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Pension legislation: At long last!

By Jim O'Connell, Ceridian vice president of Government Relations and HR Policy

At least two years in the making, the HR 2830 bill, the Pension Protection Act of 2006, seems at long last poised to become law. It's the most comprehensive retirement security legislation in a generation.

After languishing in a House-Senate conference committee for months, the logjam seemed on the verge of breaking in mid-May on the biggest retirement measure since the Employee Retirement Income Security Act of 1974 (ERISA).

The landmark legislation will be framed by three pillars:

• New funding rules for defined benefit plans.
• Extensions of Economic Growth and Tax Relief Reconciliation Act savings incentives.
• Improvements in defined contribution plans.

Defined benefit plan funding rules
The most controversial part of the new legislation, indeed the issue that has held up the bill for two years, are provisions that would change the funding formulas for defined benefit pensions. Fundamentally, a huge gulf has developed nationally between defined benefit pension assets and pension promises made to millions of U.S. workers.

The Pension Benefit Guaranty Corporation (PBGC), the agency Congress created in 1974 to insure pensions, estimates that defined benefit plans have cumulative under-funding in excess of $450 billion. According to the Bush administration, this monumental shortfall can be attributed in part to 1970s-era regulations that allow some plan sponsors to overestimate their assets and underestimate plan liabilities.

To be sure, the 2000 stock market collapse and the lowest interest rates in decades combined into a double-whammy for defined benefit plans, plunging their asset values at the same time as they sharply increased estimated pension liabilities. Nevertheless, it has become clear to policymakers, employees, retirees and employers alike that new rules are required to make sure pension contributions are sufficient to be able to meet future pension promises.

While it's not possible to predict exactly how House and Senate conferees will tighten the rules for how much companies must set aside to meet future pension liabilities, it's clear that some plan sponsors will need to contribute significantly more funds, over time, to bring pension assets into line with long-term promises. For example, it's likely that plans will be required to use a new, and generally lower, interest rate benchmark than current law, increasing the price tag of today's pension liabilities and forcing employers to increase pension plan funding. The new law may also limit the practice of "smoothing" asset values, requiring plan sponsors to use more current valuation estimates.

EGTRRA extensions
The 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) contained a number of tax incentives for retirement saving, including an increase in the 401(k) plan elective deferral limit to $15,000; an increase in IRA limits to $5,000; the creation of "catch-up" contributions for those over age 50; and an increase in the amounts that could be saved in defined benefit plans to $40,000.

The difficulty for savers, however, is that these limits are all scheduled to "sunset" in 2010, a mere four years away. A consensus has emerged on Capitol Hill to extend these expiration dates for some period of time, with Republicans generally supporting permanent extension of the EGTRRA provisions and Democrats urging a limited extension to allow future administrations and lawmakers flexibility to modify these limits as needed.

To be sure, the present expiration dates will be extended, with a high likelihood that the limitations will be extended permanently.

Defined contribution plan improvements
With 401(k)-type plans now occupying a central place in America's retirement savings landscape, lawmakers have become more concerned in recent years about low savings and participation rates in defined contribution plans.

For example, one of four eligible employees elects not to participate in their employer's 401(k) plan. Of those that do participate, only eight percent contribute the maximum allowed. At the same time, 20 percent of distributions from such plans are not rolled over into another plan, as participants opt to cash out in lump-sum payments. This and other data expose a striking fault line in retirement security: Americans aren't saving enough for their retirement. Incredibly, in 2005, for the first time since 1933, the U.S. savings rate was negative -- at minus 0.5 percent. Collectively, we actually spent five cents more than every dollar that we earned! It's estimated that the typical worker aged 55-64 has a 401(k) balance of only $42,000.

To address these concerns, the Pension Protection Act would dramatically alter America's defined contribution retirement plan system by shifting participation and savings from employee opt-in to employee opt-out. Put another way, HR 2830 proposes to change the "default setting" for America's 401(k) system from employee nonparticipation to employee participation.

The legislation would achieve these goals by offering employers special new incentives to adopt employee "automatic enrollment," i.e., enrolling all new hires as soon as they become eligible for participation. Incentives also would be provided to encourage employers to set default payroll deduction rates above three percent, select default investment allocations based on employee age, and rollover 401(k) balances into other employer plans when employees terminate. Employees would be free, of course, to opt-out of these steps within a reasonable period of time.

Plan sponsors who choose to offer these new retirement savings features would enjoy two important advantages: a legal shield from any fiduciary liability associated with participant investment losses and a "safe harbor" from annual anti-discrimination testing. Employers would have no fear that automatically enrolling employees in 401(k) plans and selecting on their behalf a mix of investments would expose plan sponsors to lawsuits for investment losses.

Congress is so confident that shifting to automatic enrollment and employee opt-out will work to increase participation and savings that it will allow employers to substitute the new approach for the 1974 ERISA requirement of nondiscrimination testing. Annual testing ensures that defined contribution plans don't favor highly-compensated employees at the expense of lower paid employees. Congress believes that this vestige of 20th century pension legislation would become superfluous as the employee opt-out approach boosts participation rates.

Finally, it's likely that 2006 defined contribution reforms will include authorization to employers to arrange investment advice for employee participants. Concerns about fiduciary liability today generally discourage employers from providing investment advice. Subject to conflict of interest protections, the new legislation will specifically modify existing fiduciary rules to allow employers to offer advice from neutral third-parties.

What to do about "pension deficit disorder"?
Capitol Hill leaders have for some time argued that the 1974 ERISA law is overdue for an update. The vast under-funding problem facing the nation's pension plans demands urgent action to make sure plan assets are sufficient to meet pension promises. Expect Congress soon to come to agreement on a bipartisan basis on strengthening pension plan funding, extending expiring retirement saving limits and catch-up provisions, and reforming 401(k) plans to encourage automatic enrollment and employee opt-out.

With Social Security on financial thin ice, retirement savings inadequate and defined benefit pensions vastly under-funded, Congress and the president must act quickly to shore up existing pensions and create new systems to increase 401(k) savings. Look for the Pension Protection Act of 2006 to become law soon and begin to help the U.S. and millions of baby boomers and their children and grandchildren build a more solid foundation for retirement security.