America, Welcome to the Poorhouse

by Jane White

  From 1974 to 2004, the percentage of Americans covered by a defined benefit plan shrank from 44% of the workforce to 17% of it, according to the Employee Benefit Research Institute. At the same time, more than 60% of the workforce is employed by a company that offers only a 401(k) plan. What’s remarkable about this downward trend is that while the law that governs pensions, the Employee Retirement Income Security Act (ERISA), has been amended at least 40 times in the past 30 years, the result is fewer pensions, not more or better pensions.

  In fact, during the nine months after ERISA was signed into law, the Pension Benefit Guarantee Corporation, the agency that insures pensions, was socked with 5,000 terminations (plans that were ended), a result that has not registered on the minds of members of Congress or the general public, since few in the media have covered this trend. At the same time, in the following three decades, employers proceeded to raid and shut down pensions when times were good and terminate them when times were bad.

  Remember the 1980s? The images that come to mind aren’t just bad fashion and big-lens glasses, but also corporate greed—remember Gordon Gekko? High interest rates earned on pension investments created “surpluses” that the companies could use to acquire other companies. The companies would simply terminate the pensions and pay out the smaller pension in the form of an annuity. At the same time, corporate raiders targeted companies with “overfunded” plans, using the surpluses to pay off debt associated with their leveraged buyouts. Congress put an end to this practice in 1990 by imposing a 50% excise tax on reclaimed surpluses. (Needless to say, in a logical world there would be tolerance for the concept of overfunding, since this so-called surplus is needed to bolster balances when the stock market is heading south.)

  On the other hand, the bear market during the first eight years of this century was also damaging for defined benefit plans. With stocks plunging and the Fed cutting interest rates, many companies were forced to kick in substantial amounts of cash. While employer contributions to pension plans averaged about $30 billion a year from 1980 to 2000, during 2002 and 2003 companies had to kick in close to $100 billion annually.

  In the same fashion that the creation of ERISA caused the death of the very pensions it was intended to protect, the so-called Pension Protection Act of 2006, which makes funding requirements more costly, may protect pensions for some but will shrink them for many others. Roughly 20% to 25% of the nation’s $2.3 trillion of assets in defined benefit plans have recently been frozen—meaning that some or all of the employees stop earning benefits, and others who are new hires won’t have any coverage.

  Too Many Rules + Voluntary Pension Plans = Dead Plans

  The problem with putting too many rules on a voluntary scheme is that employers react by dropping out of the scheme. As Thomas Donlan of Barron’s put it, “The new pension law will drive companies in financial stress to put their pension plans into the care of the government insurance agency. At the same time, it will drive prosperous companies to take their retirement plans out of the defined benefit system.” In 2007, more than 1,200 employers ended their pension plans, according to the Pension Benefit Guarantee Corporation.

  ERISA: Simultaneously Complex and Useless

  Former Secretary of Labor Robert Reich called ERISA the “single most complicated piece of legislation ever to be enacted, subsequently providing guaranteed livelihoods to thousands of lawyers and administrators”—detractors have nicknamed it “Every Rotten Idea Since Adam.” The irony about 401(k) plans is that although ERISA has strict requirements for the “fiduciaries” of the plan, the people responsible for overseeing the investments—which include acting solely in the interest of plan participants, diversifying plan investments, and charging only reasonable expenses, there is no requirement to carry out the most prudent practice of all, which is to tell people how much to contribute to their accounts.

  Although 401(k) plans are also called defined contribution plans, to my knowledge no elected representative has ever attempted to amend ERISA to require that the necessary contributions be defined so that the participant can retire with a benefit as generous as that of a defined benefit plan. While the Pension Protection Act provided clarification on the ability of 401(k) advisers to tell participants which funds to invest in, it provided no guidance on advising the participants on their required contribution rate based on how much they’ve already saved and their “investment time horizon,” that is, how many years they are away from retirement—communication that is vastly more vital to help participants achieve retirement readiness than advice on which funds to invest in.

  While the Department of Labor is constantly issuing guidance and regulations about investment advice—the latest is allowing participants to get advice by a “computer model certified as unbiased and through a fiduciary adviser compensated on a level fee basis,”—there is no component of the advice feature that deals with how much you need to contribute. What’s more, nobody should have to pay a human being for this advice. Participants should be able to buy software that essentially gives the same advice to everybody, which is to contribute the maximum, don’t time the market, and stick with index funds—advice that I’ll detail in the next chapter. (Disclosure: I’m interested in developing this software.)

  Finally, investment advice that takes place at the workplace flies in the face of common sense: If the typical American changes jobs an average of every four years, most of their 401(k) assets are often in rollover IRAs or at previous employers, not in their current 401(k) accounts.

  Why Has There Been No Retirement Reform? Most So-Called Experts Are Clueless About What’s Needed to Make 401(k) Plans Walk, Talk, and Quack Like a Pension

  In reality, the 401(k) plan is an “accidental pension.” The IRS code that spawned the 401(k) plan was meant to clear up a dispute over the taxation of profit-sharing plans, not to create retirement security. According to Ted Benna, the consultant who “invented” the 401(k) plan in 1980, his idea was to redesign a retirement program to capitalize on tax breaks and add security to an existing defined benefit plan—not to replace it.

  The problem is that very few people who advise 401(k) plans or sponsor the plans seem to know the formula for making a 401(k) account adequate enough to replace a defined benefit pension. One exception is David Wray, the president of the Profit-Sharing/401k Council of America, a group of 1,200 employers, who was quoted in the Seattle Times in 2005 as saying that 401(k) participants need to aim to have the equivalent of ten times their final pay in their accounts. “Ten times final pay gets it done,” Wray said. “The issue is the 40 years. You’ve got to start at 25 to retire at 65.”

  Wray hit the nail on the head. Or if 401(k) participants haven’t started contributing to their accounts at age 25 and are contributing less than 10% of their salaries to their accounts, they’ve got to goose up their contributions—even higher if they’ve waited until age 35, 45, or 55, as I’ll explain a little later.

  Incredibly, at the time this book was going to print, if you Google the phrase “ten times final pay,” you’ll only get nine results. Why is this phrase no longer coin of the realm? That’s because the pension actuaries who used to be hired by employers to make sure they followed ERISA’s rules for funding pensions aren’t required to play this role when it comes to 401(k) plans. Since there are no rules for funding 401(k) plans, pretty much the only role pension actuaries play is to help employers follow other ERISA rules pertaining to 401(k) plans, such as “nondiscrimination” testing and other counterintuitive rules that prevent highly paid people from contributing enough to their accounts so that they can retire.

  My Testimony Before the U.S. Department of Labor on Recommended Disclosure of Required Contribution Rates

  Until we get genuine 401(k) reform, at a minimum, 401(k) participants have the right to know how much to contribute to their accounts—their “co-pay” if you will—to fund a nest egg that will equal ten times their final pay at retirement. With the input of pension actuary Jame
s E. Turpin of the Turpin Consulting Group, I developed formulas for contribution rates required based on the current typical employer match of 3%. I was invited to present these findings as a witness before the Department of Labor’s (DOL) 2007 ERISA Advisory Council’s Working Group on Financial Literacy and the Role of the Employer. As a result, the Working Group ultimately recommended to the DOL that employees should be told how much they need to contribute to achieve a multiple of their salary nearing retirement. Unfortunately, even if the DOL agreed that this communication was necessary, its recommendations aren’t laws that employers have to follow.

  What was disclosed in my testimony is that the most important advice that 401(k) participants need isn’t which investments to pick but the percentage of their salary they need to sock away depending on their investment time horizon. In other words, the earlier you start saving, the smaller the percentage of income you have to set aside—and vice versa.

  Also, assuming a typical employer contribution rate of 3% of pay, even the tiny minority of participants who are savvy enough to start contributing at age 25 must save 10% of their salary to build an adequate nest egg by age 65. The longer the participant postpones starting to contribute, the greater the required contribution. For example:

  • Waiting until age 35 increases the contribution rate to more than 17%.

  • Waiting until age 40 increases it to more than 23% of pay.

  • Finally, waiting until age 50 requires nearly a five-fold increase from the rate at age 25, to 48% of pay. Needless to say, this over-50 requirement flies in the face of the meager current $5,500 limit on “catch-up contributions” currently allowed by the IRS.

  Mutual Fund Companies Are Unaware Their Clients Can’t Retire

  Unfortunately, few pension advocates appear to have consulted pension actuaries to figure out what’s needed—and therefore they don’t appear to know how far behind most Americans are. Nor to my knowledge, have any mutual fund executives lobbied Congress to make 401(k) plans work—this is particularly outrageous because they are stewards of 401(k) participant assets—especially since reform would mean they’d have more assets under management. Nor has anyone proposed mandating that employers contribute more to each account so that the “co-pay” required by the participant isn’t unaffordable for those who have waited until their 30s or later to start contributing—that is, most of us.

  In a November 2006 Wall Street Journal article titled “As the 401(k) Turns 25, Has It Improved with Age?” a spokeswoman for the Investment Company Institute offered the oblique assessment that “the 401(k) is hitting its stride” without offering evidence that participants are on track to achieve an account balance equal to ten times their final pay.

  In addition, while several of the large mutual fund companies produce annual reports on the 401(k) assets under management with detailed statistics on account balances, asset allocation, loans, and withdrawals, I’m unaware of any report on whether their clients are on track to reach a nest egg goal of ten times final pay—or any goal. And while many of them have launched “target date” mutual funds that gradually shift the asset allocation of the participants’ accounts from stocks into bonds or cash equivalents as the participant gets closer to retirement, there is no advice to investors on the contribution rate needed to meet that target, nor is the target ever defined.

  In a rare departure, Fidelity Investments issued somewhat of an alarm, albeit one that you had to dig hard to find, in its November 2007 report on corporate defined contribution plans. In the report, Fidelity introduced a “new measure of retirement readiness” called the Retirement Income Indicator, which “measures employees’ progress toward accumulating sufficient workplace savings to replace at least 40% of their preretirement income.” Why such a low replacement ratio? Because Fidelity assumes that participants can count on other sources of income such as a rollover IRA and/or a defined benefit pension for the rest of the income stream. Fidelity should know better, especially when it comes to the topic of shrinking defined benefit pension coverage, given that Fidelity froze the pension plan covering its 32,000 employees in March of 2007.

  At least Fidelity attempts to use a measure of retirement readiness and acknowledges that a portion of its participants face bleak financial futures. In contrast, the Vanguard Group’s 2007 “How America Saves” report describes 401(k) plans as “broadly successful in encouraging millions of employees to save for their retirement.” What’s more, it depicts enrolling employees in the plan as putting the participant “squarely on the path for success: plan participation, regular savings increases and a balanced investment program.”

  Nor do mutual fund managers appear to know what contribution rate is necessary for 401(k) participants—or the fact that the rate increases the later the participant starts to save. According to T. Rowe Price’s 2005 report on its clients, “Some financial experts recommend that employees save 10% to 20% of their salaries each year.” Gee, T. Rowe—aren’t you supposed to be financial experts?

  A lack of knowledge by the mutual fund industry about how much participants need to save and what size nest egg they should aim for based on their salary near retirement is evident by the flawed assumptions offered by at least two of the mutual funds in their online calculators. At the time of this writing, Vanguard instructs its users to “estimate the percent of your current [italics mine] income you’ll need to maintain a comfortable lifestyle in retirement,” as if it didn’t matter whether the user was 20 or 50 years old. On the page on Fidelity’s website titled, “Are You Saving Enough?,” it tells users to determine how much they need based on how much they’ve currently saved and when they are going to retire, not their projected salary at retirement.

  Media Is Unaware of Retirement Crisis

  Perhaps the most frustrating obstacle to progress is the lack of media interest in the crisis. Despite sending out press releases half a dozen times a year for two years, the only publication I could convince to address the problem is the Employee Benefit News, for which I used to write a column.

  At a forum sponsored by the Employee Benefit Research Institute in 2004 on the decline of defined benefit plans, journalist Michael Clowes, then of Crain’s Pensions & Investments, suggested that the media won’t provide much coverage of this crisis. “I think the general press has missed the overall direction of the impending demise of the corporate defined benefit plans and its implications,” Clowes said. “What’s more, if the media does cover 401(k) plans it will happen during a bull market and focus on the excitement of having a 401(k) plan.”

  Clowes almost hit the nail on the head, but perhaps even he didn’t realize that having a 401(k) account in a bull market isn’t anything to get excited about, a point that is also lost on most journalists when they write about the plans. After a 1997 Wall Street Journal article during a bull market titled “Waking Up Rich: Retirement Accounts Stashed in Stocks Make Employees Millionaires,” Ted Benna, the creator of the 401(k) plan, wrote an article in a benefits publication that served as a “correction” to the Journal piece. Most likely Benna was forced to do so because the Journal refused to publish his letter or op-ed because it would be an exposé of a poorly researched article.

  “Frankly, I have been amazed at the attention that the recent Wall Street Journal article about 401(k) millionaires has received,” Benna wrote in Compensation and Benefits Review. “The average account balance for these participants is generally regarded to be around $35,000. Study after study indicates that the average participant is not saving enough for retirement. As a result, the major concern of most knowledgeable individuals is that we may be facing a serious retirement crisis.... In fact, ever since 401(k) plans began, they have been attacked as not being real retirement plans.”

  Even if the average account balance were $1 million, it doesn’t make you a millionaire—it’s the minimum for those earning $100,000 at age 65. What’s tragic about The Wall Street Journal article is that the employees in the article were among the tiny
minority in the United States who have accumulated what they need for a secure retirement—for example, a human resource manager pulling down a $100,000 salary who had $1 million in his account. But because the mutual fund companies aren’t required to communicate what size nest egg is necessary to be able to retire, he didn’t realize that $1 million is the minimum needed to replace 70% of a $100,000 salary for 20 years or more, as opposed to a windfall. So he decided to cash out part of his 401(k) account to buy a sports car.

  Another 55-year-old couple with a combined annual income of $200,000 decided that their $800,000 joint account balance was a windfall and quit their jobs, paying $180,000 for a 42-foot boat—when in reality they needed to pass up on yacht purchases and stay in the workforce in order to save up a minimum of $2 million to replace their incomes. As a result of these self-defeating maneuvers, those profiled in the article will end up in the same or worse predicament as those participants who don’t have the resources to save enough.

  The Wrong 401(k) Reform: Replacing an Employer Match with Taxpayer-Subsidized Investments

  One of the problems with the field of finance is that remedies to problems are too often viewed through an ideological lens, rather than a logical one—resulting in a lack of “evidence-based finance.” For example, many Democrats typically view stocks as scary and reckless and bonds as safe and secure—witness AARP’s lobbying efforts against privatizing Social Security. And many Republicans view the stock market as magical—witness the popularity of Jim Cramer’s Mad Money TV show.