Private Pensions: Key Issues to Consider Following the Enron Collapse
Published: 2002-02-27T00:00:00

Fast Facts:

Highlights:
section_title: What GAO Found
paragraphs: The collapse of the Enron Corporation and the resulting loss of employee retirement savings highlighted several key vulnerabilities in the nation's private pension system. Asset diversification was a crucial lesson, especially for defined contribution plans, in which employees bear the investment risk. The Enron case underscores the importance of encouraging employees to diversify. Workers need clear and understandable information about their pension plans to make sound decisions on retirement savings. Although disclosure rules require plan sponsors to provide participants with a summary of their plan benefits and rights and to notify them when benefits are changed, this information is not always clear, particularly in the case of complex plans like floor-offset arrangements. Employees, like other investors, also need reliable and understandable information on a company's financial condition and prospects. Fiduciary standards form the cornerstone of private pension protections. These standards require plan sponsors to act solely in the interest of plan participants and beneficiaries. The Enron investigations should determine whether plan fiduciaries acted in accordance with their responsibilities.

section_title: Letter
paragraphs: 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,  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.
subsections: section_title: Background
paragraphs: 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. 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  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.
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.
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  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. 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.
Enron’s employee stock ownership plan, like other ESOPs, was designed  to encourage employee ownership in their company. The plan provided  employee retirement benefits for workers’ service with the company  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.
section_title: Greater Diversification and Investment Sophistication May Be Needed
paragraphs: 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.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.  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  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 meet 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  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.
section_title: Enhanced Disclosure Could Help Employees Understand Investment Risks They Face
paragraphs: 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.
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 plans, we found wide variation in the type and amounts of  information workers receive about plan changes and that can potentially  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.
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, 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.
section_title: ERISA Requires Fiduciaries to be Prudent and Reasonable
paragraphs: 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  transfers. 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.
section_title: Conclusions
paragraphs: 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.