Starting in 2010, millions of American workers could get the chance to have their retirement savings cake and eat it, too.
The 2006 Pension Protection Act allows for businesses with 500 employees or fewer to offer hybrid defined benefit/defined contribution plans. These so-called DB(k)s provide a low employer-paid guaranteed lifetime monthly retirement benefit that can be supplemented by voluntary tax deferred contributions from employees.
In an era when government and businesses have shifted the burden of preparing for retirement from employers to employees, these DB(k)s combine the security workers enjoy through traditional pensions, with the individual control over investments, straightforward approach and tax advantages that first made defined contribution plans so popular.
It takes [out] some of the guesswork, said Tom Foster, national retirement plans spokesman for The Hartford in Hartford, Conn. The income stream in a 401(k) defined contribution plan is predicated on how youve invested your funds, he said.
Although many people, at first, like the idea of picking their own investments, too often, they fail to participate because they are intimidated, or simply dont save enough. Defined benefit plans, on the other hand, offer greater security with guaranteed payouts starting at retirement. Employees can look at it and say, At least I know I have something, and there will be something on autopilot when I begin taking distributions.
The laws provision also offers promise for the annuities industry, where sales have suffered as 401(k) plans favor the $10 trillion mutual fund industry, and for defined benefit plans, which often rely heavily on annuity products and have seemed to be headed the way of the dodo.
Better Cost Controls
Just as the plans will offer employees security through a predictable retirement income stream, the law offers sponsors more control over costs. Thats because it legalizes cash-balance defined benefit plans that allow employers to make annual commitments based on an employees age, rather than to base contributions on the projected lifetime earning potential of workers, which can fluctuate wildly due to inflation and other external forces, said Brian H. Graff, executive director and chief executive of the American Society of Pension Professionals & Actuaries. The Fairfax, Va.-based organization lobbied hard for the inclusion of combined defined benefit/defined contribution plans in the 907-page law.
Particularly with the cash-balance, annuities are well suited for that kind of [DB(k)] plan, Graff said.
While the law says that only small businesses can adopt DB(k)s, the potential market is pretty big. In fact, about 86% of the 5.77 million companies in the United States employ fewer than 500 employees, according to the 2002 Economic Census published by the U.S. Census Bureau in Washington. While mom-and-pop corner shops may be unlikely to offer retirement plans, those companies with between 10 and 499 paid employees still account for 21% of all businesses, and 40% of all employees, according to census data.
For employers, the new retirement hybrids will function as a single trust, offering efficiencies never before available. Sponsors will be required to file a single Form 5500 with the federal government, for example. For those companies that already offer the typically costly-to-fund defined benefit plans, the new model offers a way to reduce their responsibility, while not eliminating the benefit to employees completely, said Dallas L. Salisbury, president and chief executive of the Employee Benefits Research Institute in Washington.
That doesnt mean they come cheap. Like traditional pensions, DB(k)s require a significant funding commitment on the part of the employer, and are best suited to companies with high profit margins or those flush with cash. But sometimes, its worth the investment in recruitment and retention, especially in hard-to-staff fields, or those subject to widespread worker poaching.
For small companies especially, if you have a different retirement package than your competitors, you can have a better opportunity to hire high-quality workers, said David L. Wray, president of the 401(k)/Profit Sharing Council in Washington.
Adoption of the plans will be slow, experts agreed. Wray noted that professional firms, such as doctors and lawyers offices, most often are the types of small businesses to offer pension plans, making them a potential target for the new hybrids.
Graff expects small manufacturing and engineering firms, competing for employees at their larger counterparts, to be those most likely to adopt such models.
What these plans will look like in their final form remains unclear. Financial companies working to design these products and employers alike await rules about converting existing plans, or whether there will be restrictions on certain products from the Department of Labor and the Internal Revenue Service.
However, the law does prescribe a structure that will allow companies to begin developing products, and more importantly, alert plan sponsors about the upcoming opportunities.
As passed, the law calls for the defined benefit portion of the plan to be funded at either 1% of the employees final average pay for up to 20 years service, or using the age-dictated cash balance method.
When it comes to the defined contribution part, sponsors will be required to automatically enroll employees at 4% of their salary and offer a 50%, fully vested match on that amount. Employees must be 100% vested in both the defined benefit and defined contribution portions after three years tenure.
All pans would be subject to anti-discrimination tests and other provisions that already govern both defined benefit and defined contribution plans.
There will be more tweaks to the legislation before it becomes effective, Graff said. Well have some time to play around with it.
While it may be a bit early for financial companies to start selling DB(k) plans or for employers to scrap existing programs, its never too soon for education, experts said.
Education is tantamount, Foster said. So when it comes to laying down the groundwork with employers, third-party administrators, distribution channels and the public, time is on the side of financial firms.
This is not until 2010, Wray noted. Plan sponsors will not start looking at this until 2009, so well have to wait and see what happens.
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