The Pension Protection Act of 2006 has been passed and signed into law. Legislators are now touting it as the salvation of the defined-benefits plan. In August 2006, Sen. Edward Kennedy said, "This bill says to millions of Americans who fear their pensions will disappear that help is on the way." In truth, this bill will ensure that millions of Americans will never get a pension at all. Discover the potential negative effects of this bill for future retirees.
The Act requires most under-funded defined-benefit pension plans to be fully funded within seven years (airlines get an extension). Current laws require such plans to be funded at a 90% level, which many aren't. Advocates tout the fully-funded requirement as the salvation of the nation's pension's plans, but in reality, the Pension Protection Act is more likely to be a paper tiger, at best.
At first glance, this latest legislation is a noble effort, as under-funded pension plans are notorious, and the number of companies declaring bankruptcy and passing their pension plan obligations on to the Pension Benefit Guarantee Corporation has all but bankrupted the organization.
The Act also enables employers to enroll employees automatically in company-sponsored 401(k) plans as a way to help workers amass retirement savings that they can take with them when they change jobs, unlike pensions, which often require a significant number of years of employment for eligibility and don't continue to grow if the employee changes jobs. When an employee changes jobs, the Act also makes it easier to roll over 401(k) plan assets into a Roth IRA. In the past, rollovers had to be made into a Traditional IRA and then a conversion had to be made to a Roth because 401(k) plans and Traditional IRA are both funded with pretax money. Now, the tax calculations can be made automatically if a Roth IRA is selected. Investors still will need to meet all qualifications in order to contribute to a Roth. (To learn more, see Roth IRAs Tutorial.)
Another feature of the new Act will make it easier to contribute to an IRA by providing the option to have any tax refund checks automatically directed to your IRA. It also makes the increased amounts that investors can contribute to their IRAs permanent. For 2006 and 2007, workers 50 years old or younger can deposit $4,000. For 2008, the limit climbs to $5,000. After 2008, it increases based on inflation. It was scheduled to drop back to $2,000 per year in 2010, but now the higher limits will remain in place. A similar stipulation applies to 401(k) plan contributions, which are currently capped at $15,000 per year for 2006, but were scheduled to be reduced in 2011. The "saver's credit" was also given permanent status, enabling lower-income workers to claim up to $1,000 tax credit and reduce their income tax liability. (To learn more, see The Saver's Tax Credit: And Added Incentive To Fund Your Plan.)
Investment advice is another feature. The Act permits 401(k) plans to offer specific investment advice. This feature should make it easier for employees to make investment selections. The same goes for automatic enrollment, which lets employers deduct 3% from an employee's paycheck and automatically invest it in the 401(k) plan. The deduction rate can be increased by one percentage point per year until 6% is reached.
While the items listed are not comprehensive, they do hit the major points as pertaining to retirement savings. The act itself is 900 pages long and addresses issues such as withdrawals from 529 plans, charitable donations from IRAs and taxation on donated goods, among other things.
When Theory and Reality Collide
Although the Pension Protection Act may look pretty good at first glance, a close inspection reveals another picture. In theory, the Act will force companies to fund their pension plans fully within seven years. In truth, the legislation provides an enormous incentive for employers to eliminate their pension plans altogether. Why dip into profits to fund the pension plan when you can eliminate it altogether? Not only does eliminating a pension plan free companies from funding them, but it also wipes out all future obligations, not only to existing employees, but also to new ones.
Similarly, the provision that allows employers to enroll workers automatically in so-called "voluntary" 401(k) plans is also a double-edged sword. You don't have to be a mathematician to determine that encouraging employees to save for themselves is a sign that the company is rethinking its obligation to save on behalf of its employees. The same goes for the Roth IRA rollover provision and the automatic redirection of refunds from the IRS. Both your employer and the government are sending a message: If you want to retire, fund it yourself. (For more insight, read Determining Your Post-Work Income and The Demise Of The Defined-Benefit Plan.)
Additionally, employees that are enrolled automatically have the contributions directed to investments that they did not choose. While some savings is better than nothing, counting on investments that you didn't choose is a scary way to plan for the future. Firms that institute automatic enrollment are not required to offer a company match, but if they do choose to provide at least a 3% match, it enables them to avoid the non-discrimination testing designed to restrict the contributions of highly-compensated employees.
Therefore, while the act increased contribution limits, the higher limits mean little to lower-income workers. Having the option to contribute more is of little value if you can't afford to save anything at all. Portability is another questionable benefit, as workers already can roll their 401(k) assets into an IRA. Most workers would prefer a guaranteed pension check for a job that lasts for 30 years as opposed to saving for themselves and being able to take it with them when they get laid off or change jobs.
As for advice, the mutual fund company providing the funds will have a clear incentive to recommend their own products, which suggests that this part of the act may have limited benefits.
A Double Standard for Government Employees
Of course, the Act is a great development for government employees. While everyone else is forced to fend for themselves by squirreling away their pennies in a 401(k) plan and gambling on their futures in the financial market, the legislators and other government employees are breathing a sigh of relief, all the way to the bank. The new legislation assures that they will continue to get paid now and in the future. This makes sense - after all, how would it look if the government closed down its own pension system after passing a pension protection law?
According to Standard & Poor's, 20 large U.S. cities have seen their funding levels for government pensions drop from 99.8% to 84% on average in the period between 2000 and 2005. Boston, Chicago and Philadelphia are some of the biggest laggards, with plans funded at 63%, 65% and 53% respectively. Fortunately for them, the taxpayers now have seven years to fill the coffers so that city employees can retire in style.
Advice for Everyone Else
If you are looking for the promise of a pension to help you pay for retirement, get a job in government. Like the government's healthcare plan, politicians and other governmental employees will be taken care of with taxpayer dollars, but the taxpayers themselves are on their own. If you can't get a government gig, you had better start saving.
To learn more on preparing for retirement, read Fundamentals of Successful Savings Program and Why is retirement easier to afford if you start early?