The humming of
paper shredders had scarcely ceased before Congress started discussing how to prevent future Enron-style debacles. While the loss of jobs at the company was bad enough, the real outrage for many employees was watching their retirement savings evaporate at the same time. That's why some politicians are now considering plans to regulate retirement plans such as the 401(k) -- also known as defined contribution plans -- that have become the mainstay of U.S. retirement investing.
To find out how the system could be improved, we talked to pension expert Steven Charlton. A partner at New England Pension Consultants, he heads up the defined contribution consulting group, where he helps set up and evaluate pension plans.
He explains that legislation may be able to reduce some of the worst risks for 401(k) investors. But that doesn't address another problem: To invest well for retirement, participants need to be much better educated about basics such as the importance of diversification.
In fact, because investing can be so risky, Charlton says, the average worker may be better off not investing in a 401(k) at all. Given the choice, a traditional pension plan with fixed payouts, known as a defined benefit plan, could be the best financial option for many Americans. Read on to learn more.
TSC: One of the criticisms directed at Enron is that the company matched employee contributions with stock, so people quickly became over-concentrated in company stock. How common is that practice?
It's actually more common than you think, especially for big companies. One reason is that employees don't seem to mind when the company stock is going up and up and up -- but as soon as the company has problems, of course, people are going to reconsider. If you think of Enron, it's not so different from what happened at
, where employees had a large portion of their assets invested in company stock. They didn't think it was a big deal until the company started losing money.
The big difference with Enron is that participants couldn't move their money out of the company stock, and were in fact required to maintain certain assets in company stock for a certain period of time.
And a critical issue is, how much did Enron and Lucent and everybody else that's had problems tell investors about the risk of investing in a single security, vs. a mutual fund or portfolio of diversified stocks and bonds?
TSC: In fairness, we can criticize Enron's policies, but workers there may bear some responsibility for investing too much in company stock on their own. Is that an issue we'll hear more about?
Absolutely. This is a critical issue that faces the defined-contribution marketplace. When you think about the risks that are inherent in investing in something as unpredictable as a company stock, it goes against everything professional investors try to preach, which is all about diversification. By investing your retirement assets in company stock, not only is your paycheck tied to the fortunes of the company, you also tie a portion or all of your retirement savings to the company's fortunes.
To get back to your question about defined contribution plans, this will become a giant issue -- whether or not participants, your average, everyday Joe on the street, are able to make good decisions about how to invest their money. The whole defined-contribution, 401(k), participant-driven investment model is built on the premise that participants who invest in them are able to make good investment decisions. There is a lot of anecdotal evidence that tells us participants aren't real great at it. This is a social experiment that may not work out real well in the future. There's an article by Peter Bernstein in which he says the participant-directed defined contribution plan could be the worst social experiment ever conducted by the government.
TSC: When did the shift away from traditional pension plans and towards 401(k)s happen? Did it really take off in the '90s?
Defined contribution plans started in the late '70s, and in the '80s you started seeing them more. But the '90s were kind of their heyday. They were a way for companies to save money, and they were offering a visible benefit to the employees. From the employee standpoint, why wouldn't you do it?
TSC: So the popularity of 401(k)s really coincided with the stock boom of the '90s.
That's what made these plans so attractive. Everybody thought they were a great investor because they put money in the stock market, and it went up by 20% every year. And when you think about Enron's case or Lucent, employees invested in company stock, and it went up by even more than the market.
TSC: Let me ask about a more specific issue. At Enron, rank-and-file employees did their retirement investing through a 401(k), while executives had access to other plans that paid guaranteed returns. Can you explain how these plans for executives work?
The reason why a company puts a deferred compensation or executive compensation plan in place is to retain employees. They want to pay their best employees a lot of money, and this is just one more way to pay people and give them a benefit. Companies generally offer deferred compensation plans like this to anybody making over X dollars a year, with a minimum of between $80,000 and $150,000. They have this benefit as a nice perk, in addition to whatever the employees want to put in their 401(k)s.
As the name might indicate, the contributions aren't considered part of an employee's salary until the participant takes receipt of the assets -- typically when they leave the company or when they retire. It's not considered part of their salary, but it is something they negotiate. It helps highly paid employees save more money on a tax-deferred basis.
The reason why you're hearing something along the lines of a guaranteed return is because most of these deferred compensation plans are invested in insurance products. So there is some implicit guarantee by the insurance companies that the assets are invested in a way that will end up benefiting the company from a tax standpoint, while still providing some minimum return for the employee.
There are types of deferred compensation trust vehicles, such as a secular trust or rabbicular trust (which turns into a secular trust upon bankruptcy) that can protect the assets of the plan in the event of bankruptcy.
I am not familiar with all of the particulars in Enron's case, including the type of trust vehicle used, so I can't tell you what exactly will happen to the deferred compensation plan assets.
TSC: Why can't ordinary workers have access to plans like these?
In actuality they can. They're typically not offered to lower-paid employees because of the cost to the company. The lower-paid employees want every dollar paid in current compensation, not deferred compensation. They just don't have the money to invest.
As for the guaranteed return mentioned earlier, the ordinary worker has the choice to invest in a guaranteed-return product
through a 401(k), and the implicit guarantee is through an insurance company, your stable-value investment product. I'm sure one was offered in the Enron defined-contribution plan, so participants had that choice, except for the assets that participants were forced to keep in company stock.
TSC: In light of problems at Enron and other companies, there's been talk about the need for more education for people who invest in 401(k)s. Back in November, the House passed legislation that would let investment companies offer advice to people in retirement plans as long as they disclosed conflicts of interest. What do you think of that plan?
It's a really good idea, though there are some issues that need to be contended with in who actually provides the advice. I'm not sure it's a great idea to allow the company that is investing the assets to actually give advice on the assets. There are Internet-driven companies that provide
independent advice, like
Financial Engines and
TSC: In terms of other reforms, there's a proposal in the Senate that would cap how much employer's stock you could hold. It would also limit the amount of time employers could make people hold onto matching contributions in company stock. What do you think about suggestions like these? Would they make pension plans better? Or do they not go far enough?
That's the kind of thing that everybody's struggling with. If you think about it, there are a lot of things that could lead to a better-defined contribution plan, particularly when it comes to company stock. Limiting how much you can invest in a company stock is a great idea. Communicating and educating people on the risks
of investing is another good idea.
TSC: What are some of the ingredients of a really good pension plan?
The ideal situation you're talking about is companies that offer the defined contribution, 401(k) types of plans, but also offer a defined benefit plan. With companies that go to defined contribution plans
only, they're offering a benefit that is strictly driven by participants' ability to invest their money. We both know that is not necessarily an easy thing for participants to do.
TSC: So do you think there are advantages to the traditional kinds of pensions that people have overlooked? Are people too quick to think those plans are old-fashioned?
Absolutely. They have never taken the time to understand it. They would rather have their money to invest
themselves, and that is the biggest downfall of us all. I'm just like you and everybody else -- I like to have my hands on my own money. But who is to say I am a better investor than somebody who spends all day, every day, investing my money? That's the whole idea of outsourcing.
TSC: Do you think there could be a trend at companies to reinstate more traditional pension plans with a set payout? Or would that be a mistake?
Personally, if I were an investor, I would love to have a pension plan. You're going to make a certain amount of money; you're going to have a guaranteed benefit at the end of the day based on how much you make and how long you work at the company. On top of that, the benefit is implicitly guaranteed by the company, and it is also guaranteed by thePBGC
Pension Benefit Guaranty Corp. to a certain extent. Those are a lot different, and a lot safer, so to say, than the traditional 401(k) plan.
But companies are always looking for ways to save money, and pension plans are typically more expensive as a benefit than defined contribution plans.