A 401(k) plan is a qualified employer-sponsored retirement plan wherein employees make salary-deferral contributions on a post-tax and/or pretax basis for investment purposes. Investments are riskier and carry the potential for loss of principal. Most 401(k) accounts are composed primarily of investments.
The Federal Deposit Insurance Corporation (FDIC) covers deposits, not investments. Therefore, 401(k) plans are not FDIC-insured because they are typically composed of investments rather than deposits. However, bank deposits in a 401(k) account are covered by the FDIC, as are funds held in money market accounts.
The FDIC protects bank accounts up to $250,000. This insurance on bank deposits was introduced in the early part of the twentieth century to end bank runs and increase confidence in the financial system.
Banks are at the heart of a successful capitalist economy. Faith and confidence in the banks' ability to make good on customer deposits is a necessary ingredient for credit creation. Depending on interest rates and economic conditions, banks give out a certain percent of loans against these deposits. However, this would not be possible if customers pulled their money from banks at any moment they felt uncertain.
The FDIC was created in 1933 under President Franklin Delano Roosevelt as a remedy to the bank runs, which were exacerbating the Great Depression and hindering any sort of recovery.
Basically, banks pay into a fund. The fund pays for oversight of the banks and is used to compensate deposit holders if a bank goes under. The net result is fewer bank failures, due to the regulatory oversight and confidence that deposits are safe. Since its inception, no FDIC member bank has lost any customer deposits.
Unfortunately, it is not possible to apply the same protection to 401(k) accounts, as they are full of riskier investments. If the FDIC were to begin insuring investments in 401(k) accounts, it would lead to excessive risk-taking and distortion of asset prices. This would undermine one of the primary mechanisms of financial markets – price discovery.
However, the FDIC does insure safer assets held in 401(k) accounts, such as bank deposits and money market funds. For example, if a 401(k) account, worth $100,000, has 50 percent invested in stocks, 25 percent in bonds and 25 percent in money market accounts, then $25,000 of the 401(k) is covered by the FDIC in the event of some catastrophe in which the banking institution goes under.
It simply is not practical for the FDIC to cover the entire spectrum of possible investments in a 401(k) account without imposing draconian restrictions on the type of investments that can be made. The budget and credit line for the FDIC would have to be dramatically increased for it to have the resources to insure against these investments. While customers can trust their banks as long as they are FDIC-insured, they must do due diligence when making their own investments to find the optimal balance between risk and return.