Pension Plans Favor Employee Participation
Fewer and fewer defined-benefit plans.
Many plan sponsors are abandoning traditional pension plans in favor of 401(k) and defined-contribution plans.
Employees participate more in their own retirement, direct their own investments, and get a very visible benefit. Defined-contribution balances are also more portable than traditional defined benefits, and employees—especially those who start young—are better able to control their retirement time frames and lifestyles.
It’s not all roses though. Many plan sponsors are surprised at the cost to operate a defined-contribution plan, even when employer contributions and match are set at a low level. Liability for investment-returns theoretically belongs to the participant if the plan sponsor has toed the line in a number of areas. Finally, in this brave new world, secure retirement is still a question for many Americans, despite the increasing availability of defined-contribution plans and more favorable IRA treatment.
Increasing acceptance and use of defined-contribution plans.
Statistics suggest that a majority of employees are actually participating in defined-contribution plans. One major study shows that by the end of 1998, over 80 percent of employees who were eligible to participate in a defined-contribution plan, were.
Participation rates do tend to vary from company to company, and although 100 percent participation probably isn’t realistic, some employees will inevitably choose to hold onto all of their earnings for one reason or another. If your current participation rate is less than 80 percent, the program is being under-utilized. Ninety percent participation or better is above average for most industries and means that your workforce is taking advantage of an important benefit.
Boosting participation rates.
There are a number of reasons for a company to put effort into increasing employee participation in defined-contribution plans. High participation means more people are taking advantage of a benefit the company is already funding as a fixed cost, and higher participation also suggests that employees are finding value in the benefit itself, which could also boost loyalty and retention.
Another very good reason to increase participation is that employees considered "highly compensated" will benefit by being able to defer a higher percentage of their income. An employee is deemed "highly compensated" if he or she was a 5 percent owner of the employer during the current or preceding year; or had compensation in the preceding year of $80,000and was in the top 20 percent of employees in terms of compensation for that year.
ERISA guidelines mandate that employees in the highly compensated category can defer no more than 2 percent above those considered "non-highly compensated".
Most participants also have a wide variety of investment options available in their plans. In fact, 80 percent have five options or more, and almost 20 percent have more than 10 options in their plan.
Most of these options are well-used, with increasing amounts directed to growth investments. As money follows investment returns, fixed income and stable investments are getting fewer dollars. Expect this to change when investor attitudes become more conservative following a significant market downturn or economic pessimism.
Employers are contributing as well, both in the form of direct contributions (often profit sharing), and matching monies. In 1998, only 10 percent of employers were not contributing to defined-contribution plans they sponsored. Eight percent were contributing on a lump-sum basis, and 82 percent were contributing in the form of a match subject to vesting.
How big were those matches? A majority of plan sponsors contribute at the standard 6 percent level. Over 20 percent of plan sponsors contribute more than that. And a little less than 20 percent contribute 3 percent or less. Vesting schedules on this money may be as short as three years and as long as seven, but many are five years in even, 20 percent increments.
Service? The Sky’s the Limit.
Never ones to sit on their laurels, defined-contribution service providers are innovating like crazy to solve some of the problems of choice, to increase assets under management, and increase participant confidence. First on the scene were Lifestyle and Lifecycle funds, which are essentially diversified, balanced funds targeted to levels of risk or retirement time frames. These make it easier for the uninitiated to "just get invested" what they’ve managed to save.
At the opposite end of the spectrum are self-directed brokerage accounts providing access to mutual funds and/or stocks and bonds—for the participant who can’t have too many choices. Some providers show large increases in the number of plans they take on that take advantage of this option. Availability and usage of both types of options is on the rise, with Lifestyle and Lifecycle funds gaining the most ground.
The newest plan services include full Internet access, allowing participants to view, model and change balances and elections, and an advisory service to assist in making decisions. Today’s advisory services are costly for the average plan sponsor to install, (around $100,000 to customize software, plus $30-50 per person per year to maintain) and are primarily available to employees who can get to the Internet easily. Advice is a hot topic, but cost and liability issues have most sponsors talking—but not implementing.
The key is for fiduciaries to conduct the same due diligence on this investment as with any other, making sure the vendor is reputable, competent and qualified in the field. This is particularly important because there can be liability issues around providing financial advice to employees regarding their investments (the courts continue to wrestle with this issue). Plan sponsors shouldn’t give specific advice on investment decisions, but should only educate participants on general risk.
Once many of the legal and service issues have been addressed, these services will become more widely used and competition will bring prices down dramatically. They’ll also begin to include this in their basic package, priced within their current asset-based fees.
General communication, including advertising, is a big-ticket item. Many providers allocate $15 a head or more to this effort. The combined impact of strong market performance with this communication commitment have gone a long way to raising awareness and familiarity, though financial planning and investment knowledge are the two areas in which participants consistently clamor for more assistance.
What about non-defined-contribution benefits?
However, defined-benefit plans aren’t dead, and they may be gaining new life under the cash-balance approach. These plans are becoming more popular despite limited exposure to IRS and DOL scrutiny.
Technically a defined-benefit plan, cash-balance plans act more like a defined-benefit/define-contribution hybrid than anything else. Note: They do retain the ability to be actuarially funded, rather than cash funded. This characteristic is more defined-benefits-like.
Under a cash-balance plan, employees receive an annual credit to a retirement account in their names. Typical credits are 6 percent of the year’s compensation. In addition, account balances earn a return, often a conservative 5 to 7 percent. Here’s an example:
Pat earns $50,000 in 1998. On January 1, 1999 Pat’s cash balance account is credited with $3,000 ($50,000 x .06 compensation credit).
Pat earns $50,000 again in 1999. On January 1, 2000 Pat is credited with $3,000 for 1999 earnings, plus $150 earnings credit for 1999’s cash balance ($3,000 x .05).
At some future point, employees may be allowed to direct investment of their balances, which would make these plans look a lot like a 401(k) with a mandated company contribution.
Professionals have been challenged to stay ahead of the game, given constant change in retirement markets in the last two decades. More flexibility and more tools are coming. Having a good sense of what’s available, and great resources, will help you incrementally innovate competitive benefit programs that truly work for employees.
Workforce, September 1999, Vol. 78, No. 9, pp. 80-82.