Wealth in our Woods Column: The Story Behind Your 401(k)
What are exchange-traded funds?
By Kyle Green, CFP®, Sherwood Wealth Management
SHERWOOD, Ore. — During the 1970s, several problems began to emerge in the American retirement system. People were living longer, inflation was rising, and traditional pension plans were becoming increasingly expensive for employers to maintain. At the same time, workers were changing jobs more frequently, often leaving behind retirement benefits that were difficult to transfer. Lawmakers also recognized that Social Security alone was unlikely to provide enough income for most Americans to enjoy a comfortable retirement.
In response to these challenges, Congress passed the Revenue Act of 1978, which created Section 401(k) of the Internal Revenue Code. The provision was intended to expand deferred compensation arrangements by allowing employees to set aside a portion of their earnings without immediately paying income taxes. At the time, it attracted little attention.
That changed in 1980 when employee benefits consultant Ted Benna realized Section 401(k) could be used to create a new type of workplace retirement plan. His design allowed employees to contribute a portion of their salary on a pre-tax basis and receive matching contributions from their employer. The money could then grow tax-deferred until retirement, when withdrawals would be taxed as ordinary income. This paved the way for the modern 401(k) plan.
These plans fall into a category known as defined contribution plans. Unlike traditional pensions, which promise a specific retirement benefit, defined contribution plans allow employees and employers to contribute money to an individual account maintained for the employee's benefit. They are considered qualified retirement plans because they receive favorable tax treatment under federal law.
Although 401(k) plans would not emerge until several years later, much of the regulatory framework governing employer-sponsored retirement plans was established by the Employee Retirement Income Security Act of 1974, or ERISA. It was enacted after several high-profile pension failures exposed weaknesses in the retirement system.
ERISA established rules designed to ensure retirement plans operate for the benefit of the employees. It created standards for fiduciary responsibility, reporting, disclosure, and participant protections. In many ways, ERISA has been just as important to the modern retirement system as Section 401(k) itself. Without it, Americans would likely have far less confidence in a system that now holds trillions of dollars in retirement savings.
While Section 401(k) and ERISA established the rules, they do not determine what employees actually see when they enroll in a retirement plan. That responsibility falls to the employer and the service providers they select. When an employer offers a 401(k), they typically hire a company such as Fidelity Investments, Vanguard, or Betterment to administer the plan.These firms handle recordkeeping, participant services, compliance requirements, and the menu of investment options available to employees.
Many assume more investment choices automatically lead to better outcomes. Research has shown the opposite can be true. When employees are presented with too many investment options, participation rates may decline and decision-making can become more difficult. Known as choice overload, this phenomenon can cause employees to delay enrollment or struggle to build an appropriate portfolio.
As a result, most modern 401(k) plans offer a carefully selected menu of investment options rather than an endless list of choices. Many plans also include target-date funds designed to provide a simple, diversified solution for participants who prefer a hands-off approach.
The next time you log into your 401(k), remember that the plan did not appear overnight. It is the product of decades of legislation, regulation, and innovation aimed at helping Americans prepare for retirement. From Section 401(k) and ERISA to the investment options available in your account today, an entire framework exists behind the scenes to encourage saving, protect participants, and make retirement planning more accessible.
