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, perhaps 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 expectation was that workers would assume responsibility for more of their
own 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 percent 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
of traditional pension plans, an employee “doing nothing” will regularly end up saving about 9.5 percent of salary that will be invested
in a relatively safe, diversified fund that is socked away for retirement. Employers adopting this “model plan” will be rewarded with an
automatic pass of the ADP/ACP tests. This is a significant reward and
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From the Editor
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 economic 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-sizefits-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 portfolio of outside investments; and will retire around age 65.
While those assumptions will prove wrong for some workers, they
offer the most likely predictions anyone can make for employees who
do not make investment choices on their own. Particularly troublesome would be a situation in which an employee, after a brief period
of participation, opts to withdraw the 401(k) funds or opts to invest
more conservatively just as the stock market swoons and ends up suffering 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 otherwise. 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 exception 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.
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From the Editor
In the meantime, employers who decide to offer automatic enrollment 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
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