Benefits Brief: March 2004 Vol. 17, No. 2

Dear Reader: You should recognize this "Dear Reader" intro as the promised second of three warnings to our plot to pare our lengthy mailing list by deleting anyone who fails to ask us to continue sending Benefits Briefs. So. . . if you are one of those who think life is not worth living without a periodic ERISA fix, but who failed to heed our first warning, just e-mail (rwild@nixonpeabody.com) or fax (866-947-1338) your request to continue Benefits Briefs. To those of you who have already let us know that you are not dead or disappeared, our thanks. To all of you who may know someone who gets their kicks out of ERISA, send us their names and addresses, and we will happily inflict the Briefs on them too.

Retirement Income Policy – A Viewpoint

While some employees are doing quite nicely accumulating the assets they need for a comfortable retirement, evidence is piling up that the average employee is headed for a distinctly uncomfortable retirement. A new report from the Employee Benefits Research Institute ("EBRI") concludes that the median individual nearing retirement today has virtually no possibility of saving enough money to generate the retirement income needed to meet basic needs, to say nothing of trying to maintain some semblance of his or her pre-retirement standard of living. This conclusion is supported by a laundry list of dreary facts and statistics from EBRI and other sources, including the basic fact that half the workforce appears not even to participate in any retirement program besides Social Security. Or, consider the following data supplied by Fidelity, our firm's 401(k) recordkeeper:

Participation Rates: Only 68% of employees eligible to contribute to a 401(k) plan actually did so in 2002, down 1.5% from the previous year. The other 32% may be independently wealthy, but it seems more likely they think they have a better plan – or maybe they simply aren't thinking at all.

Contribution Levels: Fidelity reports that, on average, those who do contribute to a 401(k) plan contribute 7% of compensation. Given the reportedly dismal savings rate of the citizenry as a whole, this is a fairly impressive percentage. However, it is still modest compared to the need. Consider the fact that employers and employees contribute double this rate to Social Security, which buys them benefits most people don't consider to be sufficient; or consider that financial planners seem to think a savings rate in the range of 10% to 20% is necessary for all but the lowest wage earners. It appears, then, that even those who are saving aren't saving hard enough.

Account Sizes: The average account size in 2002 for Fidelity-managed plans was $44,000, down from $50,000 a year earlier and from $55,000 two years earlier. Even in a plan like our firm's that is filled with high income lawyers and has a generous employer contribution, the average account size is only around $100,000. True, the account size moves up to roughly $250,000 for those in the 51-65 age group, but since financial planners advise taking as annual retirement income no more than 4% to 5% of one's account, this $250,000 does not portend a particularly rich retirement picture for anyone earning more than about $25,000 to $30,000.

Investments: Although the average plan has sixteen fund options and the average participant allocates his assets among 3.5 of these options, approximately 25% of participants use a single option. If the one option is a life cycle fund, terrific. However, while we have such participants in our plan, we also have seventy-five participants who have invested 100% of their savings in a single fixed income fund and another four (obviously with a risk tolerance much the opposite of the fixed income group) who put everything in our international fund option. It is possible that these elections make sense from some overall financial plan, but it seems more likely that the principles of asset allocation have failed to reach these participants.

Rebalancing of Investments: In our plan, as in Fidelity plans generally, only 12% of participants make any investment changes at all during a year, whether in up markets or down markets. In one sense, this inactivity is reassuring because studies have shown that many of those who do make changes tend to do so at the wrong time (e.g., selling when stocks are in the dumper or buying after they've already gone up). Given the late-nineties bubble and the subsequent bubble burst, however, there should have been much more activity if participants had properly rebalanced their accounts back to their target asset allocations. Failure to rebalance misses the whole point that asset allocation works only if it is combined with periodic rebalancing to enforce the discipline of selling high and buying low.

If you haven't enough, add these facts to the litany of gloom and doom: the long-term demise of defined benefit plans, the fact that participants continue to cash out their accounts when changing jobs rather than keeping them intact for retirement purposes, the fact that participants take too many loans and hardship withdrawals, the fact that too much money is being skimmed off by high fees, administrative costs and now, apparently, illegal or unethical activities.

In theory, of course, a voluntary defined contribution system can produce equal or better outcomes than the defined benefit system from which we have been retreating these last couple of decades. Our ability to set our own contribution levels and to tailor our investments to our individual circumstances gives us the perfect tools to meet our specific goals (Want to retire early? Contribute more. Or take more investment risks, etc., steps not available in a pension plan). However, as the statistics cited above show, we have demonstrated that we are not all equally capable of using these tools. Perhaps 20% of us are doing fine while the vast majority are in some stage of failure, starting with those who appear to have simply given up on even trying to those who find it too difficult to save and invest on their own. The au courant ideas for changing this state of affairs are "education," staying in the workforce, and employing default options. The first two may well be a part of the solution, but they can't be THE solution because they also depend on the voluntary actions of individuals, and we have already proved that this problem is too big for most individuals to solve on their own.

On the education point, the theory is that you need only tell employees what to do, and your story will be so compelling they'll follow your suggestions. The problem with this "solution" is that education works only if the audience is receptive, and the evidence suggests that the receptivity is not what it needs to be. Sure, the 20% who are succeeding will always demand more education – probably to validate what they've been doing or to see if they might just have missed something. But it seems very unlikely that turning up the volume on education will register with the 30% of us who have failed to participate despite our ability to do so and the education already aimed at us to date.

Continuing to work is a nice option, but one again expects that the individuals with the ambition and selfdiscipline to charge off to work into their seventies are the same ones with the ambition and self-discipline to have been saving all along for their retirement. For the rest, continuing to work will require many things to fall into place, such as one's health, energy level and the willingness of employers to supply the jobs. The last time we looked, the divorce rate between corporate America and its employees continued at a high level – and well before age 65. This suggests that even employees who are willing and able to continue working will not be doing so in their normal jobs at their normal pay. Instead, they probably will downscale from their normal careers to positions not likely to be as financially rewarding as either their normal careers or the pension income that might have been paid them if they had just used their 401(k)s to the max.

We all know what the problem is: most of us think of retirement as just too far off, or a luxury for others with more resources, or whatever. Moreover, we mostly think of ourselves as "Lone Rangers." We wait for the disaster to appear, pull out the silver bullet and – "whamo," Heigh-Ho Silver – solved the problem. We cannot seem to grasp retirement planning not as a single, climactic battle but as a boring slugfest, one necessitating decades of tedious savings. As that philosopher Pogo once famously said "We have met the enemy and he is us."

If we were really serious about ensuring retirement security, we'd stop pretending that a wholly voluntary system of defined contribution plans will provide the same levels of income for the average employee as the defined benefit plans we have so easily ditched. An ideal system would forget the carrot approach and make us do that which we cannot: mandatory participation, mandatory contributions, automatic investment allocations based not on our own guesses, but on years to retirement, automatic asset rebalancing wherever our accounts get out of whack and reallocating when we get near retirement, use of investment managers selected by people who actually know (as opposed to our brother-in-law) who the superior, low-cost managers are, and more limitations on withdrawals. Scary stuff, right? But just think of what income source current retirees actually rely upon as the base (or in many, many cases, the entirety) of their retirement income and what government benefit they most cherish of all: Social Security. And Social Security has many of the above features: automatic required contributions, prescribed investments (albeit in Treasury bonds instead of something that might actually produce better results), limited withdrawals prior to retirement, and an annuitized benefit stream. Sure it's imperfect, but the bottom line is that mandatory Social Security has proved its superiority over a voluntary system.

So how might we use a bit less carrot and a bit more stick? If we are really, really serious, we'd adopt a defined contribution Social Security system and scuttle the employer plan system we now have. Workers and employers would be required to contribute at specified levels into funds managed in accordance with government standards, and benefits would be paid out by the Social Security Administration at retirement (ideally, annuitized like regular Social Security to make some or all of it last a lifetime). This suggestion is terrific except for one thing – it seems to be politically impossible. Even if one forgets the politicians, the whole private sector from employers to fund providers to recordkeepers to professionals like we lawyers, would raise a ruckus (and our PAC contributions) to protect our perceived loss of business. And, of course, we Lone Ranger participants would resent the removal of our freedom to do it ourselves.

A more moderate approach would be to retain employer plans but revise the tax qualification rules to require every employer that wants to adopt a defined contribution plan to adopt either (1) a safe harbor plan with certain minimum standards, such as an annual employer contribution of at least 3% of pay for every employee or (2) a 401(k) or similar plan with employee participation being mandatory and requiring appropriate defaults for persons who don't elect out with respect to contribution levels, investments and the like. This would leave the private sector to continue its work of providing plans and plan services (and presumably even increased fee income from the increased participation) and if everyone was in the same boat presumably it would avoid the current imperative to reduce benefits costs to remain competitive. One can argue that the safe harbor requirement might discourage employers from adopting any plan at all but it seems more likely to be a spur to their adopting a minimum plan to avoid the alternative of a more complicated plan with a mix of required and default provisions that has fewer design options.

An even more moderate, yet still slightly coercive, approach would leave the current Code provisions alone and leave it to individual employers to adopt their own default provisions. To some extent, employers already do this (for example, if you fail to make an investment election, bingo, you are in the bond fund) but they trigger only if the employee fails to act. The results could be much improved if we took advantage of employees' inherent inertia and used it against them, i.e., all first choices would be made automatically by plan design, and the employee would be "stuck" there unless he overcame his inertia to undo it. Mandatory participation is an obvious first step. It seems un-American in the current environment, but it is not unprecedented. In the olden days mandatory contributions to pension plans were commonplace. Even today, many employers require their employees to participate in a health plan – either their own or another employer's. In any event, it seems probable that many employees who now do nothing to get into a plan are likely to stay where they've been put and for many others the defaults will be seen as a guide for what they should be doing and will move closer to that model. Automatic increases from contribution levels would also be a great addition. For example, an initial default of, say, 3% of pay could automatically increase by 1% every five years or whatever schedule might make increased savings relatively painless. Beyond that, initial defaults could appear wherever choices do now. For example, a plan could state that all contributions will be placed in a life cycle fund that matches the participant's time to retirement age. Or, if assets were not held in a life cycle fund, a plan could provide for automatic rebalancing whenever an account varied from initial target allocations and more conservative reallocations as retirement age approached.

Mandates and defaults are unpleasant but as more and more of us suddenly realize what it means to reach the end of our working lives and see that we have too little to live on for too many years of retirement, we might not think of a mandate as all that subversive. And if you are too young to picture yourself nearing retirement, think how lucky you will be if your parents were forced to save sufficient funds to relieve you of the financial burden for their support or of the taxes you would need to pay if the government were to provide that support.

Fiduciaries Under Attack – An Enron Antidote

Last fall, the fiduciaries of Enron's retirement plans failed utterly to derail a legal action brought by participants with the support of the Department of Labor following a complete collapse in the value of Enron stock. As you know, Enron's plans were heavily invested in company stock. Sixty percent (60%) of the 401(k) plan's assets, for example, were invested in Enron stock, which meant that the company's bankruptcy following disclosures of accounting shenanigans resulted in plan participants' losing both their jobs and much of the value of their 401(k) accounts. Most of the fiduciaries sought dismissal from the lawsuit because their fiduciary duties had nothing to do with the plan's investments (Board members, for example, only appointed committee members and did not have investment oversight) or if their duties did relate to the investments, the fiduciaries said they lacked discretion and were simply following the terms of the plan documents and participant directions to invest in Enron stock. In refusing to let the fiduciaries out of the case, the court effectively held that a fiduciary has an overriding obligation to protect the interests of participants even if his specific fiduciary duties are unrelated to investments and even if the plan documents and the participants required investment in Enron stock.

The new case involves pretty much the same scenario as the Enron case but with key factual differences – no alleged hanky-panky by fiduciaries and no bankruptcy. Crowley v. Corning Incorporated, 2004 U.S. Dist. LEXIS 758 (W.D.N.Y. 1/14/04). Crowley was a participant in Corning's 401(k) plan during a period when Corning's stock plummeted from a high of $113 per share to less than $20 per share (it eventually dropped to around $1). He brought a class action against Corning's directors, Investment Committee members and others claiming they had a fiduciary duty either to warn plan participants of Corning's deteriorating business prospects or to liquidate the Corning stock fund when the stock began to lose value. Crowley's factual argument was as follows: Corning converted itself from a conservative company selling consumer products to a high flier selling high tech products to the telecommunications industry. When the latter industry went into the dumper, Corning was stuck with no market, unsalable inventory and excess manufacturing capacity. Since the company, its officers and directors knew all about this state of affairs, he claimed they breached their fiduciary duties when they failed to use their insider knowledge to protect the participants from losing their retirement benefits.

Like the Enron defendants, the Corning defendants moved to dismiss the case. Unlike the Enron defendants, in December 2002 the court granted the motion of the Corning defendants. The current opinion addresses Crowley's motion to reopen that decision. In his support, Crowley beefed up his arguments and submitted a handful of new cases, including the Enron decision and a similar decision involving WorldCom. Nevertheless, the court distinguished all of these cases and affirmed its prior decision. Motions to dismiss come at the very beginning of a case, even before a plaintiff can introduce the facts that might prove his claims, and are rarely granted because to prevail a defendant must prove that regardless of whatever facts the plaintiff might prove as being true, the law would not provide any relief. Here are the court's holdings on that matter: First, neither Corning nor Corning's directors were fiduciaries of the plan; only the Investment Committee could be considered a fiduciary because it was the entity named in the plan documents as a fiduciary. Second, the Investment Committee, although a fiduciary, had no duty to act because it had no discretion either to override the plan's provisions requiring it to establish a Corning stock fund or to disregard the participants' elections to invest in that fund. Finally, the Committee had no obligation under ERISA to disclose inside information to participants for their protection where the securities laws prohibit it from using or disclosing such inside information to benefit other investors.

So how did two courts reach such opposite conclusions based on the same law and similar facts? Primarily because the context was different. As the Corning decision pointed out, Enron went bankrupt while Corning did not. Moreover, Enron went bankrupt in the context of accounting irregularities, hiding business losses that those in a position of authority knew would lead to stock losses (as evidenced by their own sales of Enron stock) or should have known (due to their financial acumen) would lead to losses, while there was no hanky-panky at Corning. The court attributed Corning's problems to market forces. In short, its business turned sour, and Crowley was unable to point out "anything unusual or specifically related to [Corning's] viability as a company." At first glance, the emphasis on "viability" seems misguided. From a participant's point of view, his loss is hardly any easier to take when a stock price goes from $113 to $1 than if it goes from $113 to $0. An employee left with only a pittance is still likely to think that someone should have protected him. But viability is important because it means there is the potential for future gains. Let's say the Corning fiduciaries did decide to liquidate the company stock fund at some point during its downward trajectory as Crowley claimed was their duty. Although this might have protected him against future losses, what up to that time would have been only paper losses would be transformed into permanent real losses on the liquidation date. If the stock value later recovered, one imagines Crowley or other angry participants clamoring for the heads of those who permanently locked in their losses. Lest one consider this a theoretical situation, Corning's stock had spectacular gains off its lows. Hence, company viability should be a relevant factor.

The other main difference between the Enron and Corning cases is the court's view of the law. While the Enron court embraced the Department of Labor's expansive view of who is a fiduciary and why a fiduciary has an overriding duty to act to protect participants regardless of plan document requirements, the Corning court looked at ERISA in more traditional terms: The decision to offer a company stock fund was not a fiduciary function to this court but a settlor function; the Corning plan document expressly required the maintenance of a company stock fund; ERISA imposes on fiduciaries the obligation to follow the terms of the plan document; and because the Corning plan document does not give fiduciaries the discretion to invest or not in Corning stock, it "creates no potential for fiduciary liability with regard to investments in Corning stock."

In reaching its conclusion that Corning fiduciaries had a duty only to follow the terms of the plan document, the court did not expressly analyze the entirety of the key ERISA provision: "a fiduciary shall discharge his duties with respect to a plan . . . in accordance with the documents and instruments governing the plan insofar as such documents and instruments are consistent with the provisions of [ERISA]." The Enron court put its emphasis on the "insofar as" clause, clearly buying into the DOL's position that the fiduciary duties of prudence and of acting solely in the interests of participants are so important that they override the requirement to follow the plan document. While the Corning court did not expressly so state, it obviously concluded that the duty to follow the terms of a plan document should be afforded the same weight as ERISA's other fiduciary duties. To this court, it appears, one can only apply the "insofar as" clause and have prudence or some other ERISA provision override the plan document requirement if there exist special factors such as bankruptcy or malfeasance of officers. Otherwise, fiduciaries must follow the plan document. Makes sense. Otherwise, why did Congress waste its time with its plan document rules (or other provisions of ERISA for that matter) if the only thing that counts in the headlong rush to nail fiduciaries is prudence as defined by the DOL and plan participants.

Supremes Save Benefits Plans from "Reverse Discrimination" Claims

In a closely-watched case, the Supreme Court has held that an employer may provide benefits to a select group of older employers while not providing the same benefits to a similar group of younger employees even though the younger employees are also protected by federal age discrimination laws. General Dynamics Land Systems, Inc. v. Cline, 124 S. Ct. 1236 (2/24/04). A lower court decision to the contrary had threatened long-standing employer practices of grandfathering older employees from adverse changes in benefits plans and of offering early retirement incentives only to older employees.

The Age Discrimination in Employment Act ("ADEA" or the "Act") protects employees age 40 and over from discrimination on account of age, including discrimination in benefits plans and other terms and conditions of employment. In Cline, General Dynamics negotiated with its union to eliminate retiree health benefits for future retirees but agreed to grandfather current employees who were 50 and over at the time of the agreement. The lawsuit was brought by Cline and others between the ages of 40 and 50 who claimed that since they were in the protected group, they also should have been grandfathered. The case had "legs" both because of the plain wording of ADEA and because the EEOC had long taken the same position as the Cline plaintiffs. The Act prohibits discrimination "because of [an] individual's age." The plaintiffs and the EEOC pointed out that it does not prohibit discrimination on account of older age. Thus, they argued, the statute has a two-way application: while one can't discriminate against older protected employees, one also can't discriminate against younger protected employees. And Cline was surely discriminated against on account of age because the only reason he was not grandfathered was because he hadn't reached the age of 50.

The Supreme Court majority was unwilling to look only at the bare words of the Act but instead said that it had to be interpreted in context, in this case the context of the social injustice that the statute was meant to correct. Citing numerous statements in the Act's legislative history, the Court concluded that the statute was intended only to prohibit discrimination against older employees and the word "age" in this context was, and is, common usage for the term "older age." The legal arguments arriving at this conclusion cover many pages of colorful commentary ("If Congress had been worrying about protecting the younger against the older, it would not likely have ignored everyone under 40 . . . prejudice suffered by a 40-year-old is not typically owing to youth, as 40-year-olds tend to find out. The enemy of 40 is 30, not 50.") The Court also summarily dismissed the EEOC's ability to dictate the result in this case. Normally, a long-standing position by the agency charged with enforcing a law is granted deference by the courts. However, the Court here effectively held that because the EEOC's position was clearly wrong on the face of the statute, it was owed no deference.

The importance of the case, however, is not in the legal reasoning but in its practical consequences. The Cline plaintiffs and the EEOC clearly believed that their position would result in employers having to provide benefits to more employees. In effect, they used the age discrimination argument as a lever to require employers to spread benefits intended only for older employees to all employees age 40 and over. Their assumption, however, seems clearly misguided because the more likely reaction of employers would be to provide no benefits to any employees. We all know, for example, that retiree health benefits are very costly and many employers are eliminating them. General Dynamics tried to manage the cutback in a humane way by promising to continue to provide the benefits to persons already retired and to employees not yet retired but over the age of 50. Because of the costs, General Dynamics' alternative to this arrangement is not likely to be a grandfathering of all employees over 40 but no grandfathering for any current employees. Another common employer practice – early retirement incentives – were also at risk in this case and for the same reason. When an employer has too many employees and needs to cut back, it generally has two options, involuntary layoffs or voluntary incentive programs. Typically, voluntary programs are favored by employers as well as employees, not only because they work but because they are much better for morale. These programs work because older employees, say those over 55 or 60, are typically thinking about retirement and an incentive program is often the factor that tips them in the direction of retiring sooner rather than later. Thus, a typical incentive program might be to offer a lump sum payment of several months to a year of pay for anyone over a certain age who wishes to retire. If this program had to be offered to anyone over 40 it would simply cost too much and many valued employees an employer would otherwise want to retain might take the money and run. Instead of taking these risks, an employer would be much more likely to resort to layoffs – an approach that does not benefit anyone. It is fair to say that the Supremes have done a better job of ensuring benefit enhancements to older workers in general than the EEOC could have accomplished by requiring employers to give younger employees any benefits extended to older employees. In a voluntary benefits world, an obvious reaction to mandates is providing nothing.