The collapse of the US energy giant Enron, and the impact of this on the company’s pensions plan, has placed a question mark above defined contribution (DC) schemes in general and 401(k) plans in particular.
More than 60% of Enron’s 401(k) retirement plan was invested in company stock and Enron employees lost some $1bn of their retirement savings as the company spiralled towards bankruptcy.
The affair has raised broad questions of how corporate DC plans should be governed. Some have argued that there must be regulatory limits – a cap on the amount of an employer’s stock that can be held in a company’s plan. Others argue that such limitations run counter to the purpose of DC plans which is to place investment decisions squarely in the hands of employees.
The affair raises other questions. Is it right for a company to lock employees in to company shares, as Enron did? Should the freedom to buy an employer’s stock be matched by the freedom to sell?
European pension plans may not yet provide the freedom of investment choice offered by DC schemes in the US. Yet many European pension fund managers and asset managers believe it is only a matter of time before they do. Perhaps now is the time to re-think the whole idea of individual investment choice within a pension scheme.
In this month’s Off The Record we ask what you think about investment choice, its use and abuse by Enron, and the lessons that can be learned from the affair.
A clear majority of you (60%) believe that employees should be free to invest as they wish within DC plans. There are a few qualifications, however. Some feel that full investment choice is fine in theory but “unwise” in practice. Others said employees needed investor education to enable them to make informed choices.
An even larger majority (80%) think that employees should be able to decide their own asset allocation. However, some of you suggest that this need not necessarily be an individual decision. In Denmark, for example, the selection of unit-linked funds is made by a board of trustees on which the employees have a majority of seats.
However, many of you feel it should be part of the fiduciary duties of a pension fund board or investment committee to decide how many investment options an employee should have. A majority (68%) think that employers rather than the employees should decide how many investments options an employee may have.
There is a wide range of opinion about how many options the employer should offer from “unlimited” to “more than five but less than 25”. Some suggest three risk/return options with percentages of bonds and equities distributed 25:75, 50:50 and 75:25 Others suggest five basic investment variables – cash, bonds, shares, active and passive.
Employers may also offer life-cycle options to employees who do not want to bother with investment choice. Most of you (80%) agree this is a good idea.
More adventurously, one fund manager suggests the choice of a fund fully invested in the company’s own stocks, plus at least three balanced funds. A majority of you (68%) believe that employees should be able to invest in their own company’s stock within a DC plan.
However, a larger majority (84%) say there should be a limit on the amount of own company stock that employees can hold in a plan. Most of you feel a limit of 5% to 10% is appropriate, the investment restriction already in place in most European countries.
However, a substantial minority (32%) say that employees should not be able to invest in their own company’s stock within a DC plan. “No way,” one pension fund manager responds briskly. “It should be a prohibited investment to avoid any conflict of interests.” Another pension fund manager puts it even more bluntly: “The employee’s own job is enough risk already.”
One fund manager points out that employees do not need to invest in their employer’s stock to benefit from their company’s performance: “A company pension fund should not invest in its own stock. If the company is doing well the employees will benefit through wages, bonus and other rewards. If the company is under performing the employees will at least have some security through their pension money, even though their wages will suffer.”
When it comes to the practice of employers making contributions to pension plans in their own shares rather than cash, there is less of a consensus. A small majority (56%) disapprove. “It could lead to another Enron,” says one pension fund manager “Furthermore a company may simply dilute shareholder equity by issuing more shares.”
Even those of you who approve of the practice insist that there should be no restrictions on employees trading these shares whenever they want to, and in an effective, liquid market. Enron employees saw the value of their pension plans disappear largely because they were not allowed to sell their holdings of company stock.
Yet few of you (16%) believe that the Enron affair has weakened the case for company DC plans or would slow the move by European companies to replace DB with DC plans. You feel there are other, more significant factors militating against the spread of DC plans. “Good guidance is sufficient to avoid Enron-like problems,” one pension fund manager points out. “The fall of the equity markets in the past six years is a bigger deterrent to DC plans than Enron.”
So are there any lessons, in terms of pension fund governance, that can be learned from the Enron affair? According to you, there are plenty. Auditing comes top of the list of things that need improvement. “Attention must be paid to reforming the audit functions,” says one. “Do not assume your auditors are working for your benefit,” warns another.
The need for employee protection and employee education is another lesson that needs to be learnt. One pension fund manager thinks the Enron affair demonstrates “the blindness of some decision-makers, both employers and employees, when left totally free in their choices”. Another fund manager even confesses to having “second thoughts about the social implications of a full free choice and the connected education needed for private responsibility”.
The education of employees should explain the benefits of diversification , you say. “Diversification is an absolute must,” says one manager. “You must never put too many eggs in one basket.”
This is a recurring response, and a lesson that DB schemes can perhaps teach DC plans. The manager of a large UK pension fund comments: “The one obvious learning message from Enron, so far as pension funds are concerned, is that it is madness, whether in the US or the UK, to invest personal savings heavily with one’s employer and hence put all your eggs in one basket.
“The sort of employer-related investment rules which apply to defined benefit schemes in the UK would appear to be a very sensible safeguard for all types of pension scheme, whether in the UK or the US.”
Another lesson is that protecting the pension fund is quite as important as protecting the employee: “Pension plans, whether DB or DC, should have no exposure to their sponsoring company,” one manager says. “All pension obligations should be held in a separate trust, or at least covered by an insurance policy,” says another.
It is a mistake to assume that the interests of a company and its pension fund are the same, you warn: “A company and its pension fund are two totally different entities and they should each be managed separately in their own best interest,” one fund manager comments. “A company’s best interest is not necessarily the best interest of the fund. Pension fund money should be managed in the interests of the beneficiaries only, and not in the interest of the company.”
And that, surely, is the real lesson of the Enron affair.