Over the last few decades, the American retirement landscape has changed dramatically, with defined contribution (DC) plans such as 401(k)s becoming increasingly popular. Individuals can save for retirement with tax-advantaged savings. However, as the retirement landscape evolves, it is worthwhile to consider what the future holds for these plans.
The history of DC plans in the United States
To gain a comprehensive understanding of the retirement landscape in the United States, it is essential to delve into the historical context of company-sponsored retirement plans. In the 1970s and 1980s, defined benefit (DB) plans, commonly known as pension plans, reigned as the predominant form of retirement provision. These plans offered employees a guaranteed fixed retirement income, typically based on a formula incorporating their years of service and salary. However, the sustainability of pension plans encountered significant challenges, driven by factors such as corporate earnings and the desire to shift pension risk from employers to employees.
Corporations, driven by a focus on maximizing their earnings, faced difficulties in maintaining the financial obligations associated with pension plans. Moreover, the rise of globalization and the decline of specific industries further strained employers' ability to sustain these plans. Consequently, a notable shift toward defined contribution plans transpired.
In the 1980s, defined contribution plans, exemplified by the introduction of 401(k)s, emerged as an alternative approach, empowering employees to save for retirement independently. These plans incentivized participation through employer contributions and tax breaks. Unlike defined benefit plans managed by employers and guaranteeing specific retirement income, defined contribution plans place the onus on employees to manage their retirement accounts, which are influenced by their own contributions, investment returns, and associated fees.
Today, defined contribution plans, particularly 401(k)s, have become the prevailing method of retirement savings for Americans. As of 2019, data from the Investment Company Institute (ICI) reveals that Americans held approximately $6.2 trillion in 401(k) plans, contrasting with the comparatively lower figure of $2.8 trillion in traditional pension plans.1
Issues confronting DC plans, including market volatility and fees
The future of defined contribution plans, however, is shrouded in uncertainty, and several challenges loom ahead. One prominent issue is the risk associated with market volatility, which directly affects participants in such plans. Unlike defined benefit plans, which are typically overseen by professional investment managers, defined contribution plans place the responsibility on participants who may have limited investment expertise. Unlike pension plans that assume market risk, participants in defined contribution plans bear the full brunt of market fluctuations. This poses a significant concern, especially for those nearing retirement. If the market experiences a prolonged downturn, individuals may witness substantial declines in their retirement savings, potentially resulting in lower retirement income or an extended working life. To mitigate this risk, there has been a growing interest in packaged investment solutions like target-date funds and managed accounts.
Fees are another issue that defined contribution plans face. Even though 401(k) plan fees have become more transparent in recent years, with employers required to disclose fees and expenses to plan participants, excessive fees can still eat into retirement savings over time. Furthermore, many participants are unaware of the impact fees can have on their retirement savings, prompting calls for greater fee transparency and accountability.
Promising future for DC plans, supported by recent legislative changes
Despite these obstacles, the future of defined contribution plans and 401(k)s looks promising. Recent legislative changes have played a significant role in this positive outlook. These changes aim to expand retirement savings options and address the needs of a broader range of workers, including those in nontraditional employment arrangements.
Efforts such as the implementation of Multiple Employer Plans (MEPs) and state-sponsored retirement programs demonstrate a commitment to extending retirement benefits beyond traditional corporate-sponsored plans. These initiatives strive to bridge the gap and provide access to retirement savings opportunities for part-time, self-employed, and contract workers, ensuring a more inclusive retirement landscape. Traditional pension plans are benefiting fewer retirees as most of the American workforce works for companies that no longer sponsor the traditional pension plan. making defined contribution plans an essential retirement savings vehicle.
Recent legislative changes have sought to improve the accessibility of defined contribution plans. The Setting Every Community Up for Retirement Enhancement (SECURE) Act and its follow-up, SECURE 2.0, made several changes to 401(k) plans, including allowing long-term, part-time employees to participate in employer-sponsored plans and requiring employers to offer automatic enrollment in any newly established plan.
As we look to cover more people in 401(k) plans, the adoption of automatic enrollment and automatic escalation features take out some of the barriers to participation for defined contribution plans. These features can increase participation and contributions by making it easier for people to sufficiently save for retirement. According to a Vanguard study, plans with automatic enrollment had a 93% participation rate on average, compared to 66% for plans without automatic enrollment.2
Financial wellness programs sponsored by employers may also become more common in the future. These programs are intended to assist employees in better managing their finances, including retirement savings. Employers can help their employees make informed decisions about their retirement savings and improve their overall financial well-being by providing access to financial education, counseling, and tools.
The impact of the COVID-19 pandemic on retirement savings and the potential for emergency savings plans
The COVID-19 pandemic has highlighted the importance of emergency savings and financial resilience. In the future, we may see a greater emphasis on accumulating emergency savings in addition to retirement savings.
The economic uncertainties and job disruptions brought about by the pandemic have highlighted the importance of having a safety net in the form of emergency savings. In response to this shift in awareness, financial experts predict a growing emphasis on accumulating emergency funds alongside retirement savings. This could involve the introduction of retirement savings plans that incorporate dedicated emergency funds or the establishment of separate automatic funding for emergency savings accounts. By having a robust emergency savings cushion, individuals can better protect their retirement savings and handle unexpected expenses during challenging times.
The issue of retirement readiness and the potential for mandatory retirement savings programs
The issue of retirement readiness is one potential challenge for the future of defined contribution plans. While 401(k) plans allow individuals to save for retirement, many do not save enough to meet their retirement needs. According to the Economic Policy Institute, the median retirement savings balance for U.S. workers between the ages of 56 and 61 is just $21,000, far short of what is required to live comfortably in retirement.3
To address this issue, some have called for the implementation of mandatory retirement savings programs like those found in countries such as Australia and the United Kingdom. These programs would require employers to automatically enroll their employees in a retirement savings plan, with contributions automatically deducted from their paychecks. While controversial, mandatory retirement savings programs could go a long way toward ensuring that Americans are adequately prepared for retirement.
Conclusion
While defined contribution plans like 401(k)s face several challenges, their future looks bright. With the continued growth of the gig economy, legislative changes designed to improve retirement savings, and the potential for automatic enrollment and escalation, defined contribution plans are likely to remain an essential retirement savings vehicle for many. As the retirement landscape continues to evolve, defined contribution plans will play an essential role in ensuring that Americans are able to retire with dignity and security.
1 ICI (March 2020). Ten Important Facts About 401(k) Plans. Retrieved July 25, 2023, from https://www.ici.org/system/files/attachments/pdf/ten_facts_401k.pdf#:~:text=Americans%20held%20%248.9%C2%A0trillion%20in%20DC%20plans%20in%20the,accounting%20for%2019%C2%A0percent%20of%20all%20US%20retirement%20assets.
2 Vanguard. How America Saves 2022: Insights to Action. Retrieved July 25, 2023, from https://institutional.vanguard.com/content/dam/inst/vanguard-has/insights-pdfs/22_TL_HAS_InsightsToAction_2022.pdf.
3 Morrissey, M. (December 10, 2019). The State of American Retirement Savings. Economic Policy Institute. Retrieved July 25, 2023, from https://www.epi.org/publication/the-state-of-american-retirement-savings/.