Originally published in the Benefits Law Journal Winter 2011

My bookshelves groan with the weight of thousands of pages of laws, regulations, and IRS rulings designed to encourage employers to include their lower-paid workers in their retirement plans and keep the plans from providing management and other high-paid employees with "too much" in benefits. The fact is, ever since creation of the federal income tax in 1913, Democrats and Republicans alike have maintained a love/hate relationship with retirement plans. Even as Congress trumpeted its efforts to make plans "fair" for lowerpaid workers, legislators were bemoaning the consequent "lost" revenue. (The feds view allowing taxpayers to keep their own earnings as a loss to the government.) As early as 1937, President Roosevelt attacked pension plans as "a legal [but] highly immoral avoidance of the intent ... to collect revenue from those able to pay."

Incredibly, at almost no time during this century-long regulatory crusade did the federal government ever step back to consider which—if any—of these rules had its intended effect. About the closest the federal government came to an inward look at whether its regulations were actually working seems to have occurred during a 1981 Presidential Commission which observed that pension plan participation "was not expected to increase significantly under current policies." Yet over the next 30 years, Congress added to the cascade of benefits legislation—and buried its collective head in the sand on whether any were hitting the mark.

The current state of pensions provides clear evidence that these regulatory efforts backfired in some serious respects. Imposing limits on contributions and benefits for executives and other high-paid employees effectively decoupled worker and management benefits, giving employers an incentive to curtail and even abandon defined benefit (DB) plans. Indeed, nonqualified executive-only plans were born in the wake of ERISA's (Employee Retirement Income Security Act) first-ever introduction of caps on pension benefits.

An excellent paper published in 2000 by a college professor and two actuaries came to that very conclusion. It found that "changes in pension regulations have not expanded coverage among low-income workers" and actually curtailed future benefits for many middle and high income workers. (Clark, Mulvey, and Schieber, "The Effects of Pension Nondiscrimination Rules on Private Sector Pension Participation.")

Over-regulation clearly isn't the only headwind faced by pension plans, but it's the only one Congress can do anything about. The government needs to examine which forms of regulation actually work, instead of relying on untested intuition concerning what it thinks should work. Also, a realistic understanding is needed of the actual tax revenue "lost" as a result of employee retirement plans. I'll cover the revenue side in a future column. For now: why are DB plans spiraling into oblivion (the number of terminations far exceeds plan adoptions and active participation levels are rapidly shrinking) and what can be done to reverse course?

THE RISE

To understand the fall of DB plans, it's crucial to first review the reason for their rise in popularity. Workers' coverage in private sector pension plans hit its heyday after World War II, when companies of all sizes adopted DB plans in droves. By 1960, some 15 million people—over one third of all full- and part-time employees—had coverage. By 1970, coverage hit 21 million. The most likely factors: a booming economy and increased hiring, high income tax rates (maximum rates during this period ranged from 70 to 92 percent), and the Supreme Court's 1949 Inland Steel decision, which made pension benefits subject to collective bargaining. In the 1960s and early 1970s, the number of participants continued to grow, but only at roughly the rate that the workforce itself was expanding. Importantly, however, employers began voluntarily adding and liberalizing plan vesting rules, so while coverage rates had leveled off, participants were much more likely to actually receive a benefit than earlier generations. Eventually, coverage of part- and fulltime private sector employees stabilized at around one in three.

THE PLATEAU

The initial fallout from the 1974 passage of ERISA was a wave of plan terminations. In 1975 and 1976 alone, over 13,000 DB plans were terminated, many by small employers (with fewer than 100 employees) who concluded that the out-of-pocket cost of compliance outweighed the benefits. However, the pension world did not end with ERISA, and eventually the overall level of participation continued to grow, with enrollment reaching a peak of nearly 41 million participants (including retirees and vested former employees) in 1984. (As noted below, the sketchiness of available participation data makes it difficult to perform an apples-to-apples analysis of coverage levels through the decades.)

THE FALL

The decline began in the mid 1980s. From 1984 to 2004, the number of active pension plan participants fell from 23 million to 16 million, even as the US labor force continued to grow. According to the PBGC (Pension Benefit Guaranty Corporation), the decline was most pronounced with small employers, where the number of plans plummeted from 90,000 to slightly under 18,000. At the same time, many larger employers instituted "soft" freezes, closing their plans to new hires. Since 2004, the number of these soft and hard freezes (in which existing participants also stop earning benefits) has steadily risen.

SKETCHY DATA

The lack of a consistent federal government methodology for capturing pension plan data makes it difficult to uncover and analyze the historical trends. For example, much of the published data failed to distinguish between active and total (including retirees and vested former employees) participants, or sometimes (but not always) excluded part-time, young, and/or agricultural workers, or focused only on those employed by either large or small employers. Some data relied on surveys rather than hard counts and, worse, often was unclear whether it considered all retirement plans or just DB plans. While the statistics on current participation rates are quite useful, it's hard to go back in time and reconfigure the old data. That makes it tough to get a clear reading of what the long-term trends are, let alone what they mean . (Here I must extend my heart-felt gratitude and thanks to Barbara Tanzer, a superb law librarian, who helped uncover and make sense of the available information.)

OUTSIDE FORCES

Economic forces outside the control of Washington seem to be one factor in the decline of pension plans. Pension coverage was always dominated by manufacturing and unionized employers, so that the shift to a more service-based economy coupled with shrinking union membership led to a corresponding decrease in pension participation. One economist at the Bureau of Labor Statistics estimated that declining union membership caused a 5 percentage point decrease in pension participation between 1992 and 2003. (William Wiatrowski, "Declines in Benefits," Monthly Labor Review , August 2004.) Additionally, while the bull market of the 80s and 90s allowed employers to reduce or totally skip cash contributions to their plans, subsequent trends of poor investment returns and declining interest rates (which increase reported pension liabilities) dramatically escalated employers' pension costs. Further, as markets and interest rates were gyrating, the accounting rules for reporting pension costs and liabilities were in a constant state of revision, giving heartburn to corporate chief financial officers. Finally, another supposed factor was the reported disinterest in DB plans among job-hopping Baby Boomers, who were never going to be around long enough to earn a meaningful pension (or perhaps even grow old). But as these same Boomers approach retirement, many are now bemoaning the fact that they don't have a guaranteed pension to look forward to, perhaps showing that job-hopping wasn't as big a cause as previously thought.

GOVERNMENT POLICY

The decline in pension coverage also coincided with a slew of new legislation intended to encourage participation by making plans more "fair" and limiting benefits to highly paid employees. The theory was that restricting benefits to senior managers would coerce them to increase rank and filers' benefits to protect their (managers) own pensions. Plus, the new rules were viewed as a populist revenue raiser, since they reduced the amount of taxes that could be deferred by highly paid workers. What follows is a quick look at several decades of alphabet soup legislation aimed at pension "reform"—and the unintended consequences.

  • 1974 ERISA. The granddaddy of retirement plan legislation instituted some much-needed improvements to the vesting, fiduciary governance, and funding rules. However, ERISA also established the Internal Revenue Code "Section 415 limits," imposing a $75,000 annual cap on pension benefits (or 100 percent of pay, if lower) and a $25,000 limit (or 25% of pay, if lower) on employer contributions to a profit sharing or other defined contribution (DC) plan, with both limits indexed for inflation. Had Congress not thereafter periodically meddled with cost of living indexing, today the caps would be around $315,000 and $105,000, respectively.
  • 1982 TEFRA (Tax Equity and Fiscal Responsibility Act). Succumbing to calls for more "fairness" (and more revenue), Congress trimmed the annual cap on pensions to $90,000 a year and the DC ceiling to $30,000 (a steep cut from the then limits of $136,425 and $45,475). Future inflation adjustments were postponed to 1986. TEFRA also added the infamous "top-heavy" rules targeting small business, which imposed minimum benefit and vesting, as well as a $200,000 limit on compensation that could be counted in calculating benefits.
  • 1984 DEFRA (Deficit Reduction and Fiscal Responsibility Act). Congress extended the freeze on the $90,000 and $30,000 Section 415 benefit limits by an additional year, to 1987.
  • 1986 TRA (Tax Reform Act (TRA '86). The most significant change in this dense layer of new regulation affected all higher-paid employees by imposing a $200,000 limit on the compensation that could be counted in figuring their pensions and other retirement benefits. Congress also reduced the Section 415 limits further by imposing lower limits on early retirement benefits. TRA '86 also tightened the integration rules by reducing the bump-up in benefits for employees earning above the Social Security wage base and replaced the undefined "pornography, I know it when I see it" nondiscrimination standard with a bright-line definition of "highly compensated employees" and precise mathematical testing formulas. (Incredibly, TRA '86 also would have penalized individuals whose DB or DC payments were "too large," although this poorly conceived "success" tax was subsequently repealed.)
  • 1993 OBRA (Omnibus Budget Reconciliation Act). After taking a breather from its pension meddling, Congress once again slashed the maximum compensation that could be considered in benefits calculations from an inflation-adjusted $235,840 to $150,000.
  • Ongoing Anti-Funding Rules. Washington's schizophrenic approach to pension regulation is perhaps best evidenced by the labyrinth of rules both limiting and increasing employer contributions to DB plans. In a nutshell, the government's approach is to punish both under- and over-funding of plans. ERISA struck a blow against sound financial management by limiting funding to previously earned benefits but prohibiting employers from sensibly socking away extra money in flush times against the inevitable rainy day. (The rule punishing rainy day contributions was curtailed by the 2006 Pension Protection Act.) Worse, TRA '86 added a 10 percent excise tax on an employer's recapture of any over-funding on a plan termination, prompting many employers to terminate their plans before the tax kicked in. In 1990, the tax on reversions was increased to 50 percent (20 percent if the excess was used to pay certain retiree health benefits). For an excellent analysis of how the funding rules harm pension plans, see John Kilgour's "The Pension Plan Funding Debate and PPA" in the Fourth Quarter 2007 Benefits Quarterly.

Ironically, the group most likely to be harmed by these rules has been some of their intended beneficiaries, i.e ., part-timers and the lowest-paid employees. Based on my clients' actions over the past 30 years, it's clear to me that pushing down on the benefits of more highly paid employees hasn't resulted in better benefits for everyone else. Without benefit limits and compensation ceilings, everybody eats out of the same pot. Before the benefit and compensation limits were imposed, small business owners and public company CEOs alike (and the employees advising the bosses) were very aware that if they wanted a pension equal to half their pay, they had to offer the same benefit to their rank and file. But limiting management's pensions means they have to provide disproportionately higher benefits to those lower down the salary scale or, worse, makes it impossible for the moguls to receive a significant (for them) benefit. The natural reaction is, "why bother?" Unfortunately, it became preferable for employers to just eliminate the defined pension plan altogether and compensate the top tier in some other manner. Our government cannot legislate solid stock market returns or bend the global economy to its will. But it can rewrite the current poorly conceived rules to give small and large employers a reason to create, or at least to maintain, pension plans. While it may be politically incorrect, Congress should start by removing the benefit and compensation ceilings to increase pension coverage for workers generally. And, as I'll show in a future column, it won't cost the feds a dime.

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