Could The MyRA Be The Beginning Of The End Of The 401(k)?

Posted by Michael Kitces on Wednesday, May 21st, 7:01 am, 2014 in Retirement Planning

The employer pension plan has been a part of the employee benefits landscape for nearly 140 years. Yet the reality is that after a tremendous rise in the decades after World War II, the availability of the defined benefit plan has been in decline for over 30 years, as the defined contribution plan has risen to take its place.

Yet unlike a pension plan that was paid in addition to an employee’s salary, the defined contribution plan often amounts to little more than an employee saving his/her own money in the first place, perhaps plus a moderate match that is losing its purpose as a behavior incentive when more and more plans include automatic enrollment and automatic escalation of contributions in future years.

All of which raises the fundamental question: if employers simply paid a greater salary (with a raise equivalent to what the match would have been) and let employees choose whether to save, is there really any need for a 401(k) plan at all? And with the MyRA coming soon – which once in place, could be easily modified in the future to include automatic enrollment, and higher contribution limits similar to what 401(k)s allow today – could we be witnessing the beginning of the end of the 401(k) plan altogether?

History Of Employer Retirement Plan Benefits

The first private pension plan was established by the American Express Company in 1875, though pensions were relatively rare through the late 1800s and early 1900s, due in large part to the fact that few employers were large enough and stable enough to even offer them in the first place. By 1940, only about 15% of private-sector workers were covered by a pension plan.

However, as pensions became increasingly popular in the decades that followed, especially on the back of the post-World-War-II economic boom, a growing disparity emerged between those working for large companies that were able to offer pensions, and smaller businesses that could not. By 1960, 41% of all private-sector workers were covered by pension plans, but almost exclusively those working for larger firms. To address this gap, a series of laws were passed, creating everything from Keogh plans in 1962 (the predecessor to today’s small business and self-employed individual retirement accounts), to the Individual Retirement Account (IRA) established in 1973 (as a part of ERISA, though the first accounts weren’t available until 1975) for those who were not covered by an employer pension plan at all.

At the same time, through the booming 1950s and 1960s, some employers also allowed additional after-tax contributions to retirement plans for employees who wished to supplement their pensions, and a number of employees sought out various “deferred compensation” arrangements that would allow them to make such contributions on a pre-tax basis.  However, the tax deductions were often challenged by the IRS as tax avoidance schemes. To resolve the issue – and actually to prevent even more aggressive perceived abuses – Congress passed the Revenue Act of 1978, which created the first 401(k) plan to limit such employee salary deferral tactics. Upon realization that the 401(k) rules would actually make it relatively easy for employers to offer a supplemental savings plan to employees on a tax-preferenced basis, 401(k) plans quickly grew popular. The movement towards defined contribution plans had begun.

However, as it turns out the introduction of the 401(k) – with the new rules first taking effect in 1980 – also essentially marked the peak percentage of private sector employees covered by pension plans at 46% of private-sector workers. While there is much debate about whether the availability of defined contribution plans itself led to the decline of pension plans, whether long-term employers found their base of prior employees so large the pension plan became difficult to manage relative to the current size of the business (i.e., GM’s $134B in total global pension obligations with a $25B shortfall in 2012 when it only had $5.3B of income in 2013!), or the simple fact that it takes a lot more to provide pension coverage now that life expectancies are so much longer than they used to be, the end point is the same: there has been an incredible shift from defined benefit pension plans to defined contribution plans. In today’s marketplace, only about 18% of private-sector workers are still covered by a pension plan (some industries far more than others), while 401(k) plans are widely available from employers large and small.

Do Retirement Plans Really Need To Be Employer-Based?

With employer retirement plans being offered for nearly 140 years, it’s difficult to imagine a world where the employer does not offer such a plan. Yet the reality is that while it’s clearly necessary in an environment where a pension plan is offered by an employer and funded by an employer – in addition to any compensation the employee already receives –the case is less clear in the context of defined contribution plans like 401(k) plans, which in the end represent an employee’s own contribution of their own money to the plan in the first place. In other words, if an employee is going to be paid some amount (e.g., $80,000), and wishes to defer some portion (e.g., $10,000) of that income for future retirement use, does it really actually matter if the money goes to an employer-based retirement plan or one the individual controls directly? Either way, the employer’s “cost” is the same $80,000 salary, and the only thing that changes is where the employee decides to have the money deposited.

Historically, there have been two primary reasons that it’s preferable for employees to have access to and participate in an employer-based retirement plan. The first is that many employers offer a match to employee contributions as a form of incentive to participate and an additional employee benefit, which simply isn’t available if employees contribute to a retirement account of their own. The second is the fact that the current contribution limits for defined contribution plans like 401(k)s are significantly larger (at $17,500 plus a $5,500 “catch-up contribution” for those over age 50, in 2014) than for individual retirement accounts (where the IRA limit is only $5,500 plus a $1,000 catch-up).

However, the landscape is beginning to shift. In 2006, the Pension Protection Act established the opportunity for employers to begin to automatically enroll employees in pension plans, and by 2011 it was estimated that 56% of employers automatically enrolled employees; in addition, a whopping 51% also included automatic escalation features that lead employees to save a portion of their future raises, thereby further increasing their contribution rate in the long-term as they commit to “saving more tomorrow” (even if they can’t today). While these shifts to take advantage of our behavioral tendencies have the benefit of helping us to save, they are having an unintended side effect: there are some indications that employers are beginning to reduce how much matching they offer. After all, if the point of matching is to encourage savings behavior or to encourage employees to save more, but automatic enrollment and automatic escalation are already defaulting them to do so, there’s not much reason to have a match. At that point, there may be a perception difference between “matching” the employee and simply giving the employee a higher salary (which they can choose to save or not), but there’s no action financial distinction anymore.

Of course, the one remaining caveat is that “just” getting paid more and deciding to save it may be limited by the relatively “modest” (at least compared to 401(k) plans) contribution limits attached to IRAs. Yet arguably if the only reason that employer-based plans retain an advantage over individual plans is the contribution limit, that is something Congress could theoretically “fix” by simply increasing IRA contribution limits to align with (or fully coordinate with) 401(k) plans. Which leaves the potential for payroll-deduction-based automatic enrollment as the last distinguishing feature of the 401(k)…

Introducing the MyRA

During his State of the Union address earlier this year, President Obama announced that the Treasury would soon be rolling out a new “MyRA” program, with a pilot program targeted by the end of 2014 (implying wider rollout someone in 2015). The MyRA offering is intended as an “easy-to-use” starter retirement account, primarily for workers who do not have access to an employer retirement plan.

In practice, the MyRA will simply be a Roth IRA – with the same income and contribution limits – that can be funded directly through payroll contributions with amounts as low as $25 initially and $5/paycheck, with no fees to set up and use the accounts. Contributions will be invested in a government bond offering comparable to the Thrift Saving Plan’s “G Fund” (which provides a variable interest rate that trends with government bonds but a principal guarantee that the account value will never decline, even if rates rise). And while the proposal was nominally explained as being for those who don’t have access to an employer retirement plan, the reality is that as a Roth IRA, it could be available to anyone.

What’s significant about the MyRA is that it provides the mechanism for employees to someday be defaulted into automatic enrollment (or controversially, potentially even mandatory enrollment) and automatic escalation of future contributions, just as is now available with 401(k) plans. While such an approach would arguably be quite burdensome for small businesses, it’s far more feasible when it’s routed centrally through the existing administrative mechanisms that already exist to handle payroll taxes via the Treasury. And although it would require an Act of Congress to do so, once the MyRA structure is established and available, the question may soon become “why not” provide automatic enrollment for those participating in the workplace, if only to provide more parity with those who actually do have access to a 401(k) plan (especially if the Treasury is already absorbing most of the administrative burden from small businesses).

Yet the end point of such a path would put IRAs and 401(k) plans on their most equal footing yet – automatic enrollment, payroll deduction from the workplace, default investments with the option to change in the future – yet the IRA/MyRA version would be more easily portable (as it’s not tied to the employer in the first place), and the only material difference would be the contribution limits (which can be changed).

In other words, just as may soon be the case with health insurance as well, employers may simply be able to pay their employees a full salary, and let the employee decide whether and how much to allocate to everything from health insurance to retirement contributions and anything else. The point is not that employers would pay their employees less; it’s simply that employers would pay the same total amount to employees and let them decide where to direct it (or not), perhaps with some helpful nudges (like automatic enrollment as a default) along the way.

Which raises the question: if employers really did simply pay the equivalent of a match as additional salary, and individuals were defaulted into a MyRA with automatic enrollment, reasonable low-cost investment options, full portability, and the same contribution limits as a 401(k) plan, do we really need 401(k) plans at all? And if the MyRA plan is coming soon – with the potential for the rest to follow not long thereafter – could we be witnessing the beginning of the end of the 401(k) plan?

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