Testimony of the

American Society of Pension Actuaries

At a Hearing on Pensions Before the

U.S. Senate Committee on Finance

Wednesday, June 30, 1999

Introduction

Mr. Chairman, members of the Committee, thank you for inviting me today to testify on pension reform. My name is Richard D. Pearce. I am an Enrolled Actuary, Certified Pension Consultant and President of the Wilmington, Delaware office of Alliance Benefit Group, a pension consulting and actuarial firm. We presently provide retirement plan administrative services to over 250 small businesses in Delaware covering approximately 25,000 employees. Alliance Benefit Group is a nationwide consortium of pension consulting firms providing retirement plan administrative services to small businesses covering approximately 380,000 employees with retirement plan assets totaling over $4.5 billion dollars.

I also am a member and Past-President of the American Society of Pension Actuaries (ASPA) on behalf of whom I am testifying today. ASPA is an organization of over 4,000 professionals who provide actuarial, consulting, and administrative services to approximately one-third of the qualified retirement plans in the United States. The vast majority of these retirement plans are plans maintained by small businesses, and today I would like to focus on the myriad of rules and regulations which continue to make it exceedingly difficult for small businesses to offer meaningful retirement plan coverage to their employees.

The Small Business Retirement Crisis

Everyone agrees on the problem. Americans, as a whole, are getting older and their retirement needs are growing. The number of Americans age 65 or older will double by 2030 (from 34.3 to 69.4 million) so that one in five Americans will be retired. As reflected in the current debate, the stress and strain on the current Social Security system will be significant.

However, even if the Social Security system remains strong through the 21^st century, it will not be enough. Income from Social Security represents less than half of what the average American needs to retire comfortably. Meanwhile, according to recent surveys conducted by the Employee Benefits Research Institute one-third of the American workforce has not begun to save for retirement, and 75% of Americans believe they do not have enough retirement savings. Americans with low to moderate incomes are hardest hit since they are most likely to have no savings.

This highlights the need to expand and reform the private pension system. However, this need is especially acute with respect to small businesses. Since the enactment of the Employee Retirement Income Security Act of 1974 (ERISA), the Congress has enacted layer upon layer of complex laws, and the Internal Revenue Service (IRS) has issued layer upon layer of complicated regulations seriously retarding the ability of small businesses to maintain retirement plans for their employees. In most cases these rules were enacted not in the interest of promoting retirement savings, but to raise revenue and to fund unrelated initiatives.

The effect of these costly rules and regulations on small business pension coverage is both dramatic and rather disturbing. The facts speak for themselves. According to a 1996 General Accounting Office study,⁽¹⁾ a whopping 87 percent of workers employed by small businesses with fewer than 20 employees have absolutely no retirement plan coverage. It's only slightly better for workers at small businesses with between 20 and 100 employees, where 62 percent of the workers have no retirement coverage. By contrast, 72 percent of workers at larger firms (over 500 employees) have some form of retirement plan coverage.

This significant disparity is made even more troubling by the fact that small business is creating the majority of new jobs in today's economy. As big firms go through corporate downsizing, many of the displaced workers find themselves working for small businesses. In fact, according to the Small Business Administration, 75 percent of the new jobs in recent years were created by small business. Small business now employs over half of the nation's workforce. However, because of the many impediments to small business retirement plan coverage, small business employees will often find themselves without a meaningful opportunity to save for retirement.

The Retirement Savings Opportunity Act (S.649), introduced by you, Mr. Chairman, and Senator Baucus (D-MT), and The Pension Coverage and Portability Act (S. 741), introduced by 11 members of this committee, including Senators Graham (D-FL), Grassley (R-IA), Baucus (D-MT), Hatch (R-UT), Breaux (D-LA), Jeffords (R-VT), Robb (D-VA), Mack (R-FL), Chafee (R-RI), Thompson (R-TN), and Murkowski (R-AK), contain numerous provisions which, if enacted, would have a substantial and immediate impact on small business retirement plan coverage. Throughout my testimony I will highlight some of the more significant of these provisions.

Roadblocks and Solutions to Small Business Retirement Plan Coverage

1. Retirement Plan Limits

Since ERISA was enacted, Congress has placed significant limits and caps on retirement plan contributions and benefits. Although these provisions were enacted under the false premise of reducing the benefits of high-paid individuals, they have actually served to reduce the benefits of rank-and-file employees.

Let me begin with one specific type of limitation problem. Under current law, total annual contributions to a defined contribution plan on behalf of any employee may not exceed the lesser of 25% of compensation or $30,000. In addition, there are limitations on the deductions that can be taken by companies for contributions to a retirement plan.

There's an outstanding construction management company in Wilmington, Delaware, called EDIS, whose situation provides a real-life example of the problems caused by this current-law limitation on retirement benefits.

Andy DiSabatino is a fourth-generation chief operating officer of his family's construction management firm. His company places a very high value on its employees, and the firm has always provided fairly generous retirement plans for its staff. In addition to a money purchase pension plan providing consistent annual retirement plan contributions, the company has also maintained a discretionary profit sharing plan to provide supplemental contributions to their employees in profitable years. The company has historically made significant contributions to this plan on a fairly consistent basis; however, being in a cyclical industry, they have simply not been in a position to contribute to this plan each and every year.

Andy decided that he would like to offer his staff an opportunity to save on their own on a tax-efficient basis. This would assure that the employees would not be short-changed if the company were to go through a long period of low-profits. To accomplish this, Andy implemented a 401(k) plan that was funded by a combination of voluntary salary deferrals and employer matching contributions. Andy had no plans to abandon the profit sharing plan. Quite to the contrary, Andy intended the 401(k) plan to be merely a supplement to the existing profit sharing and money purchase plans.

Andy's employees enthusiastically embraced the new 401(k) plan. The average deferral percentage under the plan for the 1998 calendar year was more than 7% of salary, and this generated an employer matching contribution that totaled another 3% of pay. The money purchase plan contributions for 1998 were slightly more than 9% of eligible compensation. When you add these 3-pieces together, total contributions on behalf of employees under these two plans were 19% of salary.

The company had a successful year in 1998, and Andy wanted to reward the employees with a generous contribution to the company's profit sharing plan. But here's how the deduction rules work. The 15% profit sharing limit is based on net compensation after salary deferrals. After you subtract the 7% average salary deferral from eligible salary, this reduces the overall profit sharing limit to about 14% of pay. You then have to subtract the participant salary deferrals and employer matching contributions from that amount to determine the maximum profit sharing contribution. When we finished with the arithmetic, less than 4% of pay was left for the profit sharing plan. And several participants would not be able to receive even that small amount because when you count their 401(k) plan salary deferrals they had already hit the 25% allocation limit under IRC Section 415(c). Andy decided that since not everyone could benefit from the profit-sharing plan it was not worth contributing at all, and the company has taken steps to discontinue the profit sharing plan altogether.

Andy never intended to penalize employees for participating in the 401(k) plan, but because of the way the deduction limits work, that's exactly what's happened. This seems a very mixed message to send to participants: "We want you to save for retirement, but if you do, the government says we have reduce the amount your employer can put aside for you."

This particular situation would be corrected under both the Pension Coverage and Portability Act and the Retirement Savings Opportunity Act where the 25% of compensation limitation would be repealed, and employees' own elective deferrals would not count against the corporate deduction limitation. ASPA urges you to enact these provisions as soon as possible so good employers can provide the best retirement benefits for their employees.

2. Safe Harbor Defined Benefit Plan

In the typical lifespan of a small business, it generally takes a number of years before a small business has the resources to establish a retirement plan. In my experience this does not usually occur until the small business owner is in his or her mid-40s and most likely both the owner and the workers have not previously been covered under a retirement plan. Consequently, they are getting a late start on their retirement savings, and a defined contribution plan - like the SIMPLE plan - may not offer enough savings to produce an adequate retirement income.

Here is a straightforward example. Assume a small business adopts the SIMPLE plan. One of the workers who has been with the small business for 10 years is 45 years old when the SIMPLE plan is adopted and currently earns $40,000 annually. If this worker and his or her employer contribute 10 percent of pay annually to the plan until retirement at age 65, and the plan's investment return is 7 percent per year, the worker can expect to retire with an annual pension of approximately $18,000, only about 45 percent of his salary. Most retirement planning professionals will tell you that a retirement income replacement ratio of between 60 to 70 percent of final average salary is a good rule of thumb when determining whether a retirement benefit is adequate.

But what about inflation? If this worker receives an annual salary adjustment of 4 percent per year and continues to contribute 10 percent of pay to the SIMPLE plan, the worker will only accumulate enough money to fund an annual pension benefit equal to 32 percent of final salary. By contrast, defined benefit plans can provide greater benefits at no greater cost to the employer. How? By anticipating salary increases in the plan's funding assumptions, the employer contributes more dollars to the plan in the early funding years. Because of this, more investment earnings are realized by the plan, and better benefits can be delivered to the employee.

Despite the success of the SIMPLE plan, retirement plan coverage for small business workers continues to be inadequate because of the limitations on contributions to the SIMPLE plan. The administrative burdens and high costs associated with other qualified retirement plans providing greater benefits make it extremely difficult for small business to maintain such plans. In addition, small business workers who are baby boomers and who have not previously been covered under retirement plans will not be able to save enough under the SIMPLE plan or a 401(k) plan to provide an adequate retirement income. ASPA believes small business needs a safe harbor defined benefit retirement plan to complement the SIMPLE plan which is easy to administer and which will provide small business employees, including baby boomers, a sufficient retirement benefit.

Both the Pension Coverage and Portability Act and the Retirement Savings Opportunity Act create a new safe harbor defined benefit retirement plan for small business called the Secure Assets for Employees (SAFE) Plan. This will provide all small business employees with a secure, fully portable, defined retirement benefit they can count on without choking small business with complex rules and regulations small business cannot afford.

3. Other Impediments to Defined Benefit Plan Coverage

a. Full Funding Limit

The present-law funding limits, for defined benefit plans, are a prime example of how overbroad legislation can have a disastrous effect on small business retirement plan coverage. In 1987, the full funding limit - the limit on the amount an employer is allowed to contribute to a defined benefit plan - was substantially reduced. The changes were made solely to raise revenue and had nothing to do with retirement policy. As an actuary, I can tell you that the current law full funding limit seriously impairs the funded status of defined benefit plans and threatens retirement security because it does not allow an employer to more evenly and accurately fund for projected plan liabilities. One way to conceptualize the problem is to compare a balloon mortgage to a more traditional mortgage which is amortized over the term of the loan. The full funding limit causes plan funding to work more like a balloon mortgage by pushing back necessary funding to later years. This is particularly harsh on small business because a small business does not have the cash reserves and resources that a large firm has, and so would be better off if it could more evenly fund the plan. Even worse for small business, a special rule in the Internal Revenue Code relaxes the full funding limit somewhat, but only for larger plans (plans with at least 100 participants). Once again this appears to be a vestige of the view that small business plans are just for doctors and lawyers.

Small business owners are aware of the present-law funding limits on defined benefit plans, and that is why small businesses with defined benefit plans are trying to get rid of them and new small businesses are not establishing them. From 1987, when the full funding limit was changed, to 1993 - a period which saw a significant increase in the number of small businesses established - the number of small businesses with defined benefit plans dropped from 139,644 to 64,937.⁽²⁾ That is over a 50 percent decline in just seven years.

To reverse this trend, ASPA strongly believes that the full funding limit should be repealed to allow for more secure funding. Repeal of the full funding limit is supported by wide variety of organizations representing the entire spectrum of views pertaining to retirement policy. Repeal is supported by organizations representing unions, participants, employers, financial institutions and retirement professionals. It is also supported by the Pension Benefit Guaranty Corporation, which as you know is responsible for guaranteeing workers retirement benefits.⁽³⁾

The repeal of the full funding limit is included in both the Pension Coverage and Portability Act and the Retirement Savings Opportunity Act.