Report of the Working Group on Employer Assets in ERISA Employer-Sponsored Plans
November 13, 1997
Table of Contents
III. Executive Summary
The Working Group on Employer Assets in ERISA Employer-Sponsored Plans is pleased to submit its report and recommendations to the 1997 ERISA Advisory Council at its 100th session. We urge the Advisory Council to adopt the report and recommendations and to submit them to Secretary of Labor Alexis M. Herman.
Defined contribution plans, particularly those with 401(k) features
(referred to as "401(k) plans") are the fastest growing segment of
the qualified plan universe. A sizable portion of defined contribution plan
assets are invested in "employer assets." Employer assets take two
forms, employer securities and employer real property. Employer securities,
often called "company stock," are the common or preferred stock of the
plan sponsor. Employer real property is real property that is owned by the plan
and leased to the plan sponsor or an affiliate of the plan sponsor. Except for
some very modest provisions enacted as part of the Taxpayer Relief Act of 1997,
there is absolutely no limit on the amount of employer assets that can be held
in defined contribution plans. The dearth of limitations for defined
contribution plans is in stark contrast to the ten (10) percent limit on
employer assets that has applied to defined benefit plans since the enactment of
ERISA in 1974. The Color Tile case focused national attention on the issue of employer
assets in defined contribution plans because 90% of the plan's assets were
invested in employer assets. When Color Tile declared bankruptcy, participants
saw their retirement savings in the plan devalued at the same time as they lost
their jobs. Had the Color Tile 401(k) plan been more broadly diversified, the
participants would not have had so much of their financial security tied to the
fortunes of a single company. Although the facts of the Color Tile case can be
easily distinguished from the design of most defined contribution plans, the diversification issue remains to be addressed. II.
Defined contribution plans, particularly those with 401(k) features (referred to as "401(k) plans") are the fastest growing segment of the qualified plan universe. A sizable portion of defined contribution plan assets are invested in "employer assets." Employer assets take two forms, employer securities and employer real property. Employer securities, often called "company stock," are the common or preferred stock of the plan sponsor. Employer real property is real property that is owned by the plan and leased to the plan sponsor or an affiliate of the plan sponsor. Except for some very modest provisions enacted as part of the Taxpayer Relief Act of 1997, there is absolutely no limit on the amount of employer assets that can be held in defined contribution plans. The dearth of limitations for defined contribution plans is in stark contrast to the ten (10) percent limit on employer assets that has applied to defined benefit plans since the enactment of ERISA in 1974.
The Color Tile case focused national attention on the issue of employer assets in defined contribution plans because 90% of the plan's assets were invested in employer assets. When Color Tile declared bankruptcy, participants saw their retirement savings in the plan devalued at the same time as they lost their jobs. Had the Color Tile 401(k) plan been more broadly diversified, the participants would not have had so much of their financial security tied to the fortunes of a single company. Although the facts of the Color Tile case can be easily distinguished from the design of most defined contribution plans, the diversification issue remains to be addressed.
II.The Working Group's Purpose and Scope
At the 97th full Advisory Council meeting held on March 6, 1997, it was agreed that a working group be formed to explore whether the merits of having employer assets in ERISA sponsored plans outweighs the potential risks associated with investing in such assets. The working group's objective was to address the concern that some defined contribution plans may be invested in an undue concentration of plan sponsor assets. This topic was selected in part due to the pending legislation, "401(k) Pension Protection Act of 1997" (S.106), introduced by Senator Barbara Boxer, which would limit the amount of employer assets in defined contribution plans to no more than 10% of plan assets. The working group focused on both employer securities and employer real property in defined contribution plans. Recommendations would be provided on the pending legislation as well as other initiatives that should be considered by the Secretary.
The goal of the working group was to increase the safety of retirement assets without inhibiting the formation and growth of defined contribution plans. The working group was appropriately named Working Group on Employer Assets in ERISA Employer-Sponsored Plans ("Work Group").
At its initial meeting held on April 9, 1997, the Work Group decided to review the legislative history for limiting employer assets in certain types of retirement plans, the safeguards that are available for certain types of retirement plans as contrasted with others, and both the pros and cons related to the risks and rewards of having employer assets in defined contribution plans. It was also decided that the Work Group would obtain information regarding Employer Stock Ownership Plans ("ESOPs") but would not undertake a study as to whether changes should be recommended for ESOPs.
III. Executive Summary
The Work Group found a significant investment by defined contribution plans in employer assets, with large plans generally presenting the highest concentrations of employer assets. These large plan investments are primarily in the form of company stock, and on average comprised 30 to 40 percent of plan assets. Employer real property was not held as widely as employer securities, but raised serious concerns of liquidity and valuation. Whether employer assets are held in the form of employer securities or employer real property, the terms of defined contribution plans can restrict the participants from diversifying their account balances into other investments, and the result is a lack of diversification of the participants' portfolios. Gains and losses in defined contribution plans are borne by participants regardless of whether the participants have a choice in the investment of their holdings. Americans are being encouraged in a variety of ways to take responsibility for their retirement savings. Without the ability to diversify defined contribution holdings and with virtually no limit on the amount of employer assets that can be held by defined contribution plans, there is a lack of balance between the participant's responsibility for retirement savings and the participants' inability to diversify these savings.
America's passion for the 401(k) plan has been fueled by the long bull market of the 1980s and 1990s. The strong economy and the bull market have held at bay problems that lack of diversification can bring. Those participants with large investments in a single stock that drops in price will pay a steep penalty for the lack of diversification. Employers who have directed the investment of participant balances into employer assets will face serious fiduciary issues. In these enlightened times when the portfolio management concepts of asset allocation and diversification are taught at educational seminars throughout the country, theyer assets presents a danger signal that should not be ignored. The investment in employer assets affects the retirement income and security of millions of American workers, and is worthy of serious attention by the Department of Labor.
The Work Group recommendations, in summary, are as follows:
For Employer Real Property:
The Work Group unanimously recommends a limit on the investment of defined contribution plan assets in employer real property equal to ten percent of the market value of the plan assets.
Revoke the exception from diversification for the holding of qualifying employer real property by eligible individual account plans and the exemption from prohibited transactions for certain acquisitions of qualifying employer real property which are in excess of the 10 percent limitation.
For Publicly-Traded Employer Securities:
The Work Group unanimously recommends that, at a minimum, the ESOP diversification rules be extended to all participants in defined contribution plans (except ESOPs). Accordingly, such participants, who have reached age 55 with at least ten years of plan participation, would be able to diversify up to 50% of their account balances over a 6-year period under diversification rules similar to ESOPs.
The majority of the Work Group supported stronger measures. The majority of the Work Group recommends that all participants in defined contribution plans (except ESOPs) be given the right to diversify their account balances into assets other than employer assets when they become vested.
For Non-Publicly Traded Employer Securities:
The Work Group unanimously recommends a limit on the investment of defined contribution assets in non-publically traded employer securities equal to ten percent of the market value of plan assets or that the plan follow the ESOP rules with respect to employer securities.
The Work Group unanimously recommends that rules be established for disclosure to plan participants about company stock performance and risk.
Areas Not affected by Recommendations:
The Work Group makes no recommendations with respect to defined contribution plans that allow participants to direct the investment of all contributions among a series of investment alternatives.
The Work Group makes no recommendations with respect to ESOPs.
The Work Group held seven public meetings and heard testimony from 16 expert witnesses that included six from government agencies, six from employee benefit organizations, two from individuals, and two from the Work Group. Additionally, written testimony was submitted by one individual, two statistical surveys from organizations and 30 written references consisting of periodical articles, newspaper articles, prepared statements and industry group pamphlets were provided as reference to the Work Group. The testimony is recorded in verbatim transcripts of the Work Group, as further summarized in the Executive Summary prepared of each Work Group meeting. Therefore, this report will not attempt to review or present all of it again.
The following individuals were witnesses before the Work Group. Many of these individuals also submitted written testimony and/or statistical data.
Written testimony was received from Raymonda Handler Almand, the lead plaintiff in the Color Tile Employee Investment Plan lawsuit. The two statistical surveys are "1996 Defined Contribution Survey" by RogersCasey/IOMA and "Retirement Benefits in the 1990's: 1997 Survey Data" by KPMG Peat Marwick LLP.
Three Models of Plan Design for Investments in Employer Assets
For purposes of this study, the Work Group gathered testimony on the three basic models for investment in employer assets by defined contribution plans. The first model is the most common today and allows the participant to direct the investment of all contributions among a series of investment alternatives. We call this the "Participant Investment Model" because the participant is responsible for and empowered to manage the investments of his or her own account balance. Under the second model, which seems popular among larger companies, the participant freely directs the investment of his or her own contributions, but all or a portion of the employer contributions is directed into employer assets typically called "company stock". We will call this the "Directed Match Model." Under the third model, the plan sponsor or an investment manager appointed by the plan sponsor directs the investment of all the plan assets. We will call this model the "Sponsor Investment Model" since the plan sponsor has all of the investment authority, including the ability to invest the plan assets in employer assets. This model is the most troublesome because the investment authority rests with the plan sponsor, but the risk of gain or loss falls on the participants.
The Participant Investment Model allows participants to freely choose how their retirement savings are invested among a series of investment options. Participant choice extends to all employee contributions as well as any contributions made by the employer. Company stock can be one of the investment options that the employee may select. The Rogers Casey/IOMA 1996 Defined Contribution Survey ("RCI Survey") shows that the average number of options offered in 401(k) plans continues to grow. Over 60 percent of the plans offer seven or more options and 91 percent offer five or more options. The RCI Survey shows that 30 percent of plans offer company stock as an option, down slightly from 31 percent in 1995 and well ahead of 25 percent in 1994. The larger the plan, the more prevalent is the use of company stock as one of the investment alternatives. The RCI Survey shows that 80% of plans with over 10,000 participants offer company stock as an investment alternative, whereas only three percent of plans with under 250 participants offer company stock.
Under the present state of the law, defined contribution plans following the Participant Investment Model can invest in employer assets with no limit whatsoever. Accordingly, should a participant wish to invest exclusively in company stock, they may do so without any restrictions. Under this model, participants may choose to avoid investment in company stock as well. Participants are empowered to make their own investment choices and they bear the risk of gain and the risk of loss for these investments. Many employers who utilize this model provide educational programs aimed at teaching basic investment concepts including diversification and asset allocation to help employees prudently manage their retirement savings.
Directed Match Model
Under the Directed Match Model, the participant freely chooses the investment of his or her own contributions but all or a portion of the employer contribution is directed by the plan sponsor. Generally these investments are in employer assets. Although the predominant form of the employer matching contribution is generally in the form of cash the RCI Survey shows that the greater the number of 401(k) plan participants, the more likely that company stock will be used for the matching contribution. Forty-five percent of plans with over 10,000 participants use company stock as the matching contribution whereas only four percent of companies with fewer than 1,000 participants use company stock as the matching contribution. The KPMG survey shows that of the plans surveyed only 7% of plans match with company stock but those plans cover 20% of the participants in defined contribution plans.
The most common rate of employer match is 50 percent of the first 6 percent of employee salary reduction. In other words, an employee who defers six percent of his or her salary into the 401(k) plan would receive an employer matching contribution in the amount of three percent of the employee's salary. Accordingly, one-third of all plan contributions would be directed into employer assets in the typical plan of this model. The plan may require that the employer contributions remain invested in employer assets until the participant receives a distribution at retirement or separation from service. Some plans allow the participants to diversify their company stock after a period of time or upon attainment of a specified age. There is nothing in today's law, even with the modest reforms enacted in 1997, that would require the plan sponsor to allow the employees to diversity the matching contribution. Additionally, the plan does not need to allow pass through voting rights to the participant, although most plans permit this. Under this model and under the Sponsor Investment Model, participants have fewer rights than other shareholders of the company, including ESOP shareholders.
Sponsor Investment Model
Under the Sponsor Investment Model, the plan sponsor or an investment manager appointed by the plan sponsor makes all of the investment decisions for the plan. Here, the participants have no choice in how their qualified retirement savings are to be invested, although they continue to bear the risk of gain or loss. The plan sponsor is subject to the prudence requirement, the exclusive benefit rule, the conformance rule, and other ERISA fiduciary requirements. However, should the plan sponsor decide to invest in employer securities or employer real property, the plan sponsor is specifically exempt from ERISA's overall diversification requirements. Accordingly, the employer can invest some or all of the plan's assets in the common stock of the plan sponsor or in other employer assets with no duty to diversity the holdings, no duty to notify the participants of the specific investments, and no obligation to allow the participants the opportunity to change or diversify the investments. This is true whether the defined contribution plan is funded by employer contributions only, employee contributions only, or a combination of employer and employee contributions. Unfortunately, the Color Tile Plan followed the Sponsor Investment Model.
Virtually all defined benefit plans follow the Sponsor Investment Model so that either the plan sponsor, or an investment manager appointed by the plan sponsor, manages the assets. Unlike defined contribution plans that use the Sponsor Investment Model, defined benefit plans may not invest more than 10 percent of their assets in employer assets. This requirement was enacted by ERISA in 1974 to safeguard and diversify defined benefit plan assets. Although the legislative history is sparse, testimonies received by the Work Group point to three reasons for the different treatment of defined benefit plans versus defined contribution plans in this area. First, defined benefit plans were the predominant retirement vehicle when ERISA was enacted; defined contribution plans were viewed more as savings vehicles. Second, the PBGC insures the benefits of defined benefit plans, and it was argued that the government had less interest in legislating diversification requirements for defined contribution plans. Third, defined contribution plan investments in employer stock was a common and established practice and the Southland Corporation had a large investment in employer real property in its defined contribution plan and mounted a vigorous and successful lobbying effort.
A second limitation was placed on defined benefit plans in 1987 with respect to their holding of employer securities. Section 407(f) of ERISA provides, in addition to the ten percent limit, that a plan cannot acquire more than 25 percent of the issued and outstanding stock of the plan sponsor. Furthermore, at least 50 percent of the stock of the plan sponsor must be held by parties who are independent of the plan sponsor. These limitations do not apply to defined contribution plans.
Effective for plan years beginning after 1998, the Taxpayer Relief Act of 1997 ("TRA 97") will impose a ten percent limit on certain defined contribution plans similar to the limitation that applies to defined benefit plans. There is a large number of exceptions that undercut the impact of the new law. The limitations apply only to the portion of the plan assets that represent employee elective deferrals, and do not apply if any one of the following conditions is satisfied:
In the case of the Sponsor Investment Model, TRA 97 would impose the ten percent limit on the employee elective deferrals of the plan only if (1) the total amount of employer assets in all individual account plans sponsored by the employer exceed 10 percent of all the assets of all pension plans sponsored by the employer, and (2) more than one percent of the employee's compensation contributed to the plan is required to be invested in employer assets, and (3) the plan is not an ESOP. TRA 97 does not apply to defined contribution plans under the Participant Investment Model or the Directed Match Model, which account for the vast majority of defined contribution plans. Accordingly, the protections of TRA 97 will not enhance the retirement security of most defined contribution participants whose accounts are invested in employer assets.
ESOPs are a type of defined contribution plan that, by law, must be invested primarily in employer securities. As such, ESOPs were designed to make employees the owners of their companies. According to Michael Keeling, President of the ESOP Association, there are approximately 9,000 ESOPs today and 95 percent of these ESOPs are sponsored by closely held companies.
Although ESOPs do provide a component of retirement savings, the body of law and regulations governing ESOPs is fundamentally different from that for other defined contribution plans. The difference in the treatment of ESOPs under the law includes a series of tax and financing advantages for the employer that are balanced by a series of participant protections.
The tax and financing advantages for employers are as follows:
Dividends: Dividends paid on ESOP stock are deductible under certain circumstances including when dividends are paid out to the participants.
· Private Owners: Owners of closely-held companies can sell their shares to the ESOP and defer their gain on the sale if the ESOP holds 30 percent or more of the outstanding shares of the company and other requirements are met.
The ESOP provisions which protect plan participants are as follows:
It is the balance of sponsor advantages and participant protections that sets ESOPs apart from other defined contribution plans. In other defined contribution plans, the law does not require that participants whose accounts are invested in employer assets have any voting rights (except certain stock bonus plans) or the right to diversification at any age. Participants in ESOPs of closely held companies have the protection of annual appraisals and put options, which are not required for other defined contribution plans (except stock bonus plans). Furthermore, ESOPs are rarely the sole or primary retirement vehicle. Where ESOPs are the primary retirement vehicle, clearly the investment will be in employer securities, so there are fewer opportunities for surprises as asserted in the Color Tile case. The Color Tile plaintiffs asserted that participants were unaware of the heavy investment of their 401(k) assets in Color Tile property.
For these reasons, the Work Group is making no recommendations with respect to ESOPs at this time. Should significant restrictions be placed only on the employer securities of other defined contribution plans, the Work Group foresees the potential that some sponsors will convert their 401(k) plans to KSOPs. A KSOP is a 401(k) plan where a portion of the plan assets is invested in employer securities through an ESOP. A KSOP conversion would circumvent any employer securities limitations for the plan. However, the ESOP rules would be in place for the employer securities portion of the plan that would provide some additional protections to plan participants.
A key goal of the Department of Labor is to encourage plan sponsorship so that more workers have private retirement income. Legal and regulatory hurdles, whether they be changes to the operation of the plan or restrictions on plan design, can inhibit plan sponsorship, which would reduce private retirement income. A leading reason for the success of defined contribution plans is their relative simplicity and flexibility as compared to defined benefit plans. Employers need to be encouraged to provide retirement programs for their employees and not discouraged by additional legislation. In this regard, the employer must have the flexibility to design retirement programs that best suit its business needs while assisting its employees in meeting their retirement goals.
The Work Group heard testimony and reviewed numerous documents and surveys in which it was opined that any restriction in the amount, quality or duration of the investment of defined contribution plans in employer securities would serve to inhibit plan sponsorship and plan participation. There are great benefits both for the employee and for the employer by including company stock in defined contribution plans. These benefits include:
Many plans that invest in company stock do so as the result of providing an employer matching contribution. This match is not mandated by ERISA but provided as a means to assist plan participants in reaching their retirement goals and encourage their participation, while at the same time rewarding and motivating these employees through stock ownership. The existence of an employer match either in cash or company stock encourages participation in the plan and therefore increases retirement savings. Surveys have shown that the average participant rate for plans with an employer matching contribution is approximately 19% higher than the average participation rate without a matching contribution. Limiting the amount of the match that can be invested in company stock may significantly discourage employer matching contributions. Similarly, limits on the length of time that the participant must hold the company stock may discourage employer matching contributions. The argument was advanced that without employer matching contributions, there would be a twofold effect of (1) reduced employer matching contributions and (2) reduced participation in the plan.
Employer assets held in defined contribution plans such as 401(k) plans are designed to be exempt from various statutory requirements including:
In addition, these types of plans can be more flexible than an ESOP. They can maintain investments primarily in assets other then employer securities (i.e., real estate). If other investments are made, however, investment decisions are subject to the diversification and "prudent man" rules. Additionally, defined contribution plans are not subject to the many technical requirements of ESOPs in that distributions can be made in stock or cash, can hold non- voting stock, and are not subject to the diversification requirements of ERISA 404(a)(1) with respect to investments in employer securities.
Finally, it was submitted that the notoriety of a few spectacular plan failures such as Color Tile should not preclude well-run plans from continuing to provide retirement saving through the use of company stock or other employer assets. There is strong evidence to support that the highest concentration of company stock in defined contribution plans is typically in large companies that have demonstrated long-term financial success and that offer employees other types of plans, such as defined benefit pension plans, which reduce the risk of defined contribution plan investments in employer stock. According to the KPMG survey, approximately 90% of all company stock is held by plans of companies with more than 5,000 employees. Smaller plans have significantly lower concentrations of company stock.
Currently defined contribution plans are allowed not only to invest in employer securities but also in employer real property. Employer real property is simply real property owned by the plan and leased to the employer or an affiliate of the employer. These transactions are subject to the exclusive benefit rule and the prudence rule under ERISA but again not to the diversification rules. For employer real property to be considered "qualifying real property" under ERISA it must meet the following conditions: there is (1) it is more than one parcel, (2) geographically dispersed (3) the improvements on such real property are to be suitable for more than one use and (4) the acquisition/retention of such property complies with the fiduciary provisions (ERISA 407(d)(4)). Because this is a statutory exemption from the prohibited transactions provisions there is no need to seek permission to engage in such transactions that would normally be prohibited.
The vast majority of the testimony indicated that employer real property should be subject to further restrictions. Employer real property is generally not regarded as a desirable plan investment for several reasons. In contrast to owning employer securities, the theoretical benefits of company stock ownership do not exist, so there is neither an alignment of interests nor a gain in productivity to protect. The valuation issues are greater with employer real property than with most employer securities. Although the real property is to be valued at "fair value" this does not necessarily require that the property be appraised in order to determine its value. Moreover, liquidity concerns are greater with employer real property. In addition to the concerns of diversification, valuation and liquidity, there is the potential for self-dealing when plan sponsors and other fiduciaries finance company real estate with plan assets. Color Tile is an employer real property case.
The RCI Survey showed that 30 percent of plans offer company stock as an investment option. Over 90 percent of the plans surveyed offer some form of company match, and 15 percent of the companies surveyed offer the match in the form of company stock. Therefore, there is a mix of plans, some of which offer company stock as an option and others that require that the company match be directed into or made in company stock.
The 1996/7 Investment Management Study of Greenwich Associates looked at corporate retirement plans with assets over $1 billion and found a significant investment in company stock. The defined contribution plans in this survey invested an alarming 33 percent of their assets in company stock whereas their defined benefit counterparts invested a mere 2.6 percent of their assets in company stock. Similarly, testimony from Charles Vieth of T. Rowe Price revealed that 32 percent of the assets of the plans serviced by his company were invested in company stock.
The Work Group concluded that there is a significant investment by defined contribution plans in company stock. The investment affects the retirement income and security of millions of plan participants and is worthy of serious attention by the Department of Labor.
It is more difficult to assess the amount of the investment in company stock that is made by participant choice or by plan sponsor choice. Statistics are not maintained to this level of detail by the DOL, the GAO, or other sources that were questioned. The data available to the GAO did not distinguish between full participant direction (as in the Participant Direction Model) or partial participant direction (as in the Directed Match Model). The GAO classified both such cases as participant direction and found that 69% of the plans containing employer assets allowed some participant direction. As outlined above, there are three basic models of investment and the employer directs some investment into employer assets in two of the three models. We can concluy that a significant amount of employer asset investments is made at the direction of the plan sponsor. In these cases, the investment risk rests with the participant without the concomitant ability to manage the investments. The national trends are placing more and more responsibility for retirement savings on workers. It is difficult for workers to manage their retirement savings prudently when defined contribution assets can be invested with no limit in employer assets, and the worker has no ability to diversify.
Defined contribution plans are becoming the primary retirement vehicle
With the stagnation of defined benefit plans, defined contribution plans are becoming the primary retirement vehicle for American workers. Coverage under defined contribution plans has tripled since 1975 while coverage under defined benefit plans has remained fairly constant. Many defined benefit plans have been terminated or frozen and have been replaced with 401(k) plans. The RCI Survey showed that 43% of plan sponsors that have a 401(k) plan also have a defined benefit plan; however, the same survey shows that 25 percent have frozen the defined benefit plan to use the 401(k) plan as the primary retirement vehicle. The retirement security of the American workforce is increasingly dependent on prudent management of their defined contribution plans.
Lack of diversification creates undue risk and volatility
Roger Smith, a partner with Greenwich Associates, states, "The most disturbing factor is the participants' degree of dependence on a single asset whose value is closely linked to that of the participant's other principal financial standby: his or her job. If a company runs into problems, the participant with 33% of his pension assets in company stock faces a double problem: Not only is his job in jeopardy, but so is a high percentage of his pension." John Webster of Greenwich Associates adds, "The other disturbing factor is the lack of diversification. It would be a bold asset manager we assets of a pension plan into a single stock, but here are people putting in an average of one third! As if one third wasn't undiversified enough, that obviously means that many are putting more than one third of their eggs in a single basket."
Clearly, prudent investment management principles would askew a concentration of assets in any single stock. The performance of a single stock is far more volatile than the performance of a group of stocks. Volatility brings price fluctuations which can tempt unsophisticated investors to sell when a stock is declining in value rather than take a longer term view. Moreover, when that investment is company stock and the plan sponsor has financial difficulties, the employee faces the loss of his or her job at the same time as the value of a large share of his or her retirement income has been devalued.
Participants bear the risk of loss
Unlike defined benefit plans, the risk of loss for defined contribution plans rests with the employee not the employer. Denying participants the right to diversify their qualified account balances while placing on their shoulders the obligation to save for retirement is woefully unbalanced. The risk of loss from poor investment choices is difficult at any age, but it is particularly difficult for those in and near retirement. Those near retirement have little opportunity to recoup the loss of failed investments. If the entire market collapses, there is little that any investor can do to protect his or her assets. However, broad diversification of assets is an excellent safeguard if one sector or one company faces financial distress. With no government safeguard for the vast majority of defined contribution participants, we leave the door open to Studebaker-style tragedies. The Studebaker retirees resorted to pumping gas and bagging groceries to survive their failed pensions. No one has recommended that the PBGC protection available to defined benefit plans be extended to defined contribution plans. However, a reasonable limit on the amount of participants' qualified retirement savings that an employer can direct into employer assets and a reasonable duration for such investment would go a long way toward balancing the scales of qualified retirement savings. Similarly, there is no government safety net of coverage for failed investment in defined contribution plans: defined benefit plans provide participants with PBGC protection.
Employer securities in defined contribution plans creates second class shareholders
Although many defined contribution plans allow pass through voting on employer securities, except for ESOPs and certain stock bonus plans, there is no legal requirement in this regard. Without the right to vote, participants have limited ability to participate in the control of the enterprise.
More importantly, participants in many forms of defined contribution plans are denied the right to sell their employer securities. This may be true in the Sponsor Investment Model and in some forms of the Directed Match Model. Some directed match plans allow the participants to diversify out of employer securities after a period of time or at a certain age. Other plans require that the match be held in employer securities until retirement. How many shareholders would buy stock without the right to sell it until they retire or change jobs? What discount on the price of the shares would they demand in order to accept the restriction on sale? Proponents of unlimited amounts of employer stock in defined contribution plans tout the advantages to employees of ownership in their companies. Yet these employees are, at best, second class citizens paying full value for stock with an inferior set of shareholder rights. Additionally, these shareholders have little or no part in decisions impacting the management of the company.
Conflicts of interest
Norman Stein's testimony points out that " . . . the decision to invest in employer stock is made by managers who have their own interests that are not necessarily aligned with either those of employees generally or other shareholders." The problems associated with these types of conflicts are not susceptible to clear rules or simple enforcement. Although the plans are subject to the exclusive benefit rule, it is difficult to determine managerial intent when decisions are made to invest in employer securities, particularly without participant direction. Among these issues are the fair valuations for closely held and thinly traded stock because there is no readily available market. Conflicts of interest and valuation issues create difficult enforcement issues for the government and expensive compliance costs for plans and employers.
Fiduciary Concerns of Employers
Conflicts of interest, matters of fair valuation of closely held stock, and other issues create fiduciary concerns for plan sponsors. The RCI Survey showed that asset allocation is a key objective among plan sponsors. In the interest of plan sponsors, clear limits on the proper level of investment in employer assets would be helpful.
Contributions to qualified plans are deductible from the taxable income of plan sponsors. Since the government provides large tax subsidies to employers who sponsor qualified plans, the government has a right to limit the types of plan investments are eligible for the tax subsidies or deductions. In other words, the government should not take a hands-off approach.
The Work Group carefully considered different points of view in its mission to provide greater retirement security without placing undue restrictions on plan sponsors. The Work Group saw the value of instituting certain diversification rules that conform to existing legislation for ESOPs. It was agreed that any recommendations should conform to existing regulations for other types of plans in order to foster equivalence among plans. Additionally, plan sponsors need to be cognizant of the risks associated with investing plan assets in employer assets and communicate those risks to the plan participants. Specific recommendations relate to employer real property, publicly traded employer securities, non-publicly traded employer securities, and disclosure.
Adopt a 10% limitation on the amount of qualifying employer real property that can be held by a defined contribution plan, which would not otherwise have adequate protection from the current legislation.
Revoke the exception from diversification for the holding of qualifying employer real property by eligible individual account plans and the exemption from prohibited transactions for certain acquisitions of qualifying employer real property which are in excess of the 10 percent limitation and thereby require the plan sponsor to seek permission from the Department of Labor to enter into sale lease back transactions that exceed 10% of plan assets. In effect this proposed treatment of investments in qualifying employer real property under defined contribution plans is comparable to the requirements under defined benefit plans.
For defined contribution plans where employer securities are publicly traded and the participant has freedom of choice (Participant Investment Model) to invest in employer securities and/or to freely transfer in or out of the company stock fund, the Work Group makes no recommendations. It is the consensus of the Work Group and its witnesses that plans that allow participants to make their own investment choices can place the obligation of adequate diversification on the participants themselves.
For all other defined contribution plans (the Sponsor Investment Model and the Directed Match Model) a majority of the Work Group supported a proposal that employees be given the right to trade company stock when they become vested in the stock. For this purpose, the majority agreed upon a five year class vesting proposal. There was considerable support, but not unanimity, for allowing participants to diversify based upon plan vesting requirements as well as for a class year vesting. The Work Group was unanimous in recommending, at a minimum, the participant should have the right to diversify at age 55 in the same manner as is afforded to participants in ESOPs under Code Section 401(a)(28). In an effort to bring consensus to our recommendations the Work Group agreed to this minimum recommendation as a proactive approach to safeguarding plan assets and minimizing risks for the plan participant as well as the plan sponsor.
For defined contribution plans where employer securities are not publicly traded on an exchange, it is recommend that these plans limit investments in employer securities to no more than 10% of plan assets unless the plan conforms to the existing rules for ESOP plans in all respects except for the rule requiring ESOP's to invest primarily in employer securities.
The last recommendation is for rules to be established for disclosure to plan participants about company stock performance and risk. The DOL pension education campaign should provide materials that will educate both plan sponsors and plan participants of the risks associated with investing most or all plan assets in employer assets. Plan sponsors should provide to plan participants the performance history of the stock, the company's earnings and expenses, the stock performance of companies in the same or similar sector, the risks associated with its line of business, and the risks of holding a single undiversified asset. The types of disclosures provided in a mutual fund prospectus can serve as guide for this purpose.
Marilee Pierotti Lau--Chair
Barbara Ann Uberti, Esq.--Vice Chair
J. Kenneth Blackwell
Kenneth S. Cohen
Carl S. Feen--Vice Chair, Advisory Council
Neil M. Grossman, Esq.
Thomas J. Healey
Richard McGahey, Esq.
Dr. Thomas J. Mackell, Jr.
Joyce Mader, Esq.--Chair Advisory Council
Zenaida M. Samaniego
Meeting of April 9, 1997
The Working Group expressed an early interest in the perception that participants in defined contribution (DC) plans may be invested too conservatively for long-term retirement planning, relative to defined benefit (DB) plans. The information submitted in this document suggests that DC and DB allocations are in fact "quite similar," but does note a problem of potential concentration of DC allocations in employer stock, limiting the diversification of their portfolios.
Most of the data concentrate on corporate pension plans with assets over $1 billion, and Working Group members wondered if allocations were different for small plans. Aggregated at a broad level, the data on large plans show similar asset allocations--62.4% for stocks in DB plans versus 65.3% in DC plans, for example. But at a more detailed level, the data show intra-category differences, such as only 2.8% company stock in DB plans versus 37.8% in DC plans. Conversely, DC plans had significantly lower allocations to domestic and international equities.
Thus the overall level of stock investment is similar between the two types of plans, but the diversification of those investments varies quite sharply. This may produce higher risk for DC plans. Risk in plans as measured by the expected standard deviation on returns was 10.5% for DB and 15.2% for DC plans, not only because of diversification issues, but because DC plan retirement benefits are highly correlated with current income for plan participants.
This could create post-retirement problems for those participants who are in DC plans, and whose income drops sharply just prior to retirement due to job loss or income reductions. However, the data also show that pensions make up only 20% of average income for those 65 and older. Working Group members asked if including low-income retirees in the data were skewing this result, but subsequent data showed that even in the highest income quintile of those over 65, pension income accounts for around 26% of income, compared to only 2.1% for those in the lowest quintile.
Consideration of applying ESOP diversification rules more broadly to employer securities.
Meeting of May 14, 1997
Mr. Grossman, who also serves as an employer representative on the Advisory Council, outlined the application of the Internal Revenue Code (the "Code") and the Employee Retirement Income Security Act ("ERISA") on tax-qualified employee stock ownership plans ("ESOPs"), profit-sharing plans, and defined benefit pension plans ("DB plans") that invest in employer securities. Using a chart that was distributed to working group members, Mr. Grossman addressed seven topics: (1) the diversification of plan assets, (2) types of permissible employer securities, including certain required features, (3) special distribution rights for employer stock, (4) the plans' normal forms of benefit, (5) the diversification of participants' accounts, (6) fiduciary responsibility, and (7) special tax incentives to acquire and hold employer securities.
First, Mr. Grossman reminded the working group that DB plans are allowed to invest no more than 10% of their assets in employer securities. ESOPs and profit-sharing plans, on the other hand, may be designed to invest up to 100% of their assets in employer securities and ESOPs must invest "primarily" (at least 51%) in such securities.
Second, Mr. Grossman noted that the three plans differ in the type of employer security they may acquire and hold. DB plans are restricted to marketable stock and marketable debt instruments. ESOPs and profit-sharing plans can invest only in stock and marketable debt instruments. ESOPs must include a "put" under which the employer offers to buy participants' stock if it is not readily tradable. There is no marketability requirement for profit-sharing plan stock. In addition, at least 51% of an ESOP's assets must be (1) readily tradable common stock or (2) if such stock is not available, other common stock with significant dividend or voting rights, or (3) preferred stock convertible into either of the above. ESOPs must pass through voting rights to participants.
Third, Mr. Grossman stated that ESOPs must offer participants the opportunity to receive their benefits in employer stock. In certain circumstances, ESOP participants can choose to accelerate the payment of their benefits. These requirements do not apply to profit-sharing and DB plans.
Fourth, Mr. Grossman discussed the requirement that DB plans provide pre-retirement survivor annuities and joint and survivor annuities, which can be waived only with the consent of a participant's spouse. ESOPs and profit-sharing plans are exempt from these requirements if they provide a surviving spouse with a death benefit equal to the participant's vested account balance.
Fifth, ESOPs are subject to special account diversification rules, according to Mr. Grossman. These plans must permit employees who are at least age 55 with at least 10 years' participation to elect, over a 6-year period, to receive a distribution of no less than 50% of the employee's account or, alternatively, to reinvest such amounts in 3 or more other investment options. He noted that additional account diversification requirements apply if an ESOP or profit-sharing plan is designed to comply with ERISA Section 404(c). Section 404(c) relieves plan fiduciaries of certain responsibilities in participant-directed individual account plans.
Sixth, Mr. Grossman stated that ERISA's duties of care and loyalty and prohibited transaction rules apply, generally, to any plan's acquisition and management of employer securities. However, applying the rules to ESOPs is more difficult, because (1) ESOPs are both retirement plans and corporate financing vehicles, (2) by definition, ESOPs must invest primarily in employer securities, and (3) some ESOPs, established to repel hostile takeovers, contain "mirror" voting and tender offer provisions. Mr. Grossman noted that ESOPs are the only plans allowed to borrow from an employer, or on an employer's guarantee, in order to purchase employer securities. This facilitates the acquisition of a large block of employer securities in a single transaction.
Finally, Mr. Grossman reviewed a number of special Federal tax incentives associated with employer stock plans, including (1) for employers, the ability to deduct dividends on ESOP stock and principal payments on an ESOP loan, (2) for shareholders of a closely held company, the ability to defer taxation of gain on the sale of their company stock to an ESOP, and (3) for participants in ESOPs and profit-sharing plans who receive lump sum distributions, the ability to defer taxation of any net unrealized appreciation in their securities.
Following Mr. Grossman's formal presentation, he and David Lurie, an Employee Benefit Specialist with the U.S. Department of Labor, answered questions from members of the working group. In response to a question, Mr. Grossman opined that, if limits were placed on employer securities for some types of plans, such as profit-sharing plans, employers that valued employee stock ownership might just convert those plans to other types of plans without the limits. Mr. Grossman explained that an ESOP can be part of a 401(k) plan, so that employees buy employer securities with their pre-tax contributions. Mr. Grossman and Mr. Lurie agreed that employer stock plans often are supplemental to other retirement plans maintained by an employer.
Mr. Lurie discussed the history of legal restrictions on employer assets in plans and the Department of Labor's public position on such restrictions, noting that the agency had, in a letter of September 12, 1996 to Senator Boxer, supported a 10% limit on the amount of employee elective contributions under 401(k) plans that can be invested in employer securities or real property, in the absence of participation direction. Mr. Lurie emphasized that ERISA's prudence standard applies to fiduciaries, even where a plan document authorizes a high concentration in employer stock.
Testimony of David Lurie
Mr. Lurie reported that diversification concerns were the primary reason for the 10% rule limiting employer securities under defined benefit plans. He stated that defined contribution plans were not covered by the same regulation because DC plans had been a small part of the market and deemed not a major source of retirement savings. At the time, there were also strong lobbying efforts by a large profit-sharing plan.
In response to several other questions from the workgroup, Mr. Lurie presented the following views:
There may be an SEC, not ERISA, problem when company insiders are the ones deciding to buy or sell company stock in ESOPs and profit-sharing plans.
The DOL has issued a letter requesting Senator Boxer to legislate restrictions on unilateral investment of employee contributions.
The DOL has supported limits regarding the investment of employee contributions that are not self-directed.
The DOL agrees that there is a diversification issue, which can be resolved with more education and voluntary action rather than individual restrictions.
Testimony of Michael Keeling, CAE
Mr. Keeling stated that he does not support any new restrictions on the use of employer securities in ERISA plans, although he conceded the ESOP community at large did not oppose providing employees a measure of control over elective contributions in a 401(k) plan.
He expressed the view that the amount of employer securities used in tax qualified deferred compensation plans is no greater than in past years. He stated that he had reviewed data indicating that most corporations utilizing any significant amount of employer securities, in ERISA plans other than ESOPs were mostly large, successful publicly traded corporations. He expressed the view that the employees of these companies had benefitted economically from having the stock in their plans.
Mr. Keeling then described the difference between ESOPs, or employee stock ownership plans, and 401(k) plans. The differences were enacted by Congress to make ESOPs better "ownership" and "ERISA" plans, whereas Congress had not enacted laws to make 401(k) plans "ownership" plans.
He said that one difference was that the statutory definition of an ESOP was that is must be primarily invested in employer securities whereas the law provided that a 401(k) plan may be invested in employer securities.
He noted that Congress had enacted a statutory exemption from the prohibited transaction rules of ERISA so that an ESOP could borrow money to acquire its assets, the employer's stock, whereas there was no similar provision applicable to 401(k) plans.
He then noted that Congress had enacted several tax incentives to encourage the creation of employee ownership through ESOPs, which are not available to a 401(k) plan. These were:
The ESOP sponsor may deduct up to 25% of payroll plus the interest on the stock acquisition loan. 2. Dividends paid on employer stock in an ESOP are deductible under certain circumstances. 3. A seller to an ESOP may defer tax on his/her gain on proceeds from sale of stock to an ESOP under cer hold at least 30% or more of the outstanding shares of the ESOP sponsor.
On the other hand, Congress had enacted a series of laws that some thought were restrictions, or extra requirements, on ESOP operations that do not apply to 401(k) plans because they were not required to be invest in one asset, the employer's stock. These unique ESOP rules included:
A trustee of an ESOP must vote allocated shares of stock in the ESOP in accordance with directions from the employee participants if the stock outside of the ESOP is traded on a recognized stock market, and the trustee must vote the allocated stock as directed by employee participants on major corporate issues if the stock is not publicly traded.
Since 95% of the sponsors of ESOPs in the U.S. are not publicly traded, these special ESOP rules are particularly important. The expense and administrative burden of these special ESOP rules may explain why despite the tax incentives there are very few ESOPs in the U.S. compared to 401(k) plans sponsored by closely held corporations.
Mr. Keeling then set fourth his interpretation of a recent court case in the Federal system, MOENCH V ROBERTSON ET AL, United States Court of Appeals for the Third Circuit, as supporting his view that there was no need to have a new law regulating the amount of employer securities contributed to a 401(k), or similar plan. In this case, the facts, in the opinion of the Court, shifted what it said was an obvious, and Congressionally sanctioned, presumption that a trustee of an ESOP would always acquire employer securities for the ESOP in order to create more employee ownership through an ESOP, to a situation where it might not be prudent, or in the best interest of plan participants, to continue acquiring employer stock for the ESOP. The Court then remanded the case back to the District Court level.
Mr. Keeling's point was that if the plan in the Moench case had been a 401(k) instead of an ESOP, which the Court spent a great deal of time pointing out was both an "ownership" plan and an ERISA plan, then there was no doubt in his mind that the Court would have found the trustee had violated the standards of ERISA by acquiring employer stock for the 401(k) plan, which Congress had not sanctioned as an ownership, but as an ERISA plan only.
In answer to a question about whether additional protections are required with regard to employer assets in ERISA Employer-Sponsored Plans, Mr. Keeling stated that any such restrictions on ESOPs would be a total change in Congressional policy, and that with regard to further restrictions on employer assets in 401(k) plans, they were not necessary. He further stated that additional plan regulations would lead to an overall decline in retirement plan coverage, which would be worse overall than the benefits of new regulations preventing isolated problems caused with defined contribution plans having employer assets in plans such as 401(k).
Testimony of Ian Dingwall
Mr. Dingwall provided some insights into the reviews performed by the DOL on the different types of assets in plans.
He reported that the DOL would audit and investigate cases with stocks and real property holdings mainly to ensure that the valuation is prudent. He added that field audit manuals only give general guidance in interpreting the statute. He also confirmed that the information on the 5500 might show large amounts of unappraised assets or large funds with mostly commingled assets that could be further investigated.
Mr. Dingwall suggested that a more extensive review and audit of plan filings are precluded by the limited size of his staff.
Meeting of June 12, 1997
Mr. Beaver provided some background on the investigative procedures and projects that are handled by the Office of Enforcement.
He stated that the enforcement standpoint is strictly guided by the statute and regulations. He further described the enforcement strategy to maintain a balanced investigative program that covers different kinds of plans or specific areas where there is widespread or systemic abuse or potential problems, both at the national and regional levels. This is augmented by several common targeting devices, such as computer-based audits, customer complaints and media attention on specific issues.
As such, he reported that there are no special procedures or special projects with respect to employer assets, securities and real estate where most of the issues revolve around, first, the percentage of these investments allowed by the plan and then, the proper valuation of these kinds of investments. There may be a few occasions involving a breach of fiduciary duty as in self-dealing or misrepresenting certain information to plan participants, but these also would fall within the standards of the law.
Mr. Beaver suggested that policy type questions or problems with the law in its current state might be better addressed outside of enforcement.
Testimony of Kent Novell
(Abstracted from Mr. Novell's prepared statement)
Access Research has conducted surveys and compiled statistical data from interviews over the past 10 years relating to trends in use and selection of employer securities in defined contribution plans and since 1989, particularly with respect to 401(k) plans. Generally employer securities represent a significantly higher percentage of total plan assets in 401(a) plans, where participants have less control over investment selection, than in 401(k) plans.
According to 1995-1996 data, employer securities did not exceed 32 percent, regardless of plan status. For 401(a) plans, less than 10 percent of account balances are maintained in employer securities. It is important to note that, based on their findings, were participant investment selection is common, less than 10% of account balances are maintained in employer securities. According to Mr. Novell, this would suggest that although inclusion of employer securities in defined contribution plans does, in some cases, pose unusual investment risk, plan participants seem to be aware of the potential risks and have minimized their exposure. These findings are based on averages across all segments of the defined contribution market and no representations are made with respect to specific plans where greater concentrations of company stock exist.
Mr. Novell stated that 25% of plans present participants with 6 or 7 choices, with the mean number of investment alternatives at 6.3, and the average contribution is allocated to only 2.2 investments. Despite the lack of diversification within the average participant directed account, employer securities represent, on average, under 10% of total assets. This would suggest that exposure to risk is far smaller than the potential for risk in the use of employer assets in 401(k) plans.
Between 1990 and 1996, Mr. Novell stated that all types of equity investment options have shown increased availability except employer securities, which have remained relatively static. Further, the availability and selection of company stock approximates the trends shown for guaranteed investment funds which are generally regarded as a conservative or ?safe' investment alternative. This appears to demonstrate that participants' perceive employer securities as a stable investment, representing only a small percentage of total assets in their accounts.
Continued study of the long term consequences of usage of employer assets as investment alternatives and matching contributions for defined contribution plans is advisable. Mr. Novell stated that their research show no evidence that employer assets currently represent either an abnormally large percentage of participant accounts or that the number of investment options available to a participant would tend to create such high concentration.
Testimony of David L. Wray
[Abstracted from Mr. Wray's prepared statement and testimony]
The legislation proposed in 1996 to restrict the amount of company stock in a defined contribution plan to a maximum of 10% of plan assets is unnecessary because plan fiduciaries are already required by law to maintain plan assets for the exclusive benefit of participants.
Restricting the amount of company stock employees may hold in their defined contribution plans is essentially a restriction on employee ownership, and therefore contrary to the expressed public policy that employees should own a part of the company at which they work. In 1992, there were more than 11 million employee owner-participants in defined contribution plans, making those plans a major vehicle for attaining the goal of employee ownership.
Employee ownership through the medium of the defined contribution plan has demonstrated unusual stability. Over the last two decades, the percentage of plans using more than 50% of their assets to invest in company stock has stayed at around 20%.
Defined contribution ownership of company stock has demonstrated self-regulation. Historically, when the risk of investing in the stock has outweighed the benefits, plan fiduciaries have not permitted it. The percentage of defined contribution assets invested in company stock declined from 30.7% in 1980 to 23.8% in 1992 despite a sevenfold increase in total defined contribution assets during the same period. In addition, the highest concentration (90%) of company stock in defined contribution plans can be found at corporations with more than 5,000 employees.
In practice, employees can benefit greatly from long-term company stock investments. At one plan, individuals who retired in 1996 after 30 years of service received twice the retirement benefit they would have received had the plan been invested in a 50:50 combination of an S&P equity fund and an intermediate government bond fund.
Plan investment in company stock saves money for participants (thus increasing their returns) since federal rules prohibit payment of commissions in connection with the sale or purchase of company stock in a defined contribution plan. These savings have been estimated at $900 million annually.
The sponsoring company can benefit in two ways: (1) improved company performance as employees recognize that their own work can benefit them through increased value of the stock, and (2) access to significant capital as defined contribution assets are invested. In 1992, defined contribution plans with more than 100 participants held $168 billion in company stock.
The use of company stock in defined contribution plans has been very successful. More restrictive policies would reduce the number of companies offering retirement plans and reduce the company contributions to some existing plans.
No action should be taken that would restrict the amount of contributions by either employers or employees, but as a group the Profit Sharing/401(k) Council of America would not oppose a change that expands the empowerment for participants over their own investments.
Meeting of July 17, 1997
Mr. Strasfeld first discussed the General Motors (GM) exemption, which is important in that it provides major exceptions for qualifying employer securities. In March, 1995, the Department of Labor granted the largest exemption to date to GM. It permitted the contribution of $10 billion in cash and stock to GM's largest defined benefit plan, which covered 600,000 participants.
Mr. Strasfeld outlined the key features of the exemption as: an independent trustee, a cash credit balance reserve, an independent appraisal of stock value, and a limitation on GM's access to funding credit balances generated by the stock contribution. He said that the acquisition and exemption permitted the holding of the stock by the plan, which would have been a violation, and it permitted subsequent cash sales of the stock by the plan. Further, it permitted exchange of the stock for other securities under the same terms as were available to other shareholders; that is, GM would not have to seek additional exemptions for subsequent exchanges.
Mr. Strasfeld then discussed why GM needed an exemption from the otherwise prohibited transaction rules, First, GM stock represented a higher percentage of the plan's assets than is allowed under 407(a) of ERISA. Second, the contribution would have violated the requirement that no more than 25% of the company's stock be held by the plan. He added that the exemption lowered GM's unfunded liability tremendously. He then said the exemption was different from the other the Department had previously approved in terms of its complication, its involvement with another federal agency, and in the amount of money involved. He said the agreement restricted the use of GM's contributions. In July, 1996 the plan's stock was offered publicly and made a large profit.
When asked if fiduciary implications were considered in the context of the exemption, Mr. Strasfeld stated that there were prudence issues in trying to align the interest of the plan and GM. GM was concet if all the stock were sold and lowering the price, but that was the same concern of the plan so it ended that the interests were aligned. Mr. Strasfeld said that other organizations have asked for similar exemptions but could not demonstrate why the exemption would be beneficial. He said that the Department required independent appraisals of the securities, an independent knowledgeable fiduciary to represent the plan's interests and a provision that required companies to guarantee a floor amount. He said due to these requirements there have only been a few exemptions requested .
Mr. Strasfeld then switched topics to employer real property, which is subject to two sets of rules: general fiduciary responsibility provisions under 404 and prohibited transactions provisions. These transactions are subject to the exclusive benefit rule under ERISA and the prudence rule, and the diversification rule. Individual account plans are not subject to diversification requirements. Prohibited transaction provisions deny specific transactions, but there are exceptions. Mr. Strasfeld noted that a defined benefit plan can only hold ten percent of its assets in the aggregate in qualifying employer securities or employer real property. To qualify as employer real property, there must be a substantial number of parcels dispersed geographically; each parcel must be suitable for more than one use, and the acquisition and retention of the property must comply with the fiduciary provisions other than diversification. Employers can comply by selling parcels to the plan and leasing them back, or acquiring parcels which are already subject to leases with the employer. Exemptions for single parcels are different; there is still a requirement of an independent fiduciary, but also required are an MAI appraisal and periodic adjustment of the lease terms.
Testimony of Charles E. Vieth
The ability to use company stock in their defined contribution plans is the most viable solution for many employers who wish to provide retirement plans which are appropriate for their workforce while meeting business needs.
Mr. Vieth provided statistics about the 137 plans serviced by his company which hold employer stock as a investment. In summary, these plans are generally sponsored by medium and large publicly-traded companies with more than 3,000 employees. They offer an average of nine investment options in addition to company stock. Company stock averages 32% of plan assets.
Mr. Vieth noted the following flaws in the prior legislative proposals to limit investment in employer securities:
There is little evidence that warrants the proposed restriction since employers, reacting to employee demands for increased investment options, are less likely to sponsor plans with such investment limitations. Additional regulation will only have an adverse effect on the creation and promotion of 401(k) plans.
The Color Tile bankruptcy was an unusual situation involving real estate. To react to it by restricting investments in employer stock is excessive. Employees are able to judge the risk and reward involved in making an investment in the stock of their employer: They are often more knowledgeable about the company for which they work than about other companies in which they might invest through other retirement plan options; the stock is generally subject to daily market valuation.
Legislation has recently been enacted to simplify plan administration and compliance. To impose additional regulatory and administrative burdens when there is no real crisis seems contrary to Congressional simplification efforts.
In response to a question about whether legislation was necessary with respect to investments in employer real estate, Mr. Vieth said he thought that it was not because a plan offering only that option would probably have a very low participation rate since it would be viewed by employees as not really being a benefit.
It is T. Rowe Price's position that proposals such as S.1837, as amended, which limits investment in employer securities to 10 percent of plan assets if no alternative investment is offered, are unnecessary. They would have the effect of reducing retirement plan sponsorship just at a time when Congress has recognized the importance of promoting retirement savings.
Testimony of Joseph Hessenthaler
Mr. Hessenthaler is a prominent attorney and a principal and retirement plan consultant with Towers Perrin. Towers Perrin is an international employee benefits consulting firm and provides services primarily to large employers. Mr. Hessenthaler presented statistical information and analysis of the client database of Towers Perrin.
Mr. Hessenthaler expressed a concern with the high level of attention devoted to employer assets in 401(k) plans. He points out that the Color Tile case involves real property with has very different issues than employer securities (lack of liquidity and no benefit of ownership). Mr. Hessenthaler does not see a significant problem in the investment of 401(k) plans in employer securities.
Of the 686 401(k) plans in the Towers Perrin database, only one percent of the plans require the investment of employee contributions in employer securities and 38% require the investment of employer contributions in employer securities. It is common, although not universal, for these plans to allow diversification into other assets classes at a certain age (e.g. age 55) or after a period of time (e.g. two to five years). Many of the plan sponsors for these plans also provide a defined benefit plan.
Mr. Hessenthaler believes that having a portion of employees' retirement income dependent upon the success of their employers is fine so long as that portion is within reason. Employers are motivated to require an investment of plan assets in employer securities to better align their employees' interests with those of the company. Mr. Hessenthaler acknowledges that there is a conflict when a significant portion of plan assets is invested in employer stock. Also, when privately-held or thinly-traded stock is held in the qualified plans, it is difficult for employees to realize and appreciate the value of the stock.
From the participants' perspective, Mr. Hessenthaler believes that most employees understand the investment in their company stock better than they understand other investments. He points out the advantages of a commission-free purchase in a tax deferred vehicle. He notes, however, that participants whose contributions are mandatorily invested into employer securities may not understand how to properly allocate their other retirement assets.
Restrictive legislation could reduce or eliminate the employer match in some 401(k) plans, which would have a further adverse impact on participation. Restricting employer securities in 401(k) plans would also result in the adopting of ESOPs as an alternative for many employers.
For the most part, Mr. Hessenthaler advocated against restrictions on employer assets in defined contribution plans. He did discuss three modest steps toward addressing the more troublesome issues as follows:
Meeting of September 17, 1997
Mr. Certner noted that while defined benefit ("DB") plan growth has stagnated, 401(k) plan growth has soared. Defined Contribution ("DC") plans are now comparable to total fund assets in DB plans and much of the increase in DC fund assets are due to employee contributions. Moreover, unlike DB plans, participants bear the risk of loss in DC plans.
The recently enacted Taxpayer Relief Act extends the DB ten percent employer asset limit to DC plans, applicable to employee elective deferrals beginning after 12/31/98, with a number of large exceptions:
Mr. Certner addressed whether employees are still subject to too great a risk, whether they are sufficiently informed to make educated decisions, and whether additional limitations or requirements are still needed even after the bill has become law. Lack of diversification is simply not prudent policy. Clearly, a 50-year-old worker whose retirement plan is invested heavily in company stock, is in a bad position if both his job and retirement plan dissolves simultaneously. Information and education is critical for a worker to make an informed choice, even if he is given a choice. Another significant question, is what rights do employees receive to the stock that they receive in a match? Arguably, if security and adequacy are the goal of retirement monies, participants should be able to trade stock received in a matching contribution after a holding period of one year. Mr. Certner noted that employer real property raised significant issues of valuation and liquidity.
Testimony of Norman Stein
Norman Stein is a Professor of Law at the University of Alabama. Mr. Stein advocated reforms to address the problems faced by participants in plans that are heavily invested in employer stock and real property.
Mr. Stein points out that most defined contribution plans may authorize investment of all of their assets in employer stock. In That regard, the plans are not subject to the diversification requirement of ERISA, but must follow the exclusive benefit rule, the prudence rule and the conformance rule. Unless the plan is an ESOP, there is no limitation on the type or class of stock, and voting rights need not be passed through to participants. A non-ESOP may also invest in certain marketable obligations of the employer.
On the other hand, defined benefit plans and money purchase pension plans may only invest 10% of plan assets in employer securities or real property, and there are other protective limits on the amount and quality of the holdings. Mr. Stein also described the protective features in ESOPs which are not available to participants in other defined contribution plans (diversification at age 55, put rights, pass through voting, and the higher quality of employer securities).
Mr. Stein lists the following objections to plan ownership of employer securities and real property:
Lack of diversification
Mr. Stein also addressed the two primary arguments that are given in support of holding company stock in qualified plans. Those arguments are (1) productivity gains from the alignment of interest of employers and employees and (2) some employers would not sponsor qualified plans if they could not invest a large part of the assets in company stock.
To the productivity argument, Mr. Stein points to the lack of any real documentation that productivity is linked to stock ownership. Also, when stock prices are falling, tension builds and there is a morale issue in the company.
The issue of whether some employers would sponsor plans without the ability to invest plan assets in company stock is more complex. The government provides large tax subsidies to employers who sponsors qualified plans. As such the government is an investor in the plans and has a right to say that certain types of plans are not deserving of the tax subsidies offered by qualified plans.
Testimony of Brian McTigue
Mr. McTigue indicated that individual account plans will soon be, if they are not already, the dominant form of private pension plan in the Untied States. The amount of company stock in these plans is significant. 42% of large individual account plan assets is invested in employer stock.
Many plans prevent employees from selling company securities held by the plan. If the company goes bankrupt, the employees are left with worthless or nearly worthless stock. Unfortunately, top company officials and inside board members often have unqualified Supplemental Retirement plans known as SERPs, which are not open to general employees. These supplemental plans typically hold IOUs from the Company which are deemed unsecured debt. As unsecured debt, these holding will have priority in bankruptcy over stock held by the individual account plan. Moreover, the same top company official typically negotiate the bankruptcy reorganization both on behalf of the plan and the debtor company. This means that it is not uncommon that these same top officials' supplemental pension plans, the SERPs emerge unscathed from bankruptcy while the individual account plan investment in company stock loses some or all of its value.
Mr. McTigue predicted further growth in company stock contributions. If a company makes contributions in the form of authorized but unissued employer stock, the employer is able to deduct an expense that was not incurred. It gives an advantage in cost of capital over competitors and induces the competitors to follow suit.
Mr. McTigue recommended that employees be given the right to trade company stock as soon as they are vested in the stock. This protection should be given across the board in individual account plans, including ESOPs. It leaves the tax and financial incentives in place for the companies at the same time increases the participants' investment freedom and ability to diversify. We should not create a class of second-class shareholders in the private retirement system. The golden rule should remain, if I do not like the company, I sell.
An additional proposal offered by Mr. McTigue was to establishment of an office of advocacy for the rights of participants in small plans which are in bankruptcy. He agreed with Professor Stein that individual direction by the participant is not the best method for investing retirement savings. He would prefer professional money management and some type of asset allocation system.
Testimony of Fred Yohey and Harry Johnson
Mr. Yohey is the GAO Assistant Director for ongoing work involving 401(k) plan investments in employer securities and real property, and Mr. Johnson is a Senior Evaluator of the Form 5500 data. They presented analysis of data from 1992, which they had earlier presented to congressional staff during deliberations of Section 1524 of the Taxpayer Relief Act of 1997. They presented a graphic handout that summarized the information in their presentation, and that handout was made part of the record.
The witnesses concentrated on five major points. First, they stated that 401(k) investments in employer stock and real property is "not extensive." They reach this conclusion by noting that, in their data analysis, of over 142,000 401(k) plans, only 1.7 percent had any investments in employer stock or real property. But those assets were relatively concentrated in a smaller number of plans-as they stated in testimony, "less than two percent of the plans had investments in employer stock and real property...[but] the assets totaled a little bit over 11 percent" of total plan assets. Further, "over 25 percent of the plan participants in all 401(k) plans were involved in plans that had employer stock and real property investments."
Their second major point, indicated by the above data, was that "very large 401(k) plans own most of the employer securities or real property." Point three is that such investments are "generally ten percent or more" of plan assets.
The fourth point is that most employer-related investments are "associated with supplemental 401(k) plans," and their last major point was that most plan participants direct their own investment decisions.
Work Group members asked a variety of questions about the data. There was a discussion of the number of primary versus supplemental plans, and whether the data could distinguish supplemental plans that were linked to a frozen defined benefit plan. The data do not seem to permit this distinction. The Work Group members were trying to establish whether the supplemental plans were tied to other active plans that participants could use.
This led to a discussion of the limits on the older Form 5500, where a variety of distinctions are not made in the information collected, and the expectations and hope that the new Form 5500 would provide better information on plan details.
Working Group members also asked more questions about the issue of participant direction of investments specifically, could the data distinguish whether all contributions were participant-directed, or just the participant's own contributions? The Working Group was also interested in whether employer assets were concentrated in primary or supplemental plans. Again, available information, including IRS data, do not seem able to make this distinction. The new Form 5500 is expected to help in this area as well.
Working Group members also raised questions about higher concentrations in small primary plans. The discussion noted that even though small plans make up a small percentage of the total asset universe, the data presented might indicated that employer assets were more heavily concentrated in small primary plans, not in supplemental plans as the presentation had indicated. The Working Group asked for further information on this issue, and the witnesses said they would provide it.
A supplemental communication to the Working Group following the meeting clarified some of the questions raised, including more detailed tables on employer assets in very large plans by detailed participant size, and the nature of participant direction of investments. Information on small plans and employer assets is still to come.
No specific policy recommendations were offered by the witnesses. Specific issues regarding information to be captured on the new Form 5500 were discussed, but not in the form of recommendations.
Written Testimony Received from Raymonda Handler Almand
Raymonda Handler Almand, the lead plaintiff in the suit against the trustees of the Color Tile Employee Investment Plan ("CTIP"), presented written testimony regarding he participation in the CTIP. She indicated that she participated at the maximum allowed under the investment plan, which was 5% of gross pay with Color Tile, Inc. providing a 50% match. Participants received a quarterly report showing a nice gain. Participants were never given reports as to what the monies were invested in but were generally told that it was invested in stock, real estate and bonds.
In 1992, a new benefits package was introduced which permitted participants to contribute an additional 5% of gross pay with no match. This was accompanied by a sales program, complete with video and representations that "No one would ever lose any money invested in the Color Tile Investment Plan". When people retired or left Color Tile, they received their money in a timely fashion. Participants continued to receive quarterly reports showing good valuation and growth.
Participants learned for the first time in early December, 1995, that the investments in the CTIP were dispersed in Color Tile Real Estate and some of this was mortgaged. At the same time, participants were informed that no one retiring or resigning from the CTIP could draw more than $50,000 in one quarter. On January 24,1996, Color Tile, Inc. filed for bankruptcy. Color Tile never filed a plan for recovery.
Ultimately, it was discovered that CTIP owned 43 stores in the United States, some in desirable locations and others in less desirable locations. The fiduciaries of the CTIP would use plan funds to build new Color Tile stores which would be leased to Color Tile, Inc. The fiduciaries of the CTIP were the Chief Executive Officer of Color Tile, Inc., the Vice-President for Human Resources and the Chief Legal Council for Color Tile. As of July, 1997, only three of these stores have been sold.
Disclaimer: *Official Transcripts/executive summaries of the Advisory Council on Employer Welfare and Pension Benefit Plans are available for a fee from the DOL-contracted official court reporter, Bayley's Court Reporting, for the April through October, 1997 meetings. Bayley's number in Washington is 202-237-7787 and the exact dates of meetings must be requested. The contact is Mike Shuman. As of the November meeting, the DOL's official court reporter contract changed and that contractor is Executive Court Reporting at 301-565-0064.
Any item **(double starred) is available from the private source, e.g. association, company, etc., as it is proprietorial in nature. It is not in the purview of the DOL to distribute private organizations' sales and marketing materials.
The final report of the Working Group will be available via hard copy from the Public Disclosure Office at 202-219-8771, or via the Department of Labor's Internet Address: http://dol.gov/dol/pwba around the first week in December, 1997. Questions regarding the Council charter, membership, nominations process, study issues and other related matters may be addressed to Sharon Morrissey, Executive Secretary at 202-219-8921 or 202-219-8753 or via fax at 202-219-5362.
1997 Index for Working Group on Employer Assets in ERISA Employer-Sponsored Plans
April 9, 1997: Working Group on Employer Assets in ERISA Employer-Sponsored Plans
3)*Executive Summary of Transcript
4)Wall Street Journal Articles: "Some Workers Find Retirement Nest Eggs Full of Strange Assets" and "Color Tile's 401(k) Plan Runs Aground", June 5, 1996.
5)Raymonda Almand, on behalf of Color Tile Employee Investment Plan v. Edie"401(k) Pension Protection Act of 1997 (S.106), introduced by Sen. Barbara Boxer on Jan. 21, 1997.
6)M. Lesok, et al, filed in the Federal Court of the Northern District of Texas, Dallas Division, June 6, 1996. (Private lawsuit filed by Color Tile employees
7)Written Material provided by Thomas Healey, Goldman, Sachs & Co. On Defined Contribution Plans and Employer Securities: Some Observations on the Risks and Rewards, April 9, 1997.
8)"The Participation of Leveraged Employee Stock Ownership Plans in Multi-Investor Leveraged Buyouts", prepared by the ERISA Advisory Council's ESOP Work Group and filed with the Secretary of Labor in November 1987
9)"Fixing the Broker MSOP" an article written by Neil M. Grossman, Council member and a representative of the Association of Private Pension and Welfare Plans. This appeared in the Journal of Pension Planning & Compliance, no date listed.
May 14, 1997: Working Group on Employer Assets in ERISA Employer-Sponsored Plans
3)*Executive Summary of Transcript
4)Letters from David Lurie, Office of Regulations and Interpretations at EBSA including:
a.February 23 1989 letter to Thobin Elrod of Citizens and Southern Trust Company regarding Polaroid Corporation and the subject of competing tender offers.
b.September 12, 1996 letter to the Honorable Barbara Boxer on possible legislative proposals to address the problems that have resulted from unilateral decisions by employers to invest employee contributions under 401(k) plans in employer securities and employer real property.
c.March 7, 1997 letter also to the Honorable Barbara Boxer relating to retirement plans and deferred compensation.
5)"Employer Securities in Qualified Plans: Tax and ERISA Framework" by Neil Grossman, Association of Private Pension and Welfare Plans
6)A sheet on Fidelity Magellan re risk provided by Tom Healey, member of the ERISA Advisory Group from Goldman Sachs. He also sent a memo to all group members on April 14 regarding the relative importance of pension income for individuals aged 65 and older.
7)A packet of information provided by J. Michael Keeling, President of the Employee Stock Option Plan Association, including:
a.His statement before the Working Group
b.A copy of the court decision on Charles Moench v. Joseph W. Robertson et al in the U.S. Court of Appeals for the 3d Circuit, Filed August 10, 1995.
c.**"ESOPS and TRA ?86: The Political Record in the Congressional Record" by Keeling from August 1987.
d.**"How the ESOP Really Works" a publication put out by the ESOP Association.
8)?"ERISA's Authorization of Unlimited Fiduciary Self-Dealing: Employer Stock Acquisitions by Defined Contribution Plan Trustees" by Barry D. Hunter, in the Journal of Pension Planning and Compliance
June 12, 1997: Working Group on Employer Assets in ERISA Employer-Sponsored Plans
2) Official Transcript
3) Executive Summary of Transcript
4) Testimony of Kent H. Novell, executive vice president of Access Research, Inc. on surveys and statistical data on the trends relating to the use and selection of employer securities in DC plans and, since 1989, particularly with respect to 401(k) plans
5) Statement of David L. Wray, Profit Sharing/401(k) Council of America, on June 12, 1997 regarding Company Stock in Profit Sharing, 401(k) and Other Defined Contribution Plans plus:
a. a copy of the Council's April 1997 Company Stock in Defined Contribution Plans, a successful partnership for employees and employers
b. a copy of PSCA's "Helping American Help Themselves: A Framework for Financial Security in Retirement."
6) Pension & Investments May 12, 1997 article "401(k) Diversity Bill Loses Some Bite and Los Angeles Daily News article of June 4, 1994, "Stock Plan Allows Owners to Pass Company to Workers plus Stock Plan Steps"
July 17, 1997: Employer Assets in ERISA Employee-Sponsored Plans Working Group
2) *Official Transcript
3) *Executive Summary of Transcript
4) Prepared Comments of Charles E. "Charlie" Vieth, president, Retirement Plans Services, T. Rowe Price Associates, Inc., Baltimore, MD
5) Prepared Remarks of Joseph S. Hessenthaler, principal, Towers Perrin Company, Philadelphia, PA
6) **"Helping Americans to Help Themselves: A framework for financial security in retirement" by Profit Sharing/401(k) Council of America, provided after June appearance of David Wray, PSCA.
September 16, 1997: Employer Assets in ERISA Employee-Sponsored Plans Working Group
2) *Official Transcript
3) *Executive Summary of Transcript4)
4) Copy of Diversification in section 401(k) plan investments (sec. 717 of the Senate amendment of the Taxpayers Relief Act of 1997, pages 293 and 294 and pages 750 and 752 with explanation of present law, House Bill, Senate Amendment and Conference Agreement
5) Prepared Statement of Color Tile Plaintiff, Raymonda Hander Almando, Boyle, Miss.
6) Written Testimony of David Certner, Federal Affairs Department, American Association of Retired Persons (AARP) on Employer Securities in Defined Contribution Plans.
7) Testimony of Norman P. Stein, Professor at the University of Alabama and visiting Professor at the University of California at Davis
8) Prepared Charts Handed Out by Fred E. Yohey, Jr. and Harry A. Johnson, Income Security Issue Area, General Accounting Office, at the session plus a second paper, letter date 9/17/97 from Fred Yohey re data relative to their testimony as a supplement.
9) Letters Provided by David Lurie, Office of Regulations and Interpretations, EBSA, re:
a.Secretary Robert B. Reich letter to Senator Barbara Boxer, dated September 16, 1996.
b.The "Polaroid" letter, actually to Thobin Elrod, Citizens and Southern Trust Co. Of Atlanta, Ga., from Alan Lebowitz, February 23, 198?
10) **Employee Benefits Law Changes, 1997 by KPMG, provided by Marilee Lau
October 7, 1997: Employer Assets in ERISA Employee -Sponsored Plans Working Group
3)*Executive Summary of Transcript
4)Draft of Outline of Report, October 7, 1997 (Not available to the public)
5)"Laying down the law on company stock" by Mindy Rosenthal, Institutional Investor of September 1997
6)Comparison of Companies' Returns on Stock, provided by Barbara Uberti
November 12, 1997: Employer Assets in ERISA Employer-Sponsored Plans Working Group
3)*Executive Summary of Transcript
4)Report/Recommendations for Secretary Alexis M. Herman (Not available until the early part of December, 1997)
5)Company Stock Performance 1997--DC Plan Investing
6)**Retirement Benefits in the 1990's: 1997 Survey Data, KPMG Peat Marwick LLP