenue-raising—and often 401(k)-limiting—provisions. The Retirement Equity Act (REACT or REA) of that same year helped protect spouses of plan participants by requiring that qualified plans provide numerous survivor benefits. REA also reduced the age at which employees became eligible to contribute to a 401(k) from 25 to 21. The Tax Reform Act of 1986 incorporated some of the most extensive, revenue-raising changes in 401(k) criteria since ERISA by imposing new coverage tests and accelerating vesting requirements. Although much of this legislation was intended to benefit employees, it has also been cited as the principal cause of the voluntary termination of thousands of pension plans—a total of 32,659 between July 1987 and September 1988. These terminations eliminated future pension benefits for hundreds of thousands of workers.

During the 1980s, many plan sponsors offered employees only two investment options for their 401(k) account: an insurance company's guaranteed investment contract (GIC) and a profit-sharing plan. Insurance companies often had full-service capabilities in place and the GICs, with their high interest rates, garnered the lion's share of plan sponsors and participants. Statistics from the Employee Benefit Research Institute and the U.S. Department of Labor showed that about 40 percent of the assets in 401(k) plans were invested in GICs, which placed the burden of performance on employers and their fiduciary agents. But a rash of insurance company failures late in the decade prompted many portfolio managers to increase the number of investment alternatives.

ERISA rule 404(c), which went into effect January 1, 1994, stipulated several changes in the ways employers administered their programs. First, plans were required to offer at least three distinctly different investment options that spanned the entire investment spectrum, in addition to the employer's stock. Qualified plans were also compelled to educate participants by providing adequate information about each investment option, thereby enabling employees to make informed choices among them. Finally, employers and their 401(k) administrators were obliged to make more frequent performance reports and allow more frequent changes in investments. These changes shifted the responsibility for choosing investments from employer to employee, thereby limiting the potential liability of employers for investment results. Although 404(c) was not mandatory, many plan sponsors complied with the new provisions in the interest of maintaining a happier, more financially secure workforce.

The ability of employees to increase their contributions to 401(k) accounts was somewhat restricted in 1995, when the government responded to revenue losses stemming from ratification of the General Agreement on Tariffs and Trade (GATT) by reducing the inflation adjustment on annual contributions. New pension legislation adopted in 1996 further expanded the scope of 401 (k) and other deferred-contribution plans, however, by making nonprofit organizations eligible to sponsor such plans. The legislation also altered IRS rules governing salary-reduction plans for self-employed individuals, allowing them to invest up to $6,000 plus 3 percent of their annual earnings in a 401(k) account.

The enactment of provision 404(c) triggered an investment shift among 401(k)s from GICs and employer stocks to mutual funds. As of the end of 1997, 73 percent of new 401(k) contributions were invested in equities. Mutual funds were seen as an easy way for employers to comply with 404(c) because of the benefits and services they afforded, including access to top professional money managers, instant diversification, portfolios managed according to specified investment objectives and policies, liquidity, flexibility, and ease and economy of administration. By 1994, 401(k) accounts held more than $480 billion in assets, and enjoyed annual growth of approximately 13.5 percent. The shift from defined-benefit plans to defined-contribution plans, through which employees select the manner in which their 401(k) funds will be invested from a range of options, continued to gather speed as the stock market enjoyed a spectacular rise in the late 1990s. In response to the demand for increased sophistication in the handling of 401(k) funds, many corporations set up internal services to establish investment options and manage 401(k) trust accounts and IRAs for their employees. Other plan sponsors turned to alliances of investment firms, such as that founded by Coopers & Lybrand and Charles Schwab in 1994, to develop and administer employee salary reduction plan investments and options. These alliances provided 401(k) participants with more investment choices and a level of services previously associated with private investments. By the end of the decade, computer-based 401(k) investment advice services were offered by major investment companies, including Fidelity, 401k Forum, and Vanguard.

At the end of 1997, approximately 78 percent of eligible workers participated in a 401(k) plan. Defined-contribution plans overall—including 401(k), profit-sharing, and thrift savings plans—are expected to grow to more than $1 trillion by the early 21st century. Changes in the tax code adopted in 1997 provided further incentive for participation by expanding the definition of hardship withdrawal of assets from 401(k) accounts to include higher education expenses and loans for the purchase of homes or automobiles. Employers also moved to increase participation in salary-reduction investment programs in the late 1990s, with many turning to the previously rare expedient of automatic enrollment (also known as "negative election") of new employees. Use of this tactic was not expected to become too widespread, however, because of the clauses of 404(c) that hold plan sponsors responsible for poor investment performance unless participants are offered a range of investment options.

OVERALL IMPACT OF 401 (K) PLANS

Increased participation in 401(k) plans also proved a boon to plan sponsors. Many corporations found that they could convince participants to divert their funds into investments that would benefit the company as a whole, such as the use of employee salary-reduction plan contributions to finance corporate takeovers. In other cases, employees used their 401(k) funds to acquire stock in their own companies. As corporate awareness of the financial importance of salary-reduction plans rose, abuses of such investments also increased, with the Department of Labor reporting 426 civil and criminal legal cases arising from alleged corporate misuse of employee 401(k) funds in 1996.

The shift from defined-benefit plans to defined-contribution plans such as 401(k)s has had both positive and negative ramifications for both employees and employers. On the downside, employees have been compelled to shoulder more of the financial burden for their retirement, and employers have had a larger responsibility to report their application of pension funds. But most observers have applauded the movement. Employees have gained greater control over their retirement assets, and recent developments in the industry have increased the range of investment choices and the flexibility of use of salary-reduction plans. These plans provide immediate tax advantages as the contributions are subject to neither federal income taxes nor most state and local taxes. They also provide long-term tax advantages, as earnings accumulate tax-free until withdrawal at retirement when withdrawals can receive favorable tax treatment. Furthermore, plan funds confer certain short-term benefits, as participants can, in effect, loan themselves their own defined-benefit funds interest-free and without penalty for a variety of purposes, including payment of educational expenses and the undertaking of a mortgage or automobile loan. Salary-reduction plans have enabled employers to share or even eliminate their pension contributions, and employer matching of participant's 401(k) contributions are tax deductible. 401 (k)s have evolved into a valuable perk to attract and retain qualified employees. Employers can even link contributions to a profit-sharing arrangement to increase employee incentive toward higher productivity and commitment to the company.