Committee on Ways and Means, Subcommittee on Oversight, 3-5-02 Testimony

Statement of Scott J. Macey, Senior Vice President, AON Consulting, Somerset, New Jersey, and
Member, Board of Directors, ERISA Industry Committee

Testimony Before the Subcommittee on Oversight
of the House Committee on Ways and Means

Hearing on Employee and Employer Views on Retirement Security

March 5, 2002

Good afternoon, Mr. Chairman. I very much appreciate the opportunity to speak with you and the Subcommittee today about employer-sponsored individual account plans.

I am appearing today on behalf of The ERISA Industry Committee, commonly known as “ERIC.” ERIC is a nonprofit association committed to the advancement of the employee retirement, incentive, and welfare benefit plans of America’s largest employers. ERIC’s members provide comprehensive retirement, incentive, and other benefits directly to some 25 million active and retired workers and their families.

I am Senior Vice President of AON Consulting. In addition, for 25 years I was a senior member of the law department at AT&T, where I was responsible for employee benefit issues affecting that company. I am also a member of the Board of Directors and a former Chairman of ERIC.

TAX TREATMENT OF STATUTORY STOCK OPTIONS

Initially, ERIC would like to strongly commend the Chairman for introducing H.R. 2695, which clarifies the tax treatment of statutory stock options by providing that neither the exercise of a statutory stock option nor the disposition of option shares is subject to income tax withholding or employment tax. ERIC strongly believes that H.R. 2695 is consistent with current law and applauds the Chairman’s effort to clarify current law to facilitate the grant of stock options to employees.

Recruiting, retaining, and motivating talented employees are essential to a company’s success in today’s highly competitive global economy. Many employers grant stock options to employees throughout the workforce, including rank-and-file employees. These employees, and rank-and-file employees in particular, will be harmed if their statutory options are subjected to employment taxes.

Employers use stock options to recruit, retain, and motivate employees, to give employees a stake in their employer, and to align the interest of employees with the interests of the employer. H.R. 2695 will help employers and employees to achieve these important objectives, which are critical to the current economic recovery.

We are deeply appreciative of the Chairman’s efforts. We will be pleased to continue to support the Chairman’s efforts to secure prompt enactment of H.R. 2695. With the thought that it might be helpful to the Subcommittee, I am attaching to this statement a copy of ERIC’s submission to the Internal Revenue Service on the stock option issue.

EMPLOYER-SPONSORED INDIVIDUAL ACCOUNT PLANS

Employee accounts in employer-sponsored § 401(k) and other individual account plans have been enormously successful in providing employees and their families with financial security and retirement savings. As of the end of 2000, approximately 42 million employees had accounts in § 401(k) plan accounts, representing $1.8 trillion in assets.[1] Individual account plans have enabled millions of individual employees to accumulate very substantial savings that have allowed them and their families to enjoy a comfortable retirement. It has been estimated that within the next 25 years, § 401(k) plans may be producing retirement benefits exceeding those produced by the Social Security system.[2]

At the same time, employer-sponsored retirement plans are voluntary arrangements. Employers are not required to sponsor retirement plans for their employees; they are not required to contribute to their profit sharing and stock bonus plans; and they are not required to make matching contributions to their § 401(k) plans. Total § 401(k) plan contributions are clearly higher, however, in plans where the employer matches employee contributions than in plans where there is no employer match.[3]

Plan Investments in Employer Stock

In addressing the many issues raised by the Enron matter, Congress is faced with a difficult decision regarding the treatment of individual account plan investments in employer stock. As recent events demonstrate, although employees whose retirement benefits are based on the value of employer stock have the opportunity to enjoy substantial gains and an increase in their retirement benefits if the stock price appreciates, they also are exposed to the risk that the value of the stock will fall, with a concomitant reduction in their retirement benefits.

But for every employee who suffered as a result of Enron’s collapse, there are a great many more who have benefited mightily by investing in employer stock under other companies’ § 401(k) plans. It has been estimated that if § 401(k) plans were not permitted to invest in employer stock, employees’ investment returns under their § 401(k) plans would be substantially reduced.[4]

If Congress responds excessively to the risks associated with stock-based plans by imposing restrictions that prevent these plans from meeting employers’ business needs, Congress will have addressed one risk by creating a different and more dangerous risk: that millions of employees will be unable to share in their employers’ success. In addition, excessive legislative limits on investments in employer stock may cause employers to reduce their commitments to their plans, resulting in significant reductions in employees’ retirement savings.

The task facing Congress is made more difficult because the issues do not relate solely to employer-sponsored retirement plans. Many of the issues relate to the accuracy, adequacy, and timeliness of the disclosures made to shareholders generally, including those who hold stock outside of an employer-sponsored plan. The way in which such disclosure issues are resolved could affect, and to some extent may obviate, Congress’s decisions regarding the stock held by an employer-sponsored plan.

Employer Stock Plans

Employee stock ownership, stock bonus, and other stock-based plans are not only permitted by ERISA; they are strongly and affirmatively promoted by numerous provisions of law that have encouraged employers for nearly a century -- since 1921-- to maintain stock-based individual account plans for their employees.[5]

Employee benefit plans serve important business purposes in addition to providing a safety net for retirement. A key business purpose is to attract and retain talented employees. Employers compete with each other for talented employees by, among other things, designing and offering benefit plans that respond affirmatively to current and prospective employees’ wishes and needs, which often include highly-valued access to the employer’s stock.

Employer stock plans give employees the opportunity to purchase employer stock economically, conveniently, and tax-efficiently. Employees highly value the opportunity to invest in employer stock, the stock they know best.

Employees have benefited enormously from participating in employer stock plans. These plans have allowed employees to benefit from substantial appreciation in the value of the companies that employ them.

Employer stock plans also serve the important purpose of aligning the interests of employees with the interests of the employer’s business and encouraging employees to be attentive to the interests of the business. The following simple anecdote illustrates this point. After one company suffered losses because its delivery people regularly discarded expensive containers after they took the company’s merchandise out of the containers and placed the merchandise on retailers’ shelves, the company responded by printing the logo of its stock plan on the containers. The delivery people immediately got the point: they saw the connection between their returning the containers to the company for reuse and their own benefits from the company’s stock plan. The company, and its employee-owners, saved millions of dollars a year as a result of this program.

ERIC Opposes Caps on Employer Stock

Congress should allow employees to make their own decisions regarding the diversification of their participant-directed accounts. Congress should not restrict an employee’s right to allocate all or part of his or her participant-directed account to any investment offered by the plan, including employer stock.

The Treasury Department recently reported that placing arbitrary caps on individual § 401(k) account holdings in employer stock would have a widespread impact on plan participants, and potentially severe disruptive effects on the stock prices of major companies. The Treasury report also found that arbitrary caps fail to take into account workers’ total retirement portfolios, that arbitrary caps will be very difficult to administer (requiring tens of thousands of individual computations annually or even more frequently), and that arbitrary caps would require a large number of participants to sell their current holdings of employer stock and also would discourage employers from making matching contributions.[6] Moreover, arbitrary caps would have the perverse effect of limiting employee investments in America’s most successful companies as their stock prices rise.

Employees place great value on the freedom to make their own investment choices. Congress should not abridge that freedom.

Likewise Congress should not reduce the deduction to which an employer is entitled merely because its contribution is made in employer stock rather than in cash. An employer should be permitted to deduct the value of its contribution to the plan, regardless of whether the contribution is in cash or in stock.

Diversification Rights

In light of the Enron matter, it may be appropriate for Congress to amend existing law to give employees greater rights to diversify their individual account plan investments. Current law requires an employee stock ownership plan to allow a participant to diversify a portion of his or her account balance after attaining age 55 and completing 10 years of participation.[7]

On the other hand, Congress also should allow stock-based plans to achieve their objective of aligning the interests of employees with the interests of the employer’s business. It is one thing for Congress to give employees the right to diversify their investments at some point. It is quite another to give them diversification rights so early that the employer’s objective in having a stock-based plan is subverted.

The vast majority of major employers sponsor both defined benefit plans and individual account plans for their employees. In these circumstances, the employer’s individual account plan is only one component of the employer’s comprehensive retirement program; employees do not rely on the individual account plan alone for retirement security. As a result, it can be quite misleading to measure the diversification of an employee’s retirement savings by looking only at his or her § 401(k) account. A substantial portion of many employees’ retirement savings is attributable to their benefits in the employer’s defined benefit retirement plan under which benefits are determined by the plan’s formula rather than the investment performance of the plan’s assets. Moreover, under most stock-based programs, it is only the employer’s contributions (not the employee’s payroll deduction contributions) that are subject to investment restrictions.

The challenge facing Congress is to strike the correct balance between diversification and the objectives of a stock-based plan. Although it is difficult to state with certainty just how and where to strike the balance, there are a number of possible alternatives that merit consideration. The Subcommittee might consider, for example, one or more of the following:

Several alternative diversification schedules, any one of which a plan could adopt. Under this approach, a plan could comply by granting employees diversification rights after they meet the requirements of a schedule that is at least as favorable to employees as one of several alternative statutory schedules (based, for example, on years of plan participation, age, or both). Congress has followed this approach under ERISA for vesting and benefit accrual purposes.

A “class year” approach under which investments attributable to contributions made for a given year would become eligible for diversification after the employee completes a specified number of years of participation after the year for which the contributions were made.

Differentiating among types of contributions, so that employees would have earlier diversification rights with respect to some types of contributions than with respect to others. For example, distinctions might be drawn among employee contributions (including § 401(k) contributions), matching employer contributions, and nonmatching employer contributions.

Distinguishing between types of plans (e.g., between traditional § 401(k) plans and employee stock ownership plans), so that employees would have earlier diversification rights under some types of plans than under others.

Distinguishing between situations involving employee choice and those not involving choice (e.g., distinguishing between plans that offer a greater match if the employee elects to have it made in employer stock and plans that do not offer employees such a choice).

We will be pleased to work with the Subcommittee and its staff to explore the issues involving diversification rights and to develop these possibilities into specific legislation.

Transition and Effective Date Issues Should Be Addressed

The Subcommittee should carefully address the transition and effective date issues raised by the pending bills. Many stock-based plans have been around for decades. They hold substantial blocks of employer stock. If new employer stock rules go into effect immediately, without adequate transition or phase-in, there is a substantial risk that stock prices will be adversely affected and that significant losses will be imposed on the very employees the bills seek to protect.

If Congress enacts legislation that requires or encourages plans to dispose immediately of their substantial holdings of employer stock, the shares sold by the plan could easily represent multiples of the average daily trading volume for the stock, flood the market with stock, and significantly reduce the stock price. The primary victims will be the plan participants who are attempting to diversify their retirement savings.[8]

Accordingly, we urge the Subcommittee to consider providing for a deferred effective date or a phase-in period for any new diversification requirements. An appropriate deferred effective date or phase-in period will protect plan participants by permitting plans to liquidate their stock holdings in an orderly way that does not put unnecessary downward pressure on the price of employer stock. H.R. 3669, introduced by Congressmen Portman and Cardin, makes a good start at addressing these important issues.

Investment Advice

ERIC supports efforts to help employees to make their investment choices wisely. For example, ERIC supports changes in current law to facilitate employers’ efforts to make investment advice available to plan participants.

For example, we support the provisions of H.R. 3669 that would permit employees to elect between receiving taxable compensation and qualified retirement planning services. ERIC will be pleased to work with the bill’s sponsors to achieve enactment of this very constructive provision.

ERISA's Fiduciary Standards

Many of those advocating amendments to ERISA’s fiduciary standards proceed from the mistaken premise that stock-based plans are largely exempt from those standards. To the contrary, the fiduciaries of all ERISA-governed plans, including stock-based plans, are subject to rigorous fiduciary duties under ERISA. These standards are enforceable by plan participants and beneficiaries, by other plan fiduciaries, by the Secretary of Labor, and, in some cases, by the Internal Revenue Service.[9]

Fiduciaries are subject to a duty of loyalty under ERISA. They must act solely in the interest of plan participants and beneficiaries, and for the exclusive purpose of providing benefits to participants and beneficiaries and paying reasonable plan administration expenses.[10]

Fiduciaries are also subject to a duty of prudence that requires them to act with the care, skill, prudence, and diligence that a prudent man familiar with such matters would use in similar circumstances.[11]

In general, fiduciaries must diversify the investments of the plan to minimize the risk of large losses, unless under the circumstances it is prudent not to do so.[12]

Fiduciaries also must act in accordance with terms of the plan -- but only to the extent that the terms of the plan are consistent with ERISA.[13]

While these general rules also allow stock-based plans to acquire and retain substantial holdings of employer stock, the fiduciaries of stock-based plans remain subject to the duties of loyalty and prudence. [14]

ERISA subjects fiduciaries to the duties of the trustees of an express trust -- the highest fiduciary obligations known to the law.[15] The Supreme Court has made it clear, for example, that the duty of loyalty forbids a fiduciary from making intentional misrepresentations about the plan to employees. As the Supreme Court put it, “To participate knowingly and significantly in deceiving a plan’s beneficiaries in order to save the employer money at the beneficiaries’ expense is not to act ‘solely in the interest of the participants and beneficiaries.’”[16]

Fiduciaries who breach their duties under ERISA are personally liable to make good any losses to the plan as a result of the breach and are personally liable to restore to the plan any gains the fiduciaries realize through the use of plan assets. They are also subject to any other equitable relief that the court deems appropriate.[17]

In addition, ERISA's prohibited transaction provisions categorically bar certain transactions between the plan and related parties and prohibit misconduct by fiduciaries, such as self-dealing, representing parties with interests contrary to those of the plan, and receiving kickbacks.[18]

The Supreme Court has recognized that ERISA permits a cause of action against not only fiduciaries, but also nonfiduciaries who participate in a prohibited transaction.[19]

Co-fiduciary Liability

ERISA's fiduciary duties are supplemented by rigorous co-fiduciary liability provisions, which make every fiduciary potentially liable for misconduct by every other plan fiduciary.

Under the co-fiduciary provisions, one fiduciary is liable for a breach by a second fiduciary --

if the first fiduciary participates knowingly in, or knowingly undertakes to conceal, an act or omission of the second fiduciary, knowing that the second fiduciary is violating his fiduciary duties;

if the first fiduciary’s failure to discharge his or her own fiduciary duties enables the second fiduciary to commit a breach; or

if the first fiduciary knows of a breach by the second fiduciary and fails to make reasonable efforts to remedy the breach.[20]

Proposed Expansion of ERISA

The widely-reported losses suffered by participants in the plans of Enron Corporation have been attributed to the alleged misconduct of Enron officials. If the allegations are correct, the alleged misconduct goes well beyond a violation of ERISA's fiduciary standards. If the allegations of corporate misconduct are correct, they also suggest the possibility that federal securities and other laws have been violated. New fiduciary standards or new restrictions on holdings of employer stock under ERISA are not well-suited toward curbing conduct of the kind that has been alleged.

ERIC favors vigorous enforcement of the federal securities laws and ERISA to assure that employees, and investors in general, have the information they need to make informed investment decisions.

ERIC strongly opposes proposals to add new remedies to ERISA and to impose liability on persons who are not plan fiduciaries. As I have explained, ERISA already subjects fiduciaries to rigorous standards of conduct and imposes personal liability on fiduciaries who violate those standards. The Supreme Court has held that nonfiduciary parties in interest who participate in prohibited transactions also may be held liable under ERISA.[21] There is no need to go further. Expanding ERISA liability will strongly discourage employers from adopting health, retirement, and other plans for their employees. These proposals will harm employees, not help them.

ERIC also strongly opposes proposals that have been made for the joint trusteeship of individual account plans. Joint trusteeship will be divisive, disruptive, and counter-productive. It will politicize fiduciary responsibility. It will create employee relations strife. It will allow unions to speak for nonunion workers. It will require employers to spend resources on conducting elections rather than on discharging fiduciary responsibilities. It will disrupt, rather than strengthen, plan management. And because it will discourage employers from setting up plans, it will reduce retirement savings.

ERISA § 404(c) and Blackout Periods

Many individual account plans are participant-directed plans that allow each participant to allocate his or her account balance among a number of investment options made available by the plan. These are commonly referred to as “§ 404(c) plans,” after the ERISA section that allows these arrangements.

Temporary suspensions in trading activity (“blackout periods”) in participant-directed plans are often necessary to accommodate changes in plan administration, such as a change in the plan’s record-keeper, a change in the plan’s administrative system, or a merger with another plan. Blackout periods also occur for unanticipated reasons, such as a power outage, a computer failure, or other unanticipated events.

Although many participant-directed individual account plans allow participants to change the way their accounts are invested on a daily basis, plans are not required to permit daily changes in investments, and the vast majority of participants do not make daily changes. Indeed, daily investment changes are often discouraged. Frequent trading is inconsistent with the plan’s role as a vehicle for long-term retirement savings.

ERISA’s current fiduciary standards appropriately regulate plan administrators’ decisions regarding (a) the need for a blackout period, (b) the duration of any blackout period, (c) the need for, and timing and content of, a notice to plan participants regarding the blackout period, and (d) the timing of the blackout period itself.

There is nothing in § 404(c) that requires participants to be allowed to make daily changes in their accounts. In fact, the Labor Department’s regulations contemplate that quarterly changes can be sufficient in some cases. The Administration’s proposal -- under which any interruption in investment activity (no matter how brief) automatically results in the loss of § 404(c) protection -- is based on the mistaken premise that any hiatus in investment activity is outside § 404(c).

Section 404(c) plans have been enormously successful in encouraging employees to save. Employees appear to be more likely to choose to save if they have some control over how their savings are invested. Employers are certainly more likely to adopt and to expand these plans if they are not liable for the investment choices made by plan participants in light of each participant’s own circumstances and objectives.

We are concerned that any narrowing of § 404(c) could cause employers to respond by curtailing their plans’ participant-direction features. This is likely to make these plans less attractive to employees and to dampen their enthusiasm for retirement savings.

We believe it is appropriate to require plan fiduciaries to give participants adequate advance notice of any planned suspension of investment activity. Where it is feasible, advance notice will give participants a chance to make appropriate changes in their investment elections before the suspension period begins. And if the suspension period is so long that it does not give participants the right to make sufficiently frequent changes in their investments, § 404(c) will cease to apply under current law. There is no need to amend § 404(c) to achieve this result.

Any blackout-period legislation should meet the following requirements:

If advance notice of a blackout period is required, it should be required to be given no more than 21 days before the beginning of the blackout period; this is the approach taken by H.R. 3669.

Any advance notice should be required to be given only to the individuals reasonably expected to be affected by the blackout period, not to all plan participants.

Advance notice should not be required where the blackout period is the result of an emergency or other event that is not reasonably foreseeable.

The legislation should not impose an arbitrary limit on the duration of a blackout period; the duration of a blackout period is generally dictated by technological or systemic considerations that are beyond the employer’s control.

The legislation should recognize that many major employers maintain numerous participant-directed plans; a blackout period affecting one plan (covering perhaps a tiny percentage of the employer’s workforce) should not affect the rights of officers and other employees who do not participate in that plan.

The legislation should modify the generally applicable rules to take into account the circumstances in which a blackout period is necessitated by a business acquisition or disposition; any notice or other requirements imposed on blackout periods should be flexible enough to accommodate the exigencies of these situations.

The legislation should not adopt a per se rule under which a plan automatically falls outside of § 404(c) during a blackout period. A brief blackout period does not necessarily cause a participant to lose control over the investments in his or her account -- particularly where the participant received adequate advance notice of the blackout period and had a chance to make appropriate changes in his or her investment portfolio before the blackout period began.

The issues under consideration are difficult. They should not be resolved without careful fact-finding and analysis. Hasty adoption of well-intentioned but ill-considered legislation risks harming the very employees the legislation is designed to protect: the employees who participate in voluntary employer-sponsored plans. We urge the Committee to study the facts and the issues in depth before making recommendations.

For our part, we intend to continue to study the issues and develop additional recommendations which we will communicate to you promptly.

We very much appreciate the opportunity to submit this statement. We look forward to working constructively with the Subcommittee and its staff on these challenging and important issues.

That completes my prepared statement. I will be pleased to answer any questions the Chairman or any members of the Subcommittee might have. Thank you for your attention.

[1] Sarah Holden & Jack VanDerhei, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2000,” Employee Benefit Research Institute Issue Brief at 3 (Nov. 2001).

[2] James M. Poterba, Steven F. Venti, & David A. Wise, “401(k) Plans and Future Patterns of Retirement Saving,” American Economic Review at 183 (May 1998).

[3] Sarah Holden & Jack VanDerhei, “Contribution Behavior of 401(k) Plan Participants,” Employee Benefit Research Institute at 10 (Oct. 2001) “total contribution rates for participants in plans with employer contributions were 2.8 percentage points higher than total contribution rates for participants in plans without employer contributions” (footnotes omitted)).

[4] Statement of Jack VanDerhei at 5-6, Hearing on Retirement Security and Defined Contribution Pension Plans, Ways and Means Comm., U.S. House of Representatives (Feb. 26, 2002).

[5] See, e.g., Revenue Act of 1921, § 219(f) (tax exemption); Tax Reduction Act of 1975, P.L. 94-12, § 301, Tax Reform Act of 1976, P.L. 94-455, § 803, and Revenue Act of 1978, P.L. 95-600, § 141 (tax credits) (repealed); IRC §§ 401(a) & 501(a) (tax exemption), 404(k) (dividend deduction) and 1042 (tax-deferred sales).

[6] Report of the Department of the Treasury on Employer Stock in 401(k) Plans (Feb. 28, 2002) (the “Treasury Report”).

[7] IRC § 401(a)(28).

[8] The recently-issued Treasury Report supports our concern. See note 6, supra.

[9] ERISA § 502; Int. Rev. Code § 4975.

[10] ERISA § 404(a)(1)(A).

[11] ERISA § 404(a)(1)(B).

[12] ERISA § 404(a)(1)(C).

[13] ERISA § 404(a)(1)(D).

[14] See, e.g., ERISA §§ 404(a)(2), 407(b), 408(e); Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995); Kuper v. Iovenko, 66 F.3d 1447 (6th Cir. 1995).

[15] Donovan v. Bierwirth, 680 F.2d 263, 272 n.8 (2d Cir. 1982).

[16] Varity Corp. v. Howe, 516 U.S. 489, 506 (1996).

[17] ERISA § 409(a).

[18] ERISA §§ 406 - 408.

[19] Harris Trust & Sav. Bank v. Salomon Smith Barney Inc., 530 U.S. 238 (2000).

[20] ERISA § 405(a).

[21] Harris Trust & Sav. Bank, supra.