Is the 401k DOA? Time to Bring Back Pensions? Fiduciary Implications for Corporate Plan Sponsors

Horror and despair fills the newsstands. Is it about war? Natural disasters? Man-made catastrophes? No, it’s about the dreary performance of the 401k plan and its apparently universal failure to provide adequate financial support for retirees, perhaps best typified by a recent Wall Street Journal article (“Boomers Find 401k Plans Come Up Short,” Wall Street Journal, February 19, 2011) Ironically, given the squeeze on state budgets caused by public employee pension plans, some even suggest corporate America should return to the days when defined benefit plans ruled the retirement roost. Are we doomed to repeat the sins of the past because policy wonks can’t learn anything from history? Or, are they really on to something? What are the fiduciary liability implications for corporate ERISA plan sponsors in the 401k vs. pension debate?

Fiduciary News spoke to Clifford W. Smith, Epstein Professor of Business Administration and Professor of Finance and Economics at the University of Rochester’s Simon Graduate School of Business. According to Smith, it’s a question of who bears the risk for an employee’s retirement. In defined benefit plans, he says, “the company has made a fixed promise to employees. If there are risky assets in the company pension plan and there’s a shortfall, the company bears the risk. In this environment, it means the employees are carrying less risk and the owners of the firm are bearing more.”

It turns out, in terms of corporate governance, plan sponsors have fiduciary obligations to multiple constituencies. This presents a conflict similar to those familiar with split-interest trusts. Split-interest trusts commonly have multiple beneficiaries – one interested in income and one interest in growth. A fiduciary for a split-interest trust cannot maximize the benefits of one beneficiary without harming the other beneficiary. (It’s beyond the scope of this article to explain how trustees have solved this dilemma.)

Corporate executives, likewise, have to balance the interests of many beneficiaries, including workers, vendors, customers and shareholders. Tilting the balance too far to one of these groups tends to harm the others.

Smith explains how this is relevant to the 401k vs. Pension Plan debate. “There’s a certain logic with pension plans,” explains Smith. “Stockholders are diversified and therefore have greater ability to diversify their risk while most employees often had just one job. In the 1950’s & 60’s, many believed the stockholders had a comparative advantage of bearing the risk over the employees, who might find themselves working their entire 30 year career at one firm.” However, Smith explained a major disadvantage with pension plans. “If I work 10 years each at 3 different companies with defined benefit plans I earn a lesser pension than if I work at one company for 30 years. Pension plans are less transportable. One thing that makes pension plans less attractive in today’s environment is that people change jobs more frequently. The more likely you are to change employers over time, the more attractive a defined contribution plan is over a defined benefit plan.”

But that’s not all. Smith said if a company declared bankruptcy, all bets were off and you could lose your entire pension. With the establishement of the Pension Benefit Guarantee Corporation (PBGC), the government created the equivalent of the FDIC for pension plans. And, like the FDIC, the PBGC only covers up to a certain limit of pension benefits. Smith points out, “When the airlines got into trouble, the PBGC only insured a portion of the benefits of some pilots who had accumulated pension benefits that exceeded the limits of the PBGC.”

In addition, even as our nation was developing a more mobile work force, Smith pointed out the administrative costs of regulatory compliance rose dramatically. “As that [government] policy got implemented, defined benefit plans got more bureaucratic to administer. More and more companies that historically had pension plans decided the easiest way to alleviate this burden was to cancel the pension plan and morph into the defined contribution plans like 401k plans.” This shift satisfied the needs of both employees and shareholders.

Finally, said Smith, and ironically given today’s headlines, defined contribution plans offered employees better protection against economic downturns as the employee nears retirement. “How much your retirement assets are effected by a downturn in the market depends on your portfolio allocation,” says Smith. “The more critical your assets are for your retirement, the more important you allocate more to fixed income and take less risk. You have no asset allocation decision to make in a defined benefit plan, but you do have that opportunity in a defined contribution plan.”

If the 401k represents the ideal evolution of retirement plans in the modern employment environment, why are we reading so many stories from mass media markets questioning the validity of this reality? “Arguing 401k vs. pension would be like arguing using email v. the fax machine,” says Chad Griffeth, Co-Founder of Be Managed. “It is change that comes with the times, and the pension is already considered extinct in my mind. That leg of the stool should not be considered anymore.”

So, what’s the truth? Do 401k plans really work or have they failed the worker? Clearly there are examples on both sides. The famous Color-Tile and Enron fiascos show what happens when 401k investors place the bulk of their retirement savings in their company stock. Remember, PBGC only covers pension plans, not 401k plans. In addition, because the 401k plan relies on personal responsibility, there are bound to be examples where workers without self-discipline find they failed to consider various parts of their retirement (it could be spending habits, savings rate, or investments, just to name a few).

But what about the other side of the story? Roger Wohlner, CFP®, a Chicago based financial planner, says “I have several retired clients who have been able to parlay their 401ks into 7-figure retirement portfolios. These people weren’t high wage earners – they were pretty average folks. They’re living comfortable retirements. They’re doing by and large what they want.” Wohlner says retirement is part of a planning discipline.

Wohlner, who recently started a second company, Retirement Fiduciary Advisors, which gives advice directly to 401k investors, thinks the Wall Street Journal article is proof why people need professional help. He says, “they need direct investment advice that’s tailored to them and unconflicted. There’s nothing wrong with education, but unbiased advice is essential. Investors are confused and access in the workplace to financial advice is an essential element.”

Timothy Yee, Co-founder, Green Retirement Plans, paints an even more comforting picture. He told Fiduciary News the story of “Suzanne” one of his clients (we’ve change the name here to protect her identity). “Suzanne, 69, retired from the Hospital after 30 years as a dietician,” begins Yee. “She is living a comfortable lifestyle in retirement because of her work sponsored retirement plan. She also credits her discipline in saving which comes from her parents who grew up during the Great Depression.”

Yee continues, “Also key to her successful retirement was the use of a financial planner who was able to diversify her portfolio into a variety of investments. These different investment buckets, some for immediate cash, some for medium term appreciation and some for long-term growth, have served her well. Constant monitoring of the portfolio is also important as investment choices are frequently changing. In the case of a better investment and if it serves her needs, Suzanne is happy to shift her portfolio.”

“Suzanne started saving early,” concludes Yee. “She was disciplined and committed to her saving goal. She used a financial planner in retirement which gave her professional advice and access to investment choices that she could not have gotten on her own. In all, she has purchased peace of mind which has allowed her to pursue other dreams.”

And it was all made possible by the much maligned 401k. It may not be perfect – it does require some amount of personal responsibility after all – but it does seem the most appropriate vehicle in today’s America. Who knows, maybe it also offers the best solution to solve our many municipal budget crises (see “Onondaga County CFO says new county employees should be put in a 401k style plan instead of state pension plan,” CNYCentral.com, February 22, 2011).