Guest Commentary
Help! Somebody Please Get This Monkey Off My Back!
By Brooks Hamilton – Brooks Hamilton & Associates. For over 25 years, Brooks Hamilton & Associates has created and managed custom retirement solutions for a select group of large, forward-thinking companies across the United States. Their mission is to help 401k plan participants retire in dignity, not despair. You may contact Brooks at 972.233.9168 or bhamilton@brookshamilton.com.
According to the Random House Unabridged Dictionary, the slang phrase "monkey on my back" refers to a burdensome personal problem, situation, responsibility, or encumbrance. Is there a better verbal description of the impact that the dramatic change in Corporate America's retirement income strategy, from defined-benefit (DB) plans to defined contribution (DC) plans, has had on employees?
This analysis will be an attempt to identify the major monkeys that this transition has placed upon the worker's back. It will consist of three parts: (1) characteristics of the former defined benefit (DB) plan era, as compared to (2) characteristics of the current defined contribution (DC) plan period, and finally, (3) conclusions.
PART I: The Former Defined Benefit (DB) Plan Era
In order to identify whether a Really Big Monkey ("RBM") has been put upon the backs of employees, we must look searchingly into history's rear-view mirror, clearly checking backward and visualizing the road traveled by our nation's retirement income system from post-WWII to the early 1980's. What was the road like in 1974 before ERISA? What responsibilities did the typical employee have to confront, from the late forties to the early eighties, insofar as his/her personal retirement planning was concerned? What decisions, if any, was s/he required to make in those bygone days when the corporate defined benefit (DB) plan was the employee retirement benefit centerpiece in Corporate America? To answer these questions, we will look closely at six key retirement planning features and attributes.
Participation: In DB plans, it was quite common for plan participation to begin immediately.
And while some may argue that this was a precursor of the automatic enrollment mechanism that is being used in some 401k plans, it was not. Since most actuarial assumption sets included an assumption for employee turnover, there was no advance employer funding requirement for most of the employees granted immediate enrollment. Only employees who became immediate participants, and who also were actuarially assumed to remain employed until an accrued benefit had become vested, triggered an advance funding contribution by the employer. My experience suggests that a typical DB plan during this period required an advance funding contribution in the range of 6% to 8% of payroll.
Employee Contributions: It was uncommon for participants to make personal contributions to a DB plan. The administrative work and expense attendant to tracking, computing, and refunding modest employee contribution amounts made such employee contributions unattractive.
Investment Decisions: All investment decisions were either made by the plan sponsor, per se, or were delegated by the plan sponsor to an investment advisor, trustee, insurance company, et cetera. Plan participants were not afforded any authority to direct investments. DB plan assets were seldom allocated amongst plan participants, who accrued a mere benefit entitlement, rather than a dollar denominated plan account.
Market Risk: Since employees were entitled to a defined benefit at retirement, investment performance did not directly affect their benefit amount. Of course, if long term investment gains exceeded the plan's actuarial investment return assumption, this fact could encourage a plan sponsor to enhance plan benefits.
Inflation Risk: In most DB plans retirement benefits were protected from pre-retirement inflation, as such benefits were typically based on the employee's final average pay (FAP) which often was defined by the plan as the average of the employee's pay during his/her last five years of service before retirement (i.e., from age 60 to age 65). Some plans (especially municipality plans, as well as plans covering policemen, firemen, et cetera) also provided some measure of protection against inflation after retirement.
Plan Fees and Expenses: As plan expenses did not directly affect the benefits paid to Participants one way or another in a DB environment, fees and expenses were either paid by the plan sponsor (which would provide an additional corporate tax deduction), or by the plan.
We are now ready to consider a DB benefit example (Social Security benefits are disregarded throughout this analysis). Assume that XYZ Corp. had a DB plan which provided a participant with an annual pension equal to (a) times (b), where (a) equaled 1.5% of the participant's final average pay (FAP) over his/her last five years of service, and (b) equaled the participant's total years of service.
Also assume that Joe Doe has just been hired at age 35 and earns $35,000 annually. For those who may wish to duplicate the following numbers, we have also assumed that Joe Doe's future annual pay increases will average 4.5%.
As the table on the right reflects, Joe's annual pay at retirement will be $125,442, and his FAP (from age 60 to age 65) will equal $115,093. Since the XYZ Corp. plan provides a DB benefit equal to 1.5% of Joe's FAP multiplied by his total years of service, Joe's projected annual pension benefit at age 65 will equate to 45% (i.e., 1.5% for each of his 30 years of service) times his FAP of $115,093, or $51,791.85.
In order to compare the DB plan benefit herein illustrated with DC plan benefits illustrated later, it is desirable to commute this annual pension benefit into an equivalent lump-sum value. While there are many elements that enter into what is generally called a present value computation, two factors really dominate the calculation: the number of years after retirement that we assume the pension benefit will be paid, and the time value of money (i.e., the future investment return rate assumed).
In order to get a reasonable monetary spread, the following table illustrates three future investment yield rates, and four periods of future life expectancy. For example, if life expectancy is 15 years, and money will earn 4% annually, the present value of a pension is 11.56 times the pension. To facilitate the discussion to follow, we will be conservative and assume a joint life expectancy for Joe and his spouse of 21 years, and that money will earn 5% annually. Thus, the present value of Joe's $51,791.85 annual pension is $697,118.
There are several useful benefit yardsticks (or ratios) regarding the interpretation of these several numbers. First, as we noted above, Joe's pension equals 45% of his FAP. It is also noted that the present value of Joe's pension at retirement is 5.6 times his annual pay at retirement.
We are now ready to identify the "RBMs" (if any) put upon the backs of today's employees as they struggle to prepare for their Golden Years after retirement.
PART II: The Current Defined Contribution (DC) Plan Phase
Participation: Surveys vary, but many suggest that about 70% of the employees eligible to participate in their employer's 401k plan actually elect to do so. We will assume that XYZ Corp. has 1,000 employees; that 850 are eligible for a typical 401k plan; and that 595 (i.e., 70%) have elected to join the plan. We note that this plan does not provide for the Automatic Enrollment of persons initially eligible to participate in the plan. Thus, it takes an affirmative election and action by an eligible employee to become a Participant in the plan.
We note that about 60% of the XYZ workforce will have an account in the XYZ Corp. 401k plan this year; 15% are not eligible to join the plan; and 25% were eligible to join the plan but did not take the affirmative action required to join.
Thus, 25% of the employees working for XYZ Corp. have a "RBM" on their back - that is, they are required to both make an informed decision regarding whether or not to join their employer's 401k plan, and then to take the required affirmative action necessary to do so by deciding how much to contribute, how to invest their funds, et cetera. As for this 25%, this "RBM" was just too big.
Employee Contributions: The statutory 401k test has provided some motivation for management to focus on the challenge of getting regular employees joining their employer's 401k plan to also elect to make significant personal contributions to the plan. The following table summarizes a few additional assumptions we will make regarding the XYZ Corp. 401k plan.
Thus, of the 595 persons that join the XYZ Corp 401k plan, we assume that 95 will be members of the Highly Compensated Employee (HCE) group, while 500 will be members of the Non-Highly Compensated Employee (NHCE) group.
Of the 500 NHCE, we are assuming that 150 are employees already over age 50 who elect to contribute an average of 7.3% of pay, while 100 are age 35 to 50 who elect to contribute an average of 4.2% of pay, with the 250 remaining being employees under age 35 who elect to contribute on average just 2% of pay (the plan minimum). The average annual contribution for all 500 employees in the NHCE group is thus 4.03% of pay.
We also assume that the 95 members in the HCE group will contribute an average of 6% of their pay. Accordingly, the plan will pass (but barely so) the ADP statutory test. Unfortunately, as aforesaid, the XYZ plan does not have any default employee contribution mechanism, nor any feature that would modestly ratchet-up employee contributions each plan year.
In conclusion, the above table makes apparent that 70% of the 500 members of the NHCE group materially under-contribute to the Plan, and most are thus forfeiting significant XYZ matching funds each year (XYZ Corp matches 50¢ per $1.00 contributed by the employee, up to 6% of pay). For example, for the 250 younger employees in the NHCE group contributing just 2% of pay, the XYZ match is a meager 1% of pay.
While "RBM" #1 (whether to join the plan) was confronted and subdued by many, "RBM" #2 (how much to contribute) proved to be just too big for 70% of the NHCE group. As a result, these 350 employees are dangerously under-contributing to the XYZ Corp 401k plan (many studies show that these initial elections are sticky and typically are never changed).
Was this low contribution level an informed decision by these 350 employees? Probably not - but that can be caused by the mental fatigue that comes from carrying too many "RBMs" on one's back!
For those keeping score, and assuming that all 95 in the HCE group (the group average is 6%) are individually making material contributions (which is unlikely), we have an interim total of 245 (i.e., 24% of the 1,000 persons working for XYZ Corp) employees traveling down the road to retirement in fairly decent condition. On the other hand, 755 (76%) have run into one or more (and dare we say fatal) road hazards - in most cases the culprit being a "RBM".
Investment Decisions: As books are being written about this particular issue, what can be said in a few words? We will go no further than to make a few observations.
First, while not (yet anyway) deemed to be a legal wrong, a growing number of gurus are asking a troubling question: is it morally right (or even ethically sound) to force financial novices, most of whom don't know a stock from a bond, to take personal responsibility for the investment management and oversight of probably the single most important asset they will ever possess?
Second, however the legal, moral, and ethical issues pan out, does an ERISA fiduciary dare to bet the company farm (and his farm too, by the way) that such conduct will not, some day, be deemed to be the proximate cause of why most employees retire in despair and go broke?
Third, is there any acceptable reason that would permit any of us to accept the perpetuation of the dismal 18 year investment results disclosed by John Bogel in his recent Senate testimony (i.e., that the average fund holder earns 2.6% annually while the market earns 12.2%)?
If the average fund owner only manages to capture about one-fifth of the market's return over an 18 year period, one is reminded of that famous warning: "Houston, we have a problem!" At last check, we had a total of 245 employees traveling down the road to retirement in decent financial condition, with 755 poor souls having run into one form of serious financial trouble or another. But that was before we considered investment performance. Now we will assume that 70% of the HCE group do poorly (i.e., materially under-perform the market) insofar as managing their retirement nest egg, while 90% of the NHCE group are assumed to do poorly.
We thus now have a total of just 43 employees (i.e., about 4% of the 1,000 persons working for XYZ Corp) traveling down the road to retirement in decent financial condition. Of these, 28 are in the HCE group, and just 15 are in the NHCE group. On the other hand, 956 (96%) have encountered one or more serious road hazards, in most cases the culprit being a sorry gang of "RBMs".
The following table reflects how the initial 1,000 XYZ employees have simply melted away to just 43 who have survived the "RBMs" and are thus OK at this point on their travel down the long, long road to retirement!
(Sidebar Comment: Some may be tempted to believe that the foregoing assumptions were contrived in order to show that a mere 4% of XYZ Corp employees are traveling down the road to retirement in good financial condition, while 96% are in trouble, but that is not the case. On the contrary, our experience is that this illustration is representative and not uncommon.)
Market Risk: With just 4% of XYZ employees surviving the "RBM" assault described above, some may say it is piling on to bring up this subject! Nevertheless, in the former DB world, market losses did not directly affect the employee's retirement benefit.
Today, with fresh memories of Enron lingering; with markets being negative for three years straight for the first time in the memory of most of those living; with the 401k plan now being mocked on Late Night TV as a "201(k) plan" - well, you get the picture.
What is the bottom line? Shifting the market risk to the employee has the potential for "RBM" #4 to be the biggest "RBM" of them all.
Inflation Risk: This is, for the most part, an undiscovered concern. But any student of history well knows the financial cancer that inflation can become, and should thus fear any opening of this Pandora's Box.
Complicating this issue is a related fact: the enormous recent explosion in life expectancy. When our father's father worked 40 years or so and then had just a few Golden Years in retirement, post retirement inflation was not a concern. But if our children, and their children, are going to work the same 40+ years, and then have Golden Years stretching out for 20 - 22 - 24 or more additional years, post-retirement inflation must be seen as a currently caged monster that cannot be allowed to escape.
"RBM" #5, shifting the inflation risk to the employee, may prove to be yet another huge "RBM".
Plan Fees and Expenses: When Corporate America paid these fees and expenses, they were both identified and managed. Now that the current DC paradigm has shifted the payment of plan fees and expenses to employees, a funny thing has happened. NOBODY (and least of all "RBM" #6) seems to be minding this store!
Plan fees and expenses are excessive by a factor of two or three (or as some contend, even four or more). In this writer's opinion, they may explain the greater portion of the startling disparity between Bogle's testimony regarding the 12.2% market performance compared to the 2.6% average fund owner's performance than any other single item.
In a 10% investment return world, it is vital that an employee earn "nine something" as an investment return. Not meaning to sound alarmist, many gurus believe that a lousy return of three something (in a 10% to 12% market) will eventually become a threat to our freedom and liberty, which history teaches cannot be bequeathed to our children, but must be earned anew, generation after generation.
As in the DB era, DC fees and expenses must be both identified and managed.
We are now ready to consider a DC benefit example. Have the slippery six "RBMs" identified above made retirement in dignity an impossible dream for as many as 95% of our employees? Is retirement in despair for most employees inevitable?
XYZ Corp. has a 401k plan and, as aforesaid, makes a 50% match on the first 6% of pay contributed by an employee participant. Like Joe Doe in the DB example above, Charlie Doe is also hired at age 35 with a starting annual pay of $35,000. With a wife and three kids to raise, Charlie decides not to join the XYZ 401k plan when first eligible at age 35, but does elect to join the plan at age 42 (at which time his annual pay is $47,630) and also elects to contribute 3%. Like studies have shown, this election is sticky and is never changed by Charlie. Result? He has taken a severe beating from "RBM" # 1 and #2! Further, knowing very little about the investment world, Charlie does not make any investment election at all, and, as a result, his account is invested by default into a money market fund, which we will assume has average annual earnings of 2% (annual plan fees and expenses average 1.5%). "RBM" #3 has scored a knock-out!
As the table above for Joe Doe reveals, Charlie's annual pay at age 65 is the same as for Joe; that is, $125,442, and his FAP is the same $115,093. During the 23 years he was a Participant, he saved $55,637 and received a matching XYZ contribution of $27,819. Money market investment income added $16,548, but expenses took away $12,413, leaving a net investment yield (over 23 years) of just $4,135. Summing up this sad case reveals that Charlie has a plan account of $87,591 at his age 65 retirement.
As with Joe, we will be conservative and assume a joint life expectancy for Charlie and his spouse of 21 years, and that his money will earn 5% annually after his retirement. In fact, this would not really be our expectation, but is simply assumed in order to compare DB apples to DC apples.
Since we already know that the present value of Charlie's 401k account at age 65 is $87,591, his annual pension would be $6,508 (i.e., 87591 divided by 13.46). And again, there are several useful benefit yardsticks (or ratios) regarding these several numbers for Charlie.
First, Charlie's pension equals 5.6% of his FAP (Joe's benefit was eight times greater, or 45%); it is also noted that the value of Charlie's benefit at retirement is 0.7 times his pay at retirement (and again Joe's number was eight times greater).
Could Charlie do as well as Joe? In a word, yes. By joining when first eligible, contributing 9%, and being lucky enough to have achieved an average annual investment return of 8.5%, Charlie would have accumulated a little over $672,000 at age 65 - close to the present value of Joe's DB benefit.
The table on the right illustrates these two scenarios for Charlie: Sad and Happy.
Of the $584,790 increase in benefits for Charlie, 30% was due to his joining the plan at age 35, not age 42, and 70% was due to an annual investment return of 8.5%, not 2%. Obviously, the "RBM" was #3, and proved decisive.
It is important to note that Charlie paid most of the cost of his inadequate age 65 retirement benefit, had the total investment responsibility, took all of the market risk, all of the inflation risk, and paid 100% of excessive plan fees and expenses. Wow! On the other hand, while Joe's benefit was eight time greater, he paid none of the cost, had zero investment responsibility, took no market risk, no pre-retirement inflation risk, and paid none of the plan fees and expenses.
PART III: Conclusions
We started with the query - has a new burdensome personal problem, situation, responsibility, or encumbrance been put on today's employees, insofar as planning for their future well being at retirement.
That is to say, have one or more "RBMs" been put upon their back? For the reasons cited above, we unhappily answer this question in the affirmative.
Query: Is there a fix for this dreadful (and we believe, systemic) problem? Can we help get these "RBMs" off the back of the average employee? After all, being from Mars, we men like to fix things, don't we? You bet we do! And a terrific solution could be in plain sight.
In early 2001 it was our privilege to make a presentation at the PSCA Midwest Regional Conference in Chicago. We suggested, in lieu of forcing financial novices to make vital personal financial decisions, which most were simply not prepared to undertake by either education, experience, or disposition, that plan sponsors put their 401k plans on auto pilot instead. That is, that we set the various critical benefit control levers to a position that would assure a safe journey for all aboard! This simple auto pilot expediency thus takes the "RBMs" off the employee's back, UNLESS s/he decides to actively reclaim those responsibilities.
The Automatic Enrollment feature in a 401k plan is a simple illustration. As we saw above, this feature was quite common in the former DB era. In the DC example above, Charlie would probably be some $175,000 better off at age 65 had the XYZ Corp. plan included this feature, since very few employees make an affirmative decision to not join such a plan. A key to understanding the auto pilot feature is to recognize that a plan's defaults are the actual flight controls in play for 75% to 85% of a plan's participants. Management thus has the opportunity (and a growing number say responsibility) to define and establish intelligent plan defaults.
Unfortunately, in far too many DC plans, participation defaults are either structured to exclude employees, or in a manner deemed (often erroneously, in this writer's view) most likely to minimize potential fiduciary liability. Notice the XYZ Corp. plan: if Charlie does not join the plan when first eligible at age 35, the Plan's default mechanism excludes him from the plan - which is plainly not in his best interest! And in addition, if Charlie does not know a stock from a bond, and thus declines to actively direct the investment of his account, the plan's default mechanism invests his funds in a money market fund account (in the belief that since such a fund could never lose any of Charlie's money, fiduciaries could never be sued, could they? Not!). And likewise, if Charlie under-contributes a mere 3% of his pay, and heads down the long road to retirement straight toward a town named Despair, with the plan's fiduciaries knowing (yes, knowing) that he will retire into despair on perhaps just 5% of his final pay, well, such fiduciaries can just look out the plan window, and whistle Dixie, can't they? For the law is well known; and an ERISA fiduciary (like Cain) is not his brother's keeper, right!?
Query: Is this really who We the People are? Can a brazen display of deliberate indifference by far too many ERISA fiduciaries really be genetically descended from the human spirit, courage, and moral authority that cleared this great land of the free in order to build homes for the brave? As an ERISA attorney since the fifties, I have seen the wheels of our (social) justice system often turn s-l-o-w-l-y, but turn they do.
Whether actively or passively, with the grave consequences to follow intended or not, ERISA fiduciaries absolutely should not, must not, knowingly facilitate and then tolerate a new DC retirement plan paradigm that ensnares ordinary employees in a treacherous trap where they are overwhelmed by "RBMs" and left to retire in despair, an embarrassment to themselves and a burden to their children (the curious may want to see how the law defines the word knowingly). For if they do, such ERISA fiduciaries may be shocked, shocked, if (when?) they are found legally (and personally) liable, pursuant to a new emerging ERISA rule of law. That is, liable for having first voluntarily accepted the highest fiduciary honor and duty yet defined by Western Civilization, but then having been deliberately indifferent to the grievous predicament in which their demonstrated ignorance and apathy will have placed employees, which the core essence of fiduciary honor obliged them to faithfully safeguard.
The good news is that such ERISA fiduciaries have a unique opportunity seldom offered by history. Paraphrasing Winston Churchill, ERISA fiduciaries now have an opportunity to do so much for so many. In the spirit of Adam Smith's less famous book, "The Theory of Moral Sentiments," (written while a young man well before he penned The Wealth of Nations), now is the time for good men and women who have committed to a morally virtuous life to demonstrate their fiduciary honor and leadership. It is indispensable to our country's great social contract that employees retire in dignity, and thereby be positioned to continue their active participation in our consumer driven economy, thus helping to produce the wealth of nations.
It is time that "We the People" put all 401k plans on auto pilot, and thus get these odious really big monkeys off of the employee's back. Our children, and their children, will bear witness and are depending upon us.
Postscript:
Most of us recall one of the most successful advertisements of all time: the Fram Oil Filter ad with the punch line, "Pay A Little More Now...Or Pay A Lot Later." The customer had a choice.
We too have a choice. We can pay a little more right now by confronting and fixing the flaws in the current retirement income system, or we can pay a whole lot more later on, after tens of millions have retired into despair. Unless we address this issue promptly, an ad you will soon see will look something like this:
| Friends, are you forced to make investment decisions regarding your retirement nest-egg by your employer, when he knows full well that you don't even know a stock from a bond? And further, that you really don't care to go back to school to learn how to become your own investment manager and expert (anymore than to become your own doctor!)?
And is this being done to you in a conniving attempt by your employer to avoid his responsibility to you and your family under the pension laws of America? Are you now growing old, and ever poorer as well, destined to be a financial burden to your children and an embarrassment to yourself?
Finally, even though you have sacrificed and saved enough to have assured your well being in your Golden Years, will you only be reaping fool's gold because of your employer's treachery and his deliberate indifference to the despair he has selfishly inflicted upon you?
Well, relax my friends. Just call our class-action lawsuit hotline 800 phone number and you and your family can fully recover the riches that rightfully belong to you in the first place.
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