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| Fiduciary Focus: The Pension and 401(k) Hybrid |
| by
W. Scott Simon
| 03-21-06 |
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More and more corporations in America are changing the structure of the retirement plans they offer to their employees. In many cases, this means that a company will "freeze" its defined benefit plan and, in its place, provide plan participants with enhanced benefits in a defined contribution plan such as an existing (or a new) 401(k) plan at the company. IBM, for example, announced recently that it will freeze its defined benefit pension plans and enhance its 401(k) plan as of Dec. 31, 2007.
Advantages and Disadvantages of Freezing a Defined Benefit Plan
In making this kind of change, a company achieves two primary goals: (1) a sharp reduction in the appreciable costs the company incurs for maintaining a defined benefit plan and (2) a shift in the burden--and therefore the risk--of investing employee retirement savings from the company to the participants in a 401(k) plan.
While achievement of these goals is, indeed, advantageous to a company, the flipside is that they are often deemed harmful to existing plan participants (and future employees). When a defined benefit plan is frozen, employers stop making contributions on behalf of existing plan participants (although all retirement benefits the participants have accrued in the plan are preserved fully). A frozen defined benefit plan, of course, is closed to any newly hired employees so they will never get the chance to become participants in it.
The perceived harm to participants doesn't stop there. Shifting participants out of a defined benefit plan into a 401(k) plan makes them primarily responsible for investing their own plan accounts. This is softened, though, by the fact that a company will usually provide enhanced benefits to the participants in an existing or a new 401(k) plan. These benefits include annual contributions made on behalf of a participant that typically range from 2% to 8% based on the participant's pay and years of service (whether or not the participant makes contributions), plus annual contributions matching the participant's contribution of up to 5% of pay.
Despite this, many believe that shifting plan participants out of a defined benefit plan into a 401(k) plan means that a company is "throwing its employees out into the cold." This is based on the underlying concern that participants simply don't have the investment skills and understanding possessed by professional investment advisors managing a company's defined benefit plan. It is feared, as a result, that participants won't be able to accrue a pot of money large enough to finance a comfortable retirement lifestyle.
Two Unpleasant Choices Facing a Company
A company faces two unpleasant choices as it goes about deciding whether to freeze its defined benefit plan.
The first choice is to retain the plan and continue to incur significant costs. Many companies find this unacceptable because they really have no other option than to control the runaway costs of maintaining their defined benefit plans. These costs are caused by longer life expectancies, people continuing to retire at the same (or earlier) ages, and shifts in demographics and labor productivity from the past when more and more employees were supporting few retirees to the present when fewer and fewer employees are supporting many retirees.
The second choice is to jettison the defined benefit plan and incur the wrath of plan participants who perceive that they are getting the shaft. Many companies find this unacceptable because they are concerned about resentful employees being forced from the comforting womb of a defined benefit plan into the cold, cruel world of a 401(k) plan. And if resentful employees were not enough, companies that do make the decision to freeze their defined benefit plans are vilified in the mainstream media as treating their employees heartlessly.
It need not be this way. There is a third choice.
The Third Choice Open to a Company
The third choice open to a company needing to terminate its defined benefit plan, while little known, is often the best choice for all concerned. That choice is for the named fiduciaries of the company's existing (or new) 401(k) plan to (1) ensure that the plan is a trustee-directed plan (instead of a participant-directed plan) and (2) retain a bank, insurance company, or registered investment adviser and require it to manage all the plan's assets as an ERISA section 3(38)-defined "investment manager."
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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