Lessons learned from ERISA

The Employee Retirement Income Security Act — which marks the 40th anniversary of its signing into law Sept. 2 by President Gerald R. Ford — established a long overdue framework for operating pension plans and protecting their participants.

For plan sponsors, it set out minimum pension funding standards, seeking to ensure that companies that made pension promises would keep them. For participants, it shortened vesting periods, protected their rights to collect pension benefits they had earned, and created the Pension Benefit Guaranty Corp. as a safety net in case a pension plan sponsor failed.

ERISA was a farsighted law in many aspects, especially in defining and assigning fiduciary responsibility, including prohibition on conflicts of interests, to those overseeing pension funds. That provision contributed to safeguarding pension benefits by requiring fiduciaries act solely in the best interest of plan participants.

It also required those overseeing pension fund investments to use an enhanced prudent-man standard for investing. This added the words: “and familiar with such matters” to the traditional standard requiring a fiduciary to act as a prudent person would act in a like situation.

By specifying the prudent-man standard, rather than specifying or prohibiting investments, ERISA gave fiduciaries full latitude to invest in the global markets, which encouraged investment strategies that enhanced pension fund risk-adjusted returns, making benefits more affordable. It also stimulated expansion of the capital markets and the economy.

Private single-employer defined benefit plans had $163 billion in total assets as of the end of 1975, according to the earliest data of the Department of Labor's Employee Benefits Security Administration. The higher returns defined benefit plans earned by diversifying into higher-returning investments from bonds and insurance contracts common before ERISA was passed, combined with the greater contributions required to meet the law's funding standards, dramatically boosted the growth of pension assets.

ERISA also created a uniform set of rules for plan sponsors, replacing a wilderness of state and federal laws that were inadequate to provide guidance and protection and that led to uncertain outcomes. That set of uniform rules encouraged the growth in DB plans that occurred in the decade after ERISA's enactment.

But ERISA in the long term failed to expand defined benefit coverage. Total private DB plans peaked at 175,143 in 1983 and their active participants at 30.1 million in 1980, according to EBSA data. But ERISA's anti-discrimination provision ensured broad participation, not just highly compensated employees, at least at companies that offered plans.

ERISA didn't envision the transformation of retirement programs to defined contribution plans from defined benefit plans, encouraged in part by a section of law enabling 401(k) plans codified in 1978. It should have put more emphasis on the start of defined contribution plans than it did. In aggregate assets, annual contributions and annual disbursements, defined contributions plans were already about half those of defined benefit plans in 1974.

Legislative changes to ERISA in the 1980s complicated administration and added to employer operational risk and costs, and contributed to driving corporations away from sponsoring DB plans. The total number of private defined benefit plans was down to 45,256 with 16.5 million active participants as of 2011, according to the latest EBSA data.

Modifications to ERISA reduced incentives for maintaining defined benefit plans and played a part in weakening funding and triggering terminations. Even though corporations assumed all the investment risk in defined benefit plans, Congress imposed an excise tax to prevent sponsors from recapturing assets accumulated in excess of the full funding level.

This disincentive drove sponsors to minimize funding to avoid building pension assets beyond regulatory requirements, leaving funding levels weaker in the face of market downturns, such as the 2000 dot-com crash or the 2008 financial crisis, causing many companies to terminate or freeze their plans. The pressure increased with the passage of the Pension Protection Act of 2006, which tightened ERISA's funding requirement, and the low interest rates produced by the Federal Reserve's policies increased pension costs, leading to more plan terminations.

ERISA was designed to provide participants with pension security, but it wound up playing a significant part in triggering the shift to defined contribution plans and raising participant risk by placing all investment exposure and much of the funding risk on to them.

Plan sponsors, other asset owners and policymakers can draw lessons from the law and related laws that followed, including the results compared to expectations.

For asset owners lessons include:

Taking a realistic market-based approach to valuation would correct a shortcoming of ERISA. Using past investment returns for valuation made the costs of the promised benefits appear more affordable than they were and resulted in weaker funding levels, especially in unfavorable markets. Realistic valuations must be used.

Appreciating the relationship of the plan sponsor's business risks and the retirement plan's risks, both in assets and liabilities, and the need to balance and diversify them to avoid the enormous financial damage caused by business downturns or unfavorable markets.

For policymakers, the lesson is they must keep laws simple, flexible and stable. Frequent changes of rules will cause employers to drop out.

One of the most important parts of ERISA, but also one of the most flawed, was the establishment of the PBGC.

ERISA saddled the PBGC with a weak financial and governance structure. First, ERISA should have been given startup capital by the government. Second, the insurance premiums were set artificially low, and held low for the first two decades. Third, the PBGC should have been given the authority to set its own premiums based on the financial well-being of plan sponsors and their defined benefit plans.

In addition, the PBGC should have an expanded board to provide more accountability and transparency, instead of its makeup of three Cabinet secretaries — labor, treasury and commerce — cited by the Government Accountability Office for rarely meeting and forming no key committee such as on investing and auditing.

Increasingly ERISA-type legislation and regulation must focus on defined contribution plans. In 2011, DC assets totaled $3.8 trillion, 50% more than total DB assets, EBSA data show. But legislation has been slow to recognize that transformation, although the Pension Protection Act brought necessary improvements to ERISA rules for DC plans.

After 40 years, there is one lesson still not learned well enough by Congress, the Federal Reserve and regulators: A sustainable pension system needs a strong market and economy. Policymakers could do more to strengthen plans and stimulate plan formation by promoting economic and market environments that encourage growth.

This article originally appeared in the September 1, 2014 print issue as, "Lessons learned from ERISA".