By Sandra Block

Kiplinger’s Personal Finance

The 401(k) plan may be as integral to retirement in America as Social Security and Medicare, but it wasn’t conceived as a cornerstone of retirees’ financial security.

In 1978, the provision was inserted into the Internal Revenue Code to clarify that employees who invested a portion of their salary in company profit-sharing plans could defer taxes on the money. That led a handful of large companies to offer 401(k) plans to senior executives who wanted to supplement their pensions.

By the mid-1980s, companies began to see the advantages of abandoning traditional pensions entirely and replacing them with 401(k) plans. Companies no longer had to put aside enough money to cover lifetime payments to retired employees. And 401(k) plans shifted investment risk from employers to plan participants.

The more than 54 million participants in 401(k) plans today hold about $5.1 trillion in assets, according to the Investment Company Institute. The plans cost the government more than $115 billion a year in tax revenues, but a proposal by Republican lawmakers to cap pretax contributions at $2,400 a year was shelved following objections from the financial services industry. At first, employees embraced 401(k) plans, too. The 18-year bull market that began in 1982 led to healthy growth in their portfolios. And unlike traditional pensions, which are typically based on an employee’s salary and years of service, 401(k)s give participants more flexibility to choose how much to save starting a year or less after they join a company. Plus, employees can change jobs and take the money with them.

But as 401(k) plans became the primary source of retirement savings for millions of people, problems began to emerge. Some plans were riddled with high fees and subpar investment options. Forced to manage their own portfolios, many novice investors made poor investment decisions. More troubling, many workers didn’t bother to sign up, or they cashed out when they changed jobs.

The financial services industry, which has reaped a windfall from the growth of 401(k) plans, says many of those problems have been solved. Average expenses fell from 1.02 percent of 401(k) assets in 2009 to 0.97 percent in 2014, according to a 2016 study by the Investment Company Institute and Brightscope, which rates 401(k) plans. Automatic enrollment has led to an increase in participation, particularly among millennials.

Meanwhile, the rapid growth of target-date funds has simplified investing choices. These funds allocate investments in stocks and bonds based on your expected retirement date. The investment mix gradually becomes more conservative as you get closer to retirement.

Target-date funds eliminate the paralysis that often sets in when investors are faced with too many choices, says Leon LaBrecque, a certified financial planner in Troy, Mich.

Sandra Block is a senior editor at Kiplinger’s Personal Finance magazine. Send your questions and comments to moneypower@kiplinger.com .

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