Shifting the 401(k) ‘Balance’?

A week or so ago, I came across an announcement that IBM was making changes to its 401(k). More specifically that, effective next year they were going to replace their matching contribution in their 401(k) with an employer contribution to a cash balance plan.[i] In the days that followed, the news was picked up in a couple of different trade publications—the implication being that this might be signs of a new shift in plan design. Heck, even Teresa Ghilarducci weighed in, championing the “evolution” to a defined benefit structure from the “flawed” 401(k). She never misses an “opportunity.”

Readers here are likely familiar with the basic concepts of a cash balance design. Technically a defined benefit plan, it’s generally referred to as a “hybrid” because it also has a number of participant-friendly aspects that it shares with a defined contribution plan, notably an account balance (though it’s a “notional” one) that is shared with participants. The benefits accumulate somewhat evenly over time, rather than being more service “back-loaded” as traditional pension plans tend to be. But just like a traditional DB plan, cash balance plans are funded by the employer on an actuarial basis, and the investments are employer-directed, ostensibly with an eye toward the benefit obligations that are accruing. Also, some cash balance plans are insured by the Pension Benefit Guaranty Corporation (PBGC), just like traditional pensions (and yes, the employer has to pay premiums).

Of course, cash balance designs aren’t new, nor are they new at IBM, which (in)famously shifted to one from a traditional defined benefit plan back in the late 1990s. I say “infamously” because it triggered a couple of participant lawsuits from individuals who thought their benefits had been reduced in the move—an age discrimination suit they won, only to lose on appeal. That said, even in finding for IBM the appellate court acknowledged that older workers were generally correct in perceiving "that they are worse off under a cash-balance approach" because such a plan eliminated the possibility of earning larger benefits as they neared retirement. "But removing a feature that gave extra benefits to the old differs from discriminating against them," the judge wrote. 

That controversy notwithstanding, cash balance plans have, in recent years, proven to be quite popular—particularly among smaller employers because they provide more funding flexibility than a traditional DB plan, and the potential for better benefit accumulation than the non-discrimination and top-heavy test limits often allow with defined contribution plans, such as a 401(k). But what IBM has done—basically replacing its 401(k) match with a cash balance plan contribution does appear to be unique—and worth noting.

As for IBM, while external perspectives on the announcement appear to be largely positive,[ii] it remains to be seen how it will be accepted by those it is ostensibly designed to benefit. Some have already commented that the loss of a match will reduce incentives to save in the 401(k)—others that the resulting diminishment in the 401(k) balance will undermine the amounts available for loans and hardships, though that arguably isn’t the purpose for those 401(k) savings, either. On the other hand, all eligible IBM employees stand to get this employer contribution, not just those who contribute to the 401(k) (though with what is said to be a 97% participation rate, it seems that few are left out at present, though we don’t know their contribution rates). You don’t have to be a cynic (though it helps) to imagine that IBM has done the math here, and that the change is either neutral, or inures favorably to their bottom line.

People tend to forget that the contributions defined in a defined contribution plan can be (re)defined each plan year—and while reductions are rare, they are not unprecedented. That said, even in rolling this new benefit out, IBM has (according to an internal communication memo posted online) acknowledged a reduction; “IBMers will also receive a one-time salary increase to offset the difference between the IBM contributions they are currently eligible to receive in the 401(k) Plan and the new 5% RBA pay credit”—though arguably that’s trading a pre-tax benefit for one on which taxes will be due immediately.   

While it’s certainly an interesting move—by a company with a history of interesting benefit moves—and, despite the enthusiastic response of Professor Ghilarducci, it seems unlikely to catch on more broadly.  Retirement savers have not only long understood and appreciated not only the value of an employer match, and so seem unlikely to embrace “losing” that to new plan they don’t understand, however even the tradeoffs are presented. As for plan sponsors—well, inertia is a powerful force in plan design as well—and a big design change that requires sensitive (and likely) ongoing communication will almost surely give pause to even the most innovative.

That said, it should serve as a reminder that plan designs can, and should, serve multiple purposes. It will be interesting to see how this one pans out.

- Nevin E. Adams, JD  

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[i] It’s actually referred to as a Retirement Benefit Account (RBA), though the description fits a cash balance plan, and it’s described as being offered “within IBM’s Personal Pension Plan.”

[ii] Not exclusively, of course—there’s cynicism to be found with regard to IBM’s true motives here. 

Reference 'Points"

We started setting money aside for our children’s college education relatively early, but as they began actually considering their options, it was clear that our savings wouldn’t be enough to cover the expense at some of the schools on their lists. Moreover, while all three wouldn’t all be in college at the same time, there was enough overlap to make it “complicated.”

While we didn’t want to limit our kids’ college choices, we had certain real world constraints—and so we told them how much we could contribute to their college expenses, and that they were free to make up the difference between that figure and the actual expense of the college they chose through their own work, scholarships, and/or debt. As a practical matter, defining our “contribution” may have taken some options off their lists, but, certainly in hindsight, it seemed to give them focus and some real-world context—a reference point—for one of the biggest financial decisions of their lives.     
Employers have been interested in and have tried to implement the “defined contribution” concept for health benefits in a number of different ways. The Revenue Act of 1978 started it with Sec. 125 and flexible spending accounts and “cafeteria plans.” A recent EBRI Issue Brief outlines some of the more recent history, the introduction of health reimbursement arrangements (HRA) in 2001, health savings accounts (HSA) in 2004, and the more recent trend toward private health insurance exchanges, where employers provide a fixed amount of money for workers to use toward the cost of health coverage.

However, the primary focus of the report is another defined contribution approach called reference pricing (RP), under which plan sponsors either pay a fixed amount or limit their contributions toward the cost of a specific health care service. If a plan member chooses a health care provider or service that costs more, he or she must pay the difference in price. Reference pricing is receiving more attention and consideration today because of growing plan sponsor interest in managing health care costs, but the approach is still relatively new; in 2012, 11 percent of employers with 500 or more workers were using some type of RP, and another 16 percent were considering it.

How might such an approach impact cost? EBRI’s analysis indicates that the potential aggregate savings could reach $9.4 billion if all employers adopted reference pricing for the health care services examined in the paper, some 1.6 percent of all spending on health care services among the 156 million people under age 65 with employment-based health benefits in 2010.

As the report notes, savings from reference pricing materializes through the combination of 1) patients choosing providers at the reference price, 2) patients paying the difference between the reference price and the allowed charge through cost sharing, and 3) providers reducing their prices to the reference price. Obviously, any increase in prices among providers below the reference price would reduce the potential for savings.

From an employer perspective, the approach establishes a cost threshold for the service(s) selected, but as the EBRI analysis notes, plan sponsors should obviously consider a number of issues as they weigh adopting reference pricing, including how the reference price is determined and how providers may react. Communication to plan members is also key to effective use of reference pricing.

For plan members, it could represent the potential for expanded choice with some pricing context—but, as with my kids’ college selection process, they’ll likely need more data on prices and quality in order to make truly informed decisions.

Nevin E. Adams, JD

The full report is published in the April EBRI Issue Brief, “Reference Pricing for Health Care Services: A New Twist on the Defined Contribution Concept in Employment-Based Health Benefits” available online here.

"Better" Business

It has become something of a truism in our industry that defined benefit plans are “better” than defined contribution plans. We’re told that returns are higher(1) and fees lower in the former, that employees are better served by having the investment decisions made by professionals, and that many individuals don’t save enough on their own to provide the level of retirement income that they could expect from a defined benefit pension plan. Even the recent (arguably positive) changes in defined contribution design—automatic enrollment, qualified default investment alternatives, and the expanding availability of retirement income options(2)—are often said to represent the “DB-ification” of DC plans.

However, a recent analysis by EBRI reveals that DB is not always “better,” at least not defined as providing financial resources in retirement. In fact, if historical rates of return are assumed, as well as annuity purchase prices reflecting average bond rates over the last 27 years, the median comparisons show a strong outcome advantage for voluntary-enrollment (VE) 401(k) plans over both stylized, final-average DB plan and cash balance plan designs.(3)

Admittedly, those findings are based on a number of assumptions, not the least of which include the specific benefit formulae of the DB plans, and the performance of the markets. Indeed, the analysis in the June EBRI Issue Brief takes pains not only to outline and explain those assumptions,(4) but, using EBRI’s unique Retirement Security Projection Model® (RSPM) to produce a wide range of simulations, provides a direct comparison of the likely benefits in a number of possible scenarios, some of which produce different comparative outcomes. While the results do reflect the projected cumulative effects of job changes and things like loans, as well as the real-life 401(k) plan design parameters in several hundred different plans, they do not yet incorporate the potentially positive impact that automatic enrollment might have, particularly for lower-income individuals.


Significantly, the EBRI report does take into account another real-world factor that is frequently overlooked in the DB-to-DC comparisons: the actual job tenure experience of those in the private sector. In fact, as a recent EBRI Notes article(5) points out, the data on employee tenure (the amount of time an individual has been with his or her current employer) show that so-called “career jobs” NEVER existed for most workers. Indeed, over the past nearly 30 years, the median tenure of all wage and salary workers age 20 or older has held steady, at approximately five years. Even with today’s accelerated vesting schedules, that kind of turnover represents a kind of tenure “leakage” that can have a significant impact on pension benefits—even when they work for an employer that offers that benefit, they simply don’t work for one employer long enough to qualify for a meaningful benefit.

So, which type of retirement plan is “better”? As the EBRI analysis illustrates, there is no single right answer—but the data suggests that ignoring how often people actually change employers can be as misleading as ignoring how much they actually save.

Nevin E. Adams, JD

(1) In the days following publication of the EBRI Issue Brief, (“Reality Checks: A Comparative Analysis of Future Benefits from Private-Sector, Voluntary-Enrollment 401(k) Plans vs. Stylized, Final-Average-Pay Defined Benefit and Cash Balance Plans,” online here),  a number of individuals commented specifically on the chronicled difference in return in DB and DC plans; outside of some exceptions in the public sector, DB investment performance generally has no effect on the benefits paid.

(2) A recent EBRI analysis indicates that, even in DB plans, the rate of annuitization varies directly with the degree to which plan rules restrict the ability to choose a partial or lump-sum distribution. See “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here.

(3) While the DC plans modeled in this analysis draw from the actual design experience of several hundred VE 401(k) plans, in the interest of clarity it was decided to limit the comparisons for DB plans to only two stylized representative plan designs: a high-three-year, final-average DB plan and a cash balance plan. Median generosity parameters are used for baseline purposes but comparisons are also re-run with more generous provisions (the 75th percentile) as part of the sensitivity analysis.

(4) The report notes that a multitude of factors affect the ultimate outcome: interest rates and investment returns; the level and length of participation; an individual’s age, job tenure, and remaining length of time in the work force; and the purchase price of an annuity, among other things.

(5) The EBRI report highlights several implications of these tenure trends: the effect on DB accruals (even for workers still covered by those programs), the impact of the lump-sum distributions that often accompany job change, and the implications for social programs and workplace stability. “See Employee Tenure Trends, 1983–2012,” online here.

Compliance “Deportment”

Recently, the Internal Revenue Service (IRS) announced that it was sending a questionnaire out to about a thousand 401(k) plan sponsors. The IRS said it developed the questionnaire because of the “critical role 401(k) plans play in our private retirement system” (see “IRS Provides 401(k) Questionnaire Details”).

Make no mistake: It’s going to take some effort to respond to the questionnaire—and respond you must. Described as a “compliance check,” the IRS notes that “failure to complete the Questionnaire will result in further enforcement action.” So, what does the IRS want to know?

Well, there’s a lot of information to be gathered about the plan from plan years going back to 2006: the number of employees, participants, their deferral levels, eligibility standards, service and age requirements, the existence and administration of loans and hardship withdrawals, the results of nondiscrimination tests, the determination of top-heavy status, the level(s) of match, and any changes to those levels.

The more interesting part of the questionnaire, IMHO, is the other questions the IRS asks; things like, Have recent financial conditions led to an uptick in hardships and loans? Does the plan allow for Roth contributions (and how many participants have opted for that feature)? Can participants use a debit card to take a loan? And, for plans that embraced automatic enrollment, did they do so retroactively or prospectively? And I’m curious not only about what plan sponsors have to say about the impact of factors like age, compensation, matching levels, and plan communications on participation levels—but what the IRS might do with that information.

There are, however, some areas that seem a bit like a baited trap: questions about if notices are provided timely, if excess deferral contributions were returned within the legal timeframes, even if the respondent as a SIMPLE plan exceeded the contribution limits.

And, make no mistake, this is a prelude to something deeper. In unveiling the project, the IRS noted that its Employee Plans Examinations previously conducted a baseline study of 79 market segments, and “the findings indicated that 401(k) plans are by far the most non-compliant plan type in the retirement plan universe,” going on to note that “since these plans make up over 60% of the retirement plan universe, it is important to the future of the private retirement system that these plans maintain the highest level of compliance possible.”

What will the IRS do with the information? It says that it will “ultimately result in a report published by the IRS describing the responses and identifying those areas where additional education, guidance, and outreach is needed”—and, perhaps somewhat more ominously, help the IRS focus its enforcement efforts “to address and/or avoid non-compliance related to these plans.”

All in all, I wish the IRS questionnaire wasn’t quite so long, complicated, and—for lack of a better word—intimidating. For plan sponsors, I’m sure it’s going to wind up being one more thing that has to be done when they already don’t have enough hours in the day—and one that could serve to plant a big red flag on their plan, to boot.

Here’s hoping that some good comes out of it—that the IRS does indeed discover some areas in which they can help plan sponsors do a better job of keeping these important programs in compliance—and that, perhaps, it will find that the programs are in better shape than they seem to think they are.

—Nevin E. Adams, JD

More information is at http://www.irs.gov/retirement/article/0,,id=223440,00.html

A version of the online questionnaire is online HERE

'Hind" Sighted

A year ago, with the financial world feeling still very much on the precipice, and with the 2008 election results still ringing in our ears, I noted that “the impact on much-improved defined benefit plan funding levels—and on the confidence of retirement savings plan participants—has been severe, and potentially serious. We are all inclined to wonder (hope?) if, like 1987, the market will find its way back to solid footing before year-end—and worried that 1929 will be the better analogy.”

Well, as we head into 2010, it seems fair to say that this is not a repeat of 1987 and—not yet, anyway—a second Great Depression. Here’s a look at the trends that were on our mind this past year – and are just over the horizon.

Doctor Bill? Curing Health Care

Where we are: Aside from the financial crisis and unemployment, health care has been the great issue of the past year and remains so as we go to press. That the current system needs reform is scarcely an issue for debate anymore—but what constitutes “reform,” and whether or not it can (or should) be paid for, is another matter altogether.

What’s ahead: Even at this stage, it is nearly impossible to guess how this one turns out—and what it will mean for employers. It is still hard to believe that the Senate and House positions on any number of key issues can be reconciled—but then, there was a point in the summer of 2006 when many felt the same way about the Pension Protection Act. But if it does pass—or if it does not—it seems safe to say that the issue is not going away any time soon. What remains to be seen is if the “cure” is worse than what it aims to remedy.

Fee Fie? Revenue-Sharing Litigation

What we said: Deep pockets continue to be the apparent target of revenue-sharing litigation. The early signs have been promising for employers, with most jurisdictions holding that revenue-sharing, per se, was not a problem, and that disclosure of those arrangements to participants was not required.

Where we are: The courts have, by most measures, continued to be willing to give the employers the benefit of the doubt in nearly every case. A recent decision by Caterpillar to settle its litigation might be seen by some to be a crack in that otherwise unspoiled landscape, but that seems unlikely (Caterpillar was an unusual case in that an internal division actually managed money for the 401(k) for a number of years). Though a revenue-sharing case filed in June in a case involved a much smaller plan, the fact pattern seems unusual enough, and the contingent fees so limited, that it seems unlikely to portend a big shift in focus to smaller plans.

What’s ahead: Barring a smoking gun discovery among the cases already filed, it seems likely that the laws—and disclosures—will change before the litigation has any real impact. On the other hand, it is entirely possible that the mere existence of that litigation—and the ever-present litigation threat—will serve to reform the system in a way, and on a schedule, that would not otherwise have been possible.

Auto-Premonition—Doing It for Participants

What we said: It is entirely possible that an Obama administration will, as mentioned during the campaign (see “Political Pairings,” PLANSPONSOR, June 2008), advocate workplace automatic enrollment IRAs. More significantly, there is a growing suggestion that the automatic design—having been successfully deployed for enrollment and investing—might work equally well at distribution, forestalling the tendency of participants to take—and spend—those lump sums. .

Where we are: This has been a tough year for participants and plan sponsors alike, and among some 6,000 plan sponsor respondents to PLANSPONSOR’s annual Defined Contribution Survey, the pace of automatic enrollment basically flatlined, with just under a third having embraced the design (more than half of the largest plans have, however). More significantly, just 16.2% of respondents had embraced it in the past year, roughly half the pace in 2008. Meanwhile, though the appeal of the concept of a more broad-based automatic enrollment retirement savings initiative has been touted, including by those in the Obama Administration, those efforts have taken a back seat to other matters.

What’s Ahead: Automatic enrollment may have taken something of a “holiday,” but it seems unlikely to be “over” as a trend. Look for it to pick up the pace again in 2010—and for the Obama Administration to turn its attention to the issue in the next year (or two).

Default Lines—Targeting Target-Dates

What we said: We ended 2008 with a growing awareness that all date-based solutions are not created equal. In a very real sense, we are in the first year of a new generation of participants who have not only been defaulted “in,” they have been defaulted into these funds—and just in time for the most tumultuous market in memory. It will be interesting to see how participants—and plan sponsors—respond.

Where we are: Congress has held hearings, and the Department of Labor and Securities and Exchange Commission are not only on the case, they are on the case together. The market rebound has served to restore some of the damage, but the scars remain. However, the target-date manufacturers have become more explicit about their glide path designs, and the notion that a fund family is oriented to take you “to” or “through” retirement is now an open dialogue.

What’s ahead: We don’t know yet what regulators may try to do to help ensure that investors—particularly near-retirees—are not misled by the simplicity of a fund title and marketing pitch. Plan sponsors are on notice that there are differences here, and with luck, will continue to ask pointed questions. Because, after all, when you’re selling “you don’t have to worry about it”, somebody has to.

Conflicts of Interests—Advice Regulations

Where we are: One of the last acts of the outgoing Bush Administration was the publishing of a set of final rules governing the provision of investment advice to participants—regulations for which the foundation was laid in the Pension Protection Act (PPA), but whose origins can be found in a series of legislative initiatives championed by Congressman John Boehner (R-Ohio) for more than a decade. Proponents had long said that participants clearly needed (and wanted) the advice, but that there needed to be a way in which advisers could be paid enough to want to take on the task. Opponents were just as concerned that the provision merely seemed to codify the provision of “conflicted” advice by setting out terms by which advisers could receive compensation that varied depending on the funds recommended.

Experts have long expressed amazement that the provisions survived the conference committee’s reconciliation of the PPA—but there they were. However, the controversy swirling around those regulations never subsided—and, thus, it was no huge surprise when the incoming Administration tabled, postponed, postponed again, and then officially withdrew the proposed final regulations, as it announced its intention to publish separately a proposed rule that it believes more closely conforms to the Pension Protection Act statutory exemption relating to investment advice.

What’s ahead: Will we ever get final advice regulations? Almost certainly, though almost certainly regulations very different from the ones put forth a year ago. Or perhaps they will not come until after the concepts embodied in the PPA have been recrafted by legislators, such as Congressman Rob Andrews (D-New Jersey), who has already introduced legislation (the aptly named “The Conflicted Investment Advice Prohibition Act of 2009”) that would do just that. Between now and then, participants will continue to get advice the way they always have—or have not.

Stop Gaps: Closing the Pension Funding Gap

What we said last year: The market’s tumult has taken its toll on pension portfolios and, in remarkably short order, managed to undo what had been a diligent, steady progress toward restoring the funding health of many programs. Of course, it also has served to favorably impact liability calculations, somewhat muting the damage. All in all, those workers covered by the promises represented by those programs must surely appreciate their position vis-à-vis those solely depending on defined contribution plans—but how will employers feel about those promises?

Where we are: Pension portfolios took their lumps from the investment markets last year, to put it mildly. That they were better diversified—and likely more insulated—from those travails than most defined contribution portfolios was surely a matter of some comfort, as has been their steady recovery in 2009. Still, there was a lot of damage to be undone, and for most it is still a work in progress—even as the press of more restrictive accounting and funding rules takes its toll. Fortunately, Congress has been receptive to calls for extensions that have provided some much-needed breathing room for these programs.

What’s ahead: It remains more expensive—and complicated—to walk away from pension commitments than most realize, though many employers remain committed to their pension plans for reasons that transcend those financial considerations. Still, it seems likely that freezes, both hard and soft, will continue to be applied, certainly in the private sector. The public sector’s commitment to pensions remains largely unabated—and yet, a sense remains that it may only be a matter of time before fiscal realities bring about a different result.

Tying Up “Loose” Ends—Full Disclosures

What we said: There’s little question that our industry would benefit from better disclosure about the fees paid for the services rendered to retirement plans and their beneficiaries. The proposal to expand/enhance reporting to plan fiduciaries, if imperfect, still seems to be headed in the right direction. Doubtless, some providers will adopt different business models to “duck” those disclosures just a little bit longer, but it seems clear that plan sponsors will want—and deserve—a full and fair accounting. It is less clear that participants will be as well served by an incomplete, and perhaps unbalanced, reporting of fees paid in their accounts—particularly if, as is currently proposed, the disclosures could add a dozen pages (and millions in expense across the industry) to their annual statements. It is also unclear just how much of this the current Administration will be able and willing to press into service in the short time remaining.

Where we are: In just a few short months, the 2009 Form 5500 will escort in a whole new level of plan sponsor fee disclosure, though the proposed participant disclosures are not yet on the radar screen.

What’s ahead: It is nearly impossible to argue against the critical importance of full fee disclosure, certainly to plan fiduciaries. Whether the current requirements truly constitute “full” disclosure remains a matter of some debate—but it is a start. On the participant side, the short-term implications are less clear; but then, we have some time—and a new Administration—to work through those issues.


— Nevin E. Adams, JD