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Honey, I Shrunk the 401(k)

The bear market has clobbered 401(k) accounts, and it could spark a revival of defined benefit plans.
Kris Frieswick, CFO Magazine
August 1, 2002

That rumbling sound you hear in the distance is the growing chorus of very disgruntled employees who now realize that 401(k) account balances can shrink as well as grow — and who have discovered that they're not very good at managing them, anyway. They're calling for a return of the old-fashioned defined benefit plan, or for one of the new pension hybrids that meld features of defined benefit and defined contribution plans.

According to Principal Financial Group's Well-Being Index, a snapshot of employee attitudes about benefits, 24 percent of employees want access to a defined benefit plan, up from 19 percent just a year ago. Surprisingly, some of them may soon get their way. Companies are beginning to reevaluate defined benefit plans, and some are actually implementing them or hybrid plans. The state of Nebraska, for one, recently installed a brand-new hybrid plan for some of its employees.

One Boston-based actuarial consultant, Edward Burrows, reports a recent uptick in new defined benefit plans at small professional-services firms, such as law, consulting, and accounting practices. Small companies have typically shied away from defined benefit plans because of the ongoing financial liability they represent. But the recent relaxation of statutory limits on maximum benefits and contributions for "top heavy" pension plans — and the undoubtedly shrinking 401(k) plans of the owners themselves — are paving the way for companies to adopt them.

But defined benefit and hybrid pension plans face a slew of roadblocks — some old, some new — that could make them difficult for employers to implement or upgrade. Still, businesses large and small feel pressure to do something to provide stable retirement income for their employees, and to do it now.

"They Just Let Them Go"
Until 1981, when the Internal Revenue Service gave provisional approval to the first 401(k) plan, defined benefit plans were more often than not the only retirement plan available (except for Social Security). But once the 401(k) was hatched, defined benefit plans began to fall out of favor. In lieu of perpetual funding concerns, high administrative costs, and annual premiums to the Pension Benefit Guaranty Corp., a 401(k) plan offered optional employer matching, low administrative costs, and no premiums. Employees lost a guaranteed (albeit fixed) retirement benefit, but gained portability and the prospect of hefty stock-market gains.

As 401(k)s became more popular — the number of participants swelled from 7 million in 1983 to 42.1 million in 2000 — the fledgling high-tech and services businesses of the New Economy didn't even bother setting up defined benefit plans, using 401(k)s as the primary employee retirement vehicle. The defined benefit plan seemed slated for extinction — an expensive encumbrance of Old Economy companies, at which workers often spent their entire careers.

Indeed, a recent study shows that "once a company installs a 401(k) plan, they just let their [traditional] pension plans deteriorate," says Teresa Ghilarducci, associate professor of economics at the University of Notre Dame and lead author of the study. "They don't enhance the pension benefits, they don't adjust for inflation. They don't aggressively manage them. They just let them go." Even if a company keeps its defined benefit plan, a 401(k) plan has the effect of reducing the total amount of money per employee that employers contribute annually anywhere from 14 percent to 22 percent, according to Ghilarducci's study.

This reduction in total retirement contributions, say some observers, is not just an outcome of moving to 401(k)s, but also a consequence of soaring health-care costs. "[A chief] factor was that the price of health care was using up dollars that were allocated for benefits," says Daniel Houston, senior vice president at Principal Financial Group. In smaller companies in competitive industries, cuts have to come from somewhere, and cutting health care can incite even more worker ire than cutting retirement benefits.

Meanwhile, experts claim that employees have generally placed a low value on defined benefit plans. Unlike the user-friendly 401(k), defined benefit plans don't usually come with personalized quarterly account statements displaying a "personal rate of return" on page one. Employees can't watch their nest egg grow online, in near-real time. Defined benefit plans have traditionally existed out of sight, somewhere in the corporate finance department.

Underperformers
No longer. With the end of the bull market and the implosion of Enron, employees have realized that their hard-earned savings can dwindle, if not disappear, in a 401(k). New studies have shown that 401(k) plans are underperforming the market and coming nowhere near to replacing preretirement income for most employees.

The problem is exacerbated by employees' general lack of investment knowledge. A recent survey of defined contribution plan participants by John Hancock Financial Services found that 40 percent of respondents say they have little or no investment knowledge. Fifty percent say they don't have time to manage their investments. "Human nature may be the Achilles' heel of the 401(k) system," says survey author Wayne Gates, general director of market research and development at John Hancock.


The end result of the shift to 401(k) plans is that employees have considerably less money to retire on today than they had 20 years ago, according to research conducted by Edward N. Wolff, an economics professor at New York University, and the Economic Policy Institute, a Washington, D.C.-based think tank. A recent study by Wolff shows that retirement wealth (defined benefit and defined contribution benefits plus Social Security benefits) for the median (or most typical) household headed by a person aged 47 to 64 declined by 11 percent from 1983 to 1998 — despite an increase in the Dow Jones Industrial Average of more than 730 percent. Only households in that age group with more than $1 million in preretirement income saw an increase in total retirement wealth.

In addition, the percentage of households approaching retirement that would be unable to replace half of their preretirement income rose from 29.9 percent in 1989 to 42.5 percent in 1998, according to Wolff. (Studies indicate that in order to maintain their preretirement standard of living, retirees need to replace 75 percent of their preretirement income.)

Bang for the Buck
Given the new information about 401(k) plan effectiveness, or lack thereof, as a retirement vehicle, some corporations are reevaluating the best way to get the most bang for their retirement-plan buck while meeting the needs of a mobile workforce.

"The question that employers should be asking is, 'What do I want to accomplish with these plans?' " says Steve Kerstein, managing director of the global retirement practice at Towers Perrin, a management consulting firm. "To whom do you want to provide the benefits? Is your goal to maximize the amount of money to people who retire, in which case you'd choose a DB plan, or is your goal a more equitable distribution of profits, which would mean a DC plan?"

The variety of defined benefit and defined contribution plans has increased in the past few years. Cash balance plans — a hybrid mix of defined contribution and defined benefit that allows employees to take their balances with them if they switch jobs before age 65 — represent a good choice for companies looking to adopt their first defined benefit plan. But it's unlikely that companies will flock to these plans. Regulatory agencies and the courts are still trying to determine which method will be used to calculate payouts. (Meanwhile, many companies that converted to cash balance from traditional pensions face accusations that the new plans shortchanged older workers.)

Another option on the drawing board is the DB(k) plan, created by Principal Financial Group, which would allow employers to consolidate a defined benefit plan with a 401(k) plan. The plan would allow companies to file only one set of related documents with the government, and would consolidate other reporting requirements as well. But absent necessary legislative changes, the DB(k) plan won't fly.

Even with the renewed interest in defined benefit plans, there are roadblocks keeping employers from adopting them — most notably, cost. The stock market reversal means many companies have to pony up contributions to underfunded plans, which represent a long-term, fixed financial obligation. And internal plan administration is expensive; companies must fill out a Form 5500 for every benefit plan they sponsor. (Just one Form 5500 at a major insurance company was 16 inches thick, says a spokesman for the Employee Benefits Research Institute.)

All this means that just as employees start to demand defined benefits, employers are less likely to want them. As a result, some groups are pressuring Congress to ease up on defined benefit plan administration rules and craft new rules that would build more flexibility into funding requirements. But these battles are just beginning. In the meantime, a nation of aging baby boomers marches inexorably closer to a "very severe retirement crisis," says economist William Wolman, co-author of the recently published book The Great 401(k) Hoax. "And we're going to need a real crisis before something gets done about this."

Sadly, by the time something does get done, it will be far too late for many retirees.

Kris Frieswick is a staff writer at CFO.

Heartland Change of Heart

There has already been one very large plan migration from a 401(k)-style plan to a hybrid plan with guaranteed payouts, but it wasn't employee pressure that inspired the change. It was the disturbing results of a "benefit adequacy review" that prompted the Nebraska state legislature to call for a better retirement vehicle for the 25,000 state and county employees who are part of the state's defined contribution plan.

The review compared performance of the mandatory defined contribution plan with the state's defined benefit plan (for state troopers, teachers, and judges). "The DC plan fell short of the DB plan in replacing worker wages at retirement," says Anna Sullivan, director of public employee retirement systems for the state of Nebraska. "The conclusion was that people were not as well equipped as a professional to make allocation decisions." Fully 90 percent of defined contribution plan assets were in just 3 of the 11 investment options provided, one of which was the default stable-value fund.

The result was especially surprising, says Sullivan, because the state goes to extensive lengths to educate employees about investing, offering an all-day seminar taught by investment professionals and a toll-free help number. In addition, the state is very generous with its contributions: employees put in an average of 4.5 percent of their wages, and the state matches those contributions 150 percent. Still, says Sullivan, "people don't understand the intricacies [of investing], nor are they removed enough to make good investing decisions and stick with them. They respond out of emotion and try to time the market."


As a result of the review, Sullivan has added a hybrid plan (effective December 31) in which all contributions are pooled and managed by the same manager that currently handles the state's defined benefit assets. The contribution rates for both employee and employer will remain the same, so the change will not cost the state any additional funds. However, payouts will be made in an annuity format, and employee accounts will earn a defined rate of return on the assets (based on the federal midterm rate plus 1.5 percent). "We're obviously hoping to outperform the interest credit rate," says Sullivan, and there is a possibility that if the fund performs well, "we could improve the benefit to include a percent-of-salary component." Current employees will have a choice whether to enter the new plan, and new employees will be automatically enrolled.

Sullivan says the move is a "straightforward step" toward an eventual defined benefit plan for all employees. "I think there's a place for a 401(k) as a supplement, but not as your base benefit," she says. "The foundation of your benefit needs to have more security to protect you against major downturns." —K.F.

The Rich Got Richer...

Huge gains by $1 million+ earners drove average wealth higher in preretirement families.
Sources: Edward Wolff; Economic Policy Institute

Households Headed by Person Aged 47 to 64: % Change 1983-1998

...The Middle Class Got Poorer

But wealth declined sharply in median-income preretirement families.

Households Headed by Person Aged 47 to 64: % Change 1983-1998





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