THE NEW PENSION LAW AND YOU

A sweeping overhaul of the nation's pension laws will have a big effect on how you prepare for retirement. The Pension Protection Act of 2006 was intended to bolster traditional pensions, but it also has major implications for defined contribution plans such as 401(k)s and 403(b)s.

Most observers agree the 907-page act brings the most significant change to the pension system since Congress created rules governing employee retirement plans more than 30 years ago. The pension act is intended to strengthen the system for more than 44 million workers and retirees served by public and private defined benefit plans, and at the same time accelerate the trend to defined contribution plans, which now include 43 million workers in the public and private sectors.

Changes in U.S. private-sector pensions

The number of traditional defined-benefit pension plans has been declining over the years, as has the number of active participants. They are being replaced by defined-contribution plans, especially 401(k)s.

Sources: Investment Company Institute, U.S. Department of Labor, and Cerulli Associates

This trend is reflected in plan asset levels. Private-sector defined benefit pension plans reported more than $1.9 trillion in assets at the end on 2005, while employer-sponsored defined contribution plans had assets of $2.9 trillion and IRAs had $3.7 trillion. In this respect, the most important provisions concern defined contribution plans. Specifically, the Pension Protection Act:

• Encourages employers to automatically enroll workers in defined contribution plans
• Expands the availability of annuities in defined contribution plans and allows the combination of annuities with long-term-care insurance policies
• Permits plan providers to offer investment advice to participants under certain constraints
• Makes permanent the increased contribution limits that were enacted in 2001 and scheduled to expire in 2010

Plans needed improvements

Suffering from stagnant participation, flagging contribution rates, and unwise investment decisions by a large percentage of participants, defined contribution plans needed a boost. New research shows that:

• Median account balances at retirement are only $44,000.
• Average balances, which give a large weight to higher income earners, are only $112,000.
• One-third of eligible workers don't take part in their defined contribution plans.
• One-half of participants contribute too little to receive their employer's full match.
• Most participants either have no equities or almost all (80% or more) equities in their portfolios.
• The Pension Protection Act has the potential to improve these statistics. "With these changes, tens of millions of additional American workers will join those currently participating in defined contribution plans," predicted David Wray, president of the Profit Sharing/401(k) Council of America. "These new participants will accumulate trillions of dollars, which will help them enjoy the best retirement experience of any generation in history." A close look at four major defined contribution provisions in the Act indicates why.

1. Automatic Enrollment

Effective January 1, 2008, plan sponsors may automatically enroll employees in defined contribution plans, unless they opt out, without fear of violating state laws that prohibit withholding wages without permission. An employee may take money out of the plan without penalty within 90 days of the first election. Plan sponsors may automatically increase participants' contributions each year, starting with deferrals of 3% in the first year and increasing one percentage point annually to 6%.

Automatic enrollment is the result of research that showed that people have a bias in favor of the status quo that keeps them from signing up for a 401(k) or other saving plan. Once they are automatically enrolled, however, that same status quo bias keeps them from dropping out. So the tendency that once kept non-savers from participating will now help them to build a bigger retirement fund.

Meanwhile, there's stirring in the Department of Labor (DOL). Congress instructed the DOL to issue guidelines designed to allow default investments that are more suitable for long-term investing than money market funds. The intention is to protect plan sponsors from fiduciary claims on how automatically withheld assets are invested. This should open the door to managed accounts, balanced funds, and risk- and age-based asset allocation models as default investments. The guidelines are due by January 2007.

Currently, about 17% of all employers who offer a defined contribution plan — and 30% of organizations with more than 5,000 workers — enroll their employees automatically. If more plan sponsors do so, plan participation could climb substantially. Indeed, automatic enrollment typically increases participation to more than 90%. Expectations are high: The automatic enrollment provision could result in an estimated $2 trillion more being set aside over the next decade to help people pay for their retirements.

2. Annuities

Effective immediately, the pension act removes a significant barrier for employers who want to offer an annuity as a distribution option from defined contribution plans. The DOL has until mid-August 2007 to clarify its position that only the "safest available annuity" is appropriate. "That implies there's only one safe available annuity," said Alane Dent, of the American Council of Life Insurers (ACLI). "Employers need to feel safe they're not going to be sued for choosing the wrong annuity."

This could help many retirees achieve a more secure retirement income by annuitizing their retirement savings, providing them with monthly checks for the rest of their lives. As more and more employers give up on traditional defined benefit pension plans, an annuity option will be an attractive alternative for many people.

Also, effective January 1, 2010, annuities may be combined with long-term-care (LTC) insurance. This way, a retiree can receive annuity income, the ACLI's Dent explained, and "if you have no long-term-care incident, you don't feel like you're losing money. But if you need long-term-care coverage, you'll have that protection."

3. Investment Advice

As of January 1, 2007, representatives of plan providers were allowed to offer investment advice to defined contribution plan participants if strict conditions are met. Under the bill, qualified "fiduciary advisors" regulated by applicable insurance, banking, and securities laws may provide prudent, objective investment advice to plan participants. Employers will still shoulder the fiduciary responsibility for selecting and reviewing advisors, while the advisors will be personally liable for their advice. The advice transaction must occur only at the participant's direction and at reasonable fees.

All recommendations must be suited to a participant's individual needs and be based on a proprietary computer model that takes financial and family circumstances into account, as well as planned retirement age and risk tolerance. The computer model must be certified and audited by an independent third party. The DOL has been directed to determine the requirements that an independent investment expert must meet, but it's clear that the expert must have no material affiliation or contractual relation with the fiduciary advisor.

This provision could lead to "a major shift toward advice," rather than just investment education, said Lynn Dudley of the American Benefits Council. Already, more than one-third of large employers provide their defined contribution plan participants with access to third-party investment advice, according to 2005 survey data from Hewitt Associates. Among large employers that don't currently offer automatic enrollment or investment advice, one of the top reasons for not doing so was concern about regulatory issues.

Provisions Made Permanent

Effective immediately, the act permanently extends savings provisions included in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 that had been due to sunset at the end of 2010. These include:

• Increased maximum annual contributions to IRAs and 401(k), 403(b), 457 plans
• Catch-up contributions for those age 50 or older
• Contributions to Roth 401(k) and Roth 403(b) accounts
• Enhanced portability between retirement plan types
• A "saver's tax credit" for low - and middle -income families contributing to retirement plans

Four Big Improvements

With automatic enrollment, annuity distribution options, investment advice, and EGTRRA permanence, the defined contribution provisions of the Pension Protection Act will help working Americans seeking to build retirement income security. Observers say the law makes defined contribution plans more beneficial for both employers and employees. Contact your financial advisor to discuss the potential impact of the Pension Protection Act on your retirement program.

Sources:

"Pension Plan Compromise Eludes U.S. Lawmakers," Associated Press, July 1, 2006
"Senate Approves Pension Overhaul," Washington Post, August 4, 2006
"Bush Signs Sweeping Revision of Pension Law," Washington Post, August 18, 2006
"Uncle Sam to Workers: Save More," Associated Press, August 16, 2006
"The Big Pension Bill: Is That All There Is?" Wall Street Journal, August 3, 2006
The Pension Protection Act (H.R. 4) Bill Summary, House Committee on Education & the Workforce, July 28, 2006
"Wake Up and Smell the Coffee! DC Plans Aren't Working," Investment Insights, June 2006
"401(k): Employers Get Creative to Get Workers to Participate," USA Today, August 7, 2006
"New Rules for 401(k)s," Fort Wayne Journal Gazette, August 17, 2006
"Automatic Enrollment in 401(k)," San Francisco Chronicle, August 14, 2006
"Pension Bill's Clarity Welcomed," Pensions & Investments, August 7, 2006
"Pension Act Would Allow LTC-Annuity Combos," Investment News, August 14, 2006
"Pension Reform Set to Become Law; Huge Win for Life Insurers," Citigroup Research, August 6, 2006
"Pension Protection Act Opens New Door to Advice," PLANSPONSOR.com, August 15, 2006
"401(k)s: Auto Enroll, Advice Get OK," USA Today, August 7, 2006
Pension Reform: What Does It Mean? Overview prepared by Lincoln Financial Group, August 18, 2006
Pension Protection Act summary by David Kolhoff, senior counsel, Lincoln Financial Group, August 14, 2006
Pension Reform Webcast hosted by Westley Thompson, president, Employer Markets, Lincoln Financial Group, August 23, 2006