A look at the evolution of the 401(k) plan

By Terry J. Diehl The Daily Record Newswire The Revenue Act of 1978 included a provision that became Internal Revenue Code Section 401(k) under which employees are not taxed on the portion of income they elect to receive as deferred compensation rather than direct cash payments. The Revenue Act of 1978 added permanent provisions to the Internal Revenue Code sanctioning the use of salary reductions as a source of plan contributions. The law went into effect on Jan. 1, 1980. Regulations were issued in November of 1981. This was the birth of our 401(k) plan as we know it. Several companies started the process to adopt a 401(k) plan between 1979 to 1982; among the early pioneers were Johnson & Johnson, Hughes Aircraft, Pepsico and JCPenney, to name just a few. Microsoft, at this same time, worked hand in hand with Fidelity, helping them develop the initial technology platform that was to set the standard for this industry -- a daily valuation platform employing multiple fund options with the ability to purchase company stock if available. Love it or hate it, this platform was what the individual had to deal with. Everyone wanted all the "bells and whistles" that went along with daily valuation plans, but an interesting phenomenon occurred -- they weren't performing as hoped. In fact, the research group Dalbar determined that the average 401(k) investor lagged the S&P 500 Total Return Index by 5.87 percent per year over a 20-year period ending Dec. 31, 2010. 5.87 percent underperformance! These platforms demanded extensive research, active asset allocation, and a working knowledge of active money management. The plans performed only as good as the funds that were offered, and some had some very high internal management fees. Not to mention the time away from work to manage your account. In 2003, researchers from Columbia University, in conjunction with data drawn by Vanguard recordkeeping systems, validated the notion "choice overload hypothesis." This corroborates the notion that consumers find an extensive array of products initially appealing and stimulating, yet they find it more difficult to make a decision when confronted with many choices. After establishing controls for the employer match, participant demographics, workplace education, existence of other retirement plans and other variables, this study predicted that for every 10 investment choices, on average, it reduces overall employee participation by 2 percent. There was also evidence in another factor called "familiarity factor," wherein employees, confronted with many choices, choose their employer's stock, an investment they think they understand, over the other options in their plan. This research (June 2003) suggested that most plans should offer a limited investment menu to simplify employee decision making or utilize a tiered investment menu to accommodate the demand for greater choice. Fast forward to May 2012, the Vanguard Center for Retirement Research is now recommending participant portfolios employ a combination of target date funds and the use of managed accounts as a complementary strategy. ---------- Terry Diehl is a vice president for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (716) 586-4680. Published: Tue, Jul 3, 2012