Private Pensions: Key Issues to Consider Following the Enron
Collapse (27-FEB-02, GAO-02-480T).
The collapse of the Enron Corporation and the accompanying loss
of employees' retirement savings highlight vulnerabilities in the
private pension system and help focus attention on strengthening
several aspects of this system. Diversification of pension assets
is crucially important, particularly where the use of defined
contribution plans--those plans in which employees bear the
investment risk--is increasing. The Enron situation suggests the
importance of encouraging employees to diversify but any action
would have to be balanced against the desires of employers and
employees to maintain a portion of retirement savings in company
stock. Workers need clear and understandable information about
their pension plans to make wise retirement saving decisions.
While disclosure rules state that plan sponsors must provide plan
participants with a summary of benefits and rights under their
plan and notification when plan benefits are changed, such
information is not always clear, particularly in complex plans
like floor-offset arrangements. Also, employees, like other
investors, need reliable and understandable information about a
company's financial condition and prospects. Fiduciary standards
form the cornerstone of private pension protections. These
standards require plan sponsors to act in a manner that is solely
in the interest of plan participants and beneficiaries.
Investigations of Enron's actions will determine whether plan
fiduciaries acted in accordance with these responsibilities.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-02-480T
ACCNO: A02821
TITLE: Private Pensions: Key Issues to Consider Following the
Enron Collapse
DATE: 02/27/2002
SUBJECT: Employee benefit plans
Employee retirement plans
Financial instruments
Financial management
Retirement benefits
Retirement pensions
Investments
Information disclosure
Enron Corporation Stock Fund
Thrift Savings Plan
Employee Stock Ownership Program
******************************************************************
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GAO-02-480T
United States General Accounting Office
GAO Testimony
Before the Senate Finance Committee
For Release on Delivery Expected at 2:00 p.m.,
Wednesday, February 27, 2002 PRIVATE PENSIONS
Key Issues to Consider Following the Enron Collapse
Statement of David M. Walker Comptroller General of the United States
GAO-02-480T
Mr. Chairman and Members of the Committee:
I am pleased to be here today to provide you with preliminary observations
on some of the challenges facing our nation's private pension system.
Pension income is crucial to American retirees' standard of living. About
half of Americans over 65 receive payments from pensions and savings plans,
and such income represents about 18 percent of their total income. Over 70
million workers participate in pension and savings plans, and such plans in
1997 represented about $3.6 trillion in retirement savings.
The federal government encourages employers to sponsor and maintain pension
and savings plans for their employees. The private pension system is
voluntary and consists of defined benefit plans and defined contribution
plans. Defined benefit plans promise to provide a level of retirement income
that is generally based on salary and years of service. Defined contribution
plans are based on the contributions to and investment returns on the
individual accounts. Such plans include thrift savings plans, profit-sharing
plans, and employee stock ownership plans (ESOPs).
The financial collapse of the Enron Corporation and its effect on the
company's workers and retirees suggests certain vulnerabilities in these
selected savings mechanisms. Enron's retirement plans, which included a
defined benefit cash balance plan, a defined contribution 401(k) plan, and
an ESOP, caused Congress to question specifically the use of employer stock
as the company match, the continued existence of floor offsets, and the
practice of investment freezes or lockdowns during changes in plan
administrators. The financial losses suffered by participants in Enron's
retirement plans have raised questions about the benefits and limitations of
such private pension and savings plans and the challenges employees face in
saving for retirement through their employer-provided plans.
You asked me here today to help provide context for considering how to
address the vulnerabilities the Enron case may suggest. Accordingly, I will
discuss three areas that, because of the experience with Enron, appear
particularly salient to policymakers' decisions: (1) the importance of
investment diversification and related investor education issues; (2) the
crucial role of disclosure, and what information employees need and can
expect about their company and their pension plans; and (3) the importance
of fiduciary rules in safeguarding employee pension assets. In discussing
these three issues, I will also address certain plan design issues such as
floor-offsets, using company stock in pension plans, and plan operation
issues, such as investment freezes or lockdowns. My
observations are based on prior GAO work, a preliminary review of Enron's
and other public companies' plans, discussions with industry experts and
senior regulatory officials, and my personal experience, including my former
position as Assistant Secretary of Labor for Pension and Welfare Benefit
Programs.
In summary, the collapse of the Enron Corporation and the accompanying loss
of Enron employees' retirement savings appear to highlight vulnerabilities
in the private pension system and help focus attention on strengthening
several aspects of this system. Diversification of pension assets is
crucially important, particularly in a world where the use of defined
contribution plans-those plans in which employees bear the investment
risk-is increasing. If both the employees' 401(k) contributions and the
company match are largely in employer stock, as was the case at Enron,
employees risk losing not only their jobs should the company go out of
business, but also a significant portion of their retirement savings. The
Enron situation suggests the importance of encouraging employees to
diversify but any action would have to be balanced against the desires of
employers and employees to maintain a portion of retirement savings in
company stock. In addition, the Enron situation illustrates the need to
provide employees with investment education and advice that will enable them
to better manage their retirement savings.
Workers need clear and understandable information about their pension plans
to make wise retirement saving decisions. While disclosure rules state that
plan sponsors must provide plan participants with a summary of benefits and
rights under their pension plan and notification when plan benefits are
changed, such information is not always clear, particularly in describing
complex plans, like floor-offset arrangements. We have also observed in
earlier work that wide variation exists in the type and amounts of
information workers receive about plan changes that can potentially reduce
pension benefits, and enhanced disclosure requirements may be warranted.
Furthermore, employees, like other investors, need reliable and
understandable information about a company's financial condition and
prospects.
Finally, fiduciary standards form the cornerstone of private pension
protections. These standards require plan sponsors to act in a manner that
is solely in the interest of plan participants and beneficiaries. In the
end, investigations of Enron's actions related to its plans will determine
whether plan fiduciaries acted in accordance with these responsibilities. In
light of Enron, policymakers may wish to consider whether current fiduciary
standards are sufficient or whether they require strengthening,
Background
and act accordingly to address these fundamental principles of pension
management.
The Enron collapse provides the Congress with clear examples of issues it
may wish to consider when deciding whether and how to strengthen the
security of plan benefits. These issues include employees' need for enhanced
education and appropriate investment advice, plan designs such as
floor-offset arrangements and the use of employer stock in retirement
savings plans, and plan operations, such as plan investment freezes and
lockdowns. Addressing these issues will require balancing the need for
greater participant protections with the potential increase in employer
burden that could undermine their willingness to sponsor or contribute to
such plans.
The Internal Revenue Code (IRC) defines pension plans as either defined
benefit or defined contribution and includes separate requirements for each
type of plan. The employer, as plan sponsor, is responsible for funding the
promised benefit, investing and managing the plan assets, and bearing the
investment risk. If a defined benefit plan terminates with insufficient
assets to pay promised benefits, the Pension Benefit Guaranty Corporation
(PBGC) provides plan termination insurance to pay participants' pension
benefits up to certain limits.
Under defined contribution plans, employees have individual accounts to
which employers, employees, or both make periodic contributions. Plans that
allow employees to choose to contribute a portion of their pre-tax
compensation to the plan under section 401(k) of IRC are generally referred
to as 401(k) plans. In many 401(k) plans employees can control the
investments in their account while in other plans the employer controls the
investments. ESOPs may also be combined with other pension plans, such as a
profit-sharing plan or a 401(k) plan.1 Investment income earned on a 401(k)
plan accumulates tax-free until an individual withdraws the funds. In a
defined contribution plan, the employee bears the investment risk, and plan
participants have no termination insurance.
The Internal Revenue Service (IRS) and the Pension and Welfare Benefits
Administration (PWBA) of the Department of Labor (DOL) are primarily
responsible for enforcing laws related to private pension plans. Under the
1 When an ESOP is combined with a 401(k) plan, it is called a KSOP.
Employee Retirement Income Security Act of 1974 (ERISA), as amended, IRS
enforces coverage and participation, vesting , and funding standards that
concern how plan participants become eligible to participate in benefit
plans, earn rights to benefits, and reasonable assurance that plans have
sufficient assets to pay promised benefits. IRS also enforces provisions of
the IRC that apply to pension plans, including provisions under section
401(k) of the IRC. PWBA enforces ERISA's reporting and disclosure provisions
and fiduciary standards, which concern how plans should operate in the best
interest of participants.
Since the 1980's, there has been a significant shift from defined benefit
plans to defined contribution pension plans. Many employers sponsor both
types of plans, with the defined contribution plan supplementing the defined
benefit plan. However, most of the new pension plans adopted by employers
are defined contribution plans. According to the Department of Labor,
employers sponsored over 660,000 defined contribution plans as of 1997
compared with about 59,000 defined benefit plans. As shown in figure 1,
defined contribution plans covered about 55 million participants, while
defined benefit plans covered over 40 million participants in 1997.
Figure 1: Participants in Private Pension Plans, 1997
The number of employer-sponsored 401(k) plans has also increased
substantially in recent years, increasing from over 17,000 in 1984 to over
265,000 plans in 1997. In 1997, 401(k) plans accounted for 40 percent of all
employer-sponsored defined contribution plans and approximately 37 percent
of all private pension plans. Approximately 33.8 million employees actively
participated in a 401(k) plan, and these plans held about $1.3 trillion in
assets as of 1997.2
The continued growth in the number of defined contribution plans and plan
assets is encouraging, but concerns remain that many workers who
traditionally lack pensions may not be benefiting from these plans, and the
overall percentage of workers covered by pensions has remained relatively
stable for many years. Furthermore, the trend toward defined contribution
plans and the increased availability of lump-sum payments from pension plans
when workers change jobs raises issues of whether workers will
2 "Private Pension Plan Bulletin: Abstract of 1997, Form 5500 Annual
Reports." US Department of Labor, Pension and Welfare Benefits
Administration. Winter 2001.
preserve their pension benefits until retirement or outlive their retirement
assets.
Similar to other large companies, Enron sponsored both a defined benefit
plan and a defined contribution plan, covering over 20,000 employees.
Enron's tax-qualified pension plans consisted of a 401(k)-defined
contribution plan, an employee stock ownership plan, and a defined benefit
cash balance plan. Under Enron's 401(k) plan, participants were allowed to
contribute from 1 to 15 percent of their eligible base pay in any
combination of pre-tax salary deferrals or after-tax contributions subject
to certain limitations.3 Enron generally matched 50 percent of all
participants' pre-tax contributions up to a maximum of 6 percent of an
employee's base pay, with the matching contributions invested solely in the
Enron Corporation Stock Fund. Participants were allowed to reallocate their
company matching contributions among other investment options when they
reached the age of 50. 4
Enron's employee stock ownership plan,5 like other ESOPs, was designed to
encourage employee ownership in their company. The plan provided employee
retirement benefits for workers' service with the company
3 Participants were immediately fully vested in their voluntary
contributions and employees hired after July 1999 are fully vested in their
company contributions after 1 year of service.
4 For defined benefit plans, ERISA limits the amount of employer stock and
real property that can be held to 10 percent of plan assets. However,
defined contribution plans, including 401(k) plans, ESOPs, and other defined
contribution plans with individual accounts, are generally exempt from this
requirement. While the vast majority of 401(k) plans are thus not subject to
any restriction on the amount of employer stock that it may hold, there are
limited circumstances under which the 10 percent limitation could apply to a
401(k) plan.
5 The ESOP provided for three subaccounts, (1) a savings subaccount where
the plan allocated shares of Enron stock equal to 10 percent of each
participant's base pay; (2) a retirement subaccount where the plan allocated
shares of Enron stock based on each participant's age, years of service, and
base pay; and (3) a special subaccount for participants active on December
31, 1994, where the participants received an allocation to this account and
the defined benefit portion of their retirement plan. This allocation in
total equaled 5 percent of their base pay and was in lieu of an accrual to
their 1995 defined benefit plan. According to Enron plan documents, the
vested portion of a participant's retirement subaccount was used to offset
the benefit they earned from Enron's cash balance plan from January 1, 1987
through December 31, 1994. The offset was calculated using the value of the
shares of Enron stock based on the earlier of when the shares were
distributed or when the shares were available to be withdrawn from the ESOP.
Once a plan participant has access to the shares of his or her retirement
subaccount, the shares' value is used to offset the benefit they have earned
from the Enron defined benefit plan for their service between January 1,
1987, and December 31, 1994.
Greater Diversification and Investment Sophistication May Be Needed
between January 1, 1987, and December 31, 1994. No new participants were
allowed into the ESOP after January 1, 1995.
Finally, Enron sponsored a cash balance plan, which accrued retirement
benefits to employees during their employment at Enron. An employee was
eligible to be a member of the cash balance plan immediately upon being
employed. According to DOL officials, the cash balance plan did not have any
investments in Enron stock as of the end of 2000. If the plan is unable to
pay promised benefits and is taken over by PBGC, vested participants and
retirees will receive their promised benefits up to the limit guaranteed
under ERISA.
The Enron collapse points to the importance of prudent investment principles
such as diversification, including diversification of employer matching
contributions. Diversification helps individuals to mitigate the risk of
holding stocks by spreading their holdings over many investments and
reducing excessive exposure to any one source of risk. Many workers are
covered by participant-directed 401(k) plans that allow participants to
allocate the investment of their account balances among a menu of investment
options, including employer stock. Additionally, many plan sponsors match
participants' elective contributions with shares of employer stock.
When the employer's stock constitutes the majority of employees' account
balances and is the only type of matching contribution the employer
provides, employees are exposed to the possibility of losing more than their
job if the company goes out of business or into serious financial decline.
They are also exposed to the possibility of losing a major portion of their
retirement savings. For example, DOL reports that 63 percent of Enron's
401(k) assets were invested in company stock as of the end of 2000. These
concentrations are the result both of employee investment choice and
employer matching with company stock. The types of losses experienced by
Enron employees could have been limited if employees had diversified their
account balances and if they had been able to diversify their company
matching contributions more quickly.
Companies prefer to match employees' contributions with company stock for a
number of reasons. First, when a company makes its matching contribution in
the form of company stock, issuing the stock has little impact on the
company's financial statement in the short term. Second, stock contributions
are fully deductible as a business expense for tax purposes at the share
price in effect when the company contributes them. Third, matching
contributions in company stock puts more company
shares in the hands of employees who some officials feel are less likely to
sell their shares if the company's profits are less than expected or in the
event of a takeover. Finally, companies point out that matching with company
stock promotes a sense of employee ownership, linking the interests of
employees with the company and other shareholders.
Some pension experts have said that easing employer restrictions on when
employees are allowed to sell their company matching contributions would
increase their ability to diversify. In 1997, a majority of the Pension and
Welfare Benefits Administration Advisory Council working group on employer
assets in ERISA plans recommended that participants in 401(k) plans be able
to sell employer stock when they become vested in the plan.6 Additionally,
legislation has recently been introduced that would limit the amount of
employer stock that can be held in participants' 401(k) accounts and provide
participants greater freedom to diversify their employer matching
contributions. Proponents of allowing employees to diversify employer stock
matching contributions more quickly say that this would benefit both
employers and employees by maintaining the tax and financial benefits for
the company while providing employees with more investment freedom and
increased retirement benefit security. However, others have expressed
concern that further restrictions on employer plan designs may reduce
incentives for employers to sponsor plans or provide matching contributions.
Even with opportunities to diversify, studies indicate that employees will
need education to improve their ability to manage their retirement savings.
Numerous studies have looked at how well individuals who are currently
investing understand investments and the markets. 7 On the basis of those
studies, it is clear that among those who save through their company's
retirement programs or on their own, large percentages of the investing
population are unsophisticated and do not fully understand the risks
associated with their investment choices. For example, one study found that
47 percent of 401(k) plan participants believe that stocks are components of
a money market fund, and 55 percent of those surveyed
6 Pension and Welfare Benefits Administration Advisory Council on Employee
Welfare and Pension Benefits Plans, Report of the Working Group on Employer
Assets in ERISA Employer-Sponsored Plans, November 13, 1997.
7 U.S. General Accounting Office, Social Security: Capital Markets and
Educational Issues Associated With Individual Accounts, GAO/GGD-99-115
(Washington, D.C., June 1999).
thought that they could not lose money in government bond funds. Another
study on the financial literacy of mutual fund investors found that less
than half of all investors correctly understood the purpose of
diversification. These studies and others indicate the need for enhanced
investment education about such topics as investing, the relationship
between risk and return, and the potential benefits of diversification.
In addition to investor education, employees may need more individualized
investment advice. Such investment advice becomes even more important as
participation in 401(k) plans continues to increase. ERISA does not require
plan sponsors to make investment advice available to plan participants.
Under ERISA, providing investment advice results in fiduciary responsibility
for those providing the advice, while providing investment education does
not. ERISA does, however, establish conditions employers must meet8 in order
to be shielded from fiduciary liability related to investment choices made
by employees in their participant-directed accounts. In 1996, DOL issued
guidance to employers and investment advisers on how to provide educational
investment information and analysis to participants without triggering
fiduciary liability. DOL recently issued guidance about investment advice
making it easier for plans to use independent investment advisors to provide
advice to employees in retirement plans.
Industry representatives that we spoke with said more companies are
providing informational sessions with investment advisors to help employees
better understand their investments and the risk of not diversifying. They
also said that changes are needed under ERISA to better shield employers
from fiduciary liability for investment advisors' recommendations to
individual participants. ERISA currently prohibits fiduciary investment
advisors from engaging in transactions with clients' plans where they have a
conflict of interest, for example, when the advisors are providing other
services such as plan administration. As a result, investment advisors
cannot provide specific investment advice to 401(k) plan participants about
their firm's investment products without approval from DOL. Various
legislative proposals have been introduced that would address employers'
concern about fiduciary liability when they make investment advice available
to plan participants and make it easier for fiduciary investment advisors to
provide investment advice to
8 These include a minimum number of investment options and related material
that must be provided to participants.
Enhanced Disclosure Could Help Employees Understand Investment Risks They
Face
participants when they also provide other services to the participants'
plan. However, concerns remain that such proposals may not adequately
protect plan participants from conflicted advice.
Enron's failure highlights the importance of plan participants receiving
clear information about their pension plan and any changes to it that could
affect plan benefits. Current ERISA disclosure requirements provide only
minimum guidelines that firms must follow on the type of information they
provide plan participants. Improving the amount of disclosure provided to
plan participants and also ensuring that such disclosure is in plain English
could help participants better manage the risks they face.
Enron's pension plans illustrate the complex nature of some plan designs
that may be difficult for participants to understand. For example, Enron's
pension plans included a floor-offset arrangement. Such arrangements consist
of separate, but associated defined benefit and defined contribution plans.
The benefits accrued under one plan offset the benefit payable from the
other. In 1987, Congress limited the use of such plans. However, plans in
existence when the provision was enacted, including Enron's plan, were
grandfathered. In addition, Enron's conversion of its defined benefit plan
from one type of benefit formula to another illustrates the types of changes
and their consequent affect on benefits that plan participants need to
understand. Enron's defined benefit plan was converted from a final average
pay formula-where the pension benefit is a percentage of the participant's
final years of pay multiplied by his or her length of service-to a cash
balance formula, which expresses the defined benefit as a hypothetical
account balance. As we have previously reported, conversions to cash balance
plans can be advantageous to certain groups of workers-for example, those
who switch jobs frequently-but can lower the pension benefits of others. 9
The extent to which Enron employees were informed or understood the effect
of the floor-offset or the conversion of their defined benefit plan to a
cash balance formula is unclear. As stated in a prior GAO report on cash
balance plans10, we found wide variation in the type and amounts of
information workers receive about plan changes and that can potentially
9 U.S. General Accounting Office, Private Pension Plans: Implications of
Conversions to Cash Balance Plans, GAO/HEHS-00-185, (Washington, D.C.,
September 2000).
10 See footnote 9.
ERISA Requires Fiduciaries to be Prudent and Reasonable
reduce pensions benefits. Based in part on our recommendations, the
Congress, under the Economics Growth and Tax Relief Reconciliation Act of
2001, required that employers provide participants more timely and clear
information concerning changes to plans that could reduce their future
benefits. The Treasury Department is responsible for issuing the applicable
regulations implementing this requirement. 11
Other types of information may also be beneficial to plan participants.
Currently, ERISA requires that plan administrators provide each plan
participant with a summary of certain financial data reported to DOL. As we
previously reported,12 the Secretary of Labor could require that plan
administrators provide plan participants with information about the
employers' financial condition and other information. Such information could
enable employees to be more fully informed about their holdings and any
potential risks associated with them.
Under ERISA, fiduciaries are held to high but broad standards. Persons who
perform certain tasks, generally involving the use of a plan's assets,
become fiduciaries because of those duties. Others, such as the plan
sponsor, the plan administrator, or a trustee are fiduciaries because of
their position. Fiduciaries are required to act solely in the interest of
plan participants and beneficiaries. They are to adhere to a standard
referred to as the prudent expert rule, which requires them to act as a
prudent person experienced in such matters would in similar circumstances.
Fiduciaries are required to follow their plan's documents and act in
accordance with the terms of the plan as it is set out. If fiduciaries do
not perform their duties in accordance with ERISA standards, they may be
held personally liable for any breach of their duty.
Yet, even with the high standards and broad guidance provided by ERISA, in
some cases the actions of fiduciaries can seem to conflict with the best
interests of plan participants. During the period when revelations about
Enron's finances were contributing to the steady devaluation of Enron's
stock price, Enron's plan fiduciaries imposed a lockdown on the 401(k) plan,
preventing employees from making withdrawals or investment
11 Public Law 107-16.
12 U.S. General Accounting Office, 401(k) Pension Plans: Extent of Plans'
Investments in Employer Securities and Real Property, GAO/HEHS-98-28
(Washington, D.C., November 1997).
Conclusions
transfers.13 Enron imposed the lockdown to change recordkeepers, an
acceptable practice. Some observers, however, have questioned whether Enron
employees were sufficiently notified about the lockdown. Observers have also
questioned the equity of treatment between Enron senior executives and Enron
workers during the lockdown. Enron's employees were unable to make changes
to their 401(k) accounts during the plan's lockdown period. However, Enron
executives did not face similar restrictions on company stock not held in
the plan. Fairness would suggest that company executives should face similar
restrictions in their ability to sell company stock during lockdown periods
when workers are unable to make 401(k) investment changes. This is
especially true for those executives who serve as pension plan fiduciaries,
including plan trustees.
The Enron collapse, although not by itself evidence that private pension law
should be changed, serves to illustrate what can happen to employees'
retirement savings under certain conditions. Specifically, it illustrates
the importance of diversification for retirement savings as well as
employees' need for enhanced education, appropriate investment advice, and
greater disclosure. All of these may help them better navigate the risks
they face in saving for retirement.
In addition to the broad issues of diversification and education, Enron's
collapse raises questions about the relationship between various plan
designs and participant benefit security. In particular, Congress may wish
to consider whether further restrictions on floor-offset arrangements are
warranted, whether to provide additional employee flexibility in connection
with matches in the form of employer stocks, and whether to limit the amount
of employer stock that can be held in certain retirement saving plans.
Resolving these issues will require considering the tradeoffs between
providing greater participant protections and employers' need for
flexibility in plan design. Finally, Congress will have to weigh whether to
rely on the broad fiduciary standards established in ERISA that currently
govern fiduciary actions or to impose specific requirements that would
govern certain plan administrative operations such as plan investment
freezes or lockdowns.
13 The Department of Labor is investigating Enron to determine whether there
were any ERISA violations in the operation of the company's employee benefit
plans. DOL also recently reached an agreement with Enron to appoint an
independent fiduciary to assume control of the company's retirement plans.
Contacts and Acknowledgments
(130128)
Mr. Chairman this concludes my statement. I would be happy to answer any
questions you or other members of the Committees may have.
For further information regarding this testimony, please contact Barbara D.
Bovbjerg, Director, or George A. Scott, Assistant Director, Education,
Workforce, and Income Security (202) 512-7215. Individuals making key
contributions to this testimony include Joseph Applebaum, Jeremy Citro,
Tamara Cross, Patrick DiBattista, Raun Lazier, and Roger Thomas.
*** End of document. ***