Posted on September 24, 2006 by David Laidlaw
In August, Congress passed and the President signed into law pension legislation that significantly changes how retirement plans are regulated. The new law impacts both traditional pension plans and 401(K) plans and some of the provisions are beneficial. However, this legislation will do very little to close the gap between how much the population needs to save for retirement and how much people will actually save.
The new pension law will also accelerate the demise of traditional pension plans. The law allows companies – as IBM did a few years ago- to transfer from defined benefit plans to cash balance plans with lower funding requirements. These changes may no longer be challenged under the age discrimination laws. The new law also requires better funding which may force some borderline plans to freeze their traditional pension plans and convert to defined contribution plans.
Most companies allow employees to save a percentage of their income in 401(K) plans. Each employee has the option of deducting a certain amount from his or her paycheck each period and contributing to these plans or not. In the past, many companies were hesitant to automatically enroll their employees in their plans since they were afraid of being sued for withholding salary even though the vast majority of employees would be better off with these contributions. The new law protects companies from this type of liability and will spur many companies to enroll their employees as the default option and force them to opt out if they do not want to participate in the plan. This change is very positive since it will increase participation in these plans. Currently, approximately 40% of employees over the age of 40 do not contribute to their retirement plans.
The pension act also allows financial companies that provide the underlying investments to give investment advice to plan participants. This section of the law should benefit those participants that lack the knowledge to optimize their investments. Many current participants keep very large sums in the money market option and limit their opportunities for the long-term gains associated with common stock investment. Others invest far too much in limited areas such as their company stock or hot sectors with good recent performance. Professional advice should help alleviate these obvious problems.
On the other hand, there is an inherent conflict of interest associated with receiving advice from the company that offers investment options within the plan. To alleviate this conflict, the law requires that allocation decisions be supported by “independent computer models,” but any company that is writing the models will be dependent on the mutual fund company for their revenues. It also remains to be seen how expensive these advice offerings will be relative to the size of the portfolios. Many of these plans are already quite expensive and additional fees will limit growth. Also, Wall Street firms were the dominant lobbying force behind this legislation.
Independent investment advice is always preferrable to advice tied to product sales. Please contact us if you would like help deciding on how to allocate your choices if you are participating in a plan sponsored by your employer. We are also able to consult with plan sponsors regarding new retirement plans or plans already in existence.
The Pension Protection Act will result in greater participation in retirement plans and probably limit the damage that the least attentive participants inflict on themselves. However, this legislation will do little to solve the nation’s funding problem. A majority of the workforce over 45 years old has saved less than $50,000 according to a survey by theEmployee Benefit Research Institute. A huge portion of the population is relying on Social Security and Medicare benefits to fund their retirement. In many cases, these benefits will not be sufficient for them to maintain their standard of living. Promised benefits also will not materialize since the liabilities are too large. Eventually, a more comprehensive solution is needed.