From promises to portfolios: How 401(k)s replaced pensions in America

In the late 1970s, 401(k)s didn’t exist. When you retired, you often received a pension from the company you worked at for decades. Then something unexpected happened: A 1978 law gave a new option. Within a decade, 401(k)s would go from early adoption to a complete retirement solution. Government commitment to the approach gave the concept needed credibility. Today these assets are estimated at $5 to $10 trillion dollars, while pensions cover just 13 percent of workers. ^[0]

It started with a nondescript provision in the 1978 tax code. Section 401, subsection (k) of the amended Internal Revenue Code gave employees choice in their own pay. Now instead of receiving a defined benefit, employees received a defined contribution. They could choose to divide their own pay in ways that worked best for them.

Businesses shed the administrative burden of managing expensive pension plans. Early adopters of the 401(k) like IBM raised its popularity and the industry seemed headed for steady growth. Then something unexpected happened: Ronald Reagan won the presidency in a landslide. His administration made a bold move to give 401(k)-style plans for federal workers. Now 401(k)s were not a fringe concept – they were endorsed at the highest level.

What are pensions?

A pension is like a promise: You work for a company for decades and when you retire you get a set amount for life. But what if you didn’t want to stay at the same job for decades? Private pensions were not portable. If you hated your job, tough luck. If you left you’d get back what you put in, but what made pensions attractive is that your company put in more than you did. Leaving the company basically meant losing out on retirement.

For businesses, pensions were a heavy promise they struggled to keep. Pension plans had to be actively managed. This meant entire departments focused on administering significant assets. Business decisions had to be weighed against future responsibilities to employees that never ended.

Some businesses wanted to keep their pensions but actually couldn’t. Bethlehem Steel famously rebuked the 401(k) shortly after its introduction. Ted Benna, a benefits consultant who popularized the 401(k), went to the company to get them to switch. Benna relayed to Barron’s how the HR department told him "Hey, look. We take care of our employees forever; they don't need to do anything like that." The company would go bankrupt in 2001. The U.S. Pension Guaranty Corporation took over their pension plans and was forced to cut benefits for employees anyway. ^[1]

A 401(k) wasn’t a promise, but it made it possible to keep retirement benefits across jobs and, crucially, didn’t rely on a company’s balance sheet.

Pensions, a short history

The challenge of saving for retirement is as old as written civilization itself. One of the earliest examples of a pension-like system comes from the Roman Republic when general Gaius Marius reformed military service. Before his time, soldiers had to own property and provide their own equipment to fight. The military was made up of the few who could afford their own armor, weapons, and horses. Marius opened the ranks to landless citizens. Veterans who served for 25 years or more were rewarded with land and cash—laying the basis for higher recruitment and a professional standing army. In a real way, what we think of as retirement benefits were critical to Rome’s development and future conquests. ^[2]

_{Silver denarius depicts Gaius Marius as triumphator. The Marian reforms laid the basis for the development of a professional Roman military. American Numismatic Society. Public Domain.}

As societies evolved, so did the concept of retirement. The first pensions in the U.S. date back to the Revolutionary War in the late 1700s. Thousands of soldiers had been disabled during the course of the war and had no way to provide for themselves after their sacrifices. The Continental Congress promised benefits to many of these soldiers. A few years later, they would extend benefits regardless of disability to a larger share of soldiers. ^[3]

For much of history, though, retirement planning was a personal responsibility. Most elderly Americans in the 1920s relied on family support, personal savings, or continued working. American Express was the first major corporation to offer pensions in 1875. By the 1920s, other large companies like U.S. Steel, AT&T, and Eastman Kodak had their own pension plans. By 1930, around 2.7 million active workers — 10 percent of the workforce — were covered by private pension plans. ^[4]

A study from that time showed that more than three-fourths of the pension plans established between 1874 and 1929 were entirely employer-funded. ^[5]

October 29, 1929 ushered in the Great Depression which, to fund pensions completely would change the direction of benefits. Within three years one in four workers were unemployed. Millions were forced to wander the streets for food, creating social turmoil. Companies strained by economic pressure were forced to cut benefits in order to survive.

The old way of employer-funded pensions had to change.

With the onset of the Great Depression in 1929, businesses began having great difficulty acquiring cash to meet operating expenses, including rising pension payments. Profits plummeted and, as a result, employers were forced to cut costs drastically, including pension benefits.

As a result, more firms began to require employees to contribute to their plans. Some companies actually abolished their pension plans, while others reduced the amount of benefit payments.

“Evolution of employer-provided defined benefit pensions.” Patrick Seburn

The passage of the Social Security Act of 1935 and other programs that collectively became known as the New Deal ameliorated extreme poverty. For businesses, the New Deal brought a lifeline to managing pensions. Employees now received a guaranteed amount from the government, lessening pressure on businesses to completely fund pensions.

Pensions grew most rapidly in the following decade with the onset of World War II. This happened for two reasons: a tax amendment clarified how pensions could develop; and price controls to curb inflation also froze wages. Companies had to turn to non-cash benefits like health insurance and pensions to attract workers. A key decision by the IRS in 1943 made these benefits tax-free, transforming what began as a wartime necessity into a permanent feature of American employment.

_{Tuskegee airman stands on airfield in Ramitelli, Italy. World War II changed the employment landscape and forced changes to employer-sponsored benefits. Library of Congress.}

By the 1970s, pensions had become central to the American workplace. They offered workers a secure retirement and were considered the gold standard of benefits. But there was a downside: pensions were tied to a single employer, limiting workers’ mobility. For most employees, changing jobs meant losing their pension benefits entirely.

This lack of portability became a growing problem as the economy shifted and workers sought greater flexibility. The promised payouts in the future made many stay in jobs they didn’t like simply to secure their retirement benefits. This wasn’t tenable; this needed reform.

Cutting the golden handcuffs: the quiet revolution of the 401(k)

The issue became so widespread that Congress stepped in with the Employee Retirement Income Security Act (ERISA) of 1974. ERISA aimed to protect workers’ retirement benefits while introducing flexibility into the system. One of its most significant innovations was the creation of the Individual Retirement Account (IRA), a portable retirement savings option. For the first time, employees had a tool that allowed them to save for retirement independently of their employer.

But IRAs weren’t a perfect solution. They lacked strong incentives for employers to contribute, and tax advantages for employees were limited. By the late 1970s, it was clear that additional innovation was needed to address the growing strain on employer-sponsored pensions.

Amid the growing cracks in the pension system, an unlikely solution emerged: the 401(k). This provision of the Revenue Act of 1978 wasn’t initially viewed as revolutionary. Section 401(k) allowed employees to defer a portion of their salary into a tax-advantaged account, but benefits experts at the time didn’t see its potential. It took the creativity of one consultant to unlock its transformative power.

Ted Benna, a benefits specialist, stumbled upon the concept while working on a profit-sharing plan for a client. One Saturday afternoon, he realized that combining employee salary deferrals with employer-matching contributions could create a powerful retirement savings tool. The tax code didn’t explicitly permit it—but crucially, it didn’t prohibit it either.

Benna pitched the idea to several insurance companies, but they dismissed it as impractical. Undeterred, he implemented the first 401(k) plan for his own employer, The Johnson Companies, in 1981. The plan was simple yet effective: employees could contribute part of their salary, and the employer would match those contributions, creating a new way to save for retirement.

By the mid-1980s, millions of workers participated in 401(k) plans. The private sector had found its solution to the pension crisis, and the 401(k) quickly became a dominant feature of retirement planning.

The private sector had found its solution to retirement. Now, it was the government's turn.

Reagan administration and the new mode

Ronald Reagan’s 1980 election marked a turning point in American politics. His landslide victory wasn’t just about defeating his opponent or a response to the economic struggles of the 1970s. Reagan’s administration would reshape the country’s economy and governance for the long term.

_{President Ronald Reagan Addresses the Nation from the Oval Office on Tax Reduction Legislation in July 1981. His endorsement of the 401(k) laid the basis for its future growth. Public domain.}

One of Reagan’s most notable legislative achievements was the Tax Reform Act of 1986, a major overhaul of the tax code aimed at simplifying rates and broadening the tax base. Yet, within this sweeping reform, a quiet but intense battle unfolded over the future of 401(k) plans. Initially, the Treasury Department proposed eliminating 401(k)s entirely, arguing they were a loophole. The pushback from corporations was swift. Early adopters like IBM testified against the proposal, emphasizing the growing importance of these plans as traditional pensions faded away.

In the end, the Treasury not only dropped its misgivings about the 401(k) – they adopted them for federal workers.

Since 1920, federal employees had been covered by the Civil Service Retirement System (CSRS), a pension plan designed for long-term government careers. While the system offered significant benefits, it also had a catch: only career federal employees reaped its full rewards. For others, it lacked flexibility, earning it the nickname “golden handcuffs.”

Most workers — 70 percent — left before retirement age and received only what they put in, without any interest.

The Federal Employees’ Retirement System (FERS), introduced in 1986, aimed to modernize these outdated benefits. It replaced the rigid CSRS with a more flexible three-part system: Social Security, a defined benefit pension, and the Thrift Savings Plan (TSP), modeled after private-sector 401(k)s. The TSP offered federal workers a groundbreaking deal. They received a 100% match on the first 3% of their contributions and a 50% match on the next 2%, significantly more generous than the private sector, where most plans capped matches at 50%. Even better, federal employees were guaranteed a 1% automatic contribution from the government, whether they contributed or not—a feature unheard of in private-sector plans.

The TSP also allowed workers to choose from three types of investments: government securities, a fixed-income fund, and a stock index fund (the latter two became available in 1988). Additionally, vesting was immediate, giving employees full ownership of their accounts from the start.

Despite its advantages, FERS faced skepticism from federal employees. Workers hired after December 31, 1983, were automatically enrolled in the new system, while existing employees had the option to switch—but with no way to return to CSRS once they opted out. Adoption was slow; by May 1987, only 16% of eligible employees had signed up for the TSP. ^[6]

The main obstacle? Little trust of Congress. Many federal workers were hesitant to entrust their retirement to a political body they perceived as unreliable. As one federal worker put it: “We don’t trust them. ‘We’ being federal government employees, and ‘them’ being politicians.” ^[7]

Conclusion

What seemed radical in the 1980s is the standard today. Pension systems have largely shifted to plans where individuals bear greater responsibility for their financial futures. For federal employees, FERS and the Thrift Savings Plan represented a forward-looking innovation, creating a model that rewarded flexibility and individual initiative over long-term dependence on static benefits.

This shift underscores a broader principle: government action, when strategically aligned with market dynamics, can drive innovation and set new benchmarks. The introduction of FERS is a clear example of how policy can adapt to changing economic realities, modernizing the approach to benefits while maintaining competitiveness with the private sector. Similarly, today’s administration has the opportunity to advance initiatives like ICHRA, aligning government policies with trends toward consumer-driven choices and portable benefits.

Just as the Tax Reform Act of 1986 and the creation of FERS redefined retirement for federal employees, modern innovations in benefits policy could reshape the landscape for today’s workforce. These changes show how government leadership can spark new systems that, while initially questioned, become widely adopted and stimulate economic growth. By laying the groundwork for innovation, such policies can catalyze the development of new industries and drive economic momentum for decades to come.

References

^[0]  Max, Sarah. "Inventing Modern Retirement." Barron's 98.47 (2018): 32,32,34. ProQuest. Web. 24 Sep. 2024.

^[1] Ibid

^[2]  To show how important pensions were, Rome’s first emperor, Octavian Augustus, systematized these benefits. He created a separate military treasury to pay veterans. Retirement was expensive then, too, costing 400 million sesterces to fund. Augustus thought so highly of this fund that he had this expense included in his Res Gestae Divi Augusti, a list of achievements carved in stone.

^[3] See https://socialwelfare.library.vcu.edu/social-security/veterans-pensions-early-history

^[4] Seburn, Patrick W. “Evolution of employer-provided defined benefit pensions”. Monthly Labor Review. December 1991.

^[5]  Ibid. Quoted from a 1932 study by Murray W. Latimer, Industrial Pension Systems in the United States and Canada.

^[6] Causey, Mike. "Leave Bill in the Works." The Washington Post. 28 May 1987.

^[7] Causey, Mike. "Too Good to Be Trusted." The Washington Post. 24 Aug 1987.