Do you save enough for your retirement? Probably not. You know who does? Rich people. Not much of a surprise, I know. But you may not have considered how extravagant retirement planning for top executives beggars the rest of us. That’s something that never occurred to me before I read a new report on retirement inequality from the Institute for Policy Studies, or IPS.
The majority of working-age Americans have neither an employer-funded defined-contribution plan—typically a 401(k)—nor an employer-funded defined-benefit plan, known colloquially as “a real, honest-to-God pension.” Actually, almost no private-sector workers get real, honest-to-God pensions anymore. Opinions differ on what killed them, but the decline began in earnest during the 1980s, and President Ronald Reagan’s policies undermining labor played a large role.
The invention of the 401(k) played a large role too. In 1978 Congress added to the IRS Code a section called, yes, 401(k), which exempted employees from paying taxes on deferred compensation. The 401(k) was conceived initially as a tax shelter for the rich, since it was highly paid employees who were likeliest to receive deferred compensation (in the form of stock options and bonuses). But in 1980, Ted Benna, a sharp-eyed benefits consultant working at a Philadelphia insurance company known today as Johnson, Kendall, and Johnson, figured out how to democratize this new shelter to create tax-protected pensions for ordinary workers, and the IRS blessed his plan to do so, first at his own company and then elsewhere.
The problem was that, for businesses offering real, honest-to-God pensions, the 401(k) proved an irresistibly cheap alternative. That was because instead of delivering a defined benefit to retirees, the 401(k) delivered with every paycheck a defined contribution (a stock investment subsidized by the company), then left the rest up to the market. Between 1984 and 2020, the number of workers with defined benefit pensions fell by more than half, from 30 million to 12 million. During that same period, the proportion of employer-based retirement money going to defined-benefit pensions dropped from 64 percent to less than one-quarter. Today it’s more like 14 percent, and most of those who still have defined-benefit pensions are government employees, not private-sector workers. Benna ended up concluding he’d created a “monster” that should be “blown up.”
The switch from defined-benefit to defined-contribution was part of what the Yale political scientist Jacob Hacker has called “the great risk shift,” wherein conservative domestic policies shifted economic risk from capital to labor, very much to labor’s disadvantage. That was one problem. Another was that since maintaining a 401(k) or equivalent tax-protected retirement plan required employees to set aside part of their paycheck (which was then matched by the employer), only a little more than one-third of all working-age Americans ended up having a 401(k). Even when they did, the 401(k) didn’t have much money in it. According to the IPS study, the median 401(k) account balance at Vanguard, one of the main investment firms that manages them, is $33,472.
It’s different, of course, for the rich. According to the IPS study, at the end of 2021, the average retirement balance for an S&P 500 chief executive was $19.4 million. The IRS report is filled with examples of similarly grotesque inequalities. C. Douglas McMillon, the chief executive at Walmart, where median annual pay is $27,136, will, when he retires, receive monthly checks of $1,042,300. Ralph Lauren has $54.4 million socked away in deferred compensation for his golden years (which have begun already; he’s 83), while fully 41 percent of his employees have zero balances in their 401(k)s, which means either they never funded them or they had to pull out whatever they put in (paying a considerable tax penalty in the bargain).
What interests me is causation. Why do so many of Lauren’s employees have zero balances in their 401(k)s? Because it’s all they can do to put food on the table; median pay at his company is $26,670. Why is pay at Lauren’s company so lousy? I can’t speak to that specific example, but in 2011, Ellen E. Schultz of The Wall Street Journal explained the more general trend this way:
Cutting [defined-benefit pensions] … generates paper gains, which are added to operating income right along with income from selling hardware or trucks.… Employers’ ability to generate profits by cutting retiree benefits coincided with the trend of tying executive pay to performance. Intentionally or not, top officers who greenlighted massive retiree cuts were indirectly boosting their own compensation.
Some of that compensation was deferred for retirement. And during this same period, from the 1980s forward, corporate boards perfected an ingenious way to shelter from taxation a much larger proportion of these highest-paid executives’ retirement funds than was available to their lower-paid employees. This alchemy was achieved through something called, I kid you not, a top hat plan.
The IRS will let you put only so much cash into a tax-deferred account, on the theory that if there were no limit, the rich would take maximum advantage and economic inequality would be even worse than it is already. (Peter Thiel very obnoxiously figured out a loophole that allowed him to put $5 billion tax-free into a Roth IRA, but let’s set that aside.) The annual contribution limit on a 401(k) is $22,500, or $30,000 if you’re over age 50. That’s the limit on how much of your income the IRS is willing to let you shelter in any given year for retirement.
But a top hat plan, unlike a 401(k) or any other government-sanctioned pension, has no limit on how much money you can accrue on a tax-deferred basis. That’s because, through a variety of accounting tricks, corporate America figured out how to shelter unlimited funds for retirement.
It began, as so many things do, with a bungled attempt by the federal government to do good. In 1974 Congress passed the Employee Retirement Income Security Act, or ERISA, which regulates pensions in various ways. Businesses wanted to exempt from ERISA’s protections a certain type of retirement scheme wherein the funds would not be walled off from potential creditors in the event of bankruptcy, or be protected from some other unforeseen calamity. ERISA-covered pension funds are shielded from such dangers. Fine, Congress said, accept the risk, but you must limit participation in this unprotected arrangement to your very wealthiest employees, because only they can survive outside ERISA’s bosom. In practice, this group is typically the highest-paid 5 to 15 percent of the workforce.
The exemption created a problem. Sure, this deferred compensation wasn’t hemmed in by ERISA, but since these unprotected funds weren’t legally recognized as a pension, contributions to this retirement fund would be taxed just like any other income. Corporate America’s greatest minds set to work on this difficulty and came up with the top hat fund.
Here’s how it worked. Instead of creating a retirement account for a Mr. Top Executive, the company created a contract. In the contract, the company pledged to make a large quantity of money available to Mr. Top Executive in retirement. The precise amount would be based on the assumption that if we invested x amount of agreed-upon capital with a return rate of y (also negotiated; often it’s based on the rate at which the company 401(k) expands), then by a certain future date, a larger amount z would be available on terms resembling those of a pension. This is, as you can imagine, an enormous financial commitment for the company, and whatever cash eventually went out the door to Mr. Top Executive wouldn’t be available to pay employees struggling to set aside contributions to their 401(k)s.
Why doesn’t the IRS tax this money? Because there is no actual capital, there is no actual return rate, and there is no actual retirement fund. There’s only a piece of paper promising to pay Mr. Top Executive as if he had a retirement fund in some alternative universe. Mr. Top Executive maintains no property right to this promised payout because it doesn’t exist until he receives it. It doesn’t vest, it isn’t held in trust, and if new management comes in and says hell no, we aren’t paying this outrageous sum, Mr. Top Executive will have to take them to court.
“Congress never explicitly decided to give top hat plans favorable tax treatment,” Mark Iwry, a nonresident senior fellow at the Brookings Institution, explained to me. “But by largely prohibiting Treasury and IRS from regulating their taxation, it allowed the system, based on general tax principles, to evolve to its current state.”
Mr. Top Executive will of course have to pay taxes on whatever money he eventually draws from his top hat fund, just as you and I will have to pay taxes on whatever money we draw from our 401(k). The difference is that the quantity Mr. Top Executive will have to draw on will be much greater, and that’s partly because he will have sheltered a much larger portion of his earnings from taxation. Yes, Mr. Top Executive didn’t get the same regulatory protection you and I got in our 401(k)s. But he’s so much richer to begin with that he can afford to take some risks. And anyway, according to a 2020 Government Accountability Office report cited by IPS, when companies go bust, their Mr. Top Executives are often able to extract their top hat funds before the company files for bankruptcy. Or if Mr. Top Executive stays on after the reorganization, the GAO said, he’ll have a decent shot at keeping most or all of his top hat fund. That great risk shift? It’s not for people like Mr. Top Executive.
Top hat retirement funds are proliferating like mad. According to the IPS report, in 2022 one financial firm saw a 33 percent increase in the number of its clients offering top hat funds. Another financial firm said it advised more clients on top hat funds during the past 12 to 18 months than during the previous six years. Some of these deferred-compensation arrangements may not fit the precise parameters I describe here but are more in the way of variations. (I’m intrigued by one variation that’s called a “rabbi trust” because it started when a synagogue wanted to shelter its rabbi’s pension. L’chaim!) Perhaps collectively I should refer to these variations (with apologies to Irving Berlin and Fred Astaire) as top hat, white tie, and tails funds.
Whatever you call them, they’re an outrage. There are technical ways Congress can limit their growth. One was considered by the Republican-controlled Ways and Means Committee in 2017 but didn’t advance. Another was introduced by Senator Bernie Sanders, independent of Vermont, in 2020; it didn’t advance either. A difficulty is that corporate promises to pay out make top hat funds hard to distinguish legally from more legitimate deferred-compensation arrangements like merit bonuses or royalties or payment on completion of a construction project. Probably we’d be better off taxing more of the income Mr. Top Executive finally withdraws from his top hat or white tie or tails fund and increasing taxes on other sources of plutocratic wealth like capital gains.
In the meantime, the rich will continue to impoverish the rest of us with the blessing of the IRS. The earthy twentieth-century novelist Henry Miller (Tropic of Cancer, etc.) had printed at the bottom of his personal stationery what he claimed to be a Portuguese proverb, though its provenance is hard to pin down: Cuando merda tiver valor pobre nasce sem cu. That translates: “When shit becomes valuable, the poor will be born without assholes.” The top hat pension is merely the latest example.