It is not often that Congressional tinkering with the nation's pension laws is applauded by plan sponsors, participants and advisers alike. But, for once, we have the benefit of overdue federal legislation realistically designed to encourage the growth of retirement savings by American wage earners. It is now up to good companies, employees and plan advisors to do their part.
Pension Protection Act Becomes Law
On August 17, 2006, President Bush signed into law the federal Pension Protection Act of 2006 (the PPA), a massive 907-page law arguably the most comprehensive pension reform since the passage of ERISA in 1974. A product of years of negotiations, countless academic, industry and government studies on national retirement policy, and intense lobbying by the investment industry and others, the PPA passed into law with a broad measure of support in both the House (279-131) and Senate (93-5). The effective date for many of the pension plan changes under the law is not until the end of the 2009 plan year, but many plan sponsors are expected to begin implementing some of the more favorable provisions of the Act as soon as 2007. Included among the host of statutory and regulatory changes under the PPA are:
- New funding rules for single and multi-employer defined benefit pension plans and the federal PBGC pension guaranty program.
- Various protections and disclosures to plan participants in response to the Enron scandal.
- Important inducements to stimulate individual retirement savings through contributory 457, 403(b) and 401(k) plans.
- Better access to appropriate investment fund options and independent investment advice for participants of 401(k) plans.
Those elements of the PPA designed to incent increased retirement savings are of the greatest and most immediate significance for plan sponsors and participants of 401(k) plans.
Present Inadequacy of Retirement Savings
Recent studies of the authoritative Employee Benefit Research Institute found that two-thirds of American households have less than $50,000 saved for retirement, a savings rate far below what they need for retirement even under the most optimistic assumptions. And those within 5 years of retirement, on average, had put away amounts only three times their annual income. This is far less than the minimal savings of ten times earnings recommended by most financial planners.
The most commonly recommended retirement-income-replacement ratio is for a retiree to receive 70 to 80 percent of their final pay prior to retirement from all sources - pensions, social security, personal savings, et al. Historically, defined benefit pension plans would provide as much as 50 percent of income replacement upon the retirement of a long-term, career employee. Supplemented by social security benefits and after-tax household savings, most workers were then on a reasonably sound footing in their retirement years.
Today, however, most employees do not enjoy the security of employer-funded defined benefit pension plan coverage, as these plans have been largely superseded in the private sector by defined-contribution 401(k) plans heavily reliant on voluntary employee contributions and participant-directed investments. Unfortunately, as the typical 401(k) plan has operated over the last 20 years, the average long term participant is unlikely to receive from a 401(k) plan upon retirement much more than one-third of his or her final pay on an annualized basis. This is not half enough. The structural reasons for this retirement inadequacy include:
- Dilatory plan participation by eligible employees.
- Insufficient 401(k) contributions by those employees who do participate.
- Non-diversified and inappropriate participant-directed investment.
Presently, nearly 30 percent of all plan-eligible employees fail to participate by contributing to their company-sponsored 401(k) plan, even with an employer match of the employee's contribution. In most cases, financial behavior studies have shown, this is attributable to simple inertia and procrastination. As many as 12 million employees eligible to participate in employer-provided 401(k) plans across the nation fail to enroll in a plan and commit to a discipline of regular retirement savings. And they generally make poor investment choices under the plan, or none at all.
Auto Enrollment and Escalation
One of the features of the PPA meant to turn to advantage the common human failing of inertia and procrastination is to allow 401(k) plans to include an "automatic enrollment" provision. That is, eligible employees would automatically be enrolled and have a percentage of their pay contributed to the 401(k) plan unless they actively took steps and completed the paperwork to opt-out of plan coverage. If 401(k) auto-enrollment were universally adopted, an estimated additional 5 million employees would participate in company-sponsored plans over the next 5 years.
With regards to covered participants not contributing enough under a 401(k) plan, the PPA would further allow plans to be re-written to automatically increase an employee's contribution rate from year-to-year as she receives future pay increases from the company. Again, the participant could affirmatively elect against increased savings, but most can be expected to stay the course.
It is anticipated that inclusion of auto-enrollment and auto-escalation features in a standard 401(k) plan would increase the average income-replacement ratio of an average, long-term participating employee up to 45-50 percent of final pay from present levels of about 30 percent. This enhancement, together with social security and personal savings outside the plan, would bring an adequate retirement within reach for most households.
Appropriate Participant Investment
The PPA also enables company sponsors of 401(k) plans to arrange for outside financial advisers to provide individual guidance to self-directed investment by participants who, left to their own devices, are often confused, intimidated and short-changed by the money management process. For those plan participants who are inclined to direct the investment of their 401(k) accounts, the PPA encourages access to individual financial advisers to educate and assist them in fund selection. To ensure the independence of the financial adviser in making specific recommendations to plan participants, the U.S. Department of Labor in consultation with Treasury is expected to require such advice to be based on a quantitative "computer model" certified by an independent third party as free of marketing bias by the adviser.
The new law additionally allows 401(k) plans to include use of more suitable "default" investment funds in cases where participants have not otherwise actively selected from among those investment options offered under a plan. Those default choices are likely to be target-maturity funds containing a diversified mix of investment assets expressly geared to the age of the individual participant. The most common default option among 401(k) plans today is a low-yielding money-market type account ill-suited for long term investment savings. Alternative life-cycle funds as the default would be the simplest, cheapest and most remunerative long-term investment for the majority of 401(k) participants not interested or adept in active money management.
Higher Savings Limits Made Permanent
In further encouragement of future retirement savings, the PPA makes permanent the higher participant contribution limits for 401(k) and similar contributory plans that were set to expire in 2010. These allow participant contributions of up to $15,000 a year, plus catch-up contributions of an additional $5,000 for employees age 50 and older, plus future adjustments for inflation. Similarly, the special Roth 401(k) after-tax employee contribution option made newly available to 401(k) plans this year, also scheduled to expire in 2010, have now been made permanent.
Action Item: 2007
The above is a quick gloss of the key beneficial changes available to company-sponsored 401(k) plans under the PPA designed to encourage greater retirement savings by plan participants. These plan enhancements can be made at no great cost to company sponsors while substantially increasing necessary retirement savings by their employees. And the changes can be implemented as early as the start of the 2007 plan year.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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