AARP Recommends Changes to Proposed Hybrid Retirement Plan Regs

Dear Mr. Sandhu, Mr. Green and Ms. Marshall:

AARP appreciates the opportunity to comment on the Proposed Regulation Relating to Hybrid Defined Benefit Plans. On behalf of our millions of members, we continue to have a strong interest in ensuring that as many employees as possible are covered by employer-sponsored retirement plans; that benefits are adequate, secure and well funded; that non-highly-compensated employees accumulate their fair share of tax-subsidized benefits; that retirees are reasonably protected from financial risk to their retirement security; and that older and longer-service plan participants are adequately protected and treated fairly.

Concerns about the importance of a secure stream of retirement income highlight the critical importance of strengthening Social Security, which is the largest source of annuitized wealth for most workers. Social Security is the principal source of family income for about half of older Americans, and roughly one quarter of those aged 65 or over live in families that depend on Social Security benefits for 90 percent or more of their income. Nonetheless, Social Security was never intended to be the only source of retirement income. For those workers who have employer-sponsored retirement plans, it is important that participants and their plan benefits be protected.

Recently, older workers are have been acutely impacted by the downturn in the U.S. economy. As we have all too frequently seen, older workers are particularly vulnerable to the effects of job loss, benefit reductions, and market fluctuations. Not only do older workers have a more difficult time finding new employment after a job loss, but frequently when they do, it is for a significantly lower salary and benefit package. See, e.g., Richard W. Johnson & Corina Mommaerts, Age Differences in Job Loss, Job Search, and Reemployment at 2 (Aug 5-6, 2010), available at http://www.mrrc.isr.umich.edu/transmit/.../II-b%20Johnson-Mommaerts.pdf (reemployed men between age 50 to 61 earned 20% less). And, like most Americans, many older workers lost a significant portion of their savings and investments during the downturn in the U.S. economy.¹ Thus, whether they have experienced a cut in salary and benefits or a reduction in the value of retirement plan assets due to market losses, older workers often have too little time before retirement to compensate for these reductions.

As recognized by Phyllis C. Borzi, Assistant Secretary of Labor, Employee Benefits Security Administration, the trend away from defined benefit plans and towards defined contribution plans has resulted in a dramatic shift of risks from employers to workers. With defined contribution plans, employees now bear the investment risk, inflation risk and longevity risk. See Testimony of Phyllis C. Borzi, Assistant Secretary of Labor, Employee Benefits Security Administration, Before the Special Committee on Aging, United States Senate (June 16, 2010), available at http://www.dol.gov/ebsa/newsroom/ty061610.html. Unfortunately, many individuals are simply not prepared to handle this investment responsibility and risk. Many participants have little experience in, or understanding of, investment fundamentals. While 401(k)-type plans can be an effective savings vehicle for retirement -- especially if individuals take all the right actions and markets achieve historical rates of return -- in practice this is not the case, and many people make mistakes at every step along the way. See generally Alicia H. Munnell & Annika Sunden, Coming Up Short: The Challenge of 401(k) Plans (Brookings Inst. 2004) at 9-10, 11, 94.

In a traditional defined benefit plan, plan sponsors are responsible for making contributions, managing plan assets and paying promised benefits; employees are automatically participants in the plan. In contrast, in a 401(k) plan -- the most common of defined contribution plans -- plan participants are responsible for making contributions, determining the amount of contributions, and managing their accounts; employees also determine whether they will participate at all. All of these decisions will determine their retirement benefit. The actual result of decision-making in the 401(k) plan arena appears to be falling short of retirement income needs, as evidenced by generally less than adequate 401(k) account balances. See generally Alicia H. Munnell & Annika Sunden, supra. Some commentators have become concerned about the effectiveness of 401(k) plans, including low participation rates, low contribution rates, poor investment decisions (either too much or too little risk), and failure to rebalance investments in 401(k) plans. See, e.g., William G. Gale, J. Mark Iwry & Peter Orszag, The Automatic 401(k): A Simple Way To Strengthen Retirement Saving (Mar. 7, 2005), available at http://www.brookings.edu/papers/2005/03saving_gale.aspx. Various proposals have been suggested to make 401(k) plans more like defined benefit plans, for example, by providing for default options such as automatic enrollment, automatic contribution rates with automatic-escalation policies, and default investment options. Although the Service/Treasury had permitted automatic contribution arrangements in § 401(k) plans, Rev. Rul. 2000-8, 2000-1 C.B. 617, Congress specifically endorsed these programs in Section 902 of the Pension Protection Act. A substantial number of employers have since adopted them. See, e.g., Hewitt Assocs., Hot Topics in Retirement 2010 (Feb. 2010) at 1 ("Automatic features are quickly becoming the standard in 401(k) plans."), available at http://www.hewittassociates.com/_.../2010/Hewitt_HotTopicsRet_Survey_2010__Findings.pdf; Profit Sharing/401(k) Council of America, 53rd Annual Survey of Profit Sharing and 401(k) Plans -- Highlights of Results, available at http://www.cvent.com/EVENTS/Info/Agenda.aspx?e=63e33da5-9ccd-4ecb-92f0-f2be5803b3ee.

A hybrid plan combines features of both defined contribution and defined benefit plans. A hybrid plan can be a vehicle for sharing investment, inflation and longevity risks between the employer and the employee.² Investment risk has generally been lower for a participant in a hybrid plan because the interest-crediting rate is often tied to a bond yield, such as the 10-year Treasury bond, sometimes with a small premium added, and the principal is "guaranteed." Although the benefit in a hybrid plan is defined as a lump-sum account balance rather than as an annuity (and is typically available in a lump-sum payment upon termination of employment), the default payout option had traditionally been an annuity. Like a traditional defined benefit plan, a hybrid plan is subject to federal funding and accrual rules and is covered by the Pension Benefit Guaranty Corporation. See generally Tomeka Hill and Nancy Campbell, Hybrid Pension Plans: Yesterday, Today and Tomorrow (Dec. 2010), available at http://www.towerswatson.com/united-states/newsletters/insider/3299.

The positive defined benefit plan attributes of hybrid plans for participants -- lower volatility in account balances, "guaranteed" principal, default payout options -- are substantially diminished in the proposed hybrid plan regulations. Instead, the major attributes of defined benefit plans that the Service/Treasury has adopted in the proposed regulations are employer contributions and PBGC funding. The underlying premise of the proposed regulations -- to have hybrid plans more closely resemble 401(k) plans -- flies in the face of recognized shortcomings of 401(k) plans and the recent retirement policy trend to make 401(k) plans more like defined benefit plans. See Section 902 of the Pension Protection Act; William G. Gale, J. Mark Iwry & Peter Orszag, The Automatic 401(k): A Simple Way To Strengthen Retirement Saving, supra. By attempting to mimic 401(k) plans, the regulations dilute protections that a more balanced regulation would provide to participants and beneficiaries. As a result, the proposed regulations unnecessarily skew risks towards the employees, instead of balancing these risks between the employer and employee.

II. The Regulations Should Not Permit Plans to Use Negative Interest Crediting Rates, But Instead Should Require A Floor So That Participants Do Not Suffer Losses To Their Accounts.

It is well-known that people react very strongly to losses, a phenomenon known as "loss aversion." Loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. See Daniel Kahneman & Amos Tversky, Prospect Theory: An Analysis of Decision under Risk, 47(2) ECONOMETRICA 263-292 (Mar. 1979), at http://links.jstor.org/sici?sici=0012-9682%28l97903%2947%3A2%3C263%3APTAAOD%3E2.0.CO%3B2-3; see also Richard Thaler & Cass Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (Penguin 2009) at 33-34 ("[r]oughly speaking, [people] hate losses about twice as much as they like gains."). The recent volatility in the market has driven this point home. Given the choice to avoid large drops in the value of retirement assets versus the opportunity to gain large increases in this value, most individuals would choose to avoid large drops. Id. at 33-34, 122-24,

In order to prevent losses to participants' accounts especially right before a participant retires when they have no time to recoup these losses, AARP submits that the regulations should require an annual floor or an annual minimum rate of return for all hybrid plans. A participant's account balance at the end of the year should be no less than the account balance at the beginning of the plan.³ We understand that a floor comes with a cost, and would necessitate an account relinquishing some gains on the upside. The modeling of long-term historical returns on a balanced or blended market rate of return could provide the necessary information for both the floor and the cap. At no time should the hypothetical account balance fall below the original accrued benefit ("A") -- indeed, it should always be higher due to the addition of pay credits.

Requiring such a floor is consistent with the structure of hybrid plans, and is one of the beneficial attributes that is similar to a defined benefit plan. Also, a meaningful floor is more consistent with the proposed regulation's current requirement on the use of a minimum rate of return if certain indexes are used. E.g., Prop. Treas. Reg. §§ 1.411(b)(5)-1(4)(iv), -1(6)(ii), -1(6)(iii). Significantly, the structure of the proposed regulations themselves shows that the Service/Treasury has gone too far in the wrong direction in permitting the use of negative interest crediting rates. Special rules upon special rules are needed to make the structure of the proposed regulations work. Instead, by narrowing the corridor of the interest crediting rates, many of the troubling regulatory issues disappear (backloading) and others are greatly diminished (plan termination rules; cut back issues).⁴

AARP believes that this floor will both better protect participants' retirement security⁵ and better balance the risks between the participant and the plan. Although the proposed regulations require diversification if the rate of return of plan assets and mutual funds and other investments are used as the interest crediting rate, in recent years, we have seen that diversification, alone, is not enough to mitigate investment loss and volatility of investment accounts to participants. See Embracing Risk, PENSIONS & INVESTMENTS (Sept. 20, 2010), available at http://www.pionline.com/article/20100920/PRINTSUB/309209995.

III. The Proposed Regulations Correctly Permit Plans To Use Interest Crediting Rates After Normal Retirement Age That May Be In Excess Of The Market Rates.

The proposed regulations permit a hybrid pension plan to use an interest crediting rate after a participant reaches normal retirement age that is sufficient to provide any required actuarial increases, even if it would otherwise be in excess of a market rule of return. AARP supports this portion of the proposed rule. See generally General Dynamics Land Systems, Inc. v. Cline, 540 U.S. 581 (2004) (ADEA does not prohibit favoring older workers over younger workers).

IV. For Valuation Of Annuity Forms For Distribution, Reasonable Actuarial Assumptions Must Be Reasonable Separately As Well As In The Aggregate.

For a statutory hybrid plan with a lump sum-based benefit formula to be able to pay only the hypothetical account balance, the plan must satisfy certain rules. The proposed regulations would permit hybrid plans to value annuity forms of distribution and other optional forms of benefit payment, such as a five-year certain benefit, by applying reasonable actuarial assumptions to the hypothetical account balance. AARP makes four suggestions to the proposed regulations. First, the regulations should specify that each actuarial assumption must meet the test of reasonableness separately. Otherwise, some actuarial assumptions may adversely affect certain groups of participants, such as older longer serviced employees. Second, the regulations should specify the actuarial assumptions must also be reasonable in the aggregate. Third, the regulations should require that the reasonable actuarial assumptions take into account the experience of the plan. Fourth, the regulations could either provide safe harbors for reasonable actuarial assumptions, or examples of assumptions that would be reasonable or unreasonable. AARP supports the provisions of the proposed regulations that would facilitate payments of annuities, whether the account balance is fully or partially annuitized. By taking some or all benefits as lifetime income, participants have a better chance at not outliving their resources or having to significantly reduce their consumption in their final years because they lived longer than planned. Moreover, these provisions would be a welcome step towards reducing unnecessary barriers to employer and employee participation in lifetime income solutions. See AARP Comments to Department of Labor's Lifetime Income RFI, 75 Fed. Reg. 5253 (February 2, 2010).

V. Any Alternative Conversion Formula Must Ensure That No Participant Suffers Any Wear-Away As Well As Guarantee Additional Benefit Accruals.

One of the reasons Congress enacted the "A+B" conversion protection requirements, Code § 411(b){5)(B)(iii), was to ensure that employees, particularly older, longer-service employees, did not have a period of wear-away -- that is, a period of employment where employees did not accrue any additional benefits until their hypothetical account balances caught up with their prior accrued benefit,⁶ and employees accrued additional benefits after the plan conversion. Congress did not believe that a participant should work and only receive a benefit which s/he had already accrued years before ("A"). In the 2006 Pension Protection Act, Congress enacted provisions prohibiting wear-away transition periods because of the perception that such provisions were unfair.

Under the proposed alternative conversion formula, the proposed regulation appears to merely require that the aggregate benefit (A+B) is not less than the frozen benefit (A). This proposal, which would require employees to work after the plan conversion with ho benefit accruals, is remarkably at odds with Congress' rationale for the enactment of Code § 411(b)(5)(B). Indeed, the statutory baseline is crucial given that some commentators have intimated that potential alternatives may be a method of skirting statutory benefit protections, thus reducing benefits to employees. Consequently, AARP questions whether alternative methods of satisfying conversion protection requirements will provide the necessary benefit protections to employees -- the very reason for this portion of the legislation in the first place. Congress made it very clear that wearaway from conversions was not to be tolerated and granted relief from age discrimination rules only if there was no wearaway.

AARP strongly opposes any alternative conversion mechanism that would lead to any wear-away period and would not guarantee participants' additional benefit accruals.

VI. The Service/Treasury Should Not Permit Statutory Hybrid Plans To Offer Participants A Menu Of Hypothetical Investment Options.

In its continuing effort to mimic 401(k) plans, the Service/Treasury has asked for comments on whether a statutory hybrid plan should be able to offer participants a menu of hypothetical investment options. AARP submits that this suggestion should not be implemented for numerous reasons as discussed below.

In a recently completed study to evaluate financial knowledge, respondents were exposed to a battery of questions covering fundamental concepts of economics and finance impacting everyday life, such as calculations involving interest rates and inflation, principles relating to risk and diversification, the relationship between bond prices and interest rates and the impact that a shorter term can have on total interest payments over the life of a mortgage. While the correct response to any single question sometimes exceeded 60%, fewer than half of respondents (46%) correctly answered both a question about interest rates and a question about inflation. Less than one-third (30%) correctly answered those questions plus a question about risk and diversification correctly. And fewer than 10% of respondents were able to answer all questions correctly. For example, less than two thirds of respondents (64%) were able to correctly identify that the money in an account earning 1% interest during a year with 2% inflation would be able to buy less than today. Only one in five respondents (21%) knew that if interest rates rise, bond prices will typically fall. See id. at 37-41.

A more disturbing finding is that a significant portion of defined contribution plan participants could not even describe how their retirement assets were invested. For example, 17% did not know whether the assets in their retirement plan were invested in stocks or stock mutual funds, and 37% did not know whether their assets were invested primarily in a life-cycle or target-date fund. See id. at 27-28.

Moreover, of particular import to AARP is a study of individuals over the age of 55 showing that they lacked even a rudimentary understanding of stock and bond prices, risk diversification, portfolio choice, and investment fees. Annamaria Lusardi, Olivia S. Mitchell, and Vilsa Curto, Financial Literacy and Financial Sophistication Among Older Americans (Nov. 2009), available at http://www.nber.org/papers/w15469.

Finally, in a 2008 GfK Roper Public Affairs Survey concerning whether individuals understood financial jargon well enough to explain it to a friend, less than one-third of individuals understood the concept of rebalancing, expense ratio or dollar cost averaging, less than one-quarter understood what an index fund was and less than twenty percent understood what a basis point meant. GfK Roper Public Affairs, The Costs of Financial Jargon (February 2008).

Given the continuing low levels of financial literacy, recognized in part by the current trend of plans to use automatic enrollment features in 401(k) plans⁸ (with an apparent positive result on improving retirement savings),⁹it is counterintuitive to permit hybrid plans to adopt the investment attribute of 401(k) plans. The experience with 401(k) plans has demonstrated the problems related to individuals choosing among investment options. Although lifestyle or target date funds have been adopted to address investment shortcomings related to 401(k) plans, the recent financial downturn showed the gulf between how these funds actually worked and what participants thought they were invested in..¹⁰ See Joint DOL & SEC Hearing on Target Date Funds and Similar Investments, Panel Two (June 18, 2009). If actual individual account investments are confusing to participants, consider the confusion that will arise for participants asked |o choose a hypothetical index to use for the interest crediting rate to their hypothetical account.

Cash balance, pension equity and other hybrid plans are already among the most complicated retirement plans in the employee benefit system for participants to understand. A menu of hypothetical investment options needlessly adds to this complication, and does not fundamentally add to the financial security of participants. For all the reasons above, AARP urges a return to a more proper balance for hybrid plans, and a rejection of this investment proposal.

VII. PPA Benefits Should Not Be Extended To Plans That Do Not Meet Its Explicit Criteria.

The preamble seeks comments on whether a defined benefit that expresses a participant's accumulated benefit as a current single-sum dollar amount but does not provide for interest should be excluded from the definition of a statutory hybrid plan. We believe that Congress was explicit as to the types of plans which would be covered by the PPA's special rules. See Code § 411(b)(5)(A)(iv). Accordingly, Service/Treasury Service should not consider extending the statutory definition to other types of plans which do not meet the explicit requirements of the statute.

VIII. Given The Complexity Of The Proposed Regulations, The Service/Treasury And Department Of Labor Should Work Together To Provide Adequate Disclosures To Participants And To Prevent Employers From Misleading Participants.

The proposed regulations are complicated, and therefore raise concerns about adequate disclosure to employees, particularly given the history of this issue and the efforts of some to "hide the ball" from the employees. See, e.g., Amara v. Cigna, 534 F. Supp. 2d 288, 296, 335-344, 349-351 (D. Conn. 2008), aff'd, 348 Fed. Appx. 627 (2009), cert, granted, 130 S. Ct. 3500 (2010) (district court finding that that CIGNA intentionally misled participants by omitting information concerning wear-away of benefits); see generally Ellen E. Schultz, Actuaries Become Red-Faced Over Recorded Pension Talk, WALL ST. J., May 5, 1999, at C-1. The confusion in this area runs counter to the need to make plans simpler and more understandable for participants.

It is unclear to AARP how information concerning the "hybrid" plan provisions will be given to employees to comply with ERISA § 102, 29 U.S.C. § 1022. ("The summary plan description . . . shall be written in a manner calculated to be understood by the average plan participant . . ."). For example, the proposed regulations indicate that a plan is not required to credit interest on amounts distributed before the end of the plan's interest crediting period. Unless that provision is specifically disclosed to participants, they cannot make an informed choice as to when to apply for their benefits. Additional disclosures should be required so that employees are informed that taking their money out in a lump sum before normal retirement age will cause them to forfeit interest credits. Indeed, AARP believes that proper information is critical, and suggests that where a court finds that an employer has intentionally misled the participants concerning the provisions of these plans, a plan's tax qualified status should be at issue. Consequently, we are also copying the Department of Labor so that it may determine whether special notice rules or guidance in the form of Field Assistance Bulletins are necessary for hybrid plans.

CONCLUSION

AARP appreciates having the opportunity to provide its views on the proposed rules relating to hybrid plans. If you have any questions, please do not hesitate to contact Tom Nicholls at 202/434-3760 or Mary Ellen Signorille at 202/434-2072.

² "Certain types of defined benefit plans, such as cash balance and pension equity plans, are referred to as "hybrid" plans because they combine features of a defined benefit pension plan and a defined contribution plan." (Emphasis added.) Joint Committee on Taxation Report, JCX-38-06 (2006).

³ For example, on 1/1/2011, a participant's account has $50,000. The plan requires a pay credit of 3% of salary. This participant earns $70,000. On 1/1/2012, the participant's account should be no less than $52,100 ($50,000 (1/1/11 opening balance) + $2,100 (pay credit)).

⁴ AARP submits that the rate of return should be considered an accrual term so that if it is changed the employees can only receive the higher amount; if it is reduced it is a cutback in violation of 411(d)(6). Example: If the rate of return is 4% on 1/1/11 and then reduced to 3% on 1/1/12, the 4% rate of return cannot be reduced on the portion of the account balance in the account prior to 1/1/11).

⁵See paragraph accompanying at n. 1, supra.

⁶ For example, some employees whose defined benefit plans converted to a hybrid plan experienced wear-away periods of more than ten years. See, e.g., Amara v. CIGNA, 534 F. Supp. 2d 288, 303-306 (D. Conn. 2008), aff'd, 348 Fed. Appx. 627 (2009), cert, granted, 130 S. Ct. 3500 (2010); Engers v. AT&T Management Pension Plan, 2010 U.S. Dist. LEXIS 56881 (D. N.J. 2010); Tomlinson v. El Paso Corp., 2009 U.S. Dist. LEXIS 77341 (D. Colo. 2009).

⁷ A person who has proficient literacy would be able to explain the difference between two types of employee benefit plans, use a table to determine a pattern in oil exports across years, and using information in a news article, calculate the amount of money that should go to raising a child. U.S. Dep't of Educ, Nat'l Ctr. for Educ. Statistics, National Adult Literacy Survey at 10-11 (1992), http://www.nces.ed.gov/pubs93/93275.pdf.

⁸ In 2009, close to 40 percent of plans use automatic enrollment features, with such features being most common in large plans. For plans with 5,000 or more participants, 53.7 percent report having automatic enrollment. The most common default deferral is 3 percent of pay, present in 58.0 percent of plans, with 53.1 percent of those automatically increasing this default deferral percentage over time. The most common default investment option is a target retirement date fund (57.0 percent of plans). PSCA's 53rd Annual Survey of Profit Sharing and 401(k) Plans -- Highlights of Results, available at http://www.cvent.com/EVENTS/Info/Agenda.aspx?e=63e33da5-9ccd-4ecb-92f0-f2be5803b3ee.

⁹See Jack Van Derhei & Lori Lucas, Employee Benefit Research Inst., The Impact of Auto-Enrollment and Automatic Contribution Escalation on Retirement Income Adequacy (EBRI Issue Brief #349, Nov. 2010).

¹⁰ If the Service/Treasury does decide to move forward with this ill-advised proposal, AARP would hope that any effective date would be delayed until the Department of Labor and Securities and Exchange Commission finish their work on target date and lifestyle fund disclosures.