T (PPA) was, Too bad defined benefit plans are on the way out - - PDF document

BENEFITS LAW JOURNAL 1

• VOL. 20, NO. 1, SPRING 2007

From the Editor

The DB-ing of the 401(k)

T

he unspoken premise behind last year’s Pension Protection Act (PPA) was, “Too bad defined benefit plans are on the way out because they were really good for employees.” As it turns out, per- haps the best feature of pension plans was not that they were totally funded by the company—most employers figured pension costs into an employee’s total pay package and adjusted other elements

• accordingly. Rather, the beauty of the defined benefit plan was that

they served as a painless, automatic savings vehicle for millions of employees who did not need to make any financial decisions about their retirement savings until they left the company. What killed pension plans was decades of over-regulation by Congress and the IRS-DOL-PBGC-SEC-FASB pension police, who jointly made them impossibly difficult and costly for most employers. As 401(k)s have steadily taken the place of pensions, the expecta- tion was that workers would assume responsibility for more of their

• wn retirement planning—including how much to save, where to

invest, and when and how to withdraw the money. But it has become increasingly obvious that many workers are not up to the task—there is abundant evidence that participants in 401(k) plans are highly likely to save too little or not at all, to make haphazard investment choices, and/or to prematurely tap into their retirement nest eggs by taking loans or making hardship withdrawals from their accounts long before retirement. The PPA is responding to this troublesome trend by encouraging employers to once again assume some of the decision-making for

• employees. Starting in 2008, new Internal Revenue Code (IRC) rules

will provide an incentive for employers to add a default enrollment feature to their 401(k) plans, under which enrollment, contributions, and investments will occur automatically unless and until employees make other choices on their own. Congress has even laid out the basic terms for default 401(k) plans. Elective deferrals will start at 3 percent of pay, gradually rising to 6

• percent. The employer match will be 100 percent of the first 1 per-

cent invested by the employee and 50 percent of the next 5 percent (3.5 percent total), with two-year cliff vesting. Contributions will be invested in a life cycle or other asset allocation fund. As in the days

• f traditional pension plans, an employee “doing nothing” will regu-

larly end up saving about 9.5 percent of salary that will be invested in a relatively safe, diversified fund that is socked away for retire-

• ment. Employers adopting this “model plan” will be rewarded with an

automatic pass of the ADP/ACP tests. This is a significant reward and

From the Editor BENEFITS LAW JOURNAL 2

• VOL. 20, NO. 1, SPRING 2007

less expensive than the existing 401(k) safe harbor provisions, which require a higher match and immediate vesting. Automatic enrollment is supported by growing research by eco- nomic behaviorists, which consistently indicates that faced with a choice, most people tend to do nothing. (See “401(k)s on Autopilot,” BLJ Winter 2005.) That conclusion is supported by the experience of companies that currently have an automatic enrollment option and have found it to be highly effective in getting more employees to invest in their 401(k) plan. It is unfortunate that employers have to assume the role of Big Retirement Brother for their workers, especially when it comes to selecting their specific investment(s). My guess is that most employers will opt for age-based lifecycle funds, which, handled in accordance with Department of Labor guidance, should protect employers from fiduciary liability. The downside is that the success of such a one-size- fits-all approach to investing is dependant on numerous assumptions: that employees will not tap into their funds prematurely; will have a “normal” tolerance for market risk; will maintain a diversified portfo- lio of outside investments; and will retire around age 65. While those assumptions will prove wrong for some workers, they

• ffer the most likely predictions anyone can make for employees who

do not make investment choices on their own. Particularly trouble- some would be a situation in which an employee, after a brief period

• f participation, opts to withdraw the 401(k) funds or opts to invest

more conservatively just as the stock market swoons and ends up suf- fering a major loss. But past experience with default plans indicates that in fact most employees who do not make an election will allow the default decision to continue for years, so an investment strategy based on a long term savings horizon is likely to help many more people than it hurts. While employers may be making retirement savings decisions for their more passive employees, employers should not be held not responsible for workers’ ultimate well-being in retirement or other-

• wise. Recent comments by some in Congress, government agencies,

unions, and academics, have suggested that employers have a sort of “fiduciary duty” to help ensure their employees’ financial security in

• retirement. Nothing could be further from the truth. With the excep-

tion of Social Security, our nation’s retirement system has always been entirely voluntary. Employers are responsible, legally and morally, for the retirement programs they choose to offer to employees. At the end of the day, whether an employer offers a pension, 401(k), or no plan at all, it is up to each worker to take care of his or her own financial resources.

From the Editor BENEFITS LAW JOURNAL 3

• VOL. 20, NO. 1, SPRING 2007

In the meantime, employers who decide to offer automatic enroll- ment in their 401(k) plans will be doing a huge service for employees who otherwise will do nothing to plan for a secure retirement. Those employees may be lucky enough to “wake up” at retirement with a sizable nest egg. David E. Morse Partner K&L Gates LLP New York, NY