This week marks the 40th anniversary of a landmark event that, along with Social Security, has shaped the retirement landscape in the United States. President Gerald Ford’s signing into law of the Employee Retirement Income Security Act (otherwise known as ERISA) on September 2, 1974 is largely responsible for the evolution of the private retirement plan system. With 401(k) plans as its mainstay, ERISA has been largely successful in delivering broad-based retirement security to employees, as well as providing for a uniform, nationwide set of fiduciary and administrative standards.
Today, this system is being questioned, if not threatened, because of the perception that its coverage is limited and does not result in retirement readiness for those it does cover. This criticism is short-sighted, since it ignores the system’s positive achievements and neglects how it has adapted to meet the needs of a modern, mobile workforce. The best way to ensure the retirement security of Americans is to preserve this system and improve it with better plan design and financial products.
The event that crystalized the need for pension plan reforms was the 1963 closing of Studebaker Corporation’s automobile plant which caused many long-service workers to lose both their jobs and benefits promised under the company’s poorly funded defined benefit pension plan. ERISA addressed the concern that private pension plans were mismanaged by setting new standards for the vesting and funding of benefits, introducing new reporting and disclosure rules and imposing certain standards of conduct on fiduciaries who manage plans. Subsequent legislation would amend ERISA in important ways, such as reducing the maximum age that a plan may require for participation and creating spousal rights through mandatory survivor annuities and qualified domestic relations orders in the event of divorce.
These reforms established the groundwork for the explosive growth of the private plan system. According to Department of Labor records, in 1975 this system covered not quite 45 million participants; however, by 2011 it had expanded to include nearly 130 million people. Over the same period, the growth in plan assets has been even more impressive, rising from $260 billion to $6.3 trillion, a more than 24 fold increase.
ERISA’s original focus was on making defined benefit plans more secure for participants. These plans promise periodic payments for life, the amount of which is determined by a formula whose key variables include a participant’s compensation and length of service. Since the plan mandates a specified level of benefits, it is the employer’s responsibility to make sufficient contributions to fund this lifetime commitment.
In the 1980s, the prevalence of the defined benefit model began to give way to individual account plans which, as their name implies, provide a benefit equal to an account consisting of employer and/or employee contributions and their earnings. These defined contribution plans, which include the now familiar 401(k) plan, appealed to employers, because of the relief they provided from the investment risk associated with defined benefit plans. On the heels of the 401(k) plan came the hybrid plan, also known as a cash balance plan, which allowed considerably higher contributions helping participants build their nest eggs quickly.
Since defined contribution accounts were portable, this alternative also made sense for a workforce that changed jobs with increasing frequency. Moreover, highly mobile workers were better off, because defined contribution plans tended to have shorter vesting periods than their defined benefit counterparts. By the early 1990s, defined contribution plans had overtaken defined benefit plans in terms of assets and plan participants, a trend that has continued until they now predominate.
Notwithstanding its popularity and the fact that approximately 74 percent of full-time workers in private industry have access to a retirement plan of some sort, the private retirement system, as presently constituted, has been criticized for a lack of access by part-time employees and those working for small employers who are reluctant to establish a plan. Other complaints center on the investment risk now being shouldered by a workforce without a high level of financial literacy. One example of this issue was the Studebaker-like scandal that occurred in 2001 when Enron plan participants were unable to diversify their excessive holdings in employer stock. Critics also say that, even if plan participants accumulate an adequate level of retirement assets, they run the risk that they will outlive them.
The beauty of the private retirement system under ERISA is its ability to adapt to meet employees’ needs. Automatic enrollment and automatic escalation of employee contribution levels (with the ability to opt out) are already being used to improve the take-up rate of employees who have plan access and can be enhanced by wider use, as well as legislation that would make them more effective. For workers without plan access, legislation could authorize these same techniques to overcome employee inertia in making contributions to IRAs.
Further, small employers could be encouraged to establish retirement plans for their employees by means of tax incentives, authorizing simpler plan designs that eliminate burdensome nondiscrimination testing of the relative amounts deferred by high and low wage earners and deeming certain of an employer’s fiduciary duties satisfied in certain circumstances.
The issue of investment risk is being addressed by the further development and wider use of investment products that automatically diversify and rebalance plan accounts, a concept already legislatively approved and in use in the form of qualified default investment alternatives.
To promote lifetime income options, proposed regulations would require disclosure to participants of the level of periodic income that could be supported by their plan accounts, and work is underway to remove regulatory barriers to offering annuity options in 401(k) plans. In addition, longevity annuities with a lifetime income stream beginning as late as age 85 are now permitted, so that participants can manage a portion of their retirement assets until an advanced age and still have assurance that their retirement assets will not run out. To address participant resistance to committing assets to an annuity, consideration is being given to developing a 401(k) plan default investment in the form of a trial annuity with an opt-out clause.
ERISA critics would supplement the private retirement plan system with an expansion of Social Security or various government-controlled retirement programs that would diminish support for employer-provided plans and could eventually crowd them out. But these alternatives are flawed and do not offer the advantages of the current system. For example, Social Security is already under financial strain, and even if this were not the case, its expansion would reduce the low national savings rate, given that Social Security revenues are immediately spent by the government and the program’s putative pre-funding is a special government bond on which a future generation will have to make good.
Other proposals currently in vogue aim to provide universal pension coverage for privately employed workers under programs run by the federal or state governments. These programs would provide for contributions at an annual rate that is only half the average rate currently enjoyed by participants under the current system, effectively downsizing retirement benefits when we should be thinking of increasing them. The proposals for government controlled systems also entail such unappealing features as taxpayer-subsidized investment returns and carry the potential for misallocating assets due to political pressure. Moreover, each program would require special dispensations from ERISA’s fiduciary requirements, fracturing the nationwide scope of their application.
The private retirement plan system has been successful in providing and safeguarding retirement benefits for millions of Americans. It has demonstrated the capacity for growth and change that bodes well for meeting the needs of the future. As we celebrate ERISA’s achievements, we should realize that the system it was designed to foster is the appropriate vehicle for ensuring that all Americans are retirement ready.