16 Feb 2011

Frances Denmark

Underfunded pensions, outdated regulations and fiscal troubles threaten the nest eggs of millions of American Workers. In the absence of a national retirement policy, litigators in the courts — not lawmakers — have played an outsize role in shaping America's retirement future.

Seven years ago, Rory Albert saw a wave of litigation heading toward his clients, large corporate defined-contribution-plan sponsors. Albert, then co-chairman of the employment and labor law department at Proskauer Rose law firm in New York, knew he would need to lawyer up. So he called his friend Howard Shapiro, an ERISA litigation attorney based in the New Orleans office of Shook, Hardy & Bacon, and made him an offer. Shapiro had spent his career defending U.S. corporations accused of breaching their fiduciary duties under ERISA, the landmark statute otherwise known as the Employee Retirement Income Security Act of 1974. 

In 1998 a federal judge certified the first ERISA class-action lawsuit when defined-contribution-plan participants alleged that their investment in their company's stock — IKON Office Solutions — was not prudent. After the Enron Corp. and WorldCom accounting frauds sent shares plummeting, "stock drop" cases began to multiply. Soon these class-action suits raised legitimate complaints about high fees and opaque terms. By 2005, after Albert had talked Shapiro into working for Proskauer, more than 11,000 ERISA cases were making their way through federal courts. Tens of millions of dollars in fees later, the move seems prescient. "This is not ‘the sky is falling,' " says Shapiro, referring to the deluge of litigation. "This is real." 

In less than a decade, 800 of the largest U.S. corporations — AOL Time Warner, AT&T, Caterpillar, Delta Air Lines and General Electric Co. among them — have been sued by classes of employees who believed their self-directed retirement plans failed to meet standards set by the 1974 law. Today, Citigroup, Merck & Co., Morgan Stanley, Nortel Networks Corp., Pfizer and Wal-Mart Stores are embroiled in retirement-related lawsuits. The price tag has been steep. Corporations have already paid more than $4 billion in settlements, according to Fiduciary Counselors, a Washington-based legal advisory firm. 

In the absence of a national retirement policy, litigators in the courts — not lawmakers — have played an outsize role in shaping America's retirement future. Why? Participant-directed defined contribution plans, most often 401(k)s, did not exist as mainstream retirement schemes when ERISA was created. That mismatch has resulted in billions of dollars in legal fees and settlements as participants sue to make their savings plans look more like old-fashioned pensions as defined by the statute. The beneficiaries: attorneys on both sides of these lawsuits and the mutual fund industry, which now holds $2 trillion in defined contribution assets, half of the total in these plans. The losers: retirees who pay higher fees and employers embroiled in lawsuits to support the industry built around ERISA's shortcomings. 

Seven years in the making, the omnibus employee benefit statute was once hailed as a panacea for the major ills besetting employer-sponsored defined benefit pension plans. Its passage shortly after Watergate destroyed the Nixon presidency was praised as proof that members on both sides of the political aisle, along with agencies such as the Internal Revenue Service and the Department of Labor, could work together for the common good. But almost 37 years later, a slew of factors — legislative, economic, social, technological — have undermined the heart of the well-intended act. To begin with, the ambiguity and complexity of language have made it difficult for employers to sponsor traditional pension plans. The compendium of code and law is virtually unreadable (except by those highly motivated), a War and Peace of complex congressional provisions packed into 3,000 turgid pages. 

Making matters worse, Congress has not stopped tweaking the original act, adding components to boost tax revenue, benefit niche constituents or serve other political purposes. "ERISA is a Christmas tree," says Frank Cummings, who was general counsel to the late senator Jacob Javits and helped craft the statute. "Every year, Congress would hang another ornament on it." 

A third factor undermining the effectiveness of the act are the profound changes in the pension world. Social and financial industry upheaval — demographic developments, industry deregulation, global competition and ever-more-complex financial instruments — has altered the employment landscape, leaving millions of workers without solid retirement plans. For example, in 1974 an American worker could be expected to keep a job for his or her entire career. Today, according to the U.S. Bureau of Labor Statistics, the average worker changes jobs up to a dozen times, making it difficult to vest a pension that requires years of service to the sponsoring employer. 

The slow, often litigious efforts to make savings plans act more like traditional pensions — by defaulting employees into plans, then selecting fund options for them, for example — are not helping these amateur investors reach retirement goals. The new programs were never intended to be primary retirement savings vehicles, says Groom Law Group attorney Stephen Saxon: "That's where ERISA has failed." But ERISA had already failed to protect the entity it was designed to save: the traditional defined benefit plan. "When historians trace back the demise of defined benefit plans, the No. 1 culprit will be ERISA," says Ted Benna, who is considered the father of the 401(k) plan. "The unfortunate part of ERISA is that it's done the opposite of what it was intended to do." 

Congress, focusing on bank bailouts and health care reform legislation, has had little time or incentive to update pension law. Still, momentum has been building to create a new pension model. About 80 percent of the 78 million people in the U.S.'s private workforce are covered by a savings system that by most measures has proved inferior to traditional pensions. Even more alarming, another 78 million workers are not covered at all and must depend on an underfunded Social Security system. (Without any change to the present system, Social Security Trust Fund assets are projected to be exhausted in 2037, according to a 2010 annual report of the governing board.) 

As defined contribution plans come under pressure, concerns arise that employers may give up altogether on those programs. "What happened to DB plans?" asks Proskauer's Shapiro. "I fear that unless we do something with respect to the class-action litigation that has targeted the defined contribution plans, in 15 years we may be having the same conversation: What happened to all the DC plans?" 

ERISA plaintiff attorneys insist their role ultimately improves the 401(k) plan programs they sue, ensuring that employees will be better prepared for retirement. "Litigation like ours helps make sure that DC plans are run better," asserts Lori Feldman, a partner who handles ERISA cases at New York–based Milberg. "Unless there's litigation, companies aren't likely to take these steps, because it costs money." Fair point, observes Drexel University law professor Norman Stein, a critic of defined contribution plans as substitutes for bona fide retirement programs. But he insists litigation is no long-term fix: "We're always a lot better off in a world where you don't need lawsuits to get a result." Adds Proskauer's Shapiro, "We've already lost the defined benefit battles, and now we're in danger of losing defined contribution plans as well." 

Most ERISA historians trace the statute's origins to the 1963 collapse of the Studebaker Corp. car manufacturing plant in South Bend, Indiana. At the time, 4,400 vested hourly workers, most of them members of the United Auto Workers union, lost all or most of their benefits. Cummings, then an attorney with Cravath, Swaine & Moore in New York, was sent to work on the plant closing. The South Bend pension plan was so underfunded that workers with 20 to 30 years on the assembly line could only expect benefits of about 15 cents on the dollar. Some received nothing. Resolved to avoid such insult to future workers, senator Javits tapped Cummings as his general counsel and put him to work on reform. 

Beginning in 1967 lawmakers and representatives of the Department of Labor and IRS worked to hammer out viable legislation. Cummings and others traversed the country speaking to companies and labor unions, urging support for the legislation. It took seven years to get all the elements in place, Cummings recalls. On Labor Day 1974 newly appointed president Gerald Ford signed ERISA into law. 

Although the statute codified the provision of employee benefits through a private employer, it was never intended to mandate employer-sponsored pensions. The concept of providing pensions and benefits as a substitute for salary had sprung up before World War II, then kept growing; in the early 1970s legislators believed pensions would continue to expand. After ERISA's passage there followed growth in trusts, pension funding and vesting. Of critical importance, Title IV of ERISA established the Pension Benefit Guaranty Corp., a government safety net designed to avoid future Studebakers. Many pension industry observers agree that the first few years after ERISA's enactment were a promising period for pension beneficiaries and employers. 

By 1982, however, a national recession hit its nadir, and Congress began its practice of raiding pension funds for tax revenue. Lawmakers, unhappy at large sums of tax-free money accumulating in pension plans, passed the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), kicking off a series of reductions in creditable compensation — the amount of money used to build up pension plans. Along the way, a 50 percent excise tax was imposed on any pension plan that was judged overfunded. 

These revisions to ERISA — Cummings's so-called Christmas ornaments — effectively reduced the level of benefits that could be provided or funded through tax-qualified retirement plans. Ultimately, as highly compensated executives were squeezed out of pension plans, they were forced to create their own, non-tax-qualified plans. No longer participating in their company pension plans, they lost interest, making it easier for them to freeze or terminate plans. "Every significant piece of legislation adopted between 1982 and 1993 affecting pensions slowed the flow of pensions by limiting the amounts that plan sponsors could put into their plans," says Sylvester Schieber, an actuary with consulting firm Towers Watson. "We were setting ourselves up for a train wreck. We forgot the biblical lesson about famine" — that savings need to be set aside during times of plenty. 

It could be argued that the passage of the Revenue Act of 1978 changed the course of retirement security, and not for the better. The end-of-the-year law inserted paragraph "k" under section 401 in the ERISA tax code, enabling employers to establish participant-­directed savings plans. Benna, now president of the 401(k) Association, was a defined-benefit-plan vendor at the time. He saw the difficulty of selling defined benefit plans under the new code and created the first 401(k) plan. "It was a fluke," he says. "It was never meant to result in this massive shift in DB plans and this monster, 401(k)." Benna is not alone in disparaging defined contribution plans. Ross Eisenbrey, vice president of the Economic Policy Institute in Washington, regrets that the 401(k) gave employers a legal alternative to conventional pensions. "It made it incredibly easy for employers to offer something else," he says. 

The 401(k) concept took time to catch on. But as defined benefit plans came under legal attack, employers began to see these ancillary savings plans, once viewed as a perk, as a viable substitute for standard pensions. Employees would manage their own accounts — hence no liabilities posted to company balance sheets. Moreover, companies would no longer be responsible for the expensive promise of lifetime income to retirees. By 1990, $35 billion, or 9 percent, of 401(k) assets was invested in mutual funds; by June 2010 the mutual fund industry held $2 trillion in 401(k) assets, or 55 percent of the market. With the increasing size of these assets came a myriad of costly services needed to maintain them: administrative services like recordkeeping and transaction services; participant-focused services that include education, advice, communications, loan processing and in some cases insurance and annuity services. Over time, employees realized that the new plans were less effective than many of the old plans and in some ways more expensive. 

Growing discontent with defined contribution plans created a fertile medium for class-action lawsuits that would, for example, restore assets lost in sinking company shares, improve investment education, obtain enhanced advice or professional asset management and, in general, make savings plans look more like traditional pensions (see "Class Action," page 34). "Employees have an expectation that their money is put in options that are prudent," explains ERISA attorney Feldman. "If that stock becomes too risky and otherwise imprudent, plan fiduciaries need to take action to prevent losses." 

The pressure or threat of litigation led to further adjustments in the already shaky edifice of ERISA. The Pension Protection Act of 2006, for instance, made it easier for employers to automatically enroll employees into "qualified default investment alternatives," or a mix of investments, including target-date funds, without fear of a fiduciary breach (and consequent lawsuit). The Labor Department hopes this will bring more of the one third of workers who don't participate in their companies' 401(k)s into the plans, resulting in what it estimates will be between $70 billion and $134 billion in additional retirement savings by 2034. Then last year two new defined-contribution-plan fee disclosure regulations went into effect. The first enables plan sponsors to evaluate whether a plan provider is reasonably priced. The second helps participants make informed decisions about their assets. 

At the risk of stating the obvious, defined contribution plans have been a bonanza for the mutual fund industry. Try to speak with their gatekeepers about problems with the 401(k), such as the litigation deluge, and risk causing offense. In fact, neither Vanguard Group nor Fidelity Investments, two of the largest plan providers, would speak with Institutional Investor for this story. "There's nothing in it for us," a Fidelity spokeswoman said. 

At least one member of the mutual fund industry is willing to critique its ability to serve retirees. Robert Pozen, chairman emeritus of MFS Investment Management in Boston, believes change is due. Pozen is well suited to give ERISA a critical look: Former president George W. Bush tapped him a decade ago for a task force on fixing Social Security. "Target-date funds are a very crude tool," Pozen observes, but he also has reservations about defined benefit plans. Investors don't like seeing unfunded pension liabilities on company balance sheets, he explains. Pozen also believes that risk management and risk rating should have been written into the original ERISA, to assess both the plans and the PBGC, ERISA's insurance agency, which functions without an underwriting mandate. Nothing conceived to date seems to have solved the retirement planning conundrum, he contends. "We've had the simple plan, the very simple plan and the very, very simple plan," Pozen says. "It hasn't worked."

In 2008, U.S. corporations and multiemployer plans, mostly union-­sponsored, spent more than $200 billion on workplace retirement income benefits and paid out more than $460 billion in retiree benefits, according to the ERISA Industry Committee (ERIC), a Washington-based organization representing the interests of the largest U.S. employers. Despite this enormous outlay, consulting firm Mercer put the deficit in defined benefit pension plans sponsored by companies in the Standard & Poor's 1500 index at $315 billion at the end of December. This deficit corresponds to a funded status of 81 percent, compared with a funded status of 84 percent on December 31, 2009. In 2009 the PBGC, the insurance agency established by Title IV of ERISA, paid out $5.6 billion in benefits to 1.5 million Americans whose companies had disappeared through bankruptcy or other hardship. In November the agency announced a $23 billion funding deficit. Karen Ferguson, director of the Pension Rights Center since its founding shortly after ERISA's enactment, underscores the need for action by pointing out that the U.S. has the fifth-highest elderly poverty rate among the 34 countries in the Organisation for Economic Co-operation and Development. 

Reform efforts abound, some more promising than others. A national consortium called Retirement USA wants to build an entirely new retirement system. Made up of five member organizations — the AFL-CIO, the Economic Policy Institute, the National Committee to Preserve Social Security and Medicare, the Pension Rights Center and the Service Employees International Union — Retirement USA believes a new retirement system should include universal coverage; adequate income; shared responsibility among employers, employees and government; required contributions; pooled, professionally managed assets; lifetime payouts only at retirement; effective oversight; and efficient and transparent administration. In 2009 the group asked industry leaders to come up with proposals for a new, viable retirement plan. The ideas for an improved pension system vary, but the best ones have merits that will influence whatever master plan emerges. 

The ERISA Industry Committee board of directors created a 12-member task force to design a new employee retirement model because employers felt that they were losing control of the workplace retirement system. "Speaking for employers, it's clear employers remain committed to providing life security benefits," says Mark Ugoretz, ERIC's president and CEO. In answer to one of the biggest concerns, Ugoretz says it would be necessary to get executives back into the system, fund a portion of their compensation in a defined benefit plan and ensure their interest in it. ERIC's model is a voluntary program that would provide retirement income in the form of a hybrid, account-based retirement arrangement, such as a cash balance plan, with elements of both defined benefit and defined contribution plans. It has the advantages of a guaranteed benefit, limited liability for employers and economies of scale to keep costs and fees down. Called the Guaranteed Benefit Plan, it would, at minimum, guarantee the principal assets that employers and employees contributed to the plan, and it would be insured by the PBGC. 

New entities dubbed "independent benefit administrators" would run the accounts, selecting investments and taking on the bulk of the fiduciary duties, leaving employers with only limited obligations. Benefit administrators could be set up as competitive for-profit or not-for-profit entities that would make plan arrangements with retirement product and service vendors. Through the administrator, the GBP would serve both large and small employers, potentially allowing 1 million participants in a plan. The economies of scale would reduce the costs to participants, enabling them to accumulate more assets in their accounts. 

A second proposal, called Retirement 20/20, comes from a group that should know something about pensions: the Society of Actuaries. Since 1974, ERISA has required an annual actuarial certification of pension plans. "We're trying to break out of the world of DB and DC," says Emily Kessler, senior fellow of intellectual capital at the Society. "Target-date funds are not designed to produce a target of income. A DC plan is a pot of money. It's not retirement income." Kessler points to the 4 to 6 percent performance difference between retail mutual funds and institutional funds. The actuaries' goal is a stream that is more tolerant of market shocks and not just a pot of money, says Kessler. "The 20/20 uses smarter risk management," she says. In this scheme, if a participant wants a monthly income of, say, $2,000 in retirement and the benefit stands at $1,800, he or she can decide if that is sufficient to retire on." This eliminates some of the volatility of defined benefit plans, along with the expectation that employers would have to take money from operations to manage long-term risks. 

In contrast to the 20/20 and Guaranteed Benefit Plans, which aim to keep private pensions in the private sector, a third proposal, the Guaranteed Retirement Account, is based on federal government intervention to build worker nest eggs. Designed by Teresa Ghilarducci, director of the Schwartz Center for Economic Policy Analysis at the New School for Social Research, at the request of the Economic Policy Institute, the GRA mandates a contribution of 5 percent of earnings for all workers, evenly divided between an employer contribution of 2.5 percent and 2.5 percent from participants. 

Even in Congress, which created the original monster, there has been some positive movement, particularly from the senators on the Health, Education, Labor and Pensions (HELP) Committee. George Dean, general counsel to Wyoming Senator Michael Enzi, ranking Republican on the committee, explains that passing complex pension law within a narrow, budget-constrained window of time makes the process arduous. Nonetheless, Enzi and his HELP Committee chairman, Iowa Democrat Tom Harkin, have been holding a series of hearings on the future of the pension system. The committee hosted a session in November to explore whether the PBGC needs stronger management and oversight. "We need to work with the business community, or the business community will switch to defined contribution plans," said Enzi, a former accountant. Harkin pointed out that the three cabinet members who oversee the PBGC were too busy to come to meetings in the past. Joshua Gotbaum, the new head of the pension insurance agency, assured the committee that he would be holding meetings to address the PBGC's problems. "Pensions are so complicated that the only progress comes when we work together," Gotbaum said. 

Terrence Deneen, a former chief insurance program specialist at the PBGC, tells Institutional Investor that better risk management and underwriting are needed to backstop pensions. On the design side, Deneen recommends creating a central national program similar to a defined contribution plan but with mandatory employer-employee contributions. "It would be a true retirement fund, with no withdrawals and minimal administrative costs," says Deneen. 

In the House of Representatives, George Miller, ranking Democrat on the Education and Welfare Committee and author of defined-contribution-plan fee disclosure legislation, voted against the last major bill amending ERISA, the Pension Protection Act of 2006. He felt the stepped-up funding rules were too inflexible, and he turned out to be right when the markets crashed not long after, leaving pension sponsors with giant liabilities that were impossible to correct given the narrowed time frame. He sides with the Democratic view of pension reform: Either improve Social Security or mandate employer contributions to retirement plans. 

For the 78 million workers without any retirement plan coverage, an automatic IRA was first proposed in Congress in 2007, but it never left committee. In the last, 111th session of Congress, a new version was resubmitted, with President Obama's blessing. Although this scheme would get more workers into retirement plans, unlike the proposals coming out of Retirement USA, it does not break much new ground. In August, Senator Jeff Bingaman, a Democrat from New Mexico, and Representative Richard Neal, a Massachusetts Democrat, introduced bills in their respective chambers that would require companies that do not offer retirement plans and have more than ten workers to sign workers up for Auto IRA, as it is called. Companies would deduct 3 percent from workers' paychecks to deposit in the IRA, and employees would manage these accounts as they would regular IRAs, selecting investment options or opting out of the program. According to ERIC, employers have concerns about the cost of an automatic IRA, even though both bills would give employers two-year tax credits and the Senate bill offered a phase-in of the program. Although the bills died in committee in the last congressional session, Neal plans to resubmit the House version again this session. 

While lawmakers are struggling to get their arms around the pension issue, what are asset managers, who might be viewed as gaining the most from the retirement system, doing to enhance it? As it stands, not much. They could play a much bigger role in creating more-appropriate securities and better market instruments for retirement plan participants, including better fixed-income products and better hedges on equity returns. One intriguing suggestion was offered in September by Kevin Hanney, head of United Technologies Corp.'s defined contribution plan, speaking at a hearing on lifetime income options hosted by the IRS and the Labor Department's Employee Benefits Security Administration. Hanney pointed to work done at BNY Mellon Asset Management on a new investment vehicle using amortizing nominal and inflation-linked securities. Thirty-year Amortizing Treasury Inflation-Protected Securities, or A-TIPS, would provide a stream of income in inflation-adjusted terms. They would be inexpensive to trade and highly liquid, in contrast to the insurance-­company-sponsored annuities offered in defined contribution plans today. He also recommended that participants in defined contribution plans be offered access to TreasuryDirect accounts. 

Reformers seem to agree that a new kind of retirement plan will build on the best elements of defined contribution and defined benefit plans. It would have to be simple and clear, unlike the tangled, complex statute of today. "There are still many question marks in the law," says attorney Albert, who started practicing ERISA law soon after it was enacted. For now, Albert and ERISA litigator Shapiro do not expect a slowdown in ERISA lawsuits.