The law of unintended consequences is once again in evidence 10 years after the passage of the Pension Protection Act of 2006.
The PPA was passed to bolster the stability of defined benefit plans and the Pension Benefit Guaranty Corp. Instead, its greatest impact was on defined contribution plans, and it might have hastened the demise of the defined benefit plans it was designed to strengthen.
The outcome is a reminder that legislators must not consider just the results they hope legislation will produce, but also should think long and hard about the possible negative effects using the insights of behavioral finance research to determine what those might be.
As Earl Pomeroy, former Democratic representative from North Dakota, told Pensions & Investments: “It (PPA) was sold on the basis we were going to shore up funding (of defined benefit plans) to protect workers.” But he added that most people developing the law didn't understand how the new funding rules would affect the cost and volatility of such plans.
This is unforgivable. Academics could have modeled the impact of the proposed changes, and corporate fund executives could have provided advice based on real-world experience. Clearly, whatever advice the legislators received was inadequate. As a result, as Mr. Pomeroy noted, the law's changes scared away “thousands” of pension plan sponsors.
The costs, and especially the volatility of those costs, of defined benefit plans in a highly competitive global economy probably have doomed defined benefit plans in the private sector, but the demise might have been slowed with better-designed reform.
Companies can't offset higher pension costs with higher prices for their products or services in a highly competitive world. Further, while it might be possible to offset the higher costs with productivity through investment in better equipment, such investment is inhibited by the volatility of the required annual contributions and PBGC premiums.
The PPA failed to achieve a primary objective of improving pension plan funded levels. In aggregate, the pension plan funded level has fallen to 75.7% at the end of July down from nearly fully funded at the end of 2006 when it was 99.7%, according to Milliman Inc.'s analysis of the 100 largest U.S. corporate defined benefit plans. A Willis Towers Watson study of the 413 companies with U.S. defined benefit plans in the Fortune 500 list of the largest companies found they were in aggregate 82% funded at year-end 2015, down from 99% funded at year-end 2006.
On the plus side, the PPA gave defined contribution plans a boost by providing a legal basis for automatic enrollment of employees and automatic escalation of contributions. It also created default options allowing plan sponsors to direct employee contributions toward age-appropriate and risk-appropriate funds when the employees do not make a choice.
However, PPA did not help fix the greatest weakness of the defined contribution plan system — the low rate of employee contribution.
Employers must also increase their contributions, matching any increase in the employees' deferral rates up to a more generous level, especially in the absence of any defined benefit plan. The employees can't be expected to carry all the burden.
Employers must take the initiative or Congress eventually will step in to either require increased initial deferrals, or through national savings plans designed to supplement, or even replace, employer-sponsored defined contribution plans.
The U.S. retirement income system has evolved to meet the needs of employers and employees in an age of rapid technological change. The defined contribution system that provides more flexibility and cost certainty for employers and portability of accumulated balances for employees has replaced the defined benefit system that was too volatile and burdensome for employers and rigid for employees.
It will likely to continue to evolve. Smart legislation and/or regulation can direct that evolution to improve the system for employees without harming the economic prospects of employers. But legislators and regulators must take note of expert advice in academia and industry as they develop any such legislation or regulation.
From the evidence of the unintended consequences of the PPA, it's clear Congress did not seek, or did not heed, the available advice.