No Mad Money on the Taxpayer Dime

Whether it's private equity, crypto, or chinchilla breeding bets in 401(k)s, the thinking on tax-deferred retirement is wrong.

Does the spirit of American democracy require tax-favored retirement plans to be encouraged to invest in Andy Warhol posters, chinchillas, and Beanie Babies?

Tax-favored, employer-provided 401(k) plans traditionally have been invested in a mix of stocks and bonds, avoiding riskier “alternative assets” like real estate, private equity, and cryptocurrency. The caution of plan managers has resulted from fear of lawsuits alleging they have violated their fiduciary duties to avoid excessive risk. In addition, the IRS has prohibited investment of 401(k) funds in life insurance contracts and collectibles like artworks, rugs, antiques, gems, metals, stamps, coins, and alcoholic beverages (narrow exceptions include U.S. Eagle coins in gold, silver, platinum, and palladium).

The Trump administration wants to enlarge the kinds of assets in which 401(k) plans can invest to include riskier assets. On Aug. 7, in an executive order entitled “Democratizing Access to Alternative Assets For 401(k) Investors,” the Trump administration declared its intention to provide “safe harbors” from litigation and government regulation of 401(k) plans that invest in a variety of “alternative assets,” defined as “equity, debt, or other financial instruments that are not traded on public exchanges” (i.e. private equity); real estate investments; digital assets or cryptocurrency; commodities; projects financing infrastructure development; and “lifetime income investment strategies including longevity risk-sharing pools.”

There are two kinds of employer pensions in the U.S.: defined benefit (DB) pensions, based on an employer’s promise to pay fixed retirement benefits, and defined contribution (DC) pensions such as the 401(k) in which the employer sponsors tax-favored employee contributions to investment plans without assuming responsibility for guaranteed retirement outcomes. In 1926 and 1928, Congress created the first tax breaks for DB pensions. Five decades later, Congress established the individual retirement account (IRA) in 1974, followed by the 401(k) in 1978. Eager to shift the risk of investment failures to employees, nearly half of big companies offered 401(k) plans by 1983.

Subsidizing pensions costs the taxpayers a lot of money. According to the Joint Committee on Taxation (JCT), in 2024 the federal government lost $1.9 trillion in revenue—mostly individual and corporate income tax revenues—because of tax expenditures, sometimes called tax breaks or tax loopholes. The single largest tax expenditure was for DC pensions, which cost $251.4 billion in lost revenue; DB pensions came in fourth at $122.1 billion, according to the JCT.

Most of the commentary and controversy about Trump’s new policy has revolved around the prudence of allowing the retirement money of 401(k) plan participants to be invested in private equity firms, which are less transparent and less-regulated than publicly traded corporations. Supporters claim that 401(k) investments in private equity, and perhaps cryptocurrency and other alternative assets, can boost tax-favored retirement savings. Many critics blame the push for liberalizing 401(k) investment rules on the desire of private equity firms, crypto sellers, and others to profit from access to the huge pools of money controlled by 401(k) plans.

But all of this misses the really interesting question: what is the purpose of a 401(k) plan and why should taxpayers subsidize it, in the form of deferral of taxation before withdrawals after retirement? Should we think of a 401(k) as an employer pension plan whose purpose is to provide a secure retirement income for employees, or is it a pool of venture capital whose beneficiaries should be thought of as (mostly) little capitalists?

The Trump administration clearly thinks of 401(k) plan participants as little capitalists who should not be denied the opportunity to get rich in the same ways as big capitalists. Thus the title of the executive order, “Democratizing Access to Alternative Assets.” The executive order makes the parallel between rich investors and 401(k) participants explicit, asserting that it is only fair to equalize the investment opportunities open to wealthy capitalists and 401(k) “capitalists” alike:

Many wealthy Americans, and government workers who participate in public pension plans, can invest in, or are the beneficiaries of investment in, a number of alternative assets. Yet, while more than 90 million Americans participate in employer-sponsored defined-contribution plans, the vast majority of these investors do not have the opportunity to participate, either directly or through their retirement plans, in the potential growth and diversification opportunities associated with alternative asset investments.

If we accept the logic that 401(k) participants should be considered to be (mostly) small venture capitalists who seek not merely to preserve their wealth but also to get rich, then of course these bantam versions of Warren Buffett should be allowed to invest in anything a billionaire can invest in. Indeed, from this perspective, the list of “alternative investments” in Trump’s executive order, which includes private equity, cryptocurrency, and real estate, is still too cautious and too exclusive. Why not allow 401(k) plans like millionaires and billionaires to speculate in Picasso paintings and Warhol posters, or antique cars, or Beanie Babies, or chinchilla breeders, or to gamble on the outcomes of horse races and political elections? In all of those cases it may be possible to beat average stock and bond market returns, at least for a time.

The answer is that ordinary Americans today are already perfectly free to try to get rich by investing any “mad money” they are willing to lose in speculative investments. If you want to put all of the money in your ordinary, taxable savings account into a Bored Ape Yacht Club or Pudgy Penguin Non-Fungible Token (NFT), in the hope that it will appreciate and make you a millionaire or billionaire, you can do that already.

But the taxpayer does not subsidize your speculation. That is the difference between ordinary savings accounts and tax-favored retirement savings accounts like 401(k)s and IRAs.

Before the 1980s, most employer pensions were traditional defined benefit pensions. But from 1980 to 2008, the proportion of private sector workers participating in defined benefit pension plans dropped from 38% to 20%, while those with only a defined contribution rose from 8% to 31%.

By 2024, only 15% of private sector workers had DB plans; interestingly, the sector with the highest DB plan participation at 31% is the financial industry, suggesting that at least some on Wall Street are skeptical about the value of the DC plans being pushed on other private sector employees.

The public sector is another story. While only 15% of private sector workers had a DB plan in 2022, 86% of state and local employees had access to one. Among all federal, state, and local employees, 75% have access to a DB plan, with only 19% participating in DC plans.

For years, many state and local governments, hoping to minimize future taxpayer responsibility for promised DB plan pay-outs to retirees, have encouraged new employees to choose DC plans, but most public sector workers stubbornly insist on DB plans when given the choice. So do the many presumably well-informed financial industry workers who prefer DB to DC plans.

The reason is simple: most Americans want their pensions to function as annuities, providing a predictable if modest stream of guaranteed payments in retirement, rather than as “mad money” to be used in attempts to beat the market and get rich quick.

When it comes to providing a guaranteed stream of retirement income to former employees as part of a defined benefit pension, governments have advantages over private sector employers. Companies can fail to meet their pension promises by going out of business, but government entities are immortal, barring revolution or conquest from without. True, they can default on their promises, overtly or stealthily, by allowing inflation to shrink promised benefits, but these strategies are dangerous in a democracy.

Unlike private corporations, governments can pay retirees by one of two different methods, or both. Like private companies, government entities can invest defined pensions—either DB or DC—in stock and bond markets and perhaps alternative assets (which some public sector pension plans do). But unlike private firms, the government can also pay retirees by taxing citizens and firms directly—for example, by means of payroll taxes on employees and employers that fund Social Security in our “pay-go” system in which today’s workers and firms are taxed to pay for the retirement of today’s retirees.

From the point of view of a rational worker, the ideal pension plan would be a defined benefit plan offered by an immortal government, which can use its power to tax and its ability to borrow during downturns to ensure its ability to pay promised regular pension payments. At present, Social Security is financed solely by payroll taxes, but as I have argued, general revenues from many kinds of federal taxes can and should be used to pay for the Social Security program as well.

Ideally, direct federal taxation to pay promised retirement benefits would make it unnecessary for the federal government or state and local governments—or for that matter private companies and their workers—to have any private pension plan investments at all. After all, the government can reap the benefits of a bubble in Bitcoin or Beanie Babies by taxing the Bitcoin and Beanie Babies tycoons, rather than by investing directly in Bitcoin and Beanie Babies. Alternative assets? Fine, as long as the income from the sales of Warhol posters and Picasso paintings is taxed.

When you start to tug at the thread of the argument about alternative assets in 401(k) pensions, then, widely shared assumptions unravel. We are left with a question: what is the point of having any pensions, public or private, DB or DC, invested in private assets at all? Why have any employer pensions, including those of federal, state, and local governments? Why not just tax individual citizens directly and pay them a promised, inflation-adjusted annuity which reflects some combination of years worked and personal income? Why not have employers simply provide workers wages from which payroll taxes have been deducted?

The answer is that the present U.S. retirement system was not consciously designed, but instead has evolved haphazardly as a combination of different programs with different histories and different purposes. Defined benefit pensions were offered by some, mostly large, employers before Social Security was created in 1935. Beginning in the 1970s, private sector companies, unlike public employers, began shifting the risk of pension plans from themselves to their employees by replacing DB with DC pensions. All pensions of all kinds invested in the stock market provide profits and employment to money managers, who naturally lobby the government to push more people into the stock market while loosening restrictions on their ability to rake in fees from managing other people’s money.

If we sort out the components of this mish-mash of retirement policies: from the perspective of a worker concerned about stability of income in retirement, Social Security beats a defined benefit pension invested in stocks, bonds, and other assets, while a defined benefit pension beats a riskier defined contribution pension. Compared to Social Security—an idealized version, if not the present one—a DB employer pension is defective and a DC employer pension is…defectiver.

To make matters worse (or defectiver-er), in 2023 fewer than half of private sector workers (49%) took part in defined contribution plans, although 67% of workers had access through their employers.

The 401(k) program disproportionately benefits the affluent, although median account balances are surprisingly small even for better-off earners—$188,678 is the median account balance for those who earn $150,000 a year.

The median 401(k) balance for those in their 60s is $210,724, which at a 4% withdrawal rate would give you a mere $702 a month before taxes. For all but a few, the 401(k) is at most a supplement to Social Security and other income in retirement.

What this underscores is the unreality of both sides, pro and con, in the debate about alternative asset investments by 401(k) plans. The Trump plan to “democratize access to alternative assets” affects only the half of the population that actually takes part in the 401(k) program—mostly the more affluent upper half. But affluent as many of them are when compared to the American public in general, most 401(k) plan participants are far from wealthy, and describing them, as the administration does, as “investors” is a bit of a stretch, like lumping Little League baseball and professional baseball together as “baseball players” who deserve the same opportunities.

In his book The Intelligent Investor (1949), the legendary Wall Street investor Benjamin Graham divided investors into two types: active or enterprising investors and passive or defensive investors. The enterprising investor seeks to beat the market, while the defensive investor seeks to prevent losses by obtaining average, not spectacular, returns on investment. Graham believed that only a few had the intelligence, temperament, discipline, and luck to be enterprising investors. Most people should therefore be defensive investors, passively seeking to preserve their wealth.

John C. Bogle, who founded Vanguard to give defensive investors access to broad, relatively safe index funds with low management fees, acknowledged Graham as an influence. So has our time’s most successful enterprising investor, Warren Buffett. Although Buffett made his fortune by picking particular stocks, the plan he publicly announced for his widow’s future inheritance is one suited for a defensive investor, with 90% invested in a low-cost S&P 500 index fund, and 10% in short-term government bonds.

Missing from Buffett’s investment plan for Mrs. Buffett: alternative assets of any kind.

Some participants in 401(k) plans, like participants in retirement plans offered by Vanguard and other mutual fund companies, are offered a choice between low-risk, low-reward investments and high-risk, high-reward investments. But that allows 401(k) plan participants to choose between being defensive investors and trying to be enterprising investors.

Why give them the choice? There is no plausible case for high-risk, high-reward investments in taxpayer-favored retirement accounts of any kind, including IRAs as well as 401(k)s. Why am I, the taxpayer, subsidizing the gambling of my fellow employee? As Graham, Buffett, and Bogle all recognized, the vast majority of would-be enterprising investors will fail to beat the market if they try on their own. If they delegate the task of beating the market to mutual fund managers, those proxies are likely not only to fail but also to rake in high fees from the managed account, which they do not have to refund if their bets turn out badly.

We want brilliant capitalists who are able to spot investment opportunities to beat the market—at least when the investments contribute to productivity growth and are not wasteful or parasitic. But few people can be great capitalists. And there is no reason at all to have tax-favored programs for millions of unsophisticated, small-scale, would-be enterprising investors or their fee-raking agents, any more than there is to use tax expenditures to subsidize millions of would-be Olympic athletes or would-be Broadway stars, almost all of whom will fail.

American capitalism flourished before the spread of the 401(k) in the 1970s and 1980s, and it will survive the demise or mutation of the relatively recent 401(k) program in the future. In the meantime, if taxpayers are to subsidize tax-favored retirement programs like 401(k)s that make investments, the investment plans should be as dull and safe as that of Warren Buffett’s widow. Mad money is fine—but not if it’s taxpayer money.