401(k) vs Pension: The SHIFT That Changed Everything

401(k) vs pension: why did pensions disappear — and what does that mean for your retirement? In this episode, Wes Cuprill breaks down the shift that changed retirement planning forever.
Most people have never stopped to ask: why does the 401(k) even exist?
You'll learn:

Why corporations abandoned pensions in the 1970s and 80s (and what forced their hand)
How the 401(k) solved a corporate finance problem — by transferring all the risk to you
The four phases of 401(k) evolution: from voluntary enrollment and limited funds to Roth options, automation, and SECURE 2.0
What changed with the Pension Protection Act of 2006 — and why it dramatically increased participation
The real trade-off: more portability and individual control, but far more personal responsibility

The bottom line: the 401(k) didn't just grow in popularity — it replaced an entire retirement model. Understanding how that happened is the first step to using it wisely.

Understanding that history matters. Because when you realize the 401(k) wasn’t designed to be the “perfect” retirement system — it changes how you think about relying on it.

Next episode: Why the 401(k) took off like wildfire… and how it became the backbone of retirement in America.

Chapters:
00:00:00 – Why Defined Benefit Plans Started Failing
00:02:06 – The Revolutionary Benefits of 401k Plans
00:04:01 – The Collapse of Traditional Pension Plans
00:06:06 – Tax Advantages and Automatic Enrollment Changes
00:08:14 – Growth to 14 Trillion in Assets
00:10:03 – Early Problems and the 1990s Improvements
00:12:01 – Roth Accounts and Catch-Up Contributions Added
00:14:04 – Comparing 1980s to Modern 401k Features
00:16:04 – Individual Responsibility and Investment Competence Required

Transcript

So what I want to talk about today is why the 401k took hold, how it became the backbone of retirement in the United States, and then discuss some of the changes or evolutions that it has seen over the last 45 years. So to go back to the beginning, the 401k really solved a growing corporate problem. By the 1970s, traditional pensions or defined benefit plans were becoming increasingly expensive.(...) One of the biggest reasons behind that was the fact that Americans were living longer. So these companies were having to pay pension benefits to people for a lot longer than they originally anticipated. Also at this time, inflation was a lot higher, putting a lot of stress on the dollar and requiring these pension programs to offer higher cost of living adjustments.(...) Additionally, investment volatility was also rising. In order for a pension plan to succeed, all of the funds in the pension plan are invested and they need to grow. But if you're seeing a lot of volatility in the markets, the overall pension may not be as healthy as it needs to be in order to pay out all of the benefits that it needs to. And then lastly, pension accounting rules were beginning to tighten. I'll talk a little bit more about that here in a minute. So just to summarize, defined benefit pensions required employers to guarantee lifetime income,(...) bear all of the investment risk, and then manage the long-term funding obligations of the plan. Well, the 401(k) immediately flipped that model. Instead of offering a future benefit, employers could offer a contribution, usually in the form of a match, which required the employee to first contribute to the plan and then they would match up to a certain percentage. It also enabled employers to shift the investment risk entirely from them over to the employees.(...) This reduced long-term liabilities and it made costs much more predictable for the employer. So from a corporate finance standpoint, this was an absolute breakthrough. And ultimately, there is some attraction to employees around the 401(k). First and foremost, the 401(k) offered pre-tax contributions. So you had immediate tax savings because you could reduce your taxable income for that given year. There was also free money to be had. If your employer was offering a match, you could contribute, collect that match, and that was free money. Payroll deduction enabled the process to be easy to automate. And then one of the biggest things that made the 401(k) attractive to employees was the idea of portability. Before the 401(k), if you left your company, you couldn't bring your pension plan with you. You then had to find another employer with a pension plan. Whereas with the 401(k), if you leave your employer, you're able to take your plan over to your new employer. And this was very important during a time when the U.S. economy was shifting from a manufacturing base to more of a technology service-based economy. And employees were moving around a lot more frequently than they did before. So the portability of the 401(k) made it a very attractive option for employees.(...) Also during this time, you had sort of a cultural shift towards individual responsibility happening in the United States. It was an ideological shift. For better or worse, it is what it is. We saw people wanting more individual choice, taking more personal responsibility for things. They wanted market-based solutions, and they wanted ownership over their investing. And the 401(k) really fit that narrative well. So why then did the 401(k) become the backbone of U.S. retirement? I don't think it's very difficult to see, but let's still go through it. It wasn't so much that 401(k)s grew in popularity, it's that pensions really shrank in their popularity. We really saw a collapse of defined benefit pensions. In 1980, about 38% of private sector workers had pension benefits. That's the private sector, so that's not including public pensions. Today, fewer than 15% of workers have pension plans, and most of them are now public employees. So corporate America systematically shifted from defined benefit to defined contribution plans.(...) And accounting rules around this time really made pension liabilities more visible for these companies, market volatility, as I mentioned. There was also a lot of shareholder pressure during this time. This was really the rise of corporate takeovers, consolidation, et cetera, and really trying to raise value for the shareholder. And pension plans did not increase value for the shareholder. 401(k) plans could help with that narrative. And then global competition around this time was really forcing cost control. And pension plans being one of the biggest costs for employers, they said, "You know what? We got to get rid of these pension plans." And so the 401(k) became the replacement system by default, because ultimately pension plans are gone. There's really no other option at that time. 401(k)s are sort of a benefit that you can start offering your employees. And then to go back to the accounting rules that I talked about, the Employee Retirement Income Security Act, or IRISA, of 1974 really laid the foundation for, I think, a lot of these changes. So it created a lot of regulatory guardrails for retirement plans, really required fiduciary standards, increased transparency, and it made employer plans safer and more structured. But again, it increased cost, and the overall administrative burden on these pension plans was greater. And so by the time the 401(k) emerged just four years later, the legal infrastructure was already in place that kind of made pension plans really not that attractive anymore. There were also massive tax incentives around this time that made the 401(k) look again more attractive. The government strongly incentivized participation in 401(k)s by offering tax-deferred growth that we know to be the case. In 401(k) plans, there was employer deductibility of contributions made to employees.

(...)

Pension limits increased over time, so you continued to stuff more and more away into your 401(k), and then eventually we saw catch-up contributions become a thing for older workers. And so these tax advantages made the 401(k) extremely compelling relative to taxable investing. On top of this, there was also something that enabled a behavioral shift. When it comes to saving, it can be difficult to force yourself to put money away. With the 401(k) and deferring some of your compensation automatically to the 401(k), it shifted your behavior. If you don't ever see the money hit your bank account, it just goes straight into your 401(k), you're more likely to invest. And so because of this payroll deduction, people were starting to invest more on their own. Employer matching was making that more attractive, and we saw this behavioral shift that said, "Okay, yeah, the 401(k) makes sense because I'm doing this automatically. I don't even have to think about it." So that was another big reason why the 401(k) just all of a sudden started making sense. And then around the 1980s to 2000s, we saw an increase in investing options for 401(k)s. There was an explosion of mutual fund availability. You saw the rise of Vanguard and other low-cost funds that you could invest your 401(k) proceeds into. And eventually we saw the rise of the target date fund that said, "Okay, why don't you invest in a fund that is set for 40 years down the road and you just invest in this fund, we'll worry about the rebalancing of it and changing the investment mix over time." So for somebody who is far away from retirement, it will be invested aggressively. And then as 40 years go on, the investment mix will change to be more conservative so that by the time you are ready to retire, your 401(k) is in more of a conservative position. And so the investment industry really built an ecosystem around 401(k) plans. They said, "Okay, we see this as the future. We'll build an ecosystem to match." And then as a result, everything kind of gets rooted and it is what it is. And today there are about $14 trillion in 401(k) assets. It's one of the largest pools of capital in the world. So it's not hard to see why the 401(k) rose in popularity. It really shifted the burden from employers, which they really wanted to do, enabled them to reduce their costs, which was great for the shareholders. And then ultimately a lot of the structure around it was helpful to the employee. But again, it does shift the responsibility to the employee. It is up to them to continue to contribute to it and ensure that they have enough at the end of the day because you don't have a guaranteed paycheck. You have to ensure that you have enough in your 401(k) so that you can fund your lifestyle in retirement. So let's talk now about how the 401(k) has evolved over the last 45 years. It does look a bit different than it did 45 years ago. So in the early years during early adoption in the 1980s, here are some of the characteristics that we saw around the 401(k). There was voluntary enrollment. So when you joined a company that had a 401(k), you weren't automatically enrolled. You had to choose to do so. There were very limited funds. Around this time, there weren't really any mutual funds to invest in. So your investment selection was limited. There were a lot of high fees, this being a new thing. Companies there were probably a few who knew how to administer it. And so the fees were high. There was little participation as a result of education. There really wasn't a lot of educating employees about what this new plan is. There were mostly active managed funds that you can invest in. We talk a lot about some of the downsides to actively managed funds. They may not give you the returns that you desire. And then there was also no Roth option. So ultimately, again, participation was low and it certainly wasn't universal. Then by the 1990s, we saw a lot of rapid expansion, especially around how the 401(k) developed. Technology was really improving record keeping, so it reduced a lot of the burden on employers and plan administrators. Contribution limits were increasing, so people saw it as more of an opportunity to defer more income, ensure the 401(k) balances were increasing more over time. And we saw an increase in the investment choices. And then on top of this, I think you really saw an explosion of financial education. Because the burden had shifted to employees, people realized, "We need to educate people on what all of this is, on what investing is, what 401(k) plans are, what it means to plan for retirement." So the 90s was really a focus on that overall education. But participation gaps remained, especially amongst lower income workers. Then in the 2000s, we saw what could really be called a behavioral revolution. And some of this was the result of some legislation that was passed. In 2006, we had the Pension Protection Act. This allowed automatic enrollment in your 401(k). It also allowed automatic escalation. So you could say, "You know what? Every year, I want to increase the amount that I defer." There were also target date funds as defaults. So people were just defaulted into the target date fund. That way, they didn't really necessarily have to worry about fund selection or diversifying across several different funds. And so this dramatically increased participation rates, especially among younger and lower paid workers. Because it shifted sort of the mindset from, "You have to opt in," to, "You have to opt out." And when people have to opt out, they are much less likely to do so. Then phase four, we saw Roth and increased flexibility come into play with the 401(k). So this is about 2006 to present. So to go through some of the additions that we saw, you had the Roth 401(k) option, which is really a very powerful addition to the 401(k). It enabled people to also put after-tax income into their 401(k) that would grow tax-free. So when they retired, everything that was in their Roth 401(k) was completely tax-free. There was also the addition of implant Roth conversions. So if you had a massive traditional 401(k) balance, you could start to convert some of that into the Roth component. Catch-up contributions increased. We also saw the introduction of mega backdoor Roth strategies. I won't go into that in detail here. Probably a discussion for another time. Loan provisions were expanded so you could take a loan from your 401(k).(...) Hardship withdrawals were modified. And then we also saw some changes just a few years ago with the SECURE Act and SECURE 2.0. These acts brought with them a later required minimum distribution age. So that got raised. Required automatic enrollment for any new plans. There was student loan matching, emergency savings features, and then long-term part-time workers were also eligible to participate in company 401(k) plans. So what we're seeing is the modern 401(k) is far more flexible and accessible than the earlier versions. And there's a lot more options that you can end with the 401(k). Though even I will admit, when we look at kind of how it's evolved over the last 45 years, I don't think it's changed too much. There's been some additions, absolutely. But I think if we look at it, you know, has it really evolved as quickly as we think it should? I don't know. I think there might be room for debate there. So just to kind of summarize some of the structural shifts, you know, back in the 1980s, it was to supplement pensions. And now in the 2020s, the 401(k) has become the primary retirement plan. 1980s employee responsibility was unclear. Well, now it's entirely fully employee-directed. There were few investment options in the 80s, and now you have broad menus, as well as what I'll talk about in a future episode, the self-directed brokerage account ability within many 401(k)s. Forty-five years ago, there were high fees with little transparency. And today, you have fee disclosure because there are so many 401(k)s out there, fees are very, very low, and you have a lot of index funds that you can choose from. There was no automation in the early years. Well, now it is heavily, if not entirely automated. And when it first came out, the 401(k) had no Roth option. Now many times, the Roth is a standard option in the 401(k). So if we look at the big picture here, the 401(k) didn't just grow. It really did replace the entire retirement model. I don't think people really fully realize how transformational Revenue Act of 1978 would turn out to be. You went from employer-funded lifetime income to mostly employee, somewhat employer-funded investment accounts. You are now entirely responsible for your retirement and financial future. This shift did increase portability and individual control, but it also increased the risk borne by you, the individual worker, and it really increased the need for financial literacy. And that's the trade-off. One could look at it and go, "Man, that kind of stinks." And yeah, you could say that, but ultimately, it is what it is. I think one thing that I talk about sometimes is that, yeah, we can sit here and try and change the game, but ultimately, you are going to have to play the game and play by its rules. And this is one way in which we are having to play by the rules. The 401(k) is the option. It is incredibly powerful, and I will continue to talk about how powerful it is. In fact, next week, I'm going to talk about what the 401(k) gets right, but it does require engagement. It requires saving discipline, which I think is one of the hardest, if not the biggest problem that we have around saving for retirement and saving for our financial futures. And investment competence is something that is necessary when using a 401(k). You didn't have to worry about it with pension plans. You literally just retired, and your check came to you every month. Now, you need to be on top of everything and ensure that you are set for your financial future. So next week, again, what I'm going to talk about is what the 401(k) does well. I still think there are some great things in it. But again, what we saw over the last three weeks, including this week, I've talked about how the 401(k) really changed everything. And it was started entirely by accident, and I think people need to realize that. That it isn't the savior of retirement that some people like to preach it as being. It is just simply the tool that we have at our disposal. So it's important to understand that before we move into what it gets right. And then what I am going to talk about is what I think that it gets wrong. So that's a future episode as well. And then we'll talk about how we can kind of overcome those shortcomings and build the 401(k) in a way that really supplements our overall wealth building strategy. So that's next week. Thanks.