In the shadow of ERISA.

Part 1

Is there a crisis in our pension system? As the Employee Retirement Income Security Act turns 20, many executives are questioning whether the legislation truly serves employees and employers. There are at least two sides to the issue, so Financial Executive, along with Actuarial Sciences Associates, invited seven people who are intimately involved with ERISA to discuss Corporate America's role in retirement.

How can companies work within the ever-changing regulatory framework that often severely limits benefits? Why are 401 (k) plans dominating the retirement-savings picture? Where does the company's responsibility for a secure retirement end and the employee's begin? How can companies and employees make their new working relationships - short-term, mobile, contingent - mesh with pension protocol? The panelists take on all of these topics and more. Here are their thoughts.

SCOTT MACEY: ERISA provides a relatively comprehensive regulatory framework for employee benefits. It has been amended many times in its 20-year history, and some of us feel that certain of the provisions and regulations still are burdensome and unnecessarily costly. The economy is changing, market forces are changing and businesses are changing the way they hire, train and retain people. At the same time, the financial and health-care industries, which are so integral to employee benefits, are changing. We need to assure that our regulatory system evolves to fit the current needs of both employees and employers.

The foundation of ERISA, as I see it, is that it offers the uniformity of a single federal system underpinned by the pre-emption provision. We don't have 50 state laws governing employee benefits. But we've all had a lot of experience, both positive and negative, dealing with the federal regulatory framework of ERISA, so let's talk about where we've been and, more important, where we're going or should be going.

Vance, would you like to start since you were working with ERISA in Congress when it was passed?

VANCE ANDERSON: Clearly, one of the purposes behind the statute was to establish minimum plan standards for vesting, funding and disclosure to participants. In that regard, I think it's been a success. The other purpose was to avoid piecemeal regulation by states and municipalities and to create a single set of standards focused on preventing the application of state laws to such benefit-plan provisions as welfare plans and pension plans. The statute has been successful in this area, too.

Where it hasn't been successful is it has created some maximum limits on these plans. Today, we find ourselves in an uncomfortable position, where the corridor we run between in the minimum and maximum areas is narrow, plans probably aren't well-served and participants clearly aren't well-served.

LLOYD SWAIM: I think ERISA was enacted to also protect employees' rights, and it's been successful because the Pension Benefit Guaranty Corporation provides some insurance protection for the employees of bankrupt companies.

What's lacking is a pension policy in the United States. As a country, our pension system conflicts with our objective of cutting the deficit, because that reduces the pension amounts that can be funded and the benefits that can be protected. We also face constant attacks when our tax policy conflicts with the concept of a private pension system.

MYRA DRUCKER: I think ERISA has done quite well in protecting employees, but it's been an abysmal failure in establishing understandable regulatory processes. I've been dealing with ERISA for quite some time, and I still find these peculiarities that present limitations. For instance, there are prescribed participant-notification procedures that do absolutely nothing to inform participants about the health of their plans. In the end, that doesn't serve either the voluntary sponsors or the plan participants.

DON HARRINGTON: At the time it was enacted, ERISA addressed disclosure, vesting and funding. The creation of the PBGC determined what benefits should be insured in the case of plan failure. However, the PBGC also established a benefit - through the Section 415 limits - that was perhaps too high in absolute dollar terms. So we had a floor that was too generous and a ceiling that became arbitrary and inadequate.

I don't like absolute numbers in any situation. You should use percentages and relative numbers. After all, this is replacement of pay.

As for the funding, I was never sure how it worked. When we had the 404 minimum and the 412 maximum and the two were calculated differently, I used to put tongue in cheek occasionally and say a minimum was a minimum until it became greater than a maximum, in which case the minimum had to be reduced.

And I think pre-emption under ERISA is good when it comes to benefits design, but it's extended beyond where it should be. When you consider self-insured individuals, for example, it's confusing.

Also, ERISA is hard to write systems around. Believe me, I'm doing this now, and it's tough to continually change the standards in the system.

TERESA GHILARDUCCI: ERISA did give property rights explicitly in places where they previously were implicit. Before the act, some employers and workers did voluntarily come up with similar agreements that worked for both the unions and the employers, to soften the risk of retiring without enough money and to ensure that companies have a loyal work force. ERISA enforced those contracts and probably made good-faith players act better.

Now it's like the Cheshire cat: There's a big smile where ERISA exists, but the rest of the body has faded because the economy has changed so much. So should laws like ERISA always be defensive, looking back and codifying relationships that are already there? Or should it be forward-looking?

For my book, I asked many people, "Where did ERISA go wrong?" The most poignant response was it assumed that companies would stay in this country and they'd want to have relationships with their workers. But now that's irrelevant. Businesses are moving toward shorter employment relationships and contingency work, and financial markets are speculative.

As Don said, ERISA wanted to pre-empt those states that would be tempted to have these parochial investment rules. But I think it went way too far the other way.

DRUCKER: I beg to differ. I think one of the areas in which ERISA has been most successful is in encouraging the accumulation of what turns out to be the bulk of our national savings. Also, the regulation of those investments has been the most rational part of the apparatus, with risk being assessed on a portfolio basis instead of a restrictive, individual-investment basis.

SWAIM: Many of us had pension plans before ERISA, and these investments would have been made with or without ERISA. Actually, they probably would have been bigger without ERISA, because we wouldn't have all the funding limits that exclude so many people.

KAREN FERGUSON: Although I agree with Myra that total portfolio theory and much else that has happened in the investment area is very good, there still are problems. The system works largely on an honor system, and, while it basically works well, there continue to be conflicts of interest, churning and concentration.

Turning to Scott's opening question, if ERISA's purpose was to safeguard the reasonable expectations of workers, in most respects it was an astounding success. Where ERISA falls short isn't in the law; it's in the enforcement of the law. For instance, with small plans, there's still an astonishing degree of money mismanagement, and the Labor Department just can't address it. It doesn't have the resources.

Enforcing individual benefit rights is a problem, too, since we don't have a government agency that sees that as its mandate. But the question we face today is whether ERISA gives us an adequate retirement-income system, and the answer is resoundingly no.

MACEY: So you believe there's a dichotomy in how the system works for small and large companies?

FERGUSON: Obviously, the blatant abuses are in the small and multi-employer plans. A lot of stealing of money still goes on, although not in the large companies. The question for the large finns is whether they're investing their plan money efficiently.

SWAIM: But was that the purpose of ERISA?

DRUCKER: As the chairman of Financial Executives Institute's Committee on the Investment of Employee Benefit Assets, I want to comment on the issue of "churning" or "speculating" in pension fund investment. We annually survey CIEBA members, who represent about 150 corporate plan sponsors with 10 million participants and $800 billion in assets, about their investment practices. Our average equity turnover rate last year was 46 percent. That implies a holding period of greater than two years per stock. To me, that's not speculation.

And the average tenure of our relationships with the investment managers who make those decisions on our behalf is 7.5 years. That seems a reasonable length of time to judge if someone is giving you adequate investment performance for your plan participants.

SWAIM: We also have to focus on annual performance, because the accounting rules require us to.

ANDERSON: Both Karen and Teresa alluded to the prospect of a renewed interest in developing more extensive regulation of investments. One example is the economically targeted investment initiative in the Labor Department. I don't think any of us would ever be comfortable having a government agency direct how these funds will be invested.

We look at the data that analyzes how efficient the investment processes are, and a conflict arises. On the one hand, you can prove statistically that, on average, the managers can't beat the market, because they are the market. But, looking at individual cases, you can find an efficiently managed portfolio that's producing superior results over time. Then, looking at the cost of running the investment operations for that plan, you can conclude the managers have, in fact, added value.

I don't know how you resolve that. I just hope we move very slowly before we change the law, before we start telling Myra that Xerox has to put money in the bridge and tunnel work in the northeast.

DRUCKER: While I'm very interested in protecting participants' rights, I find the whole ETI discussion irrelevant. It has nothing whatsoever to do with helping plan participants.

HARRINGTON: What always leaves me nonplused is that the accounting and the information you collect is retroactive. Nothing is prospective. So you end up looking at the measures and trying to project, even though you don't have a good basis for the projection.

GHILARDUCCI: We need government to regulate the individual malfeasance that may happen when managers steal money from their funds. We also need government investment regulation for the people who are in good faith following the rules and doing what they feel their duty is, which is to maximize the risk-adjusted rate of return for their participants. With everybody acting just right and being very smart and having the most up-to-date models, the system can still collapse, as it did in the 1920s, when you have a whole industry managing money with no government or other overseeing institution to say we're heading to a speculative bubble.

FERGUSON: Why is that the role of government, Teresa? Why isn't that the role of the players in the market?

GHILARDUCCI: Because we have the Federal Reserve Bank and we have laws that separate commercial banking from investment banking. It's a rational response to an increasingly complicated global economy, in which you need to have certain rules and directions. The ETI initiative is probably the most misunderstood initiative in the last year. It's not a directive; it just gives some guidelines.

ANDERSON: We don't mean to beat up on the ETI initiative. We've just been very sensitive to it for the last 25 years, and I suspect we always will be. But government doesn't necessarily represent the forces of all-seeing right, truth and justice. It can be an ally to us, or it can be an impediment.

FERGUSON: Part of the investment problem is lack of accountability. The reality is, if you aren't accountable to anybody and you're investing big pots of money, certain things can happen.

HARRINGTON: But there is accountability. Right now, Myra and Lloyd are accountable.

FERGUSON: To whom?

HARRINGTON: To their corporations, their shareholders and their employees. Their companies have made a certain pension promise, and they have to fund for that promise. If they make imprudent investments and the fund goes down in value, they have to put more money into the fund to make up for those losses. There's a strict system of financial and corporate accountability.

Sure, you can find a few instances of major corporations going out of business with significantly underfunded plans, but that's the exception rather than the rule, and you can't establish a fair regulatory system for an exception.

MACEY: Lloyd said earlier that we really don't have a well-articulated, or perhaps any, national pension policy. Moreover, whatever pension policy may be implied in the system suffers from a push/pull effect because of deficit reduction and other financial issues. But we have a voluntary system, and, in general, the pension side of the voluntary benefit system works well. However, if you ignore the rules, the system won't work. Karen says there's a governmental agency that's charged with enforcing the rules, but should that agency bring every lawsuit or protect every individual's private rights? If that's the case, we'll probably need a Department of Labor that's a hundred times bigger than it is now.

FERGUSON: The reason we have fiduciary problems of any sort is that we keep control of the money in the hands of an entity, usually the plan sponsor, for whom it can be too great a temptation. The logical answer to the problem isn't government, but independent fiduciaries.

MACEY: What does independent fiduciary mean? Anyone who gains control over money can always end up with a conflict of interest, whether it's truly his money or somebody else's.

DRUCKER: The answer is to structure the system so that the enlightened self-interests of all the players are aligned. That's when it works. And there's a great deal of that in the current pension system that we ought not to lose sight of.

As Lloyd mentioned, one item that will potentially erode that alignment is the consistent lowering of the Section 415 limits, so that a company's senior executives no longer have the bulk of their retirement benefits tied up in the same vehicles as the majority of the other employees do.

SWAIM: It's not only the senior executives. With a $150,000 limit projected forward, many middle managers are included, too.

DRUCKER: That's right, but when I look at particular investments, I want to know the general partner has his money side by side with my money - so if he loses my money, it hurts him.

GHILARDUCCI: You want to get rid of the agency problem.

DRUCKER: That's exactly right. And we're a lot closer to that in this system, but we're moving away from it as we lower the Section 415 limits.

GHILARDUCCI: I have some results from my academic work I'd like you to explain. In our pension world, under the same ERISA law, we have two very different systems. First is the single-employer system. Many studies have said there's a conflict of interest here because a corporate fiduciary wears one hat as a representative of pension-plan participants and another as a representative of shareholders. Can that conflict of interest be managed? ERISA nods and says, yeah, we'll use the honor system.

The other system is the multi-employer system, a voluntary organization of unions and employers, typically very small firms, that don't have market power individually but want to get rid of the "bottom-feeders," or those companies that come into a market and don't pay their workers enough or provide good benefits. So the firms enter collective bargaining agreements with apprenticeship programs and pension funds. They have jointly controlled boards, on which the unions might wear two hats and the employers wear none at all.

I looked at the generosity index, or the normal cost per participant, for these two systems in 1981 and in 1991 for plans with more than $100 million in assets. I found that, in 1981, corporate plans were almost twice as generous as multi-employer plans, spending $723 and $443 per participant, respectively. And that makes sense, given the economic situation and the types of industries. But, in 1991, while corporate plans' generosity increased to $900 per participant, the multi-employer plan increased to $1,000 per participant.

My interpretation is this: When the corporate plans realized windfall gains in their funds from the financial markets, they wore their other hat and reasoned that they had liquidity needs, so they reduced their contributions to the plan. The trustees of the multi-employer plans had no such conflict. When the windfall gains came to their funds, they gave it to their retirees and other plan participants.

What's wrong with that story?

ANDERSON: I think you missed the effect of the maximums.

GHILARDUCCI: Both types of plans are affected.

ANDERSON: No, they're not affected in the same way. Most of the single-employer plans have faced some full-funding limitation off and on for the last 10 years, because the maximums have been ratcheted down so dramatically on many of our plans.

FERGUSON: But you could have raised your benefits. The multi-employer plans raised benefits; you didn't.

SWAIM: We've been pushing people into nonqualified plans.

ANDERSON: The multi-employer plan's benefit formulas are entirely different than ours.

HARRINGTON: The point is, in the 1960s and 1970s, you had much different actuarial assumptions long term. You had come from the Depression and World War II, and you held back the economy. The long-term rates were 3.5 percent to 4 percent.

In the late 1940s, if you happened to be waiting at the station in equities when the train came in, you made money, overpowering all assumptions. In 1982, if you were sitting in equities and had been earning 5.5 percent to 6 percent on a weighted average composite portfolio, when the train pulled out of the station and rates started to float in at 12 percent and 14 percent, your funds built up much faster than your liabilities ever did.

GHILARDUCCI: Both the union plans and the corporate plans were at the station.

HARRINGTON: The multi-employer plans were much more thinly funded because they were bargaining cents per hour. But for people who had amortized, or were reasonably far along in amortizing, any unfunded obligations, when the train came in, it overpowered everything.

Then ERISA came along, and the deficit started to increase and we started to implement full-funding limitations and cut the liabilities. That dropped a plan's normal costs through the floor because the assets grew much faster geometrically. So the rapid amortization of gains that have come into the funds did it.

SWAIM: Another thing you have to consider is that many of us have more than one plan. We have defined-contribution plans, which have been doing magnificently. So if you're looking at a generosity index, you should include these plans.

GHILARDUCCI: What happens if you hold back contributing?

SWAIM: Our plans are final-pay plans, while most multi-employer plans are flat-dollar plans. We'd already built in an indexing mechanism, but the multi-employer plans couldn't fund for the changes in their benefit levels.

DRUCKER: The fundamental question is, to whom do the pension assets belong? Teresa, you're implying the pension assets necessarily belong to the beneficiaries when, in fact, some people would say the pension assets are collateral for the defined-benefit promise the corporation has made - that the pensioners are, in effect, collateralized bondholders of the corporation, and the equity interest in those pension assets rightfully belongs to the shareholders.

FERGUSON: Where does that theory come from?

DRUCKER: It's a paradigm for the actual economic effects you see here. The employee buys the bond with a piece of his or her wages, and it's collateralized by law. The employee has an interest in knowing that collateral is, in fact, adequate. But it's ultimately the shareholders of the corporation who are on the hook to pay that promise if the collateral proves to be inadequate, regardless of its performance. If the shareholders have experienced all the down side, they need a piece of the up side, too. So, in effect, they're the equityholders of those funds.

GHILARDUCCI: And that justifies everything?

DRUCKER: No, I'm not saying that. But it points out a fundamental difference between a multi-employer plan, in which the benefits become a function of the assets, and the single-employer plan, in which you have a different economic imperative.

MACEY: The risk of accountability in a single-employer plan is, of course, on the employer, but that's not the case with the multi-employer plan. Plus, there's a diffusion of power on the employer side and a concentration of power on the union side in multi-employer plans. Many of the "jointly sponsored" plans are really operated by the unions.

The laws say otherwise, but I've found when there's a severe concentration of bargaining power with the unions, conflicts of interest can arise on the union side. Assuming the issue is the risk of accountability, if you say that not one dollar put into or earned by a pension plan - no matter how it's invested or how much it returns - will have an impact on future funding, employers will retreat from the defined-benefit plans.

So, under Teresa's theory, if an employer invests the money prudently but very successfully, it has to increase its benefits and still continue to fund the plan as if it didn't have a better return than it projected in its original funding assumptions. Why would any employer want to take a responsible tack on its employer funding under that scenario? If everything that goes into a plan has to produce a benefit, rather than possibly offset future funding obligations, and the benefit must increase if the assets are successfully invested, this theory undercuts the corporate promise and accountability. It effectively turns a defined benefit into a defined contribution but with an underlying sponsor guarantee. And, of course, right now the employer doesn't even have a choice because the minimum and maximum funding standards regulate the plan.

SWAIM: If we want to give the employees all the benefit of the investment return and also penalize the employers with any investment problems, then let's scrap defined benefits and go to defined contributions.

DRUCKER: That's the paradigm.

HARRINGTON: I think the collateralized argument ties in here. The question is, how big is that collateralization? What standard would you measure it against? For example, you don't have to push up benefits, but you have to secure them, so you collateralize them. But do you put that collateralization up against the present value of the benefit, or do you put it up against a reserve, which assumes a continuation of the corporation, and you then pay your normal cost?

If the ultimate test of value is determining if the present value of your benefits is much larger than your reserve, should you increase your benefits or flow back the value?

SWAIM: Some transfer provisions allow employers to fund health-care benefits for significantly overfunded pension plans.

FERGUSON: The reality is that defined benefits aren't being improved today. The new money is going into 401(k) plans. We now have only a third of the full-time, private work force in any kind of traditional pension or profit-sharing plan. Whether it's because of the Section 415 limits, the availability of 401(k) plans or the availability of nonqualified plans, we're seeing generosity in the traditional plan diminished in the single-employer plan universe.

That's something we should focus on.

In Part 2, scheduled for our May/June issue, the panelists tackle such issues as pre-emption under ERISA, the implications of the tax code and how the media plays a part in employee perceptions of their retirement security.

RELATED ARTICLE: The Panelists

VANCE ANDERSON Assistant General Counsel Allied-Signal

MYRA DRUCKER Assistant Treasurer Xerox Chairman of Financial Executives Institute's Committee on Investment of Employee Benefit Assets

KAREN FERGUSON Director Pension Rights Center

TERESA GHILARDUCCI Assistant Director, department of employee benefits, at the AFL/CIO

Formerly Associate Professor of Economics at the University of Notre Dame 

Author of Labors' Capital: Economics and Politics in Private Pensions

DON HARRINGTON Vice President of Benefits and Compensation AT&T

SCOTT MACEY Executive Vice President and General Counsel Actuarial Sciences Associates, a subsidiary of AT&T Panel moderator

LLOYD SWAIM Vice President and Treasurer Gillette Member of Financial Executives Institute's Committee on Employee Benefits