This week Gail discusses recent congressional action on retirement plans.
We are gathered together to witness the demise of a beloved, but badly battered relic of a by-gone age. Though it was never as popular as myth would have you believe, it was nonetheless a trusted source of peace of mind for millions of Americans. Alas, burdensome red tape, expensive regulations, and mishandling by a select number of stupid and/or greedy parties have triggered its steady decline.
I ask you to join me in bidding farewell to:
The Defined Benefit Plan, a.k.a. “Pension.” R.I.P.
Last week the U.S. Senate ratified the 907 page “Pension Protection Act of 2006” — legislation already passed by the House of Representatives and soon to be signed by President Bush. Among other things (you can cover a lot in 900 pages), this law is aimed at making companies which have promised future retirement benefits to employees fork over the money so that those benefits are actually received.
Some 44 million American workers are covered by a so-called “defined benefit” plan, typically called a “pension.” Once an employee retires, this type of plan pays a pre-determined amount of income based on your salary and years with your company. Employers providing these benefits are required to contribute enough to the firm’s pension “fund” to ensure that future obligations can be met.
For a variety of factors, including overly optimistic projections, lower than expected market returns, longer life expectancies, and economic reality, this is proving more difficult than companies projected. The financially struggling airline industry is just the latest one that has attempted to either eliminate or scale back the size of the benefits promised and many other well-know companies (GM and IBM, for instance) have taken legal steps to reduce what they now realize is a benefit they cannot afford to pay. It’s estimated that, in total, pension plans are under-funded to the tune of $300 billion.
If a company defaults on its pension obligations, American taxpayers — you and I — are left holding the bag. The Pension Benefit Guaranty Corporation (PBGC) is the government entity that steps up to the plate and pays retirees a minimum benefit when their former employer defaults. While companies are required to pay premiums to the PBGC to cover the cost of this government-provided “insurance,” these payments aren’t nearly enough to cover the deficit.
The new legislation attempts to close the gap by creating a uniform way to calculate the minimum level of funding required to meet a pension plan’s liability. Without going into the technicalities, employers have seven years to eliminate the funding shortfalls in their plans. (Airlines have from 10 to 17 years).
The Pension Protection Act also clarifies the requirements that an employer must meet if it wants to switch its expensive “pension” plan to a so-called “cash balance” plan. This type of defined benefit plan is less complex and therefore less costly. The employer’s contribution is based on a percentage of each employee’s salary. While cash balance plans can be attractive to younger employees, they may not provide as large a benefit to employees who are closer to retirement and thus have fewer years for their accounts to grow.
The problem is, up to now there have been no clear procedures that outlined how a company could make this transition. IBM (IBM) tried it and got snarled in a lengthy legal battle. The Treasury Department issued guidelines but had to withdraw them after arousing the ire of Congress.
Traditional pension plans have been on the decline ever since the advent of the 401(k) plan, which is both less costly and less of an administrative burden. And, contrary to “commonly-held belief,” even at their peak defined benefit pension plans covered only about 1/3 of the workforce. Only large employers could afford them; many companies, especially small businesses, simply could not afford to offer any type of retirement plan.
In 1988, about 57 percent of workers who were covered by a retirement plan through work said they had a defined benefit pension. By 2003, that had shrunk by about a third, to 40 percent. On the other hand, that same year, 58 percent of American workers said their primary retirement plan was a 401(k) — more than twice as many as in 1988. The fact is, thanks to the 401(k), more American workers than ever before are covered by some type of employer-provided plan.
Because the Pension Protection Act provides clear guidelines in terms of what’s required to replace a pension with a cash balance plan, more companies are expected to do so. The number of firms offering employees defined benefit plans is expected to decline even faster.
401(k)s are clearly the dominant retirement savings vehicle offered by employers, but they’re not perfect. This Act also introduces a number of requirements designed to strengthen them and other defined contribution plans, such as 403(b)s.
As you may recall, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) significantly increased the amount of money that participants in these plans can contribute. This year, we reached the maximum amount spelled out in that legislation: $15,000. If you’re over age 50, you can also make a so-called “catch-up” contribution of $5,000, for a total of $20,000. Starting next year, the contribution amounts are to be adjusted based on inflation.
In addition, the 2001 Act also gradually raised the amount of money you can contribute to an IRA each year and added “catch-up” amounts for these accounts, as well.
But the problem with the 2001 Act has always been the fact that these provisions were slated to “sunset,” i.e. disappear, at the end of 2010. At that point, we’d revert back to the lower contribution limits that had been in effect ($2,000 for an annual IRA contribution, for instance).
One of the most significant sections of the legislation just passed is that it makes EGTRRA’s higher contribution limits permanent. Based on a recent survey, I’d say Americans need all the help they can get when it comes to saving for retirement. According to the Employee Benefit Research Institute (EBRI), a non-partisan Washington, D.C. think-tank, 68 percent of current workers say they and their spouse have accumulated less than $50,000 in retirement savings.
You’d expect that folks closest to retirement, i.e. those who have had the most time to save, are doing a little better, but the results are still alarming: 52 percent of workers age 55 and older say they have less than $50,000 set aside for retirement!
A study by the Investment Company Institute (ICI), which represents the mutual fund industry, found that taking advantage of the higher contribution limits for defined contribution plans and IRAs can make a big difference.
Excluding any contributions made by an employer, the ICI looked at a hypothetical 36-year old who started saving for retirement in 2002 (when the higher limits kicked in). She contributes the maximum allowed each year, including catch-up amounts once she reaches age 50. Assuming her 401(k) earns 8 percent each year and annual inflation is 3 percent, she will have 25 percent more in her 401(k) account at age 65 than if the higher contribution limits had been allowed to expire.
The results are even more dramatic for IRAs. Assuming the same parameters as above, the ICI found that “at age 65, a worker who always contributes at the limit would have nearly 80 percent more in the IRA” than if the law reverted back to a $2,000 maximum annual contribution and we lost catch-up contributions.
There are a host of other provisions in this legislation, including (finally!) the ability for non-spouse beneficiaries who inherit an IRA, or defined contribution plan such as a 401(k) to roll over the money into their own account instead of being forced to take withdrawals.
Details on this and more in my next column later this week.
Hope this helps,
If you have a question for Gail Buckner and the Your $ Matters column, send them to: email@example.com, along with your name and phone number.