New Legislation May Change Your Retirement Plans
Congress completed passage last week of legislation to overhaul the nation’s pension systems. Here are some of its particulars.
Question: Will the bill make my pension any safer?
Answer: It depends on the kind of pension you have -- a defined-benefit plan, a 401(k) or a hybrid.
Q: What defines a defined-benefit plan?
A: Employers guarantee their retirees a certain payment every year, usually some percentage of their final years of earnings. Defined-benefit plans are increasingly unpopular with employers because the plans expose the employers to open-ended costs. The Employee Benefit Research Institute says about 20% of private workers are now covered by defined-benefit plans, down from 35% in 1980 and a peak of 62% in the 1970s.
Q: Have companies set aside enough money to pay their
retirees what they’re owed?
A: No, they have not, and that’s the crux of the problem. At the end of last year, the government estimated that pension funds were $450 billion short of what employers needed to meet their pension obligations. Most of the shortage was with financially healthy companies that stood a good chance of earning the needed funds, but $108 billion of it was with companies on shaky financial footing.
Q: Isn’t there a government agency to bail out companies that can’t meet their pension obligations?
A: There is. The Pension Benefit Guaranty Corp., in theory, is available to pay retirement benefits to companies that don’t have the needed cash. But the PBGC is itself underfunded by an estimated $23 billion.
Q: That sounds like a disaster in waiting. What does the legislation do to head it off?
A: The legislation gives most defined-benefit pension plans seven years to become adequately funded. Companies would have to be prepared to meet 100% of their pension obligations, not 90% as under current law. Beleaguered airlines -- especially Northwest and Delta, both in bankruptcy -- would have up to 17 years to become fully funded.
Q: If defined-benefit pensions are on the way out, is something replacing them?
A: Yes: defined-contribution plans. One form is the individual retirement account, fed with tax-deductible contributions. Another is the 401(k) -- which undergoes significant changes in the new legislation.
Q: How does the 401(k)
work?
A: In the Revenue Act of 1978, Congress authorized employers and employees to contribute before-tax earnings into accounts for each worker’s retirement -- spelled out in section 401(k) of the legislation. In typical cases, workers contribute some percentage of their salary to their 401(k) accounts and employers match part or all of workers’ contributions (often 50 cents on the dollar). Employers give their workers a range of investment options -- the average number is nine -- including stocks, bonds and money market funds. Nobody is guaranteed a particular benefit upon retirement; the benefit depends on how much money has been invested, and how successfully. But 401(k) plans have the advantage of being “portable” -- workers can take their savings along when they switch jobs.
Q: What does the new pension legislation do for workers whose employers offer 401(k)s?
A: There are two major provisions. One would make permanent the increased limits enacted in 2001 on the amount of salary that could be deposited tax-free into a 401(k). Without legislation, the larger limits would expire at the end of 2010. The other provision would allow employers to enroll employees automatically in 401(k)s and leave it to the workers to opt out. Experience suggests that about one worker in four fails to take advantage of 401(k)s when it is up to the worker to enroll, but fewer than one worker in 10 goes to the trouble of opting out after being automatically enrolled.
“I would not be surprised if within less than 18 months, more than half of the 401(k) participants in the country are in plans that have automatic features,” said J. Mark Iwry of the Retirement Security Project and the centrist Brookings Institution think tank in Washington.
Q: OK, so where does the hybrid fit in?
A: Hybrids, also known as cash-balance plans, offer a mix of the qualities of defined benefits and defined contributions. As in traditional defined-benefit plans, employers have some flexibility over the timing of their contributions, and they control the way those contributions are invested. Retiree benefits are calculated based on an interest rate set by the employer -- say, 4% or 5% a year. Employers generally set the rate low enough that they can earn at least that much on the invested contributions. “If they earn more, as they usually do, they pocket the difference,” said Iwry.
Q: Doesn’t that just shift the risk from the worker to the employer?
A: There isn’t much risk, but there’s another problem. In the conversion from defined-benefit plans, benefits are often frozen for a few years. This practice
hits older workers particularly hard, and conversions were thrown out by a federal court in 2003 on age discrimination grounds.
Q: What does the legislation do about hybrids?
A: It clarifies the legality of hybrid plans and imposes nondiscrimination rules. But the AARP, a seniors’ lobbying group, regards those rules as inadequate. “It does not provide additional transition assistance for workers hurt by conversions to cash-balance pension plans and weakens age discrimination protection for older workers,” said Bill Novelli of the AARP. “This bill can help make retirement more secure for many,” he said, “but it leaves much work to be done to ensure retirement security for all.”
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Pension decline
Traditional defined-benefit pension plans are rapidly being replaced by defined-contribution plans, such as 401(k)s.
Distribution of private-sector retirement-plan participants
1978
Defined benefit: 60%
Defined contribution: 16%
Both: 24%
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2004
Defined benefit: 10%
Defined contribution: 63%
Both: 27%
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Source: Employee Benefit Research Institute
