August 21, 2006 The pension reform bill that President Bush signed into law last week makes 401(k)s friendlier to workers and encourages employers to help savings-challenged Americans build their nest eggs for retirement.
"One of the lasting influences of the Pension Protection Act is to begin laying a foundation for a transformation of the 401(k) as we know it today," said Christopher Jones, chief investment officer at Financial Engines Inc., an investment advisory firm.
The most potent change is the provision that smoothes the way for employers to automatically enroll workers in 401(k) plans, bump up their contributions over the years, and put them in suitably aggressive investments to meet their retirement needs.
As much as the 401(k) is changing, workers need to change the way they think about it.
The 401(k) was invented in the 1980s as a supplement to company pension plans. The new law -- in its realization that corporate pension plans are distressed and dying, and its efforts to make 401(k)s more automatic and universal -- in effect anoints the 401(k) as America's new primary retirement plan.
The message to workers is, if you haven't been paying attention to your 401(k), you need to start.
Personal finance experts praise the law because, they say, many Americans are doing a lousy job saving for retirement on their own.
"The 401(k) has been based on the fact that individuals will do it themselves," Mr. Jones said. "That fundamental assumption is false for a majority of the population. If people are not willing or able to make informed choices by themselves, what are they going to do?"
The problem is clarified by Fidelity Investments' annual report on the state of 401(k) investing, which came out last week.
The average 401(k) account balance increased to $62,500 last year, up 3 percent from 2004, the giant mutual fund firm reported. At the same time, only 64 percent of eligible employees opted to participate in 401(k)s, a decline of 1 percentage point from 2004.
Automatic enrollment programs will "substantially boost" the rate of participation to as high as 95 percent, with particularly dramatic increases for lower-income workers, minorities and women, according to the Retirement Security Project, a partnership of the Brookings Institution, a liberal-leaning think tank, and Georgetown University.
"We estimate that automatic enrollment, when fully phased in, could generate $10 billion to $15 billion of additional contributions to 401(k) plans each year," said Peter Orszag, director of the Retirement Security Project. "Those additional contributions will bolster retirement security for millions of workers."
Many companies had been holding off establishing automatic enrollment because of legal uncertainties. Companies feared that if workers were automatically enrolled in suitably aggressive investments, and the stock market tanked, the workers could sue.
The pension law has clarified those issues. Companies receive "safe harbor" protections if their automatic enrollment programs provide for the following:
-- Automatic employee contributions equal to at least 3 percent of pay in the first year, increasing 1 percent a year until reaching at least 6 percent of pay in the fourth year, up to a maximum of 10 percent.
-- A 100 percent employer match of the first 1 percent of employee deferrals to their 401(k) plan, plus a 50 percent match on additional deferrals, up to 6 percent.
-- Fully vested employer matches after two years.
Following a trend
In many ways, the pension reform law gives more momentum to a trend that's been in the works at many companies.
"It will be a factor in continuing to move the market in the direction it actually has been heading," said Ted Benna, considered the creator of the first 401(k) plan in 1981. "Where the market has been moving is toward embracing the automatic enrollment, more aggressive investment defaults and really rapid expansion of target life retirement funds."
One Dallas company that has already instituted automatic enrollment is happy with the outcome.
"It's important to make sure that our employees provide for their future, and we took a step to make sure that they do that," said Daniel Son, vice chairman of Penson Financial Services, which clears trades for brokerage firms.
The company has had automatic enrollment since 2002.
"We contribute 10 percent of base pay for the rank-and-file employee, whether or not they choose to put anything in themselves," Mr. Son said. "We do that after they've been here for a year, but they can start contributing on their own within the first quarter after they've been here a month."
For employees who make more than $50,000 a year, Penson has a 50 percent match of their contributions, up to $5,000 a year.
Being in the investment business, Penson gives employees the choice of professional-managed mutual funds, or they can manage fund investments on their own.
To help educate workers, the pension reform law includes a controversial provision that permits financial service firms to offer advice on investing in the 401(k) plans they administer.
The idea is to help workers make the right choices, because they will have to be more self-reliant. But critics say the rule will allow investment firms to steer workers toward investments with higher fees.
To assuage conflict-of-interest concerns, the law requires financial advisers to use a computer model that's certified and audited by an independent party.
"This was a bipartisan compromise that is intended to inject more meaningful, personally tailored advice to individuals who desperately need it," said Kevin Smith, spokesman for House Majority Leader John Boehner, R-Ohio. "Enron illustrated tragically that employees who have no access to investment advice often make very unwise investment decisions."
In the Enron case, employees had more than 60 percent of their retirement money invested in company stock, violating the fundamental tenet of diversification. Workers lost about $1 billion in savings when Enron imploded in 2001 and its stock dropped from $90 to nothing.
At the same time, some 401(k) participants stay in investments that are too safe, such as money-market mutual funds, which don't provide near enough return required to fund a retirement.
The law's safe-harbor provisions would enable employers to automatically put their workers' retirement money into riskier but higher-yielding stock and bond funds, or a life-cycle fund that changes to a more conservative blend of stocks and bonds as the employee gets closer to retirement.
Workers will still be in control. They won't have to keep their money in the automatic investments if they don't want to. But they will have to get involved.
"For your rank-and-file worker, who is spending most of their time thinking about how they're going to get the kids to school, how they're going to pay their mortgage, they haven't had the time to think about a lot of the different investment options that are available to them," said Matt Moore, senior policy analyst at the National Center for Policy Analysis in Dallas, a conservative think tank.
Experts say employees can take advantage of the new law by beating their employers to the punch and starting to participate in the 401(k) plan.
"You can take actions that will improve your chances of having a reasonable retirement security," said Mr. Jones of Financial Engines. "Enroll in the plan now, save at least to get the company match. Don't opt out of auto enrollment."
And assess your needs at retirement, so you can figure how much you'll need to save, said Mr. Benna, president of the 401(k) Association and chief operating officer of Malvern Benefits Corp.
"Many participants have never done that," he said. "It's like putting a 10-year-old in a car in New York City without any signs and maps and saying, 'Your goal is to head to San Diego.' "
LAW TO HELP NONSPOUSE HEIRS AVOID HUGE TAX HIT
Besides automatic enrollment plans, participants and their heirs will also benefit from a little-noticed provision in the pension law.
The new law allows heirs other than spouses who inherit 401(k)s to escape an expensive tax hit by rolling over the funds into individual retirement accounts. The old law permitted only surviving spouses to roll the money into an IRA. Nonspouse beneficiaries couldn't do so and had to pay an immediate tax on the lump sum.
Gay-rights advocates say the change is a huge step toward equalizing the treatment of nonspouse beneficiaries in retirement savings vehicles.
"Its practical application in terms of the real world are pretty significant to people," said James Delaplane Jr., a pension law expert and partner at Davis & Harman. "For the millions of Americans who list nonspouse beneficiaries on their 401(k) plans, this is a significant improvement in the tax law that will prevent unexpected cash-outs and tax penalties."