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Pension Reform Could Hasten Exodus from Defined Benefit Plans to 401(k) Plans

If all goes according to the most optimistic of expectations, Congress will soon pass the most significant pension reform bill in a decade. If it does, it could accelerate the trend among American companies to stop offering traditional defined benefit pension plans in favor of defined contribution plans, such as 401(k)s.

When the House and Senate passed their respective pension bills late last year-HR2830, or the Pension Protection Act of 2005, and S1783, the Pension Security and Transparency Act-a key objective was to toughen funding standards for defined benefit plans. The Pension Benefit Guaranty Corp. (PBGC), the federal entity charged with backstopping the country's private pension system, recently reported that single-employer pension plans were underfunded by more than $450 billion as of September 30, 2005. Pumping up their coffers would lessen the risk of American workers being left without pension checks, but it would also ease the pressure on the PBGC itself, which is running a deficit of nearly $23 billion.

On the other hand, some employers confronted with growing pension liabilities and a requirement to pay higher insurance premiums to the PBGC-another feature of the proposed legislation-may simply throw in the towel and get rid of their plans altogether. In a recent survey of employers by asset manager SEI Investments, 78 percent of the respondents said pension reform will make plan management more complex, and 56 percent said their companies had already frozen or terminated pension plans or would do so this year.

Although passage of pension legislation of some kind is widely anticipated, the House and Senate bills diverge on important issues, making it difficult to predict just how much more complex plan management will become once House and Senate conferees have ironed out the differences between the two pieces of legislation. The Senate version is generally more onerous for plan sponsors, imposing, for example, stricter funding requirements for companies whose bond ratings stay below investment grade for two consecutive years and whose plan assets are less than 93 percent of the funding target. And while both bills would require companies to make underfunded plans whole within seven years, the House bill offers them some relief by allowing them to smooth their calculation of plan assets and liabilities using a three-year weighted average. That technicality would reduce the volatility of their funding requirements. The Senate bill, by contrast, permits smoothing over just a one-year period, limiting its impact on volatility. Melissa Kahn, vice president of government and industry relations for life insurance company MetLife, says the general expectation is that House and Senate conferees will split the difference between the two proposals and adopt a two-year smoothing period.

Other differences may not be so easy to resolve. The Senate, for example, has proposed that employers who wish to convert a traditional defined benefit plan to a cash-balance or similar hybrid format be required to offer certain protections to their existing employees, such as the option to choose between the two versions of the plan, or, for five years after the date of the change, receive the greater of their pension accruals under their old or new plan. The House bill contains no such protections. "This is probably one of the most contentious issues out there," remarks Bob Holcomb, vice president of legislative and regulatory affairs for JPMorgan Retirement Plan Assets. "Indications are the Senate is holding pretty firm on this issue, but nothing is a given." "My guess," adds Frank McArdle, manager of the Washington Research Office for human resources outsourcing and consulting firm Hewitt Associates, says, "is that the mandates desired by the Senate won't get through the conference committee unless there is some horse trading."

One potential beneficiary of any renewed push away from defined benefit plans could be the defined contribution plan industry. Employers who freeze or terminate their pension plans often make a concurrent effort to improve their defined contribution plans, where stable value products are a popular investment option. Case in point: International Business Machines Corp., which early this year announced that it would freeze its $48 billion U.S. pension plan in 2008 and enhance its 401(k) plan. It will, for example, double its current match on employee contributions to 100 percent on the first 6 percent of salary and make additional contributions unrelated to what workers kick in.

On the other hand, stable value stands to take a shot, albeit a small one, from provisions in the pension bills that would broaden the definition of investments appropriate for use as default options in defined contribution plans. Today, a majority of employers make conservative investments, such as stable value or money market funds, their default option for plan participants who don't take action to choose their own investments. But Congress, in its proposed legislation, is encouraging the Department of Labor to spell out that diversified investments, such as balanced or lifecycle funds, would be appropriate default options, too. Retirement plan providers say that even if employers embrace the change, it shouldn't have any immediate impact on the stable value industry. Investors who get defaulted into their plans are typically younger and at the lower end of their employers' pay scale; accordingly, their accounts represent a modest fraction of overall plan assets. In addition, balanced funds that are not composed of mutual funds can incorporate stable value investments into their portfolios. Indeed, Hewitt Associates, a human resources outsourcing and consulting firm that provides recordkeeping services for many large employers, recommends that its clients consider that approach. IBM already does that with four diversified "life-strategy" funds it offers to participants in its 401(k) plan.

The move to broaden the list of appropriate default investments goes hand-in-hand with another goal of the pending legislation: providing a fiduciary safe harbor for companies that automatically enroll employees in their retirement savings plan. It's an increasingly popular strategy, but one that many employers still shun because the protection from liability they enjoy under section 404(c) of the Employee Retirement Income Security Act exists only when plan participants choose their own investments. With automatic enrollment, many participants don't; they are slotted into their plan's default investment option.

To make automatic enrollment still more appealing to plan sponsors, both pension reform bills would also give ERISA preemption over laws in more than 30 states that prohibit employers from withholding money from employees' paychecks without their written consent.

Rick Lawson, vice president of federal government relations for Principal Financial Group, an insurance company and retirement plan provider, says these proposals, if adopted, will increase the number of employers willing to use automatic enrollment, and, as a consequence, boost the number of working Americans saving for retirement. A recent study by Hewitt Associates would seem to bear that out; about a third of the responding employers said they wanted to see the DOL issue guidelines on appropriate default investment options before they would adopt automatic enrollment, as well as ERISA preemption of state wage withholding laws.

While the House and Senate bills are closely aligned on the issues of automatic enrollment and default investment options, they diverge in other areas relating to defined contribution plans. For example, the House bill, championed by newly elected House Majority Leader John Boehner, R-Ohio, would make it okay for retirement plan providers to offer plan participants investment advice even when the provider has a financial interest in the funds it is recommending. The House bill mandates various disclosures by advice providers to alert investors to potential conflicts of interest. The Senate bill endorses the idea of offering advice to plan participants, but seeks to eliminate conflicts of interest entirely by specifying that it must come from an independent third party. While Boehner's recent election as House majority leader is generally seen as strengthening his hand in this fight, Washington observers are loathe to predict how the issue will be resolved. "I think both sides feel very strongly, so I don't know if a compromise can be reached," says Kahn. It's worth noting that while the lack of a legislative safe harbor for offering investment advice is cited by some employers as a reason not to make it available to their retirement plan participants, more than half already do so, according to a recent survey by Plan Sponsor magazine.

The House and Senate also are at odds over whether to extend the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001. The House has proposed to do so, the Senate hasn't. Among other things, EGTRRA increases contribution limits for retirement savings plans, allows workers over the age of 50 to make extra "catch-up" contributions to such plans, and provides a "saver's tax credit" for lower-income workers. It also authorizes the creation of Roth 401(k) accounts, which participants can fund with after-tax contributions in exchange for receiving tax-free withdrawals. EGTRRA expires in 2010 unless Congress acts to extend it.

"I think in theory both Republicans and Democrats support the extension of EGTRRA," Kahn says. "The sticking item is the cost. Right now, the cost of extending EGTRRA's pension provisions (in the form of lost tax revenues), without the savers' credit, is about $20 billion. And the savers' credit is about $10 billion. The Senate, in particular, I think is going to have concerns about that." Holcomb says the "time seems right" for extending EGTRRA but concedes that with Congress worried about the federal budget deficit, "nothing is for certain." McArdle says he's optimistic EGTRRA will be extended.

It may be some time before anyone knows the outcome. When the Senate and the House passed their respective pension reform bills late last year, there were widespread expectations that the differences between the two could be resolved as early as mid-March. By late February, however, legislators were still haggling over who would sit on the bicameral conference committee that will try to patch up the differences between the two bills. "I think a more realistic expectation is to look to an April time frame, possibly going into May," Holcomb says. "If it goes beyond May, I don't think it will happen which means we will have to start over after the mid-term elections."

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