401(k): Too Good A Deal For Employers

By the late 1990s, some 27 percent of workers depended on defined contribution-type plans as their principal retirement income, up from 19 percent in 1989, while those relying on defined benefit pension plans decreased from 15 percent to 7 percent. Workers making under $60,000 a year who have some sort of employer-sponsored retirement plan are especially dependent on 401(k)s, some experts say, because employers are less likely to provide them the kind of long-term job security that would justify a defined benefit plan. 

The 401(k) is not a pension, strictly speaking, it’s an individual retirement investment account that the employee funds out of his/her own pay. The only real differences between a 401(k) and a brokerage account or mutual fund that anyone can set up are that the holder gets a tax deferral while accumulating assets, the company gets a tax break if it chooses to make an additional contribution with some of its own stock, and financial services providers rake in hefty fees for managing and administering the accounts. 

Besides the tax break, which can be substantial, 401(k)s offer other big advantages to employers. They incur no future obligations with a 401(k). Whatever employees have in their account when they retire will be the foundation of their retirement income. The financial services companies that create different types of retirement plans and then sell them to employers call this “empowerment,” because employees get to decide where to invest their assets. 

As the stock market soared during the 1990s, 401(k)s became one of American capitalism’s great symbols of success. Free market gurus lauded them for making workers capitalists by giving everyone a stake in the financial system that supports business. Some fortunate individuals became millionaires on paper overnight as the value of the company stock in their 401(k) accounts burgeoned, promoting the idea that the market—not a guaranteed pension—was the best way to provide for your retirement. 

But there were always problems. First, the fact that no guarantee is attached to 401(k)s couldn’t be argued away: even if the stock market performs well over time, there’s no certainty who will fall on the long or the short end of the curve. The system is bound to yield losers as well as winners. Second, 401(k) “empowerment” is a dubious concept at best. 

Employers alone decide how many and what kind of investment choices the plan offers, since employees are not represented on the board of trustees that runs the plan. Employers can set vesting periods—the gap between when assets are assigned to the participant’s account and when she or he actually gains legal title to them—to last for years. When a company wants to make administrative changes in the plan, it institutes a “lockdown,” preventing workers from buying or selling any of their assets for weeks or even months. 

Because of the tax break, companies that chip in some contributions to their employees’ retirement accounts tend to do so in company stock, not cash. In 1995, 33 percent of the value of 401(k) assets was in company stock, according to the Institute of Management and Administration, a proportion that rose to 44 percent before the stock market started slumping in 2000. At many companies, stock that the employer contributes is locked into the plans for a certain period of years or until the employee nears retirement age. 

Enron, the high-flying energy company, used every trick in the 401(k) manual to augment the value of its stock. It matched employee contributions only in stock. Management, including chair Ken Lay, kept up a constant drumbeat for employees to buy more stock through the 401(k), to the point that company stock composed 47.5 percent of assets in the plan when share prices peaked. While they could sell the stock they purchased themselves at any time, employees were prohibited from unloading the shares the company contributed until they reached age 50. 

Even as it pumped its employees to buy more company stock, Enron was reducing its pension obligations. In 1987 the company terminated its traditional, defined benefit pension plan and transferred the funds into an employee stock ownership plan (ESOP). It then set up a new defined benefit (DB) plan linked to the ESOP through a “floor-offset” arrangement, which meant that whatever benefits employees earned in the ESOP—which of course was all stock—were eliminated in the DB plan. 

To calculate the offset for pensions earned from 1987 to 1995, it locked in the value of the stock in the ESOP based on prices prevailing from 1996 to 2000. That means that employees who retired between 1987 and 1995 saw a large chunk of their defined benefit pensions eliminated in favor of their ESOP holdings. Those ESOP holdings are now virtually worthless, but their defined benefit pensions won’t be restored in value to compensate. Then in 1996, Enron converted the defined benefit plan into a cash balance plan, in which older workers’ benefits accumulate more slowly. 

Meanwhile, officials like Ken Lay and CEO Jeff Skilling received special insurance policies, funded in cash, not stock, that enabled them to shelter large amounts of their compensation and even pass it on to their heirs, tax-free. (A late-term attempt by the Clinton administration to shut down these vehicles was effectively gutted in January by the Bush White House.) 

Enron also set up an “executive savings plan” to which officials could contribute 25 percent of their base pay and 100 percent of their bonuses each year. For the first two years, earnings on these accounts were guaranteed at least 9 percent and owning Enron stock through them was not a requirement. 

Litigators are focusing on the period just before last fall’s lockdown when trustees of the 401(k) plan, some of whom had at least an inkling of the problems with the company’s accounting, decided to freeze it anyway to effect a change of plan administrators. One lawsuit claims that an initial letter from the company misinformed employees about when the lockdown would go into effect, preventing them from selling off some of their Enron stock when they still had the chance. 

Other facts suggest that Enron violated its fiduciary duty towards its 401(k) plan participants. For instance, Lay continued urging them to load up on Enron stock after a vice president warned in a memo that the company’s bizarre tangle of off-balance-sheet partnerships might amount to “an elaborate accounting hoax.” 

But unless Enron employees can prove breach of fiduciary duty in court, the company will have no obligation to compensate them for the losses on their 401(k)s. Even if successful, they may never get more than a few cents on the dollar—as was the case when former employees of bankrupt Color Tile, which invested more than 80 percent of its 401(k) in company stock, sued two banks that were plan trustees in 1996. 

Standard Operating Procedure 

Loading up 401(k)s with company stock is common and Enron wasn’t even the most outrageous example. Restrictions on sale of company stock in a plan are routine as well. Creating linkages between pension plans and ESOPs is not uncommon either, because they extend employers’ tax break on the company stock they contribute to the ESOP as well. Cash balance plans are also common, although controversial, and 401(k)s have always undergone lockdowns when they change investment managers or administrators. 

At a time when Enron’s possible shady dealings are in the news it is easy to forget that until a few short months ago, few seasoned Wall Street observers questioned the company’s accounting. The business press was even less help, lapping up Enron’s self-image as a trend-setting energy-industry dynamo. Fortune, for example, lauded Enron as one of the 100 Best Companies to Work for in America in 1999 and Most Admired for Innovativeness four years straight. 

Yet most of the practices that lawmakers and regulators are examining today, especially Enron’s off-balance-sheet partnerships, were well known to those who make their living by understanding such things. While many of the details were hidden from view, plenty of clues were lying around to suggest a few inquiries might have been in order. 

Some critics charge that when a company reaches the size of pre-fall Enron, those outside experts—auditors, accountants, Wall Street analysts, and investment bankers—have too much business with the company to look critically at its books. Even if the Securities and Exchange Commission—now headed by a lawyer connected with Arthur Andersen, Enron’s auditor—can devise better oversight standards, the first line of defense for employees ought to be the rules governing the 401(k). 

Unfortunately, these rules are outmoded. When 401(k) plans were created as part of a 1978 tax law, they were not meant to be anyone’s primary retirement asset. They were designed to be supplemental, tax-advantaged savings accounts that employees of large companies could use alongside their traditional pension plans, or else that employees of small companies could contribute to if their bosses couldn’t afford to offer a “real” pension. 

Part of the attraction for employers was the ability to contribute company stock, which brought not only a tax break but a new class of investors who could be kept from reacting to bad news by selling their shares. To cement that advantage, many companies made rules that literally restricted when employees could sell. “We don’t think of the 401(k) plan as a retirement plan,” the Wall Street Journal recently quoted a spokesperson for insurer Marsh & Mc- Lennan as saying. Over 60 percent of Marsh & McLennan’s 401(k) is in company stock. 

Over the past decade, however, more and more employers have converted their pension plans into 401(k)s to cut costs and eliminate long-term pension obligations. That meant that 401(k)s were becoming many workers’ principal retirement nest egg, yet with few of the rules and safeguards under which traditional pension plans operate, such as restrictions on the percentage of company stock. 

Congress never changed the rules governing 401(k)s to reflect this new role, bowing to employers’ and money managers’ opposition. In some ways  Washington has distorted the role of 401(k)s even further. The Bush tax-cut bill that Congress passed last year allows companies to set up ESOPs within their 401(k)s so that companies can claim further tax breaks on dividends paid on the stock in the ESOP. 

The result is that the most common pension benefit in working America isn’t a pension, it’s just a tax-deferred investment account with no guarantee where it will be when you retire—in the tank, in the millions, or somewhere in between. 

The Enron debacle quickly elicited a number of proposals from lawmakers to correct some of the flaws in 401(k)s. By March, Congress had whittled them down to two. The Bush proposal, approved by the House Ways and Means Committee, would require employers to give 30-day notice of any 401(k) lockdown; allow employers to restrict sale of company stock in the plan for no more than three years after it enters the employee’s account; and prevent company executives from selling their company stock while a lockdown is in effect. The bill would also allow employees to hire financial firms to advise workers on how to allocate their 401(k) assets. 

What the Bush bill does not do is more revealing. Employers would be protected from lawsuits when the firms they hire give bad advice or when lockdowns result in losses for employees. An earlier version of the bill would have allowed employees to sell their company stock three years after joining the plan, not three years after they acquire the stock. The change lengthens the time they must hold it. ESOPs would be exempt from these limits altogether. Last minute lobbying by employers added a provision restoring a tax break for stock options that the Clinton administration had canceled. 

All in all, the Bush bill “seeks to change as little as possible to maintain the claim that this represents reform,” said Rep. Lloyd Doggett (D-TX) after the bill passed Ways and Means. 

Kennedy’s rival bill, which the Senate Education and Labor Committee has approved, offers more substance. Employers could extend company stock either as an employer contribution or as an optional investment by employees, but not both—unless the company also offered an additional pension with a guaranteed income. Company executives and outside groups such as accounting firms would be open to lawsuits if they violated pension law—currently, only money managers are vulnerable. Companies would have to give employees a seat on the plan’s board of trustees. 

Like Bush’s bill, Kennedy’s would not actually limit the amount of company stock in a 401(k), as would some earlier proposals that did not make it to committee. But the corporate management class has reaped so many benefits from 401(k)s that few are prepared to accept even a few modest steps. And so they have come out solidly against any serious reform. 

Even Bush’s mild proposals initially got a cold reception from the Wall Street Journal. The U.S. Chamber of Commerce and National Association of Manufacturers have weighed in against any pension changes. “We think that in many senses the pension issues are secondary,” sniffed Mark Ugoretz, president of the ERISA Industry Committee, which represents corporate pension sponsors. 

Employers have had a hard time arguing their case, however, since keeping company stock under control in a 401(k) has plenty of justification on investment grounds. 

Nearly every reputable investment advisor will say that diversifying your investment portfolio—not keeping all your eggs in company stock or any other single basket—is just common sense. But the Wall Street Journal recently denounced restrictions on company stock as “paternalism masquerading as investor protection.” Limiting the amount of company stock in a 401(k) portfolio, the paper said in an editorial, would “deprive workers of a chance to profit when times were good and substitute political judgment for employee choice.” 

Steering clear of too much company stock is not a “political judgment.” It’s what any well-informed investor would do. That includes Enron’s executives, who sold their shares when the stock became overvalued, according to company filings. But if Enron employees failed to diversify, it was clearly their own fault, American Enterprise Institute fellow James Glassman wrote in a Journal op-ed. 

In the wake of Enron’s collapse, big companies with 401(k)s that are top-heavy with company stock have been defiant about any attempt to force them to reduce those amounts. At General Electric, where 75 percent of the 401(k) is in GE stock, chair Jeffrey Immelt told the Wall Street Journal, “What happened in Enron has nothing to do with GE. The fact is that having GE stock has done damn well for our employees for the last 10 or 15 years.” 

Diversification Be Damned 

The cult status that 401(k)s have achieved over the last decade as the spawning ground of a new “nation of investors” has also helped blind companies to the basic contradictions of a retirement system built around them. Plansponsor.com, a Web site for pension executives, polled its readers recently and found that 56 percent considered Enron an “aberration.” This despite the fact that many companies that loaded their 401(k)s up with their own stock have gone under in recent years, including Color Tile, Morrison Knudsen, and Polaroid. 

One Plansponsor.com respondent groused, “The popular press never tells stories of how many people gained hundreds of thousands of dollars in the Walmart profit sharing plan or how low level clerks held company stock in a bank’s plan that was acquired by a larger bank then another and then another and suddenly had worth in the high six figures.” 

Actually, the “popular press” until about a year and half ago was full of such stories—the 401(k) millionaire was a figure of popular lore akin to the dot.com millionaire. This was certainly one reason why Lay’s exhortations to his employees that they hold onto their Enron stock and even buy more got such a positive response. 

Perhaps the deepest fears were voiced by the AEI’s Glassman, who said in his Journal op-ed that proposals for a cap on company stock were “stepping ever closer toward some kind of federally mandated retirement system.” Indeed, in the months since Enron’s collapse, some critics on the Democratic side have raised issues that go further than they may intend in critiquing the way America’s private retirement system works. 

What they are saying—as if they had suddenly discovered the fact after all these years—is that 401(k)s are tax-favored entities. Much of their value derives from the generous tax breaks, totaling in the hundreds of billions of dollars per year, that both employers and employees receive for contributing to them. 

“Despite the insistence of some that this money in 401(k)s is corporate money and that government should keep its hands off,” Rep. Major Owens (D-NY) said recently, “The tax subsidy means that we are all paying for it.” The public grants that tax subsidy on the expectation that it will produce a public good: greater retirement security for working people. Ultimately, the public must decide if the tax break is achieving that goal, and if not, what to do about it. 

When asked what they would do if some of the proposed 401(k) reforms were enacted, many corporate officials have responded with threats. “I’d rather not have the employer match in company stock, but it’s better than not getting a match at all,” said one Plansponsor.com respondent. As for holding employers liable for losses during a 401(k) lockdown, “You’re going to have employers saying, ‘Forget about it, I can’t afford the risk,’” another predicted. 

Employers mean such statements to suggest that if Congress does anything to fine-tune 401(k) plans, employers will have no incentive to offer them. But perhaps this argument works the other way as well: If the response to any effort at reforming 401(k)s will be for employers to discontinue them, then clearly they are not adequate to the task of providing retirement security. In that case, perhaps they should be scrapped and replaced by some other vehicle that doesn’t depend on the scale of the tax break it provides to employers. 

In the 2000 presidential campaign, Al Gore proposed a voluntary retirement savings account that any household could set up. The federal government would match individuals’ contributions with a tax deduction, the largest subsidies going to the hardest-pressed families. Capped at $400,000, these accounts would serve much the same purpose as a 401(k) and by definition would not include any employer stock. 

House Minority Leader Richard Gephardt (D-MO) proposed a bill in February that would create a similar account but would also allow younger workers to use the assets as “seed money” for education or a first home. The idea is that it would be portable—workers would not have to cash out of them or move the assets into another account when they quit or change jobs. These accounts would be overseen by the federal government, which has no marketing costs to pass on. 

The idea of detaching retirement savings from the private sector is also catching on at the state level—often the place where new ideas get a trial run in the U.S. A group of Washington state legislators have introduced a bill allowing any worker to regularly deposit pretax wages into an account managed by the state employees’ retirement system, which would offer a choice of pre-screened investment portfolios for them to invest in. 

The Economic Opportunity Institute, a local think-tank that developed the idea, estimates the administrative costs would be .1 percent of assets, versus 401(k)s, which can range from 1.5 percent to 3 percent of assets. Such differentials can have a huge effect on the kind of retirement workers can afford when they reach 65. 

Financial services providers, whose fee income has burgeoned over the past decade as 401(k)s have exploded, would resist the creation of a new type of retirement savings account that might supplant them. Employers would balk, too, since they couldn’t score a tax break on funds their workers placed in such an account. Employee advocates may not want to expend much energy lobbying for the accounts, since they provide no guaranteed minimum return and thus do nothing to make up for most workers’ lack of a real pension. 

What’s most significant about these post-Enron proposals, however, is that for the first time they represent an acknowledgment by part of the U.S. political establishment that the U.S.’s employer-based retirement system may have failed. Despite decades of tax breaks and incentives for companies, private sector pensions have never helped much more than 50 percent of the workforce provide for its retirement—and nowadays much less. 

Companies, meanwhile, fiercely resist any attempt to build even minimal safeguards into the 401(k) system. If employers can’t change their minds about 401(k)s, then perhaps pension activists will have to change their minds about employers.                 Z