Is It A Bad Thing That ERISA Killed The Pension Plan?

Is It A Bad Thing That ERISA Killed The Pension Plan?

March 18, 2024

Please read my contribution to an article published in Fiduciary News...

Is It A Bad Thing That ERISA Killed The Pension Plan?
by Christopher Carosa March 19, 2024

Recently, Alicia Munnell wrote an article entitled “ERISA Killed Defined Benefit Pension Plans, Yale Law School Expert Argues,” (Center for Retirement Research at Boston College, February 28, 2024). In it, she cites Yale professor John Langbein’s paper “ERISA’s Role in the Demise of Defined Benefit Pension Plans” which concludes, despite ongoing events that eroded the effectiveness of pension plans, “it was ERISA that ultimately sealed the fate of the American Defined Benefit pension system.”

ERISA didn’t necessarily kill the pensions, but it did hasten their death. Is that a bad thing?

Without ERISA, Pension plans, if they survived, would have gone the Social Security route (i.e., insolvency because there would not be enough workers to fund the ongoing payments) or they would have been overfunded and thus made their sponsoring companies takeover targets (as we saw in the 1980s and as emphasized in the move Wall Street.)

We’ll never know for sure because ERISA did happen. What we can surmise, with the benefit of hindsight, is the law of unintended consequences clicked into full gear with the passage of this retirement plan law.

To unravel things, we need to go back to the beginning. Actually, a bit before the beginning. ERISA was a response to a terrible calamity, a pension plan gone horribly wrong.

“The closure of the Studebaker plant and the collapse of its pension plan left a lasting impression on Defined Benefit (DB) plans,” says Richard Bavetz, investment advisor at Carington Financial in Westlake Village, California. “The incident brought widespread public attention to the lack of protection for employee pensions in the event of a company’s financial failure. It highlighted the risks workers faced regarding their retirement security and served as a wake-up call about the vulnerabilities in the pension system. The incident demonstrated the potential consequences of underfunded pension plans and the need for regulatory oversight to prevent similar failures from occurring in the future.

The Studebaker SNAFU was worse than that. It was an outright tragedy.

“The full story for this can be found in a great book called The Employee Retirement Income Security Act of 1974 by James Wooten,” says Jason Grantz, managing director at Integrated Pension Services in Highland Park, New Jersey. “Studebaker is often cited as the causal pension failure that led the regulators to start the process of writing ERISA. It took almost ten years for the law to come to fruition. The story is very interesting, but not unique. Other companies had pension failures as well. This one was interesting because the managers of the company basically asked the employees to choose between keeping their jobs today and be paid from the pension fund or lose their job today but have a pension later. For the average person, that’s no choice at all. Of course they all chose to keep their jobs and a few years later they lost those jobs and had no pension, anyway. It’s very sad.”

But Studebaker was only the tip of the iceberg. It revealed a structural problem with pension plans.

“It’s ironic to position Studebaker as presaging the fall of pension plans, as it is generally held forth as the rationale for the creation of ERISA (though it took a decade after Studebaker’s ‘demise’),” says Nevin E. Adams, JD, retirement geek, Maryville, Tennessee. “What Studebaker held up to light was that there were a fair amount of pension promises that weren’t fully backed up financially. In that respect ERISA, which initially sought to insure against such things, led to a desire/need to improve the accounting for those obligations which I would argue is what really undermined their existence.”

“Before ERISA, the financial security of a pension plan largely depended on the financial health of the employer and the plan’s management,” says Bavetz. “There was little regulatory oversight to ensure that pension promises were kept. ERISA shifted the liability from the plan participants, who had little control over the management and funding of their pensions, to the plan sponsors (employers). This meant that employers were now legally obligated to adhere to certain standards regarding the funding, management, and insurance of pension plans.”

ERISA was designed to save the pension plan, not destroy it.

“The original intention of ERISA was to create a standard ‘rule book’ by which these pension plans all had to live by,” says Grantz. “Before that, all these plans ran their own way with very little recourse for the participant to protect themselves against employers who had complete control over the funds. This led to much systematic abuse, embezzlement and gaming of the plan by shrewd employers.”

The concept was quite straightforward.

“ERISA intent with regard to defined benefit plans was to require companies to back up their promise for a retirement benefit by prefunding of the liability instead of ‘pay as you go’ operation, plus the PBGC insurance backing of that promise,” says Lawrence (Larry) Starr, executive vice president at Cornerstone Retirement/QPC Inc. in West Springfield, Massachusetts.

But they say the road to hell is paved with good intentions. And this not-so-quickly turned out to be the case with ERISA. But, was that a bad thing?

“The passage of the Employee Retirement Income Security Act of 1974 (ERISA) marked a pivotal shift in retirement planning in the U.S., moving from predominantly DB pension plans to defined contribution (DC) plans like 401k plans,” says Bavetz. “While this transition has often been viewed critically, particularly for transferring financial risk from employers to employees, several positive outcomes emerged from ERISA’s influence.”

But the 401k alternative didn’t appear until four years after ERISA, and it took another five years for companies to embrace the new vehicle. What might explain the decline of pension plans prior to the domination of 401k plans?

“The ultimate workforce changes made the DB plan mostly irrelevant to the vast majority of workers who no longer spend a career at a single company,” says Starr. “With the average worker spending only 5 years or less at a given employer and having a significant number of employers over their working career, the average worker does not accrue significant benefits under a DB plan over their working lifetime. It is the change in the workforce that has made the DB plan a less attractive retirement benefit for employees. In addition, the inability to accurately project the liability many years into the future made the funding of the DB plan less attractive as well. The gold watch at age 65 for a long career with a single company is a remnant of the past and the DB plan as a general retirement program for the employees of the plan sponsor is likewise a victim of the societal change in long term employment, rather than ERISA. ERISA did not encourage the changes in the workforce.”

Aside from these demographics, ERISA still played a role in maiming pension plans. Were those injuries fatal?

“I’m not sure that ERISA ‘killed’ pension plans,” says Grantz. “It certainly made them more difficult for employers to abuse. However, the main cause of the downfall of pensions is cost. Simply put, they’re just too expensive for most employers, especially in comparison to alternatives that came out later, such as 401k plans.”

Indeed, few could initially foresee the end of pension plans coming out of ERISA. When the bean counters started to crunch the numbers, however, they could only reach one conclusion.

“In my view, the ERISA requirements for pension plans were not enacted to phase out pension plans, but rather, they were enacted, and are necessary, to protect workers and to ensure that they would receive their promised pension benefits in retirement, a promise upon which they relied,” says Michelle Capezza, of counsel at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. in New York City. “It wouldn’t make sense for an employer to sponsor a defined benefit pension plan and make promises to employees about pension benefits if they can’t meet the fiduciary standards and funding requirements for the plan, as well as all of the other ERISA and tax code requirements that go along with it.”

ERISA, it turns out, was only the first in the one-two punch that made it difficult for private companies to justify offering pensions.

“Published in 1976, two years after ERISA, The Financial Reality of Pension Funding Under ERISA reported that the PBGC was tasked with an uninsurable risk that was close to the size of the U.S. economy,” says Ron Surz, president of Target Date Solutions in San Clemente, California. “So ERISA didn’t fail. Aspects around it failed, like the PBGC and oversight issues like contribution requirements. PBGC insurance premiums should have been highest for the weakest companies, but this would have weakened them even more, so healthy firms were subsidizing the weak—their competitors.”

It may have taken the 401k to land the knockout blow, but something else may have pushed pensions up against the ropes.

“I would argue that it wasn’t ERISA but FASB 187 that did that,” says Adams. “In that sense, it is neither necessarily good nor bad, but I suspect more people would have pensions today if that had not happened. Personally, I’m delighted to have my 401k.”

The story of ERISA begins as a seed in a dying automotive company, and the fruit it bore juiced the retirements of employees in unprecedented ways. Ironically, it wasn’t through the pension plan.

“The shutdown of the Studebaker-Packard Corporation’s auto plant in 1963 shone the light on the vulnerability of pension plans to the actions of plan sponsors, which necessitated legislation to protect workers so that they would receive their promised pensions,” says Capezza. “As a result of the loss of so many pensions under the Studebaker plan for hourly workers due to underfunding issues, the campaign for pension reform took rise. When ERISA passed in 1974, it ushered in many requirements for employer-sponsored pension plans including fiduciary responsibilities, minimum funding standards, prohibited transaction rules, and a system of pension insurance that serves to protect pensions, but the law has also made sponsorship of pension plans costly and administratively complex. Thus, over time, these requirements, as well as many other reasons, have shifted employers’ view on offering workers defined benefit pension plans.”

Thus, the law of unintended consequences comes to fruition. It’s a lesson best remembered when well-intentioned lawmakers try to “fix” a broken premise. Remember this as a cautionary tale when considering the fate of Social Security.

Christopher Carosa is an award-winning online news producer and journalist. A dynamic speaker, he’s the author of 401(k) Fiduciary Solutions, Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort, From Cradle to Retirement: The Child IRA.