401(k): Too Good A Deal For Employers


Eric Laursen 

While
official Washington awaited the latest unraveling threads of the
Enron scandal in February, wondering whether a “smoking gun”
would turn up to implicate some elected official, another tragedy
made headlines in another city. 

Two
young sisters died in an apartment fire in Newark after lack of
heat had forced them to rely on electric heaters and stoves to warm
their home. Initially, city housing authorities arrested the girls’
father, who had left the two by themselves in order to drive their
baby-sitter home, for endangering the welfare of a child. Four days
later, they also arrested the building’s owner, who, it seems,
had been the subject of dozens of complaints and violations and
had provided no heat to the family all winter. But he was the mayor’s
friend and had lent him space for a reelection campaign office that
was never reported as a political contribution or expenditure. 

Back
in Washington, a similar web of circumstances is on display. Enron
Corporation created a set of retirement plans full of booby traps
for unsophisticated workers. But like other big companies, Enron
insulated itself from any criticism of these arrangements through
lobbying, campaign contributions, and political relationship building. 

Internally,
more than one Enron executive had expressed misgivings about the
effects of the company’s accounting practices on its stock
price—a critical element in valuing its 401(k) retirement plan,
which was top-heavy with company stock. But none of these qualms
were disclosed to rank-and-file employees. Taking company officials’
relentlessly optimistic assessment of Enron’s future at face
value—and having little alternative, since the company contributed
to the plan only with stock—Enron employees concluded that
their best chance for a secure retirement was to work hard for the
company and make it prosper. 

The
stock collapsed from close to $90 a share to less than $1, wiping
out more than $1.2 billion of retirement savings belonging to some
15,000 Enron employees—over half their total 401(k) nest egg. 

The
401(k) catastrophe is just one of many educational aspects of the
Enron story, from influence peddling to creative accounting. But
none carries as many direct implications for rank-and-file workers
as the circumstances surrounding the collapse in value of Enron’s
401(k). 


The Age Of Empowerment 

Unlike
most other so-called advanced industrial democracies—or even
dictatorships—the U.S. has never had a national pension system.
Social Security is a retirement benefit that both employers and
employees contribute to, but it was never intended to provide a
substantial income all by itself. 

Personal
savings are no longer much help as the cost of living has risen
so rapidly over the last 30 years that the rate of return on a savings
account or CD is nowhere near enough to keep most people ahead of
the game. The definition of a middle class lifestyle has changed,
too, jacked up by consumer culture and the fear of not making the
grade. Dozens of new trappings from computers and cell phones to
cars for the kids to private schooling and expensive vacations have
slipped into the mix. Topped off by steeper real estate prices,
this has resulted in a debt explosion and a drastic decline in savings.

That leaves employer-sponsored
pension plans. Until the mid-1980s, a pension generally meant a
retirement plan that an employer funded and that guaranteed a steady
stream of income payments in retirement—a “defined benefit,”
in financial parlance. Then employers began launching “defined
contribution” plans, of which 401(k)s are the most popular
format. Today, 401(k) plans contain some $2 trillion in assets belonging
to 42 million participants, according to the Labor Department and
are the fastest-growing type of retirement benefit. Many companies
have converted their old, defined benefit pension plans to 401(k)s,
and some smaller employers that did not previously offer any kind
of retirement plan have added them as well. 

By
the late 1990s, some 27 percent of workers depended on defined contribution-type
plans as their principal retirement income, up from 19 percent in
1989, while those relying on defined benefit pension plans decreased
from 15 percent to 7 percent. Workers making under $60,000 a year
who have some sort of employer-sponsored retirement plan are especially
dependent on 401(k)s, some experts say, because employers are less
likely to provide them the kind of long-term job security that would
justify a defined benefit plan. 

The
401(k) is not a pension, strictly speaking, it’s an individual
retirement investment account that the employee funds out of his/her
own pay. The only real differences between a 401(k) and a brokerage
account or mutual fund that anyone can set up are that the holder
gets a tax deferral while accumulating assets, the company gets
a tax break if it chooses to make an additional contribution with
some of its own stock, and financial services providers rake in
hefty fees for managing and administering the accounts. 

Besides
the tax break, which can be substantial, 401(k)s offer other big
advantages to employers. They incur no future obligations with a
401(k). Whatever employees have in their account when they retire
will be the foundation of their retirement income. The financial
services companies that create different types of retirement plans
and then sell them to employers call this “empowerment,”
because employees get to decide where to invest their assets. 

As
the stock market soared during the 1990s, 401(k)s became one of
American capitalism’s great symbols of success. Free market
gurus lauded them for making workers capitalists by giving everyone
a stake in the financial system that supports business. Some fortunate
individuals became millionaires on paper overnight as the value
of the company stock in their 401(k) accounts burgeoned, promoting
the idea that the market—not a guaranteed pension—was
the best way to provide for your retirement. 

But
there were always problems. First, the fact that no guarantee is
attached to 401(k)s couldn’t be argued away: even if the stock
market performs well over time, there’s no certainty who will
fall on the long or the short end of the curve. The system is bound
to yield losers as well as winners. Second, 401(k) “empowerment”
is a dubious concept at best. 

Employers
alone decide how many and what kind of investment choices the plan
offers, since employees are not represented on the board of trustees
that runs the plan. Employers can set vesting periods—the gap
between when assets are assigned to the participant’s account
and when she or he actually gains legal title to them—to last
for years. When a company wants to make administrative changes in
the plan, it institutes a “lockdown,” preventing workers
from buying or selling any of their assets for weeks or even months. 

Because
of the tax break, companies that chip in some contributions to their
employees’ retirement accounts tend to do so in company stock,
not cash. In 1995, 33 percent of the value of 401(k) assets was
in company stock, according to the Institute of Management and Administration,
a proportion that rose to 44 percent before the stock market started
slumping in 2000. At many companies, stock that the employer contributes
is locked into the plans for a certain period of years or until
the employee nears retirement age. 

Enron,
the high-flying energy company, used every trick in the 401(k) manual
to augment the value of its stock. It matched employee contributions
only in stock. Management, including chair Ken Lay, kept up a constant
drumbeat for employees to buy more stock through the 401(k), to
the point that company stock composed 47.5 percent of assets in
the plan when share prices peaked. While they could sell the stock
they purchased themselves at any time, employees were prohibited
from unloading the shares the company contributed until they reached
age 50. 

Even
as it pumped its employees to buy more company stock, Enron was
reducing its pension obligations. In 1987 the company terminated
its traditional, defined benefit pension plan and transferred the
funds into an employee stock ownership plan (ESOP). It then set
up a new defined benefit (DB) plan linked to the ESOP through a
“floor-offset” arrangement, which meant that whatever
benefits employees earned in the ESOP—which of course was all
stock—were eliminated in the DB plan. 

To
calculate the offset for pensions earned from 1987 to 1995, it locked
in the value of the stock in the ESOP based on prices prevailing
from 1996 to 2000. That means that employees who retired between
1987 and 1995 saw a large chunk of their defined benefit pensions
eliminated in favor of their ESOP holdings. Those ESOP holdings
are now virtually worthless, but their defined benefit pensions
won’t be restored in value to compensate. Then in 1996, Enron
converted the defined benefit plan into a cash balance plan, in
which older workers’ benefits accumulate more slowly. 

Meanwhile,
officials like Ken Lay and CEO Jeff Skilling received special insurance
policies, funded in cash, not stock, that enabled them to shelter
large amounts of their compensation and even pass it on to their
heirs, tax-free. (A late-term attempt by the Clinton administration
to shut down these vehicles was effectively gutted in January by
the Bush White House.) 

Enron
also set up an “executive savings plan” to which officials
could contribute 25 percent of their base pay and 100 percent of
their bonuses each year. For the first two years, earnings on these
accounts were guaranteed at least 9 percent and owning Enron stock
through them was not a requirement. 

Litigators
are focusing on the period just before last fall’s lockdown
when trustees of the 401(k) plan, some of whom had at least an inkling
of the problems with the company’s accounting, decided to freeze
it anyway to effect a change of plan administrators. One lawsuit
claims that an initial letter from the company misinformed employees
about when the lockdown would go into effect, preventing them from
selling off some of their Enron stock when they still had the chance. 

Other
facts suggest that Enron violated its fiduciary duty towards its
401(k) plan participants. For instance, Lay continued urging them
to load up on Enron stock after a vice president warned in a memo
that the company’s bizarre tangle of off-balance-sheet partnerships
might amount to “an elaborate accounting hoax.” 

But
unless Enron employees can prove breach of fiduciary duty in court,
the company will have no obligation to compensate them for the losses
on their 401(k)s. Even if successful, they may never get more than
a few cents on the dollar—as was the case when former employees
of bankrupt Color Tile, which invested more than 80 percent of its
401(k) in company stock, sued two banks that were plan trustees
in 1996. 


Standard Operating Procedure 

Loading
up 401(k)s with company stock is common and Enron wasn’t even
the most outrageous example. Restrictions on sale of company stock
in a plan are routine as well. Creating linkages between pension
plans and ESOPs is not uncommon either, because they extend employers’
tax break on the company stock they contribute to the ESOP as well.
Cash balance plans are also common, although controversial, and
401(k)s have always undergone lockdowns when they change investment
managers or administrators. 

At
a time when Enron’s possible shady dealings are in the news
it is easy to forget that until a few short months ago, few seasoned
Wall Street observers questioned the company’s accounting.
The business press was even less help, lapping up Enron’s self-image
as a trend-setting energy-industry dynamo. Fortune, for example,
lauded Enron as one of the 100 Best Companies to Work for in America
in 1999 and Most Admired for Innovativeness four years straight. 

Yet
most of the practices that lawmakers and regulators are examining
today, especially Enron’s off-balance-sheet partnerships, were
well known to those who make their living by understanding such
things. While many of the details were hidden from view, plenty
of clues were lying around to suggest a few inquiries might have
been in order. 

Some
critics charge that when a company reaches the size of pre-fall
Enron, those outside experts—auditors, accountants, Wall Street
analysts, and investment bankers—have too much business with
the company to look critically at its books. Even if the Securities
and Exchange Commission—now headed by a lawyer connected with
Arthur Andersen, Enron’s auditor—can devise better oversight
standards, the first line of defense for employees ought to be the
rules governing the 401(k). 

Unfortunately,
these rules are outmoded. When 401(k) plans were created as part
of a 1978 tax law, they were not meant to be anyone’s primary
retirement asset. They were designed to be supplemental, tax-advantaged
savings accounts that employees of large companies could use alongside
their traditional pension plans, or else that employees of small
companies could contribute to if their bosses couldn’t afford
to offer a “real” pension. 

Part
of the attraction for employers was the ability to contribute company
stock, which brought not only a tax break but a new class of investors
who could be kept from reacting to bad news by selling their shares.
To cement that advantage, many companies made rules that literally
restricted when employees could sell. “We don’t think
of the 401(k) plan as a retirement plan,” the Wall Street
Journal
recently quoted a spokesperson for insurer Marsh &
Mc- Lennan as saying. Over 60 percent of Marsh & McLennan’s
401(k) is in company stock. 

Over
the past decade, however, more and more employers have converted
their pension plans into 401(k)s to cut costs and eliminate long-term
pension obligations. That meant that 401(k)s were becoming many
workers’ principal retirement nest egg, yet with few of the
rules and safeguards under which traditional pension plans operate,
such as restrictions on the percentage of company stock. 

Congress
never changed the rules governing 401(k)s to reflect this new role,
bowing to employers’ and money managers’ opposition. In
some ways  Washington has distorted the role of 401(k)s even
further. The Bush tax-cut bill that Congress passed last year allows
companies to set up ESOPs within their 401(k)s so that companies
can claim further tax breaks on dividends paid on the stock in the
ESOP. 

The
result is that the most common pension benefit in working America
isn’t a pension, it’s just a tax-deferred investment account
with no guarantee where it will be when you retire—in the tank,
in the millions, or somewhere in between. 

The
Enron debacle quickly elicited a number of proposals from lawmakers
to correct some of the flaws in 401(k)s. By March, Congress had
whittled them down to two. The Bush proposal, approved by the House
Ways and Means Committee, would require employers to give 30-day
notice of any 401(k) lockdown; allow employers to restrict sale
of company stock in the plan for no more than three years after
it enters the employee’s account; and prevent company executives
from selling their company stock while a lockdown is in effect.
The bill would also allow employees to hire financial firms to advise
workers on how to allocate their 401(k) assets. 

What
the Bush bill does not do is more revealing. Employers would be
protected from lawsuits when the firms they hire give bad advice
or when lockdowns result in losses for employees. An earlier version
of the bill would have allowed employees to sell their company stock
three years after joining the plan, not three years after they acquire
the stock. The change lengthens the time they must hold it. ESOPs
would be exempt from these limits altogether. Last minute lobbying
by employers added a provision restoring a tax break for stock options
that the Clinton administration had canceled. 

All
in all, the Bush bill “seeks to change as little as possible
to maintain the claim that this represents reform,” said Rep.
Lloyd Doggett (D-TX) after the bill passed Ways and Means. 

Kennedy’s
rival bill, which the Senate Education and Labor Committee has approved,
offers more substance. Employers could extend company stock either
as an employer contribution or as an optional investment by employees,
but not both—unless the company also offered an additional
pension with a guaranteed income. Company executives and outside
groups such as accounting firms would be open to lawsuits if they
violated pension law—currently, only money managers are vulnerable.
Companies would have to give employees a seat on the plan’s
board of trustees. 

Like
Bush’s bill, Kennedy’s would not actually limit the amount
of company stock in a 401(k), as would some earlier proposals that
did not make it to committee. But the corporate management class
has reaped so many benefits from 401(k)s that few are prepared to
accept even a few modest steps. And so they have come out solidly
against any serious reform. 

Even
Bush’s mild proposals initially got a cold reception from the
Wall Street Journal. The U.S. Chamber of Commerce and National
Association of Manufacturers have weighed in against any pension
changes. “We think that in many senses the pension issues are
secondary,” sniffed Mark Ugoretz, president of the ERISA Industry
Committee, which represents corporate pension sponsors. 

Employers
have had a hard time arguing their case, however, since keeping
company stock under control in a 401(k) has plenty of justification
on investment grounds. 

Nearly
every reputable investment advisor will say that diversifying your
investment portfolio—not keeping all your eggs in company stock
or any other single basket—is just common sense. But the Wall
Street Journal
recently denounced restrictions on company stock
as “paternalism masquerading as investor protection.”
Limiting the amount of company stock in a 401(k) portfolio, the
paper said in an editorial, would “deprive workers of a chance
to profit when times were good and substitute political judgment
for employee choice.” 

Steering
clear of too much company stock is not a “political judgment.”
It’s what any well-informed investor would do. That includes
Enron’s executives, who sold their shares when the stock became
overvalued, according to company filings. But if Enron employees
failed to diversify, it was clearly their own fault, American Enterprise
Institute fellow James Glassman wrote in a Journal op-ed. 

In
the wake of Enron’s collapse, big companies with 401(k)s that
are top-heavy with company stock have been defiant about any attempt
to force them to reduce those amounts. At General Electric, where
75 percent of the 401(k) is in GE stock, chair Jeffrey Immelt told
the Wall Street Journal, “What happened in Enron has
nothing to do with GE. The fact is that having GE stock has done
damn well for our employees for the last 10 or 15 years.” 


Diversification Be Damned 

The
cult status that 401(k)s have achieved over the last decade as the
spawning ground of a new “nation of investors” has also
helped blind companies to the basic contradictions of a retirement
system built around them. Plansponsor.com, a Web site for pension
executives, polled its readers recently and found that 56 percent
considered Enron an “aberration.” This despite the fact
that many companies that loaded their 401(k)s up with their own
stock have gone under in recent years, including Color Tile, Morrison
Knudsen, and Polaroid. 

One
Plansponsor.com respondent groused, “The popular press never
tells stories of how many people gained hundreds of thousands of
dollars in the Walmart profit sharing plan or how low level clerks
held company stock in a bank’s plan that was acquired by a
larger bank then another and then another and suddenly had worth
in the high six figures.” 

Actually,
the “popular press” until about a year and half ago was
full of such stories—the 401(k) millionaire was a figure of
popular lore akin to the dot.com millionaire. This was certainly
one reason why Lay’s exhortations to his employees that they
hold onto their Enron stock and even buy more got such a positive
response. 

Perhaps
the deepest fears were voiced by the AEI’s Glassman, who said
in his Journal op-ed that proposals for a cap on company
stock were “stepping ever closer toward some kind of federally
mandated retirement system.” Indeed, in the months since Enron’s
collapse, some critics on the Democratic side have raised issues
that go further than they may intend in critiquing the way America’s
private retirement system works. 

What
they are saying—as if they had suddenly discovered the fact
after all these years—is that 401(k)s are tax-favored entities.
Much of their value derives from the generous tax breaks, totaling
in the hundreds of billions of dollars per year, that both employers
and employees receive for contributing to them. 

“Despite
the insistence of some that this money in 401(k)s is corporate money
and that government should keep its hands off,” Rep. Major
Owens (D-NY) said recently, “The tax subsidy means that we
are all paying for it.” The public grants that tax subsidy
on the expectation that it will produce a public good: greater retirement
security for working people. Ultimately, the public must decide
if the tax break is achieving that goal, and if not, what to do
about it. 

When
asked what they would do if some of the proposed 401(k) reforms
were enacted, many corporate officials have responded with threats.
“I’d rather not have the employer match in company stock,
but it’s better than not getting a match at all,” said
one Plansponsor.com respondent. As for holding employers liable
for losses during a 401(k) lockdown, “You’re going to
have employers saying, ‘Forget about it, I can’t afford
the risk,’” another predicted. 

Employers
mean such statements to suggest that if Congress does anything to
fine-tune 401(k) plans, employers will have no incentive to offer
them. But perhaps this argument works the other way as well: If
the response to any effort at reforming 401(k)s will be for employers
to discontinue them, then clearly they are not adequate to the task
of providing retirement security. In that case, perhaps they should
be scrapped and replaced by some other vehicle that doesn’t
depend on the scale of the tax break it provides to employers. 

In
the 2000 presidential campaign, Al Gore proposed a voluntary retirement
savings account that any household could set up. The federal government
would match individuals’ contributions with a tax deduction,
the largest subsidies going to the hardest-pressed families. Capped
at $400,000, these accounts would serve much the same purpose as
a 401(k) and by definition would not include any employer stock. 

House
Minority Leader Richard Gephardt (D-MO) proposed a bill in February
that would create a similar account but would also allow younger
workers to use the assets as “seed money” for education
or a first home. The idea is that it would be portable—workers
would not have to cash out of them or move the assets into another
account when they quit or change jobs. These accounts would be overseen
by the federal government, which has no marketing costs to pass
on. 

The
idea of detaching retirement savings from the private sector is
also catching on at the state level—often the place where new
ideas get a trial run in the U.S. A group of Washington state legislators
have introduced a bill allowing any worker to regularly deposit
pretax wages into an account managed by the state employees’
retirement system, which would offer a choice of pre-screened investment
portfolios for them to invest in. 

The
Economic Opportunity Institute, a local think-tank that developed
the idea, estimates the administrative costs would be .1 percent
of assets, versus 401(k)s, which can range from 1.5 percent to 3
percent of assets. Such differentials can have a huge effect on
the kind of retirement workers can afford when they reach 65. 

Financial
services providers, whose fee income has burgeoned over the past
decade as 401(k)s have exploded, would resist the creation of a
new type of retirement savings account that might supplant them.
Employers would balk, too, since they couldn’t score a tax
break on funds their workers placed in such an account. Employee
advocates may not want to expend much energy lobbying for the accounts,
since they provide no guaranteed minimum return and thus do nothing
to make up for most workers’ lack of a real pension. 

What’s
most significant about these post-Enron proposals, however, is that
for the first time they represent an acknowledgment by part of the
U.S. political establishment that the U.S.’s employer-based
retirement system may have failed. Despite decades of tax breaks
and incentives for companies, private sector pensions have never
helped much more than 50 percent of the workforce provide for its
retirement—and nowadays much less. 

Companies,
meanwhile, fiercely resist any attempt to build even minimal safeguards
into the 401(k) system. If employers can’t change their minds
about 401(k)s, then perhaps pension activists will have to change
their minds about employers.                 Z