Senator Harkin Proposes Changes to Retirement System

As Congress approached its August recess, Senator Tom Harkin (D-IA) released a position paper entitled “The Retirement Crisis and a Plan to Solve It.” The release of the paper is notable because as the Chairman of the Senate Health, Education, Labor & Pensions (HELP) Committee, Harkin is perhaps the most influential legislator in the entire Congress with respect to qualified retirement plans. Here, I will give you an overview of Senator Harkin’s paper with some commentary. Given his position, should the Democrats retain control of the Senate and the White House, this paper likely signals a directional shift for the retirement industry.

Senator Harkin proposes two very significant changes:

• Development of Universal, Secure, and Adaptable (USA) Retirement Funds 
• Changes to the Social Security structure designed to better finance the program while providing better benefits for the lowest earners and inflation protection better geared to inflation as it affects senior citizens

USA Retirement Funds

Senator Harkin is concerned that so many Americans have essentially no retirement savings including any employer-sponsored retirement plans. The solution, as he sees it, is to give employers a choice of sponsoring their own retirement plans or putting their employees into a USA plan. Plans that are entirely voluntary for employees (401(k) without auto-enrollment or without a sufficient employer match) would not suffice as employer-sponsored. To the extent that they were to go the route of the USA plan, here are the key features as I read Harkin’s paper:

• ·         Auto-enrollment through payroll deduction
• ·         USA Retirement Funds would be professionally managed
• ·         Regions, industries, or collective bargaining agreements might have default funds
• ·         Benefits would be 100% portable
• ·         Retirement benefits would be payable as annuity with survivorship rights for beneficiaries

Senator Harkin notes in his paper that USA Retirement Funds will compete with each other keeping costs low. They will be subject to significant disclosure requirements to ensure transparency.

Social Security Changes

As we all know, the Social Security system is projected to run into a shortfall situation at some point between 20 and 40 years out depending upon which forecast we look at. Senator Harkin’s proposal is designed to address this while improving benefits for certain retirees at the same time. Here are the three key points of his proposal with respect to Social Security:

• ·         Eliminate the Social Security Wage Base (currently $110,100) so that higher earners and their employers would no longer have the phase-out of OASDI taxes. Currently, employees and their employers pay 6.2% of pay up to the Wage Base into Social Security and 1.45% of all pay into the Medicare (HI) part of the system.
• ·         The existing methods for calculating Social Security benefits use a progressive three-tier approach. Currently, 90% of a person’s Average Indexed Monthly Earnings (essentially, their average inflation-adjusted compensation over their career) up to $767 is added to two other components in calculating the benefit. Under Senator Harkin’s plan, that 90% would phase up to 105% over a 10-year period. What this would mean is that low wage earners would receive a larger benefit from the Social Security in retirement than the pay they had been receiving from their employer.

·         Today, the annual inflationary adjustment for Social Security beneficiaries is based on the increase in the Consumer Price Index for all Urban Wage Earners (CPI-W). This index would be replaced by the CPI-E, the Consumer Price Index for the Elderly which places significant emphasis on the rising costs of health care.

Leakage -- The Scourge of the 401(k)

Leakage -- it is the scourge of the 401(k). What is it? Well, it's not a really well defined term. But, in a nutshell, it's what happens to a participant's account or accounts -- their total savings -- when they have a discontinuity.

Simplified, most people are doing well until they run into some sort of hardship. Then the problems start. If they have a hardship, but they are still employed, they are likely to continue deferring, but perhaps not to the same extent. However, the news gets worse for the unemployed and the underemployed.

The Investment Company Institute (ICI) published a survey recently. They found that 63% of the unemployed who had a 401(k) account with their last employer have taken a withdrawal and 34% of the underemployed (they don't defined underemployed that I saw) have done so.

You've seen those projections. If you get your first real job when you are, say, 25 years old, and you begin deferring and you keep it at it, you'll have a wonderful nest egg by the time you reach retirement age. That's when the angels are looking down on you. But the ICI survey says that with unemployment or underemployment comes the devil known as leakage. And, these days, there just aren't that many people who will never suffer from either or from some other short-term financial hardship. It's part of the way of an extended weak economy.

Suppose we took those rosy projections starting at age 25 and running to even age 70 and looked at them. What's a reasonable rate of investment return? Many of the projections say 8% per year compounded. That means a geometric 8% rate of return. I'll bet you that you can't get a geometric 8% rate of return. If you have  gotten that this century to date, you are probably in the 99th percentile of all investors.

How do you model leakage? Consider this. Little Miss Muffet was a star student at a top school. She graduated, then got her MBA and finally took a good job at a company with a good 401(k) plan at the age of 25. She had read all the articles and began to save in earnest in her 401(k) plan. Uh, oh, Little's employer ran into some business hardships. They had to do a layoff and Little's number came up. She had a house with a mortgage. She had a car payment, and even though she had put aside a bit of a nestegg, the job market was tough. Little Miss Muffet had no alternative but to withdraw her money from her 401(k) plan.

Leakage!

Muffet was now 30 years old. Finally, she got another job, but remember those projections where you start saving at age 25. She can't go back to 25. And, while she got another job, she was desperate and it's not as good a job as she had at age 25.

So, you tell me how Little Miss Muffet is going to overcome leakage to get to a good retirement. As I asked you yesterday, has the 401(k) system failed us? Methinks it has.

Another Viewpoint on Retirement -- Has the 401(k) System Failed?

Our Ridiculous Approach to Retirement - NYTimes.com

Last Sunday, Theresa Ghilarducci, a career retirement policy person and now Professor of Economics at the New School for Social Research wrote this interesting piece for the New York Times. In it, Ms. Ghilarducci's penultimate paragraph reads as follows:

It is now more than 30 years since the 401(k)/Individual Retirement Account model appeared on the scene. This do-it-yourself pension system has failed. It has failed because it expects individuals without expertise to reap the same results as professional investors and money managers. What results would you expect if you were to pull your own teeth or do your own electrical wiring?

In the article, she makes some very interesting points. Most people underestimate what they need to live well in retirement. One of her observations, however, is exceedingly important and rarely raised; that is, the probability that your last dollar will run out on the day you die is essentially zero, and if we take it to the moment you die, that probability, for the math geeks out there, is approximately epsilon (for you non-math geeks, that means it's not going to happen).

Put differently, this implies that you need to have more money in savings than you will need. But, all this is based on life expectancy. That's a median. Fully half the population will outlive that median. So, they need more. Do you know if you are part of that half? By how much will you outlive that life expectancy? Don't know that either, do you?

Clearly, the solution lies in lifetime income options, preferably with inflation protection. Where can you find that? It's tough. You can take your assets and find an annuity salesperson who will sell you such a product, although there aren't many such products around. And, given that there aren't many products, they are not priced fairly to the consumer. Then, there is the in-plan lifetime income option. But, I spoke to representative from a large 401(k) provider the other day who said that their research suggests that neither plan sponsors nor their employers currently want them.

So, how do you get lifetime income options? Defined benefit plans? You remember them, they used to be popular. Has anyone considered a low-risk (for the employer) defined benefit solution that might help to solve this problem? Sadly, the law has made this very difficult. But, consider this hypothetical design:

• Cash balance style
• There is a non-elective employer "pay credit" and a matching employer pay credit on employee contributions (this is not currently allowed)
• Inflation-protected annuities as a distribution option

What do you think? I'd love your comments, pro or con, serious or even with a little humor.

What Do You Think of Those Retirement Plan Fee Disclosures You've Received

Ah, ERISA 408(b)(2). Those horrible fee disclosures. If you're a plan sponsor, you've gotten a bunch by now. What are you doing with them?

If you're like a lot of other plan sponsors, you have newly found information. You have a better idea of how much you are really paying for various services. So will everyone else.

That means that you are in the beginning of a time where you can find out just how high or low those fees are. Are you paying a lot for a high-priced firm? Are you getting the level of service that justifies those high fees? If the answer is yes and you are happy with that equation, that's great.

Suppose the answer is no. Suppose you haven't changed firms despite mediocre service and now you find out that you are paying top dollar for that mediocre service. Perhaps you haven't changed providers for a while because it's just a hassle and a little bit of fee savings just wasn't worth it. Now you learn that there are a lot of savings to be had.

Consider why you are paying so much. Perhaps you've been with the same firm for years and years and they've just been raising your fees over time ... because they could. Perhaps you are with a firm that has a lot of overhead which helps their best people to provide better service, but you're not getting that level of excellence. It might be that you are not quite in their market sweet spot and while they tell you how much they value your business, they have assigned a 2nd or 3rd tier team. You're still paying for the best they have, but you're not getting the best they have.

Does any of this resonate with you? You're not sure? You can find out now. Or, to the extent that you don't have all the data you need, you can certainly find out soon. If when you do, you're not happy, rest assured that there are plenty of firms out there that would love to work with you and charge you a reasonable level of fees.

Think about it. You have a fiduciary responsibility under ERISA.

Boilerplate Burns -- Why The Low Bidder May Not be the Right One

How do you choose your consultants? Your attorneys? Your accountants? Your other advisers? Price matters, doesn't it? In fact, if you are in the public sector, price is likely the single most important component in your buying decision.

Now put yourself on the other side of the equation. Suppose you are the potential vendor, be it consultant, attorney, accountant, or other adviser. You understand the importance of price in your potential client's buying decision. Therefore, you strive to make one of the lowest bids. Now that you have made that low bid and gotten the work, how are you ever going to make money on the assignment?

Frequently, the answer lies in the dreaded boilerplate. If your prefer, pull something off the shelf. For those of you who abhor consultant-speak, what I'm saying is that the consultant will re-use a document that was already used for another client. Or, worse yet, that consultant will provide you with the same solution that they or a colleague used for another client.

Why would they do this? It saves money. Suppose you have two possible ways to produce a presentation. In the first method, you think long and hard about your client and about your assignment and develop a document that is customized to your client. In the second method, you use one that you used six months ago and change a bullet point here or there to justify your assignment. Which do you think costs more?

Which delivers a better value to your client?

In most cases, I think that the customized solution is the winner from a value standpoint. No two sets of circumstances are the same. And, it's rare that a well-done assignment has cost anywhere near the value of what the vendor is consulting on.

I remember a scandal at one of the large consulting firms back in about 1994 or 1995. It broke when someone internally notified the Wall Street Journal that its consultants in a particular practice were delivering the same work product (with just minor modifications) to every client. It made front page news. If you were on the client side and you hired that firm because the price was right, do you think it was a wise buying decision?

How about the law firm that gave you the lowest bid on drafting plan documents? Don't you think that they have a template that they start from? Suppose what you need is a creative solution and that solution doesn't fit the template? Will the attorney advise you to stick with a solution that fits the template? Or, will they work with you despite their low bid?

Finally, I consider M&A due diligence. That's the process during which a company uses many of its internal resources and engages many outsiders as well at significant expense to ensure that there are no gotchas (at least none for which they are not reasonably compensated) in the company they are buying. How would you choose someone to help you with that process?

To help answer, consider a home buying decision. In some regards, that is like a corporate acquisition. You are negotiating a deal and you are hoping nothing is wrong. To assist you in ensuring that nothing is wrong, you probably engage a home inspector. In the process of deciding which inspector to use, you have some key questions that you want to ask each prospective home inspector.

While not quite a question, here is one that I personally like: "Tell me about deals that you have killed in your home inspection career."

Killing deals takes guts. It doesn't necessarily make either party happy. But, that person is much more likely worth their fee, even if they are not the low bidder.

Distribution Dilemma in Times of Tax Uncertainty

Recently, I was speaking with a top executive at a decent-sized company. The discussion had much to do with his total compensation, but paramount in his mind was his distribution from his nonqualified defined benefit plan (SERP). You see, due to Code Section 409A and its ties that bind, executives with meaningful amounts of deferred compensation are stuck in a guessing game (more about that later).

409A was added to the Code by the American Jobs Creation Act of 2004 (a misnomer if there has ever been one). It came to be in the wake of the Enron and WorldCom scandals and was put in place to ensure that plans typically limited to management and executives would provide participants with treatment that was no better than that available to participants in qualified plans. For purposes of this discussion, paramount among the restrictions on nonqualified deferred compensation intended to achieve these goals were these (simplifying somewhat):

• Prior to the year in which compensation is deferred, participants must elect both the timing and form of their distribution.
• To the extent that participant wishes to changes his distribution option(s) with respect to money already deferred, he must make that change at least one year prior to the date that distribution would have occurred, AND postpone that distribution by at least 5 years.
• Failure to comply results in significant penalties.

Consider this scenario. You were fortunate enough to be a participant in a SERP. Then, 409A came along and you had to make your "initial deferral election" in that SERP. You didn't know what to do, but you sure liked the idea of the security and favorable conditions underlying a lump sum distribution. Your fellow executives did as well.

That was prior to late 2007. The economy was booming. Smart money was saying that Bush Era tax cuts (put in place by EGTRRA in 2001, but set to expire by the end of 2012) would certainly be extended.

Oops, wrong guess.

There's no way to be sure what's going to happen to the tax rates for the highest earners. But, there is certainly a good possibility that they are going to increase. And, there might be surtaxes for those with
ultra-high (undefined term, but you know what I am talking about) income in any given year. And, you as this executive expecting a lump sum distribution from your SERP would no doubt realize how hard you were going to get hit by this.

What's going through your mind if you remember having made your initial deferral election is that perhaps you should have made a different one. Who knew? Did you think about it that carefully?

I took a highly unscientific poll of people currently in plans subject to 409A. I asked them about their initial deferral elections. Had we been in person rather than over the phone, I expect that I would have gotten funny looks had I used that specific term. But, over the phone, I was able to explain and not see the looks in their eyes. In any event, here are the results of that poll:

• 11 of the 15 had no say in their initial deferral election; it was foist upon them by HR who said that they had made their decision for them based on legal and or accounting advice.
• 9 of the 15 didn't know what the rules were around changes.
• 13 of the 15 have a DB and or DC SERP in which they are scheduled to take a lump sum distribution.
• Given the current economic and tax climate, of those 13, 12 would like to take a different form of distribution.
• Of those 12, 11 said that back when they made their 409A initial deferral election, had they truly understood what they were doing, they would have made a different initial deferral election.

Choosing that distribution option well in advance sure does create a dilemma. There are certainly options, but more people than not don't seem to understand this.