History of the Employment-Based Retirement System

Employers established retirement plans in the late 19th century in the absence of any tax advantages, although the government began granting tax-favored treatment to plans in the 1920s. After the Social Security system was established in 1935, employment-based retirement plans became widespread. In recent years, the Congress has enacted legislation to regulate retirement plans more carefully and to allow employees to actively participate in certain types of employment-based plans.

Retirement Plans Prior to Tax Incentives

Formal retirement plans in the United States developed in tandem with shifts in family ties and in the nature of the business world. Urbanization weakened the extended family, which formerly had helped support those who were too old to work. In addition, the number of elderly people grew rapidly as earlier immigrants aged and life spans increased.

Large corporations needed systematic, publicly acceptable ways of moving elderly workers out of their jobs. Pensions were considered one solution that also provided an incentive to younger employees to stay with an employer throughout their working life. By 1929, about 15 percent of private-sector employees were covered by employment-based plans, which were concentrated in large corporations and in sectors in which government oversight tended to be the strongest.

The Government Gets Involved

The Revenue Acts of 1921, 1926, and 1928 initiated tax advantages for employment-based retirement plans. The 1921 law allowed employers to deduct contributions to profit-sharing and stock bonus plans from their taxable income. Employees, in turn, were allowed to delay recognizing contributions to those plans as taxable income until the contributions were withdrawn. The legislation also exempted the investment earnings of such plans until withdrawal. The 1926 law extended those advantages to pensions, while the 1928 law allowed sponsoring employers to deduct contributions for past as well as current service.

On the basis of the reported debate, it appears that the Congress's exempting of the earnings of stock bonus and profit-sharing plans from taxation in 1921 was primarily intended to motivate workers to be more productive; increasing saving was a secondary consideration. Lawmakers' intentions in exempting pension plans in 1926 are less clear because there was no floor debate or discussion documented in committee reports. The provisions might have been intended to assist employers' nascent benefit plans or to resolve, in a purely technical way, the difficult problem of assigning trust income to a taxable entity.

Whatever the intent of those provisions, their enactment had little effect on the development of employment-based retirement plans in those years. Low tax rates held down the value of the benefits, so employers had little incentive to use them. Moreover, the provisions were barely in place when the Great Depression reversed the evolutionary trend of retirement plans: many employers terminated their plans, and a number of them failed to pay the benefits they had already promised to their workers.

Because employers' failure to pay promised benefits was exceptionally disruptive to the railroad industry, the federal government stepped in and established the Railroad Retirement system in 1935 to enable the depleted pension funds to meet their obligations. In that same year, lawmakers enacted the first Social Security legislation (although initially it covered only a portion of the labor force). Symptomatic of the general decline of employer-sponsored plans was the nearly total absence of any mention of them in the report of the Congress's Committee on Economic Security in 1935.

By the late 1930s, however, retirement plans had revived enough to generate concerns about their being used primarily as tax-avoidance schemes for the wealthy. Accordingly, the Congress passed the Revenue Act of 1938, which made pension and profit-sharing trusts irrevocable. The Revenue Act of 1942 established conditions that employer-sponsored plans had to meet before they qualified for tax-favored treatment. The 1942 law introduced the concepts of nondiscriminatory coverage and nondiscrimination in benefits and contributions, provisions that form the core of today's regulation of employment-based retirement plans. During World War II, pensions became a desirable form of compensation for two reasons: first, tax rates were very high and, second, contributions to pensions were exempted from wage controls. After the war, more and more employers began to offer pensions because tax rates remained high, Social Security benefits had been eroded by wartime inflation, and labor unions were successful in making pensions subject to collective bargaining.

Developments in the 1970s and 1980s

Changes in the tax code in recent years reflect evolving standards of adequacy and fairness in allocating the tax benefits associated with retirement plans. Lawmakers enacted plans in 1962 for self-employed workers and other noncorporate employers that were more tightly restricted than corporate plans. And the Employee Retirement Income Security Act of 1974 (ERISA) considerably tightened the qualification rules for employers' plans. ERISA gave the federal government authority to prescribe a uniform meaning for plan rules and legislated minimum standards for participation, vesting, the accrual of benefits, and funding.

Between 1974 and 1986, the Congress pursued two different lines of policy. On the one hand, it enhanced access to the tax advantages of qualified plans in ways that emphasized individual decisionmaking. The Revenue Act of 1978 sanctioned so-called salary-reduction arrangements in profit-sharing plans--now known as 401(k) plans--and in the state and local government sectors (section 457 plans). Similarly flexible arrangements had already been possible in the nonprofit sector under section 403(b) of the tax code. Then, in the Federal Employees Retirement System Act of 1986, the Congress extended salary-reduction opportunities to all federal civilian employees. Although operated by employers, salary-reduction arrangements shift several key decisions from employers to workers, allowing participants to determine how much will be contributed and, in many cases, how that money will be invested.

On the other hand, lawmakers enacted changes that further constrained employer practices by emphasizing the collective or forced-saving aspects of pensions. Examples are the top-heavy plan rules in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and the protections extended to widows in the Retirement Equity Act of 1984. TEFRA also eliminated differences between qualified plans maintained by corporate and noncorporate employers.

The Tax Reform Act of 1986 (TRA-86) reversed the trend toward individual control over retirement saving by lowering the maximum amount of compensation that could be deferred under 401(k) plans: whereas earlier law allowed annual deferrals of up to $30,000, TRA-86 limited them to only $7,000. But the law also extended a trend toward greater sharing of benefits among a firm's employees, primarily through stricter requirements for the inclusion of employees in retirement plans, faster vesting of benefits, and smaller offsets of plan benefits because of Social Security. Separately, the law's lowering of tax rates reduced the value of the tax advantages.

Recent Legislative Activity

During the 1990s, lawmakers sounded a theme of simplification. The various restrictions that the tax code placed on employers offering retirement plans were seen as placing an undue burden on small businesses that would probably discourage them from setting up plans. The Small Business Job Protection Act of 1996 established two new options (called SIMPLEs) for employers of 100 or fewer workers. Those plans allowed eligible employers to contribute to their employees' 401(k) plans or IRAs without being subject to nondiscrimination rules and the other tests that qualified plans must meet. In return for exempting employers from those requirements, the law specified formulas as the basis for employers' contributions.

In 2001, the Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which contained a variety of provisions that liberalized employment-based retirement plans. The law allows employers to contribute more to the retirement plans of high-income employees and to deduct more of what they contribute to all retirement plans. Employees are also allowed to contribute more to 401(k)-type plans on their own behalf. Additional provisions establish a credit for expenses incurred by small businesses in starting up a retirement plan and administering it for the first three years. They also enhance portability by permitting rollovers from one type of employment-based plan to another and from IRAs to employment-based plans.⁽¹⁾

Since 2001, a confluence of events has resulted in the significant underfunding of defined-benefit plans. The Congress enacted a series of temporary measures designed to make it easier for sponsoring companies to meet their legal funding obligations. The latest of those measures expired at the end of 2005. Permanent measures remain under active consideration, along with a variety of other changes to the system of employment-based retirement accounts.