Retirement Savings Policy

Past, Present, and Future

Michael P. Barry

• Publisher: De Gruyter
• Year: 2018
• Print ISBN: 9781547416455
• eBook ISBN: 9781547400355
• Edition: 1
• Topic: Personal Development
• Subtopic: Finance

Mike brings to this work his comprehensive experience and consummate technical talent in a beautifully readable book. A treasure.

-- Frank Cummings, Former Adjunct Lecturer in Law at UVA Law School, Columbia Law School, NYU Law School, and ALI-ABA

Retirement Savings Policy reviews the basic policies that govern retirement savings plans, and their real world application, focusing on the key issues of finance, taxation, fiduciary conduct, and employee choice. The discussion is framed around the three fundamental challenges confronting employers and employees today – the pension legacy, the 401(k) revolution, and the pressure, from policymakers, regulators, opinion leaders, and individuals, for changes that will put retirement security within reach of all Americans.

With more than 40 years' experience in the field, Michael P. Barry provides both a wealth of practical detail – best practices and concrete solutions – and a broad framework for understanding the issues surrounding retirement plans and strategies. The result is a comprehensive introduction to the forces that drive sponsor, participant, and policymaker decision-making.

This is the perfect book for benefits and financial professionals who want a better understanding of the basic rules that govern retirement plan administration but also serves those interested in truly understanding the nuances and issues surrounding retirement plans and policies. The approach is practical, focusing on how US retirement plans actually work, how they are taxed (and not taxed), how they are regulated.

But it is also conceptual, devoting considerable attention to an understanding of why these plans work the way they do. Why regulators and policymakers are so focused on a handful of issues – expanding coverage, reducing fees, fairness. And, at the highest level, what are the problems that we are trying to solve. As such, much of what we discuss will be of interest to a more general reader, who wants a realistic understanding of what is really at stake in current retirement policy debates.

Part I:The Defined Benefit Plan Legacy

This is a book about retirement policy: how we as Americans provide for “old age”—that period after we stop working and earning money through our labor. Our focus will be, first, the primary “tool” that we have developed to address this challenge—employer-sponsored retirement savings plans—what they are, how they work, and how they have changed over time. Second, we will consider the regulatory framework that we have developed to address the issues—of, e.g., fairness and prudent investment—that this retirement savings project presents. And, third, we will discuss the underlying factors—securities markets, interest rates, and demographics—that drive much of our decision making in this area.

In Part I, we begin this expedition into the complexities of retirement savings policy with an in-depth look at defined benefit (DB) pension plans—the “traditional” solution to the retirement challenge. “DB plan” is kind of a technical term. To explain (very briefly): a DB plan provides a formula-based benefit, that is, a plan formula determines what a DB plan participant is entitled to. Financing that benefit is generally the employer’s biggest challenge.

DB plans are one of the two main types of employer-provided retirement savings plans. The other type is the “defined contribution” (DC) plan. In contrast to DB plans, DC plans provide an account-based benefit. Contributions and investment earnings go into a participant’s account, and the participant is, and is only, entitled to what is in the account. 401(k) plans, for instance, are DC plans.

In the pages that follow we will have a lot to say about these two types of plans, DB and DC: how they, in different ways, deal with the retirement challenge. Before we begin with a detailed discussion of DB plans in Part I, let’s consider briefly the prevalence of these two types of plans and how it has changed over time.

Chapter 1
An Overview of Existing Plans

For a considerable period of time DB plans were the employer-provided retirement savings benefit. Indeed, if an employer maintained a DC plan at all, that plan served mainly to supplement the benefit provided by the DB plan.

Over the last 30 years, that situation has nearly reversed: now, for most employers and most employees, DC plans are the primary retirement savings vehicle. Figures 1.1, 1.2 and 1.3 chart this change.

As Figure 1.1 shows, there are now nearly five times as many active participants (that is, participants who are currently accruing benefits) in DC plans than there are in DB plans.

Figure 1.1: Active Participants (in millions) in DB and DC plans

When we look at total participants (and include, e.g., retirees who are currently receiving benefits), however, the gap between DB and DC coverage narrows somewhat. Figure 1.2 shows total participation in the two plan types over the period.

Figure 1.2: Total Participants (in millions) in DB and DC Plans

And DB plans still retain significant assets.

Figure 1.3: Total Assets (in Trillions) in DB and DC Plans

There’s no question about the trend here: DB plans are declining, DC plans are increasing, as the way Americans save for retirement. This is the most recent data we have from the Department of Labor, but there is no question that since 2014 the trends represented in these charts have continued.

So, why write about the past? Well, to begin with, defined benefit plans are still, in many respects, very much with us. They still cover nearly 30 million participants and hold $3 trillion in assets.

There are, at this point, more “inactive” (retired or terminated) participants than active participants in DB plans. But they represent a substantial installed retirement benefit program. A legacy.

For employers who sponsor defined benefit plans, the management challenge is primarily financial. As we will discuss at length, in a defined benefit plan, the employer bears all the risk and is ultimately liable for the payment of benefits. Managing that exposure has presented a serious challenge for many employers, putting demands on their cash position and disrupting financial statement performance.

Those risks are, however, not unique to DB plans. In fact, they are inherent in any retirement plan and, in retirement savings generally—even for Robinson Crusoe on his island, if he undertakes to save for retirement. Considering those risks in the DB context will thus enrich our discussion of defined contribution/401(k) plans, where those risks are borne by participants.

In what follows we’re going to review defined benefit plan “basics.” What are these things and how do they work? Then we will provide a relatively brief tour of DB design and, critically, the issues related to DB finance. In this regard, we provide an extended discussion of the critical financial challenge DB plans present and the controversial issue of the valuation of DB liabilities.

We then review the regulatory framework, the Employee Retirement Income Security Act (ERISA),1 the Tax Code and accounting standards, that applies to DB plans and that governs, to a large extent, their design, administration and finance.

We’ll then turn to the issue of “what went wrong”—why it was that corporate America fell out of love with DB plans. We consider three critical issues: the inflexibility and biases inherent in (traditional) DB design; DB plans’ inherent lack of transparency; and the regulatory burden imposed by recent, dramatic increases in Pension Benefit Guaranty Corporation (PBGC) premiums. (The PBGC is an FDIC-like federal corporation that insures pension benefits.)

We will review corporate responses to these issues, including the development of the cash balance plan (a DB plan with DC-like elements), the development of financial products that allow sponsors to hedge interest rate risk, and the strategies that sponsors are using to reduce their PBGC premium obligation.

We will close Part I with consideration of some “deeper” issues—what retirement benefits are, who pays for them, and the role of tax policy.

Most of our discussion will be framed around basic policy and will be of interest to readers with “hands on” experience with these issues, individuals at plan sponsors who are managing DB obligations and the financial and administrative service providers who serve them, and to the general reader. We do, however, provide one section—on managing the DB legacy—that is more technical and is likely only to be of interest to practitioners.

Chapter 2
DB Plan Basics

Defined benefit plans are what most people think of when they think of a “pension plan.” Boiling it down: a DB plan is a retirement plan that (traditionally at least) provides an annuity-based retirement income, the amount of which is determined by a benefit formula written into the plan, that begins at retirement age and continues for the life of the participant.

A Formula Benefit

The benefit a DB plan provides is “defined” by a formula in the plan document that specifies the benefit to be paid at retirement age. Typically, the benefit is accrued (pursuant to the formula) over the participant’s “career” (service with the employer/sponsor).

The benefit (as is typical for salaried employees) may be a function of pay, as in:

–50% of final pay (e.g., the average of the last 3 years’ pay)

–1.5% of final pay times years of service

–2% of career average pay times years of service

Alternatively, the benefit (as in some plans for hourly employees) may be simply a “flat” dollar amount times a service multiplier, as in:

$100 per year of service

Paid Beginning at Retirement Age

The plan will specify what typically for the company is the “normal” retirement age. The majority of plans use a normal retirement age (NRA) of age 65, but there are exceptions. Airline pilots, for instance, generally retire earlier.

The plan may also specify an “early retirement age,” for example, age 55. Early retirement benefits typically are reduced to reflect the fact that they will be paid over a longer period. Some sponsors will, however, provide for “subsidized,” unreduced (or only partially reduced) early retirement benefits for participants who meet certain requirements.

While it is a fundamental element of DB plan design, “retirement age” may also be an element of corporate policy. Early retirement benefits (and special, one-time early retirement “buyouts”) have been used to reduce employee headcount without incurring the additional pain (and possible litigation risk) brought on by layoffs.

As a Life Annuity

The “traditional” DB benefit is paid as a life annuity starting at retirement. Thus, the DB benefit provides retirement income beginning at retirement and lasting until death.

The Retirement Equity Act of 1984 amended ERISA to require that defined benefit plans pay benefits as an annuity unless the participant affirmatively consents to payment in another form. And if the participant is married, the benefit must be paid as a joint and survivor annuity, with a survivor benefit going to the participant’s spouse. If a married participant wants to elect a different form of payment (e.g., a lump sum, if the plan offers it), the spouse must consent to that different form of payment, and that consent must be notarized.

Thus, all DB plans allow for continuation of the benefit (or a part of it) to the participant’s spouse or (in some cases) beneficiary. But, generally, a DB plan does not function as a tool for accumulating a legacy that will be passed on to heirs.

There are a nearly infinite number of variations on these themes. But these are the fundamentals.

The essential features of a DB plan benefit—and their significance for the issues of sponsor finance, regulation and accounting that we’ll be discussing—can be illustrated by considering one simple design:

1.5% of the average of the employees’ highest 3 years’ pay times the employee’s years of service.

This will be the DB benefit we’ll use as an example throughout what follows.

A Design Based on the Retirement Needs of the Participant

Defined benefit plans are (or were) designed by starting with the needs of the participant for retirement income. Thus, typically, the sponsor began with an ideal “replacement income target”—the amount of post-retirement income that a participant would need to maintain her pre-retirement standard of living. This number was, typically, somewhere between 70% and 80% of pre-retirement income. Credit (to this target) was given for Social Security and (in some cases) some amount of private savings. The rest would be provided by the DB plan.

From those calculations, and assuming, for instance, a 30-year career (in the case of our example plan), you get our example formula: 1.5% of...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Acknowledgments
• About the Author
• About the Series Editor
• Contents
• Introduction
• Part I: The Defined Benefit Plan Legacy
• Part II: Defined Contribution Plans and the 401(k) Revolution
• Part III: The Future
• Index