Employee Benefits Bulletin, March 2002
ENRON. . . Potential Impacts For Retirement Plans: What Are The Reform Issues Stemming From The Collapse?
Enron is bankrupt. Obviously, the energy trading company's downfall will affect its employees and shareholders. What might come as a surprise to many is that Enron's bankruptcy might also affect millions of other Americans-people who have never worked for Enron nor owned Enron stock. How? Enron's bankruptcy has spawned a wave of interest in retirement plan reform that might change the way every participant in an employer-sponsored retirement plan saves. This article attempts to explore the issues critical to proposed reforms, beginning with a background discussion of ERISA and Enron's plans. A summary comparison of the various, proposed reform legislation appears on page five of this Employee Benefits Bulletin.
- I. Brief Background on ERISA, Defined Benefit Plans, and Defined Contribution Plans
In order to fully understand the impact that Enron's collapse might have on retirement plans as they exist today, the background of the Employee Retirement Income Security Act of 1974 ("ERISA") and 401(k) plans must be examined.
The creation of pension reform now known as ERISA was largely due to public outcry following the close of the U.S. Studebaker plants in 1963. Studebaker Corporation's underfunded retirement plan and rigorous vesting requirement caused over 4,000 workers to lose their company pensions. Although not enacted into law until 11 years later, ERISA was designed to protect workers from similar corporate failures by creating standards for minimum vesting, participation and funding in all tax-qualified plans, requiring plan termination insurance for defined benefit plans, prohibiting certain transactions involving conflicts of interest, and establishing standards for plan fiduciary conduct.
It is important to note here that 401(k) plans did not exist in 1974 when ERISA was passed. ERISA was designed largely to deal with the most popular retirement plans of the day-defined benefit (traditional pension) plans. Defined contribution plans were considered supplemental to the defined benefit plans and were rarely offered as an employer's sole retirement vehicle.
In defined benefit plans the employer provides a guaranteed benefit to participants, invests all plan assets and bears the risk of those investments. Today, if a company falters and cannot pay promised benefits to participants, a government agency called the Pension Benefit Guarantee Corporation ("PBGC") will take over the defined benefit plan and provide a certain level of benefit guaranteed under ERISA. Employers with defined benefit plans must pay premiums to the PBGC for this government-sponsored plan termination insurance. Defined contribution plans are different. They have no guaranteed benefit for participants at retirement. Instead, the employer contributes assets on a plan-defined basis to an individual account for each participant. At retirement, the participant is entitled only to the amount accumulated in the account (thus, the employee bears the investment risk). Additionally, defined contribution plans are not insured by the PBGC. 401(k) plans are defined contribution plans and were created in the 1980's, years after the sweeping ERISA legislation. Recently, 401(k)'s and other types of defined contribution plans have become extremely popular and have replaced defined benefit plans as the most prevalent retirement vehicle offered by employers. Statistics show that today 401(k) accounts hold $1.7 trillion in assets in 340,000 plans for 42 million workers.
- II. Enron's Retirement Benefit Structure
Enron sponsors a 401(k) plan, an employee stock ownership plan ("ESOP"), and a cash balance plan. Select Enron employees also participate in several other Enron employee benefit plans that are not tax-qualified, such as a non-qualified deferred compensation plan.
Under Enron's 401(k) plan, employees may contribute up to 15 % of their base pay as salary deferrals, or, if they choose, as after-tax contributions. Enron provides a 50 % match on salary deferrals up to 6% of base pay. The company match is invested solely in Enron stock, and participants may not reallocate the match to other investments until they reach age 50. However, participants may allocate their own contributions into various investment alternatives, including Enron stock, immediately upon contribution to the plan.
Enron's ESOP, like all ESOPs, is designed to encourage employee ownership of the company and invests primarily in company stock. Each Enron ESOP participant has two basic subaccounts: (1) a savings account into which the plan allocates shares of Enron stock equal to 10 % of the participant's base pay, and (2) a retirement account into which the ESOP allocates shares based on age, years of service, and base pay. The vested portion of a participant's retirement subaccount is used as an offset against a certain portion of the benefit earned in Enron's cash balance plan.
The cash balance plan is the only defined benefit plan that Enron sponsors. Enron created the cash balance plan when it converted its traditional pension plan formula (granting a retirement benefit based on a percentage of final average pay multiplied by years of service) into a cash balance formula. Cash balance formulas express a participant's benefit at retirement as a hypothetical account balance. As mentioned previously, Enron's cash balance plan and ESOP are linked by a floor-offset arrangement in which benefits earned by participants in the ESOP essentially erase a portion of the benefit earned under the cash balance plan.
- III. Effect of Bankruptcy on Enron's Retirement Plans
Enron's collapse affected participants in each retirement plan differently.
Absent the presence of company stock in the plan, the 401(k) participants would not have been affected at all-even though the company itself was in financial straits, Enron could not have touched the assets of its qualified 401(k) plan. Participant account balances would have easily weathered the bankruptcy storm. However, this was not the case. The plan was heavily invested (58% of plan assets) in Enron stock. When the details of Enron's true financial situation were revealed and the stock began to plummet, participants in the 401(k) plan were unable to sell the company stock held in their plan accounts for two reasons: (1) the age 50 restriction on reinvestment of the match account, and (2) an ill-timed, administrative "blackout" or "lockdown" period, during which no account transactions of any kind could be performed. Thus, much of the value of the Enron 401(k) plan disappeared with the decrease in stock value, and many employees lost great portions of their retirement savings.
ESOP participants received a big hit since the ESOP participant accounts are invested almost exclusively in employer stock. If the company stock is worth nothing, the participant accounts are worth nothing.
According to the Department of Labor, Enron's cash balance pension plan was not invested at all in company stock at the end of the 2000 plan year. Therefore, its participants do not face the same problems as those in the 401(k) and ESOP plans. However, the cash balance plan could face problems of its own-it could have been underfunded when Enron went into bankruptcy. In recent years, due to the incredible performance of the stock market in the 1990's and 2000, many defined benefit plan sponsors have not been required to make actual funding contributions to their plans. This year, however, the stock market's steady decline has resulted in underfunding in these same plans. Fortunately, since the cash balance plan is a defined benefit plan, the PBGC would step in to cover any guaranteed benefits that the plan could not provide. (However, if a participant had earned benefits in excess of guaranteed levels, the excess would be lost in an underfunding situation.) Additionally, the floor-offset calculations of the cash balance plan have been called into question. If Enron has determined the ESOP offset to the cash balance plan benefit in an improper manner, the plan could owe millions more to pensioners. The PBGC would insure these benefits up to the guaranteed level, as well.
Participants of the qualified plans are not the only ones feeling the crunch. Participants of the nonqualified Enron deferred compensation plans (in which employees deferred receipt of a portion of their salaries until after retirement) might be the hardest hit. Because the deferred compensation plan is a nonqualified plan, the participants' retirement benefits remain part of the company's general assets until distribution. The fact that the money is not set aside and protected for the participant prevents the individual from recognizing income in the eyes of the IRS until the actual benefit is received in retirement. However, for the same reason, deferred compensation participants who did not withdraw their entire benefit before the date of bankruptcy are now simply unsecured creditors of Enron with no special claim to their retirement money. Adding insult to injury, there are also charges that requests for early withdrawals by retired deferred compensation participants were denied in favor of withdrawal requests made by active employees.
- IV. Enron-Inspired Retirement Reforms
Indeed, the Enron retirement system is currently in a woeful situation, and it is easy to see why the circumstances prompted reform efforts. The reform proposals are directed at the tax-qualified plans (because nonqualified plans are typically supplemental benefits for highly paid employees) and particularly focus on the popular 401(k) plans. Brief discussions of the most prevalent reform proposals follow, including a more in-depth analysis of the most hotly-debated issue-employer stock in 401(k) plans.
- A. Caps on Employer Stock in 401(k) Plans
The Enron 401(k) plan participant losses are severe solely because of the heavy concentration of employer stock in the plan. ERISA currently limits the amount of employer stock in all defined benefit plans to 10 percent, but defined contribution plans usually are exempted from this limit. Thus, reformers have suggested it is time to extend the caps on employer stock to qualified, non-ESOP defined contribution plans.
In order to analyze the proposed caps, it is helpful to review the reasons why so many retirement plans contain large amounts of company stock. Recent statistics indicate that employer stock accounts for about 39 percent of all 401(k) plan assets. The employer stock normally arrives in the 401(k) plan in two ways: (1) the employer contributes the stock into the plan, and/or (2) the employee chooses to invest a portion of his account balance in company stock.
Employers like to contribute their own stock for many reasons. Stock matches are much cheaper for companies than cash contributions-stock contributions do not reduce cash flow, they are not recorded as an expense (and thus do not reduce profits), and they are tax deductible to the full extent of the stock's fair market value at the time of contribution. The employer may believe that employees who own a great deal of company stock through the plan will be more productive, loyal, and profit conscious. Heavy plan investment in company stock helps to keep share prices stable since plan participants tend to act more slowly than other shareholders in a falling market. Additionally, an employer plan holding a substantial number of company shares provides the company some shelter from hostile takeover attempts and proxy contests. And, finally, employers who are able to label their 401(k) plan, or a portion of the plan, as an ESOP become eligible for the 404(k) deduction on certain dividends paid on company stock held in the ESOP. (Normally, dividends paid are not tax deductions for the company. Look for a discussion of the post-EGTRRA 404(k) deduction in next month's Employee Benefits Bulletin.)
Employees also benefit from tax rules when they take distributions of employer stock from qualified plans (deferred taxation and long-term capital gains rates). However, the reasons most employees invest in company stock are more intangible. Employees may invest in employer stock because of feelings of loyalty, comfort, or perceived pressure from the company. As in Enron's case, employees will invest heavily in their employer's stock because it is performing well, without fully appreciating the risk of intertwining their retirement savings and job security. Furthermore, because of simple inertia, many employees will never change their plan investments from the company stock granted to them by the employer.
Enron's 401(k) plan was heavily invested in employer stock because of both employer contributions and employee-directed investments. Of the estimated $1 billion lost in Enron 401(k) retirement savings about $100 million, or 10 %, came from company stock given as the 401(k) plan match that employees were prohibited from selling until age 50. This means that 90% of the participants' loss in company stock value was the result of the participants' own investment choices.
In response, reformers propose percentage caps on the amount of employer stock a participant may hold in a 401(k) plan. For example, the Boxer-Corzine Bill would cap the amount of company stock that a participant could hold in his or her 401(k) plan account at 20 percent of account value.
These caps have many critics and supporters. Supporters claim that the caps would force participants to diversify away from company stock, thus preventing another Enron 401(k) plan disaster. Critics allege that the caps are a hasty, drastic fix for a retirement system that is not even broken. Critics claim the Enron retirement plan disaster was truly caused by securities fraud and point to the K-mart plan as proof (K-mart plan participants only invested 3.5% of their own contributions in company stock, since that company's financial audits clearly showed that the company was failing). Critics also argue that if employers are discouraged from contributing company stock because of the employer stock limit, they might choose making no contributions at all over cash contributions. In addition to potentially decreasing employer contributions, caps might close off one of the chief paths to wealth accumulation by ordinary workers (think Microsoft). Monitoring all participant accounts to comply with the limit would pose a heavy administrative burden for the plan sponsor, and the Treasury Department has stated that as many as one in five 401(k) plan participants would be forced to change their investment allocation immediately if employer stock holdings were capped at 20 percent. Small firms would be presented with cash flow problems when forced by a cap to buy their stock back from participants. Finally, critics state that measures to force diversification are simply anti-American and infringe on the rights of 401(k) participants to invest their own money as they see fit.
Supporters counter these arguments with the fact that more and more situations like that of Enron are popping up. Currently employees of Enron, Lucent Technologies, Ikon Office Solutions, Nortel Networks, and Providian have filed lawsuits revolving around losses in company stock held by the 401(k) plan. Statistics show that, for whatever reason-be it ignorance, lack of attention, or investing based on a broader portfolio-many plan participants own large concentrations of employer stock. And, when that employer stock loses its value, plan participants lose big chunks of their retirement savings. Supporters argue that the federal government spends huge amounts of money (through tax breaks for qualified plans) for the single purpose of fostering retirement savings. At $90 billion per year, the tax subsidy for qualified plans is the largest single federal tax subsidy, greater than the deductions allowed for mortgage interest and employee health insurance. Cap supporters feel Congress has an obligation to ensure that the expenditure does not subsidize highly risky investment practices that might often fail to produce adequate retirement savings for workers.
A proposed alternative to caps would be to allow employers a choice: either offer company stock as a plan investment option or match employee deferrals with company stock, but do not do both. Over time this will achieve diversification effects without some of the problems caps might trigger.
Many supporters of caps would also like to see certain diversification rights implemented with regard to employer stock in retirement plans. These diversification rights would prevent a participant's match account from being locked in company stock for years. For example, the Boxer-Corzine Bill would allow participants to sell vested employer stock in their 401(k) plan accounts within 90 days of contribution by the employer.
- B. Participant Investment Advice
Reformers say Enron proves that many 401(k) plan participants do not understand basic investment concepts, like diversification or the relationship of risk and return, and need better investment advice. Under ERISA, providing investment advice may result in fiduciary liability. Therefore, employers are wary of any communications that could be construed as investment advice. ERISA does allow employers to hire an independent investment adviser without creating fiduciary liability if the employer diligently selects and monitors the third-party adviser. Unfortunately, what the Department of Labor would deem diligent selection and monitoring is unclear and effectively prevents employers from hiring even independent advisers for fear of lawsuits. Two investment advice bills have been introduced. The Boehner Bill would amend ERISA to allow plan administrators to give personalized investment advice. Critics of the bill fear administrators might push their own investment products on participants. The Bingaman Bill does not let administrators give advice, but it creates a safe harbor for companies to follow when selecting and monitoring an independent adviser.
- C. Blackout Periods
Enron 401(k) plan participants were prevented from selling their Enron stock by an administrative blackout period due to a change in plan administrators. These blackout periods are normal and necessary for plans going though major administrative changes. However, the Department of Labor is investigating whether the notice and timing of the Enron blackout period were made in good faith. Almost every reform proposal includes more stringent employee notification requirements. Some also limit the time frame of the blackout or limit the ability of company executives to sell their company stock while plan participants' company stock is frozen in the blackout period. Other reformers would like to see increased fiduciary liability for plan investment performance (other than normal market swings) during a blackout.
- D. Fiduciary Issues
A final ERISA flaw that Enron has brought to light revolves around fiduciary duties. In brief, fiduciaries have a duty to act with prudence and in the exclusive interest of plan participants when managing the assets of the plan. However, section 404(c) of ERISA shields a fiduciary from liability for a loss when the participant exercises control over his own account (as in a 401(k) plan). This provision normally protects fiduciaries from claims of breach of fiduciary duty arising from poor investment decisions by 401(k) plan participants. However, Enron 401(k) plan participants are proceeding with a lawsuit claiming breach of fiduciary duty by company executives who allegedly encouraged purchase of Enron stock when they knew it was overvalued. The lawsuit highlights the difficulty in separating the actions of plan settlor (no duty owed to plan participants) and plan fiduciary (high duty owed) when the same person acts as both. The actions and nondisclosures of Enron executives and company trustees who were also fiduciaries to the plan will be key to the outcome of the lawsuit. Hopefully, Enron will be the impetus for clarification of this confusing issue and for additional reforms that allow ERISA's provisions to grow with the changing focus of retirement plans.
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