Reinventing Retirement Income in America

Policy Reports | Retirement

No. 248
Monday, December 31, 2001
by Brooks Hamilton and Scott Burns


  1. At the end of 1999, there were 340,000 401(k) plans with 34 million participants. Danny Hakim, "Controlling 401(k) Assets: Fight Brewing over Investment Choices for $1.7 Trillion," New York Times, November 17, 2000.
  2. Internal Revenue Code Section 401(k) was quietly inserted into the code by the Revenue Act of 1978, primarily to clear up a dispute over the taxation of profit-sharing plans. It says that an employee savings plan can include a cash or deferred arrangement - a deal in which employees can take their bonuses in cash and pay taxes on them or put them into their savings plans and postpone their tax bill - as long as the plan is designed to benefit low-paid as well as high-paid employees. R. Theodore Benna, a pension consultant, recognized that the law didn't forbid including regular salary and not just bonuses in such a plan and that companies could chip in extra money to encourage employees to save. He set up a plan for Johnson Companies which won Internal Revenue Service approval in November 1981. See Eric Schurenberg, 401(k) Take Charge of Your Future, updated edition (New York: Warner Books, 1996).
  3. U.S. Census Bureau, Statistical Abstract of the United States, 1999, 119th ed., Table No. 1421, Washington, D.C.
  4. United Nations Population Division, World Population Prospects: The 1998 Revision (New York: United Nations, 1998).
  5. Ibid.
  6. See Jonathan Gruber and David Wise, "Social Security, Retirement Incentives and Retirement Behavior: An International Perspective," Employee Benefit Research Institute, Issue Brief No. 209, May 1999.
  7. For survey
  8. This paper does not examine the income from Social Security. Workers and their employers currently pay a FICA payroll tax of 15.3 percent, split equally between them. (Most economists agree that the entire tax burden falls on the employee, as with employee benefits.) Of this amount, 12.4 percentage points goes to Old-Age, Survivor and Disability Insurance (OASDI) and the remainder to Medicare. The OASDI is levied up to a maximum covered wage base each year. In 2001 the base is $80,400, meaning the maximum tax in 2001 is $9,969.60 ($80,400 x .124). The most recent figures from Commerce Clearing House show that Social Security benefits will replace 53.4 percent to 24.2 percent of income for low- and high-wage base maximum workers. They will replace 39.7 percent of the average worker's income. See Avram Sacks, 2001 Social Security Explained (Chicago: Commerce Clearing House, 2001).
  9. Any Social Security benefits at retirement will be in addition to the private pension discussed here.
  10. The pension incomes are in nominal rather than real dollars.
  11. By law, the vesting period cannot exceed seven years.
  12. Another disadvantage of defined benefit plans is that although a worker and his or her spouse have a vested right to a pension, there is no benefit for a minor child or others if the worker dies prior to retirement without a surviving spouse (or a surviving former spouse with a legal right to a portion of the pension).
  13. Doe II's investment return is reduced 1.25 percent each year for the plan's annual fees and expenses - which are paid by employees.
  14. Report from Cerulli Associates, cited in Danny Hakim, "401(k) Accounts Are Losing Money for the First Time," New York Times, July 9, 2001.
  15. "Investment Returns: Defined Benefit vs. 401(k)," Watson Wyatt Insider, September 1998.
  16. These calculations are made from annual Form 5500s gathered by
  17. Morningstar does not own, operate or hold any interest in mutual funds, stocks or insurance products.
  18. Hewitt's results are for Oct. 1-Sept. 30 fiscal years. The 60 percent stocks-40 percent bonds portfolio had an average return of 19.5 percent for those four fiscal years.
  19. See Note 18.
  20. Plan assets of $54,353,404 produced total annual investment earnings of $9,926,774.
  21. The U.S. Treasury encourages automatic enrollment of employees in companies' 401(k) plans to increase participation rates, but the Hewitt study questioned the desirability of automatic enrollment. "Given the stickiness of defaults, employers may want to consider default funds and contribution rates that are more appropriate for the average participant over the longer run," Lori Lucas, a defined contribution consultant for Hewitt, said. "Time May Not Be on Automatically Enrolled Employees' Side," press release, July 10, 2001, Hewitt Associates.
  22. "John Hancock Financial Services Survey: Most Individuals Fundamentally Unprepared to Manage Retirement Assets," John Hancock Financial Services news release, April 24, 2001.
  23. Retail mutual funds generally charge higher management fees than institutional funds, which have lower expenses and generally are available only to institutional investors.
  24. Virginia Munger Kahn, "When Hidden Fees Erode 401(k)s," New York Times, July 22, 2001.
  25. Ibid.
  26. Beginning in 2002, this amount is reduced to $1,000.
  27. "Retirement Savings in an Unsettled Economy," survey for Putnam Investments, May 22, 2001.
  28. "Are We Cashing Out Our Future?" Working Group Report to the ERISA Advisory Council on Employee Welfare and Pension Benefits, November 13, 1998.
  29. Ibid.
  30. The 10 percent tax penalty may apply if the employee is under age 59 ½; there is no penalty for withdrawal if one becomes disabled as defined by the Internal Revenue Service.
  31. Under legislation effective in 2002, the one-year prohibition is reduced to six months.
  32. See CCH-EXP, PEN-PLAN-GUIDE, ¶4485, Participant-Directed Accounts, ERISA Reg. §2550.404c-1(b)(2) (i).
  33. Experience teaches that predicting the future meaning of seemingly simple words written long ago is far from simple. We will resist further comment, but the reader might note that where the Supreme Court Justices see a fundamental (i.e., common sense) wrong involving a defendant with actual knowledge of odious facts and circumstances who then manifests a deliberate indifference, a judicial s-t-r-e-t-c-h may occur.
  34. "Investment Returns: Defined Benefit vs. 401(k)," Watson Wyatt Insider.
  35. This would not prevent the employee from later changing the contribution rate or withdrawing from the plan altogether.
  36. Premixed portfolios typically would comprise one or more index funds.
  37. The complex testing is supposed to ensure that more highly compensated employees do not receive better treatment that less highly compensated employees.

Read Article as PDF