PART One
DC Plan Evolution and Design Trends
CHAPTER 1
DC Plans in the American Retirement System
Someone once called defined contribution (DC) plans one of the âgreat social experiments of our time.â For many people, a DC plan is the only company-sponsored retirement plan they have, and for this reason, plan effectiveness needs to be more than merely an âexperiment.â People need these plans to function because most will depend on them to provide adequate retirement income. The plans should also be designed to realistically take into account factors such as inflation.
When we refer to DC as a social âexperiment,â we should recognize that âscientistsâ in the retirement-plan field have made significant contributions to the status of DC plans today. Two behavioral economists who have done so are Professor Richard Thaler from the University of Chicago and Professor Shlomo Benartzi of the University of California at Los Angeles. Perhaps their greatest DC contribution has been to support automatic programs within the Pension Protection Act (PPA). Working from the premise that inertia is one of the most powerful forces of nature, employee auto-enrollment, auto-contribution escalation, and auto-asset allocation all work together to help put Americans in a better position to retire more successfully.
We need to find better ways to make these retirement plans succeed. What is more, each participant must succeed in a retirement plan individually . In other words, it is not good enough for a group of employees to reach their retirement-income goals on average.
Some people will resort to anything to find a creative solution to retirement planning. We saw an extreme example in the 2007 New York Times article âA Financial Plan that Comes with Mug Shots.â1 The story involved âfinancial visionaryâ Timothy Bowers, who solved his retirement income shortfall by robbing a bank and immediately handing himself over to the police. Bowers figured that if he were sentenced to a minimum-security prison with âquality programming for an aging offender populationâ and remained in jail until Social Security and Medicare kicked in, he would be able to meet his retirement-income goal.
Few of us are desperate enough to go to that length. However, this story underscores the need for our retirement plans to succeed, again, not just for most people but for everyone individually. That is why we produced this book, covering key issues in todayâs retirement field. To gather a wide variety of experienced commentary on these issues, in 2006 we started the monthly PIMCO DC Dialogue series in which we interview various retirement experts, including consultants, academics, plan sponsors, financial advisors, attorneys, and others. This book discusses a number of points from conversations with them and covers key questions and proposed solutions discussed at the Pensions & Investments Custom Target-Date Summits held in both 2008 and 2009.
EVOLUTION OF DB AND DC PLANS
To see where you are going more clearly, it is helpful to understand where you are coming from. For that reason, we asked David Wray, president of the Profit Sharing/401(k) Council of America (PSCA), to share some historical background about the evolution of DC plans in America. Wray explained that while most people think that DC plans began with the invention of the 401(k) plan, the plans actually got their start in the late 1800s with the implementation of company profit sharing plans for employers âto build partnership in the workplace and manage labor relations.â2
Procter & Gamble led the way with this type of plan in 1887, but then found that employees were spending the money instead of using it as a financial reserve or as money that could go toward their retirement. So in 1904, âto encourage saving, P&G introduced a stock-purchase and matching program in which they would match contributions made by the employee, with an additional amount based on the profitability of the company.â This, Wray noted, was the genesis of company matching.
Then the Revenue Act of 1921 initiated tax advantages for employment-based retirement plans, allowing plan contributions to be tax free until the employee withdrew funds from the retirement account. âThis law established the value of the DC plan from a tax perspective,â Wray explained, âwhich remains the real advantage of these plans today.â
These early DC plans flourished in the early part of the twentieth century, but when so many companies were forced out of business during the Great Depression, only about 300 plans remained at the beginning of the 1940s. However, World War II marked a rebirth of retirement plans and employee benefits. As Wray noted:
At the time, wages were frozen but there were no government limits on benefit plans. Competing for high-qualityâand now scarceâworkers, companies improved their benefit plans and started offering both health insurance and retirement programs. There was an increase in both traditional defined benefit plans, with which most people are familiar, as well as DC programs.
By the 1950s, the DC system had grown and evolved into three kinds of tax-advantaged plans: pure profit-sharing plans where the employer contributed the entire amount; cash and deferred profit-sharing plans in which companies allocated a profit-sharing bonus to the employee, who could take all or part of it in cash or defer all or part of it into a profit-sharing trust; and thrift savings profit-sharing plans, into which the employee contributed a certain amount of his or her income on an after-tax basis and could receive a tax-deferred employer matching contribution.
The year 1974 saw the creation of the Employee Retirement Income Security Act (ERISA), which focused on defined benefit (DB) funding issues, but also impacted DC programs. âUnfortunately,â Wray pointed out, âERISA failed to authorize the continuation of cash and deferred profit-sharing plans and, as a result, no new plans were formed and some companies withheld contributions waiting for a clarification.â
Recognizing that there were at least 1,000 of these plans and that they âwere excellent programs for workers to build retirement savings, as well as for companies to build a positive partnership in the workplace,â legislation was passed in 1978 to change the tax code and correct this oversight. However, the language inadvertently went further, opening the door âto a new type of deferred compensation savings plan, the 401 (k). . . . For the first time, workers were allowed to save not only bonus dollars, but also regular wages on a tax-deferred basis.â Following further clarification by the IRS in 1981, the modern 401(k) plan was born.
In 1982, Wray explained, when companiesbegan to allow âemploy ees who were already making after-tax contributions to the plan to make their contributions on a tax-deferred basis . . . the 401(k) then took off like wildfire. Within years, literally millions of people were participating in these programs.â
This full-speed-ahead rush to save a significant amount of tax-deferred wages in these plans was not to last. Concerned about lost tax revenues, Washington and the Internal Revenue Service (IRS) first tried to repeal the law but, with the Tax Reform Act in 1986, succeeded only in adding âoner ous discrimination testsâ and putting a cap on how much employees could contribute annually to a 401(k) plan. âThis change in legislation,â Wray explained, âled to the termination of most cash and deferred profit-sharing plans, as the new government restrictions made them impractical.â
The great irony of this legislation is that Section 401(k) was intended to reinstate cash and deferred profit-sharing plans, but the governmentâs revenue concerns regarding the potential success of 401(k) led to changes that killed cash and deferred profit-sharing plans.
When we asked Wray if he agreed with the general consensus that the Pension Protection Act of 2006 had caused many companies to close or freeze their defined benefit plans more rapidly, he agreed. He also concurred with us that, with so few companies now offering DB plans to workers, 401(k) and other DC plans are more important than ever and are currently undergoing a complete transition. âWhile they were created initially for profit sharing,â Wray explained, âtoday the employee deferral using the 401(k) has become the predominant form of DC plan. More companies ev ery year are adding the opportunity to save in a 401(k) plan, even those that already offer very rich profit-sharing plans. Weâre approaching 50 million actively employed workers who have a balance in a 401(k) plan and 60 mil lion in DC overall.â Wray is confident that the DC system will continue to grow in the coming decades.
MAKING THE MOVE FROM A DB PLAN TO A DC PLAN
We asked a variety of experts and plan sponsors to comment on how switching from DB plans to DC had changed the face of retirement. Deena Katz, associate professor at Texas Tech University, Personal Financial Planning Division, speaks about how having more than one choice in terms of retirement accounts has changed the way that they communicate with clients regarding their responsibilities. Almost 30 years ago, Katz related, when she first began in the retirement-planning field, there were DB plans âthat could take care of a good percentage of a personâs retirement-income needs.â3 Some of the plans even included cost-of-living adjustments to help clients keep up with inflation. âMany of us,â Katz remarked, âgrew up with a three-legged retirement-income stool composed of our DB plan, our own investments including defined contribution, and Social Security. Today, the truth is, we donât know where Social Security is headed. And our company-provided retirement benefits are typically limited to DC.â Even in the many cases where DC plans offer a company match, plan participants are still responsible for deciding how much of their salary goes into those plans. âIn essence, today we have a two-legged stool that tells us weâre on our own in terms of investing for our future. As advisers, we need to help people understand that they must rely on themselves and how to plan, given the available programs and other resources.â
However, Tom Idzorek, the chief investment officer at Ibbotson Associates, points out that the shift to DC as the primary retirement vehicle
doesnât necessarily reduce plan sponsorsâ responsibilities as they pertain to creating the best possible plan. Ultimately, as fiduciaries, plan sponsors still want to create a good lineup of options that enable employees to create their own diversified portfolios to meet their participant needs. In addition to designing a good lineup of single-asset-class fund options, these days we also see more plan sponsors adding a do-it-for-me optionâeither a target-date, target-risk, or perhaps a managed-account option.4
Charlene Mims, vice president of benefits, HRIS and payroll at Dole Food Company, Inc. is creatively looking at the needs of the companyâs workforce, exploring a somewhat DB-like approach to the DC plan: âBasically weâre exploring two directions. One is to give people an additional DC contribution based on years of service. A second is to offer a minimum or floor payout, again, based on years of service.â5 She feels that this somewhat â1970s approachâ helps Dole to both attract and retain employees. Since over 50 percent of its workforce will be over the age of 55 within the next three to five years, this payout approach is a benefit that older employees who are nearing retirement find highly attractive.
David Wray of PSCA concurs that there is no such thing as a one-sizefits-all solution and that looking at the unique needs of the population is important in designing the DC plan. âIâd suggest the plan sponsor take a hard look at its workforce and what itâs trying to accomplish. Often when companies transition from a DB to a DC-only system, they find very low DC participation. In this case, companies look for ways to make their DC arrangements more successful.â6
Wray is looking for creative ways to achieve greater plan participation. One approach is auto-enrollment, not only of new hires but of current employees who are not participating. He explains: âWhile an educational process can work in some cases to raise participation, if you need to really jump-start the system and bring it up to a high level of participation right away, automatic enrollment makes a lot of sense. Auto-enrollment has gained ground rapidly, especially with the recent government support and incentives to add the feature to plans.â
Wray also feels that adding âa hybrid, profit-sharing or other employer-funded program in which all employees are participants even if they donât make elective contributions like in a 401(k)â is a good strategy. âThe idea . . . is for everyone who works at your company to have an account that accumulates money for retirement. There are a lot of different ways to do that. The advantage of the DC system is that you can have a single plan with all these features integrated into it.â
Mark Ruloff, the director of Asset Allocation at Towers Watson, points out that while DB plans continue to be âa key component of retirement se curity, we see them playing less of a role than in the past.â7 Now DC plans are the primary source of most w...