ERISA's Cure for the $1.5 Trillion Health Benefits Market
Amy B. Monahan & Barak D. Richman
Abstract
Since 1974, the Employee Retirement Income Security Act (ERISA) has imposed fiduciary duties on those who manage and administer employee benefit plans. But for the largest employee benefits – retirement benefits and health plans, which together constitute 13% of total national compensation – ERISA’s fiduciary duties have played very different roles. For retirement benefits, ERISA scrutinizes plan managers and requires employers to select plan investments with care. For health plans, there is a regulatory vacuum, as ERISA imposes few federal requirements yet preempts state efforts to ensure quality plan offerings. In short, ERISA has advanced protections for retirement plans but mostly curtailed protections for the nearly 155 million Americans who receive health insurance from their employer. The tragedy is that health benefit plans are in dire need of regulatory scrutiny. The costs of health insurance have risen dramatically faster than inflation, cutting into worker take-home pay and inflicting disproportionate harm on middle- and lowerincome workers, while the value and quality of covered benefits have thinned. The sorry state of employer-sponsored health insurance is largely due to inattention and inadequate probity from the parties subject to ERISA’s fiduciary obligations. In sharp contrast, the efficiency and value of retirement benefits have improved over that same period.
Because of what ERISA requires, and because of what managers of employee health benefits have failed to do, there is enormous opportunity to employ ERISA to enhance the value of health benefits for employees, which also means enhancing the value of the nation’s entire health sector. A handful of pioneering lawsuits have just started invoking ERISA to subject health benefits managers to fiduciary obligations, and many more are certain to come. Now is the time for ERISA jurisprudence to confront the consequences of neglecting health insurance, for courts to consider what demands ERISA imposes on health benefits managers, and critically, how the Department of Labor should exercise its regulatory authority under ERISA to impose fiduciary obligations that the statute authorizes and the market sorely needs. This article documents and explains this trend, counsels how ERISA should meet this moment, and offers guidance on how the Department of Labor could establish regulatory safe harbors to bring accountability and predictability to the enormous health benefits marketplace.
Hiding in Plain Sight:
ERISA's Cure for the $1.5 Trillion Health Benefits Market
Amy B. Monahan * & Barak D. Richman **
INTRODUCTION
Nearly thirteen percent of all private sector compensation in the United States, 1 or more than $2.75 trillion per year, 2 is spent on employer-provided health and retirement plan benefits – an amount roughly equivalent to the entire GDP of France. 3 Federal law has, since the passage of the Employee Retirement Income Security Act of 1974 (ERISA), attempted to protect the quality and security of those benefits. 4 ERISA imposes fiduciary duties on employers in their management and administration of all employee benefit plans, requiring them to act solely in the best interest of plan participants and with the care, skill, and diligence of a prudent person. 5
But ERISA’s impact on workers’ and their benefit plans has been severely lopsided. About $1.1 trillion is spent on retirement benefits 6 and enjoys robust
* Distinguished McKnight University Professor and Melvin C. Steen Professor of Law, University of Minnesota.
** Katharine T. Bartlett Professor of Law and Business Administration, Duke University. Visiting Professor, George Washington University School of Law. Senior Scholar, Clinical Excellence Research Center, Stanford University.
The authors thank Darren Fogarty, Robert Kaplan, Peter Lee, Tom Miller, Arnold Milstein, Jeffrey Pfeffer, Kevin Schulman, and Sara Singer, for early and ongoing conversations that inspired, informed, and shaped this long running project. We are also grateful for helpful feedback and comments received from participants at workshops held at University of Virginia School of Law, Boston University School of Law, and Boston College Law School.
1 BUREAU OF LABOR STAT., DEP’T OF LABOR, EMPLOYER COSTS FOR EMPLOYEE COMPENSATION –SEPTEMBER 2023 4, tbl. 1 (2023), https://www.bls.gov/news.release/pdf/ecec.pdf.
2 Statista, Personal Income in the United States from 1991 to 2021, https://www.statista.com/statistics/216756/us-personal-income/ (amount calculated by author using percentages in note 1, supra).
3 World Bank, GDP (Current US$) – France, https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?most_recent_value_desc=true&locations=F R (reporting France GDP at $2.78 trillion in 2021).
4 See 29 U.S.C. §1001 (explicitly stating that “the continued well-being and security of millions of employees and their dependents are directly affected by” employee benefit plans and that “safeguards [should] be provided with respect to the establishment, operation, and administration of such plans.”)
5 Id. §1144.
6 BUREAU OF LABOR STAT., supra note 1, at 4, tbl. 1 (percentage calculated by authors based on amounts spent on retirement plans compared to the total spent on health and retirement plans)
ERISA safeguards. 7 Employers selecting investment options for 401(k) plan participants, for example, are guided by Department of Labor regulations that specify the factors that should be considered in selecting investments, the minimum number of investments that must be offered, and how the investment options must fit together to allow a participant to achieve a diversified portfolio. 8 These standards are further clarified through a significant volume of case law challenging employers’ investment selections and the reasonableness of plan fees. 9 Professional publications abound offering advice to retirement plan managers on how best to comply with ERISA’s fiduciary standards. 10 The combination of detailed guidance and significant compliance pressure appears to have been effective over time: retirement plan administrative fees have decreased and investment options have shifted toward higher quality and lower cost funds, both of which materially contribute to participants’ retirement savings adequacy. 11
In contrast, the over $1.5 trillion spent on employer health plans, 12 the funds responsible for providing health coverage for a majority of nonelderly Americans, 13 has received almost no attention from federal regulators. 14 The Department of Labor has not promulgated a single regulation detailing the factors an employer must consider when selecting a health plan administrator or the process by which employers should manage health benefits in employees’ best interest. 15 And, perhaps because of this lack of guidance, there has been virtually no litigation challenging an employer’s selection of a health plan administrator or insurer. 16 Most importantly, there is no evidence to suggest that employers engage in the type of rigorous analysis or performance monitoring of insurers and administrators that is expected of a fiduciary. Given the enormous economic significance that employer-
7 See infra Part I.B.
8 29 C.F.R. §404c-1 (2022).
9 See infra Part I.B.i.
10 See infra note 95
11 See infra Part I.B.ii.
12 BUREAU OF LABOR STAT , supra note 1, at 4, tbl. 1 (percentage calculated by authors based on amounts spent on health plans compared to the total spent on health and retirement plans). This figure only includes employer contributions to employee benefits, thus excluding employee contributions to insurance premiums, which on average amount to 17% of total premiums for single coverage and 29% for family coverage. See Kaiser Family Foundation, 2023 Employee Health Benefits Survey, https://www.kff.org/report-section/ehbs-2023-summary-of-findings/ Therefore, a more accurate estimate of figure understates the total funds controlled by employers as fiduciaries is closer to $1.9 trillion.
13 KATHERINE KEISLER-STARKEY, LISA N. BUNCH, & RACHEL A. LINDSTROM, U.S. CENSUS BUREAU, U.S. DEP’T OF COMMERCE, HEALTH INSURANCE COVERAGE IN THE UNITED STATES: 2022 2 (2023), https://www.census.gov/content/dam/Census/library/publications/2023/demo/p60-281.pdf (finding that 54.5 percent of the population was covered by employment-based coverage, compared to 18.8% covered by Medicaid and 18.7% covered by Medicare).
14 See infra Part I.C.
15 See infra Part I.C.i.
16 See id See also infra Part III.A.
provided health plans (commonly referred to as “employer-sponsored insurance” or “ESI”) play in the life of working Americans, and the central role such plans have in American social policy, this is a severe abdication of regulatory responsibility.
Not coincidentally, ESI plans are frequently criticized for their high costs, 17 faulty provider networks, 18 and role in reducing take-home pay 19 In 2023, the average premium for an employer health plan was equal to nineteen percent of median wages of an employee electing single coverage, while the average premiums for family coverage are equal to over one-quarter of the median household income. 20 And because health plan premiums are a flat dollar amount and not charged as a percentage of income, these enormous costs have an outsized effect on low- and moderate-income workers and their families. To add to the pain, these dollar amounts reflect only the cost of enrolling in coverage, and do not take into account the deductibles, co-payments, and other cost-sharing that is required of individuals when they access needed medical care.
Moreover, there is substantial evidence suggesting that employers as a group have not been good custodians of their benefit plans, that health plan insurers and administrators therefore lack strong incentives to compete on value, and that the absence of ERISA scrutiny has had real consequences. The failure of employers to demand value from health insurers and healthcare providers has permitted the broader spread of inefficiencies throughout the health sector, leading Warren Buffet to call medical costs “the tapeworm of American economic competitiveness.” 21
17 See, e.g., Aditi P. Sen, et al., Health Care Service Price Comparison Suggests That Employers Lack Leverage to Negotiate Lower Prices, 42 HEALTH AFF 9 (2023).
18 Alain C. Enthoven, Employer Self-Funded Health Insurance is Taking Us in the Wrong Direction, Health Affairs Blog (August 13, 2021), https://www.healthaffairs.org/do/10.1377/forefront.20210811.56839/.
19 See Lydia Saad, More Americans Delaying Medical Treatment Due to Cost, Gallup News (Dec. 9, 2019), https://news.gallup.com/poll/269138/americans-delaying-medical-treatment-due-cost.aspx (reporting that in 2019 a record 25% of surveyed Americans delayed treatment for a serious medical condition due to cost); David U. Himmelstein et al., Medical Bankruptcy: Still Common Despite the Affordable Care Act, 109 AM. J. PUB. HEALTH 431, 432 (2019) (finding that 58.5% of bankruptcy filers between 2013-2016 reported that medical expenses contributed either “very much” or “somewhat” to their bankruptcy); Sara R. Collins et al., The Problem of Underinsurance and How Rising Deductibles Make It Worse, The Commonwealth Fund Issue Brief (May 20, 2015), https://www.commonwealthfund.org/sites/default/files/documents/___media_files_publications_issue_ brief_2015_may_1817_collins_problem_of_underinsurance_ib.pdf (finding that 23% of all nonelderly adults were underinsured in 2014, based on their out-of-pocket costs, excluding premiums, equaling or exceeding ten percent of their household income); Fumiko Chino et al., Out-of-Pocket Costs, Financial Distress, and Underinsurance in Cancer Care, 3 JAMA ONCOLOGY 1582, 1584 (2017) (finding that 16% of insured cancer patients experienced high or overwhelming financial distress as a result of out-of-pocket treatment costs).
20 See infra text accompanying note 162.
21 Andrew Ross Sorkin, Forget Taxes, Warren Buffett Says. The Real Problem is Health Care, N.Y. TIMES, May 8, 2017.
The good news is that ERISA’s existing statutory language imposes robust fiduciary duties, including the duty to act solely in the best interests of plan participants, on both retirement and health plan managers. 22 While prior literature has acknowledged this truth, no regulatory material, judicial ruling, or academic article has explored in any detail what is means for health plan decisionmakers to be subject to fiduciary duties. Given the enormous financial and social importance of health benefits for workers and their families, articulating and enforcing ERISA’s obligations could bear valuable fruit, including mitigating how the costs of employer-provided health plans have eaten into worker take-home pay, forced layoffs, and exacerbated economic inequality.
We write not just at a time when the burdens of health insurance are intolerable, but also when a nascent collection of innovative lawsuits has just started exploring how ERISA might penalize managers of wasteful employee health benefits. These lawsuits offer insights into both the law and the current health insurance marketplace, but the most pressing lesson they offer is the need for regulatory certainty. We therefore make the case that the Department of Labor should capitalize on its authority under ERISA to promulgate regulations detailing the contours of health plan fiduciary duties, and if it were to do so as it has for retirement plans, it could require employers to consider factors such as cost, quality, and value in selecting a health plan administrator and spending healthcare dollars on their employees’ behalf. Because employers wield significant market power in purchasing healthcare, requiring employers to act prudently will generate sorely needed efficiencies not just for their employees, but in all of America’s healthcare markets. 23
Our argument rests not only on clear statutory language but also on a fundamental economic argument. Employee benefits are part of an employee’s earned compensation, and when employers pledge to manage these benefits for employees, they become custodians over funds that belong to employees. This is most cleanly illustrated in the case of pension funds, which consist of savings that employees have already earned and which employers manage for future payments. But it is also the case for defined contribution retirement plans and health benefits. Both the law and labor markets recognize that employers are not obligated to provide retirement or health plans, but employers that do not offer such benefits are
22 See 29 U.S.C. §1144 (specifying ERISA’s fiduciary duties without limitation based on plan type).
23 See, e.g. Mark Katz Meiselbach et al., Hospital Prices for Commercial Plans are Twice Those for Medicare Advantage Plans When Negotiated by the Same Insurer, 42 HEALTH AFF 1110, 110-1111 (2023) (summarizing literature on pricing dynamics between private and public payers); Jacob Glazer & Thomas G. McGuire, Multiple Payers, Commonality and Free-Riding in Health Care: Medicare and Private Payers, 21 J. HEALTH ECON. 1049 (2002) (exploring the interaction between private payer rates and those of Medicare and Medicaid).
compelled, to attract comparable employees, to compensate with higher wages. 24 Employers thus are both in spirit and in economic reality in possession of their employees’ dollars, and should be appropriately liable as fiduciaries when exhibiting inadequate prudence in managing those funds.
We begin in Part I by providing background on ERISA’s fiduciary duties and documenting how the regulation of health plan fiduciary duties has so strongly diverged from corresponding retirement plan fiduciary duties. We observe that the ERISA statute clearly and categorically applies to all employee benefit plans, including health benefits, but regulatory and enforcement attention has regrettably departed from scrutinizing the provision of health benefits. Retirement fiduciaries are subject to voluminous rulemaking and vigorous enforcement, whereas there is not a single regulation that details how fiduciary standards should operate in the health plan context and very little enforcement of the existing statutory standards.
We then turn in Part II to document the current state of employer-provided health plans, along with an examination of whether employers act as effective agents for their employees in health plan decisionmaking. We emphasize three central observations: First, although employer-provided health plans are colloquially described as a benefit, the total cost of such coverage – even amounts notionally treated as “employer” contributions towards the cost of coverage –translates into an equal reduction in take-home pay. 25 It is for this reason that ERISA’s fiduciary duties should and do apply. Second, health plan premiums represent a significant portion of overall worker compensation, especially for middle- and lower-wage employees. 26 This explains both why healthcare cost inflation, reflected in increases in insurance premiums, has significantly eroded worker take-home pay and the urgency in forcing greater conserving of employee benefit dollars. 27 And third, much of the American healthcare market, which consumes nearly one-fifth of the entire domestic economy, 28 is financed through employer-sponsored plans. If employers were to demand more value from their healthcare expenditures, the market would operate more efficiently for all
24 Jonathan Gruber, Health Insurance and the Labor Market, in HANDBOOK OF HEALTH ECONOMICS 645, 690 (Anthony J. Culyer & Joseph P. Newhouse eds., 2000).
25 Id
26 Sam Hughes, Emily Gee, & Nicole Rapfogel, Health Insurance Costs Are Squeezing Workers and Employers, Ctr. for Am. Progress (Nov. 29, 2022), https://www.americanprogress.org/article/healthinsurance-costs-are-squeezing-workers-and-employers/.
27 Health plan premium growth has far outpaced inflation and wage growth over time. See KAISER FAM FOUND., EMPLOYER HEALTH BENEFITS 2023 ANNUAL SURVEY 41-42 (2023), https://files.kff.org/attachment/Employer-Health-Benefits-Survey-2023-Annual-Survey.pdf
28 CENTERS FOR MEDICARE & MEDICAID SERVICES, NATIONAL HEALTH EXPENDITURE FACT SHEET 2021, https://www.cms.gov/research-statistics-data-and-systems/statistics- trends-andreports/nationalhealthexpenddata/nhe-fact-sheet.
purchasers, thereby creating more value for employees and substantial welfare gains for the entire American economy.
In Part III, we make the case for how and why the Department of Labor can, and urgently should, exercise its authority under ERISA to require employers to be better custodians of employee health dollars. We begin by reviewing the nascent litigation that is beginning to emerge in this space, explore preliminary lessons from these early suits, and identify why they establish the need for industry-wide regulations Consistent with existing statutory duties, we argue that the Department of Labor should provide specific guidance to employers that requires consideration of medical provider cost and quality, along with other relevant factors, as part of the existing duty of prudence owed to plan participants. We further propose that the Department of Labor should offer an incentive in the form of a regulatory safe harbor for employers who select at least one plan option that maximizes clinical quality while minimizing cost through the use of a high-value provider network.
While an employer-based system of health insurance may not be anyone’s ideal for financing a national healthcare system, ERISA offers an untapped mechanism to improve the U.S. health system as we find it. Our proposal offers a clear path to improving how healthcare is purchased by the nation’s most important purchasers, and how such improvements will increase the quality and value of health benefits, worker take-home pay, and the performance of U.S. healthcare markets.
I.ERISA’S INCONSISTENT APPLICATION TO RETIREMENT AND HEALTH BENEFITS
ERISA applies to all categories of employee benefit plans. 29 Aside from some notable exclusions for plans offered by governmental and church employers, 30 the statute applies “to any employee benefit plan if it is established or maintained by any employer [or] by any employee organization or organizations representing employees.” 31 The plain language squarely includes health insurance benefits as it does retirement benefits, and it was clear that Congress always intended the bill to apply to both types of plans. 32
The parity ends there, however. Both Congress and subsequent administrators of ERISA invested far more specificity and enforcement effort in
29 29 U.S.C. §1003(a).
30 Id. §1003(b).
31 Id. §1003(a).
32 Dana Muir & Norman Stein, Two Hats, One Head, No Heart: The Anatomy of the ERISA Settlor/Fiduciary Distinction, 93 N.C. L. REV 459, 472 (2015)
securing the integrity of retirement benefits than other employee benefits. One reason was the era in which ERISA was passed. The statute’s enacting Congress was responding to a brewing crisis in union pensions and the aftermath of wellpublicized shortcomings in pension plan management and funding. 33 The structure of the Act reflects this origin and motivation. While the statute imposes some general requirements on all types of employee benefit plans, its substantive requirements were focused solely on pension plans. 34 All plans had to comply with ERISA’s reporting and disclosure obligations, fiduciary duties, and remedies. 35 But only pension plans had to comply with substantive standards with respect to plan eligibility, vesting, and benefit accrual, and were required to participate in a newlycreated system of federal insurance for such benefits. 36
In contrast, ERISA’s drafters were relatively unconcerned with employersponsored health plans because, as one key staffer who was involved in ERISA’s passage explained, “there was no crisis in health plans in 1974” and Congress therefore felt little need to introduce substantive regulation. 37 At the time, nearly eighty percent of all employees had health coverage through an employer, 38 and there were few if any perceived problems with such coverage. 39
Health insurance benefits were relatively uncomplicated in the 1970s and did not lend themselves to detailed regulatory corrections. Nearly all employer-provided health benefits at the time were financed through the purchase of insurance contracts, 40 which were subject to state regulation and remained so even after
33 Merton C. Bernstein, ERISA: How It Came to Be; What It Did; What to Do About It, 6 DREXEL L. REV 439, 440 (2014); James A. Wooten, "The Most Glorious Story of Failure in the Business": The Studebaker- Packard Corporation and the Origins of ERISA, 49 BUFF L. REV 683, 683–84 (2001); RUSSELL L. HIRSCHHORN, ED., EMPLOYEE BENEFITS LAW ch. 1, §II (2022) (ebook).
34 JAMES A. WOOTEN, THE EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974: A POLITICAL HISTORY 122 (2004). One of the triggering events was what one Senate staffer described “the most glorious story of failure in the business,” the shutdown of the Studebaker plant in South Bend, Indiana, after which the corporation defaulted on its most of its pension obligations. Wooten, supra note 33, at 683.
35 See 29 U.S.C. §§1021 et seq. (ERISA’s reporting and disclosure requirements); §§1101 et seq. (ERISA’s fiduciary duties); and §§1131 et seq. (ERISA’s remedial provisions).
36 See 29 U.S.C. §§1051 et seq. (ERISA’s participation and vesting requirements for pension plans), §§1081 et seq. (ERISA’s funding requirements for pension plans), and §§1301 et seq. (establishment of Pension Benefit Guarantee Corporation, which insurers pension plan benefits).
37 Michael S. Gordon, Introduction to the Second Edition: ERISA in the 21st Century, in EMPLOYEE BENEFITS LAW: AMERICAN BAR ASSOCIATION, EMPLOYEE BENEFITS LAW, 2ND ED. (S.J. Sacher & J.I. Singer et al, eds., 2000).
38 Jon R. Gabel, Job-Based Health Insurance, 1977-1998: The Accidental System Under Scrutiny, 18 HEALTH AFF 62 (1999).
39 See Gordon, supra note 37 (noting that the 1950s and 1960s “brought an unabated stream of coverage and benefits improvements” with no managed care and no evidence of out-of-control medical cost inflation).
40 Laura A. Scofea, The Development and Growth of Employer-Provided Health Insurance, MONTHLY LABOR REV , March 1994, at 6-7.
ERISA’s passage. 41 In addition, health plans at the time were generally indemnity plans, which simply reimbursed the usual and customary rate for any medically necessary service. 42 Health plans in the 1970s did not direct medical care or health behaviors as is typical today and did not routinely assume responsibility for managing chronic conditions. 43 Relatedly, national healthcare expenditures were merely 7.5% of national GDP, compared to 17.3 in 2022, 44 and thus did not pose the same threats to household finances or to macroeconomic stability as they do today.
Finally, it was clear in 1974 how to apply ERISA’s core principle – the assignment of fiduciary duties 45 – to ensure proper custodianship of pension plans yet less clear for healthcare benefits. The foundational fiduciary duties, such as the prohibition against self-dealing, obligation to make sound investments, and responsibility to act solely in the interest of plan beneficiaries, all had ready and intuitive applications to pension plans. Moreover, there were well-publicized instances of employers flouting these fiduciary obligations, by mismanaging or squandering employee retirement funds or executing deals that brought personal gain. 46 None of these common sensical prohibitions readily applied to health benefits that rested upon indemnity contracts, but they clearly apply to the health benefits industry of today.
In the decades following ERISA’s enactment, its fiduciary duties have been expounded, interpreted, and implemented in the retirement plan context, where rulemaking and enforcement have produced significant improvements for plan participants, but they have not been applied to health plans in any meaningful sense. This Part begins with a brief overview of ERISA’s general fiduciary standards and then describes the divergent paths of health and retirement plan fiduciary duties.
41 29 U.S.C. §1144(b)(2)(A) (exempting state insurance laws from ERISA preemption).
42 Mark A. Hall & Gerald F. Anderson, Health Insurers' Assessment of Medical Necessity, 140 U. PA L. REV. 1637, 1647 (1992).
43 See Pamela B. Peele, Employer-Sponsored Health Insurance: Are Employers Good Agents for Their Employees?, 78 MILLBANK Q. 5, 6 (2000).
44 U.S. Dept. of Health & Human Services, Ctrs. for Medicare & Medicaid Services, National Health Expenditures Summary Including Share of GDP, CY 1960-2022
45 See Muir & Stein, supra note 32, at 474; Peter J. Wiedenbeck, Untrustworthy: ERISA’s Eroded Fiduciary Law, 59 WM. & MARY L. REV. 1007, 1010 (2018).
46 See Richard A. Ippolito, Pension Security: Has ERISA Had Any Effect?, AEI J. ON GOV’T & SOC’Y, No. 2 1987, at 15 (noting that “ERISA's genesis was the common view that fraud was a pervasive problem in the pension market: firms reduced wages in exchange for pension promises, then failed to honor these obligations”); Alicia H. Munnell, ERISA: The First Decade – Was the Legislation Consistent with Other National Goals?, 19 U. MICH. J. L. REFORM 51, 51 (1985) (noting that, prior to the passage of ERISA, some pension plans “were administered in a dishonest, incompetent, or irresponsible” manner)
A. ERISA’s Fiduciary Standards
ERISA’s fiduciary provisions are grounded in the common law of trusts, 47 and ERISA’s drafters intended to “apply rules and remedies similar to those under traditional trust law to govern the conduct of fiduciaries.” 48 This approach to fiduciary duties makes sense given the legislative focus on traditional pension plans, which are funded through employer contributions with assets held in trust for the benefit of plan participants. These common law trust duties focus on protecting plan assets and ensuring that trustees do not use such funds for their own benefit or to their own advantage. 49
An employer is not always or automatically considered a fiduciary for purposes of ERISA. Instead, ERISA provides that an individual is acting as a fiduciary only when they undertake specific actions, such as exercising discretion in the management or administration of the plan or handling plan assets. 50 Decisions regarding the establishment, design, amendment, or termination of a plan are considered business decisions, and are not subject to ERISA’s fiduciary duties. 51
ERISA specifies the duties owed by plan fiduciaries, including a duty of loyalty and a duty of prudence. 52 The duty of loyalty requires a fiduciary to act “solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits…and defraying reasonable expenses of administering the plan.” 53 The duty of loyalty is interpreted to prevent self-dealing on the part of plan fiduciaries, and operates to prevent employers from using benefit plan assets for their own purposes. An employer may not, for example, divert retirement plan contributions or health plan premiums to cover company cash flow, even on a shortterm basis. 54 Neither may an employer use plan assets to save company jobs, even if doing so would benefit only plan participants, because the employer’s motivation when using plan assets must only concern the provision of plan benefits, not any
47 Beck v. PACE Int’l Union, 551 U.S. 96, 101 (2007); Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101, 110 (1989) (“ERISA abounds with the language and terminology of trust law”).
48 Daniel Fischel & John H. Langbein, ERISA's Fundamental Contradiction: The Exclusive Benefit Rule, 55 U. CHI. L. REV. 1105, 1108 (1988).
49 Dana M. Muir, Fiduciary Status as an Employer's Shield: The Perversity of ERISA Fiduciary Law, 2 U. PA. J. LAB. & EMP. L. 391, 398 (2000). For a critique of ERISA’s reliance on common law trust duties, see Natalya Shnitser, Trusts No More: Rethinking the Regulation of Retirement Savings in the United States , 2016 BYU L. REV 629 (2016).
50 29 U.S.C. §1002(21).
51 This distinction between business decisions and fiduciary actions is not explicitly mentioned in statute, but was first noted in a 1986 Department of Labor information letter. Muir & Stein, supra note 32, at 478. These business decisions are commonly referred to as “settlor functions” in the ERISA context, further borrowing from the language of trusts.
52 29 U.S.C. §1104(a).
53 Id.
54 29 C.F.R. §2510.3-102 (2022).
other type of benefit. 55 And an employer may not accept commissions or other kickbacks for placing investments using plan funds. 56
The duty of prudence requires a fiduciary to act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent [person] acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” 57 The duty of prudence is often thought of as a requirement to put in place a robust decisionmaking process that ensures fiduciaries have access to and consult the relevant information necessary to make plan decisions, and that such decisions are carefully considered. 58 A fiduciary may not “have a pure heart but an empty head.” 59 However, the duty of prudence is evaluated based on “the circumstances…prevailing” at the time of the fiduciary acts, 60 not based on the soundness of the decision’s outcome in hindsight. In interpreting this standard, the Supreme Court has noted that “[a]t times, the circumstances facing an ERISA fiduciary will implicate difficult tradeoffs, and courts must give due regard to the range of reasonable judgments a fiduciary may make based on her experience and expertise.” 61
Fiduciaries are expected to consult outside experts to inform their decisions where the circumstances warrant, but may not blindly rely on expert advice. As the Court of Appeals for the Third Circuit has explained, “While we would encourage fiduciaries to retain the services of consultants when they need outside assistance to make prudent investments and do not expect fiduciaries to duplicate their advisers’ investigative efforts, we believe that ERISA's duty to investigate requires
55 See 29 U.S.C. §1104(a)(1)(A)(i) (providing that fiduciaries shall discharge their duties “for the exclusive purpose of…providing benefits to participants”), which is interpreted by the Department of Labor to refer to plan benefits, not general economic or other benefits. See, e.g., Interpretive Bulletin Relating to Investing in Economically Targeted Investments, 73 Fed. Reg. 61,734 (Oct. 17, 2008). For a critique of this interpretation, see David H. Webber, The Use and Abuse of Labor’s Capital, 89 NYU L. REV 2106 (2014).
56 See, e.g., Braden v. Wal–Mart Stores, Inc., 588 F.3d 585, 590 (8th Cir. 2009) (complaint survived motion to dismiss where plaintiff alleged that revenue sharing payments were “kickbacks paid by the mutual fund companies in exchange for inclusion of their funds in the Plan”).
57 29 U.S.C. §1104(a)(1)(B) (2018).
58 HIRSCHHORN, ED., supra note 33, Ch. 10, §IV.B.1. See, e.g., Wildman v. Am. Century Servs., 362 F. Supp. 3d 685 (W.D. Mo. 2019) (finding no breach of the duty of prudence where fiduciaries took into account all relevant information and relied on a set of “best practice” procedures to carefully reason to a decision).
60 Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409, 425 (2014).
61 Hughes v. Northwestern University, 595 U.S. 170, 176 (2022).
fiduciaries to review the data a consultant gathers, to assess its significance and to supplement it where necessary.” 62
The duty of prudence is implicated in all fiduciary decisionmaking, such as the process by which service providers or investments are selected, as well as compliance procedures, such as monitoring investments on an ongoing basis and ensuring staff who field plan-related questions are adequately trained and supervised. 63
ERISA contains remedial provisions that authorize relief for breaches of fiduciary duty, although such relief is limited in important ways. The section that speaks most directly to fiduciary duty breaches authorizes civil actions to be brought by the Secretary of Labor, or a participant, beneficiary or fiduciary for a breach of fiduciary duty, but provides relief only to the plan, not individual participants. 64 ERISA’s “catch-all” remedial provision has been interpreted by the Supreme Court to allow for individuals to recover for breaches of fiduciary duty, but that relief is limited to the types of relief typically available in a court of equity –thereby prohibiting the award of traditional money damages. 65
B. ERISA’s Protection of Retirement Benefits
ERISA’s fiduciary duties have been readily applied to retirement plans. The Department of Labor has been actively engaged in rulemaking to detail and clarify how fiduciary duties apply to such plans. The resulting regulations and other administrative guidance are focused in large measure on guiding the selection of retirement plan investments, but they cover a diverse range of topics such as investment policies, proxy voting, the selection and monitoring of service providers, disclosure of fee sharing arrangements, the purchase of annuities for terminating plans, and the selection of lifetime income providers. 66 As we detail below, regulation of retirement plan fiduciary duties is not only robust, but has been effective in driving plan improvements that benefit employees.
i. Voluminous Regulations and Active Enforcement
In the immediate years following ERISA’s enactment, the Department of Labor promulgated several rules addressing ERISA’s fiduciary duties as they apply
62 In re Unisys Sav. Plan Litig., 74 F.3d 420, 435 (3d Cir. 1996). See also Brock v. Tricario, 768 F.2d 1351 (11th Cir. 1985).
66 See generally 29 C.F.R. §§2550.400c-1 – 2550.408g-2 (2022)
to retirement plans. 67 Because section 401(k) had not yet been added to the tax code, these early fiduciary duty regulations primarily concerned the fiduciary responsibilities that applied to traditional pension plans, where the employer was solely responsible for funding the plan and investing its assets. Most significant for our purposes is the detailed guidance provided in the “Investment Duties” regulations, first promulgated in 1979, and amended as recently as 2022. 68 In these regulations, the Department of Labor provided guidance on the specific factors that should be considered by a fiduciary when making investment decisions in order to comply with the duty of prudence, and these factors largely reflect modern portfolio theory. 69 The regulations advise fiduciaries to consider not only the risk of loss and opportunity for gain of a given investment, but also require consideration of how that investment fits in relation to the portfolio as a whole – its diversification, its liquidity and current return relative to anticipated cash flow requirements, and its projected return relative to funding objectives. 70 While some commentators objected to rulemaking in this area, arguing that the duty of prudence was an inappropriate subject for such guidance given its fact-dependent nature, the Department of Labor took the position that specifying factors to be considered was an appropriate and helpful exercise, and that the regulations were “in the nature of a ‘safe harbor’” –providing one method of establishing prudent action, not the exclusive method. 71 Litigation has added additional nuance to the regulations, specifying additional requirements such as the duty to regularly monitor plan investments and remove any imprudent ones. 72
Although section 401(k) was added to the tax code several years after ERISA became law, 73 ERISA has always provided in section 404(c) that a person who is otherwise a retirement plan fiduciary shall not be liable for any loss that results from a participant’s exercise of investment control in an individual account retirement plan. 74 As section 401(k) plans became an increasingly important source
67 See, e.g., 29 C.F.R. §§2550.404a-1 (regulating investment duties, promulgated on June 26, 1979) & 2550.404b-1 (regulating plan assets held outside the United States; promulgated on October 4, 1977).
69 See Harry Markowitz, Portfolio Selection, 7 J. FIN 77 (1952) (introducing modern portfolio theory). For an examination of the intersection of modern portfolio theory and the duty of prudence, see Stewart E. Sterk, Rethinking Trust Law Reform: How Prudent Is Modern Prudent Investor Doctrine?, 95 CORNELL L. REV. 851 (2010); Michael T. Johnson, Speculating on the Efficacy of "Speculation": An Analysis of the Prudent Person's Slipperiest Term of Art in Light of Modern Portfolio Theory, 48 STAN L. REV 419, 420 (1996).
70 44 Fed. Reg. 37225 (June 26, 1979).
71 44 Fed. Reg. 37222 (June 26, 1979).
72 Tibble v. Edison, 575 U.S. 523, 530 (2015).
73 See Revenue Act of 1978, Pub. L. No. 95-600, §135(a), 92 Stat. 2763, 2785 (1978).
74 See 29 U.S.C. §1104(c).
of retirement savings in the decades following their authorization, the Department of Labor promulgated rules specifying the type of investment choice a plan participant must be provided in order for plan fiduciaries to enjoy the protection of section 404(c). 75 The regulations are designed to ensure that participants are offered a broad range of investment alternatives that allow a participant to meaningfully adjust the risk and return in their account and achieve a diversified portfolio in order to minimize the risk of large losses. In addition to specifying details regarding the investment alternatives that must be available to a participant in order for the plan to qualify for section 404(c) protection, the regulations also address required disclosures regarding the investment vehicles and the scope and details of how participants must be permitted to make investment elections. 76 Because these regulations are providing the terms that must be complied with in order to earn an exemption from otherwise applicable fiduciary duties, they are more prescriptive than the general investment duty regulations.
In addition to these and other formal rulemaking exercises, the Department of Labor has frequently issued less formal guidance on various aspect of retirement plan fiduciary duties, such as evaluating the reasonableness of fees charged by plan service providers 77 and the selection and monitoring of such providers. 78 There have been multiple guidance documents issued that address when and to what extent a retirement plan may consider environmental, social, and governance factors in selecting plan investments. 79 More recently, the Department has issued a compliance document strongly suggesting that cryptocurrency investment options are unlikely to be consistent with the duty of prudence. 80
Retirement plan fiduciary duties are frequently litigated, with class actions commonplace. 81 While these legal challenges take many different forms, we will
75 29 C.F.R. §2550.404c-1 (2022).
76 Id.
77 The Department of Labor has opined that to determine reasonableness a fiduciary should conduct an analysis of the quality of the services in light of the fees being charged. Dept. of Labor Adv. Op. 2002- 08A (August 20, 2002).
78 Dept. of Labor, Information Letter to Theodore Konshak (Dec. 1, 1997).
81 See Jacklyn Wille, Flood of 401(k) Fee Lawsuits Spur Wave of Early Plaintiff Wins, BLOOMBERG LAW, April 5, 2022 (finding that more than 170 such lawsuits had been filed since 2020), https://news.bloomberglaw.com/employee-benefits/flood-of-401k-fee-lawsuits-spur-wave-of-earlyplaintiff-wins See also George S. Mellman & Geoffrey T. Sanzenbacher, 401(k) Lawsuits: What are the Causes and Consequences?, Boston College Center for Retirement Research Issue Brief 2018-8, May 2018, at 2 (showing prevalence of 401(k)-related lawsuits from 2006-2017), https://crr.bc.edu/wp-content/uploads/2018/04/IB_18- 8.pdf. Similar dynamics can be seen in the higher education sector, which has experienced a wave of class action lawsuits related to section 403(b) plan management. See John Morahan & Aaron Turner, Retirement Plan Lawsuits: Preparing
briefly highlight two common types of claims: claims that the administrative fees charged by the plan’s recordkeeper are unreasonable and claims that plan fiduciaries have selected an investment menu for a participant-directed retirement plan that is inconsistent with the duty of prudence. Administrative fee cases are the simpler of the two, and are typically based on Department of Labor guidance that plan fiduciaries must determine that the fees charged by a service provider are reasonable in light of the service provided. 82 Success in these cases often turns on the ability to establish that the recordkeeping fees paid by the plan exceeded those of plans of comparable size given then level of services provided. 83
In cases challenging the selection of a plan’s investment menu, plaintiffs often challenge the inclusion of high-cost retail level funds when identical, lowercost institutional class funds are available. 84 Another common challenge is based on the selection of higher-cost actively managed funds over lower-cost passively managed funds. 85 These lawsuits have often been successful, and have led in many cases to large settlements. 86
The robust nature of retirement plan fiduciary duty enforcement likely stems in part from the relative clarity of the standards announced by the Department of Labor, as well as other factors that make related litigation financially worthwhile for both plaintiffs and their attorneys. For plaintiffs’ attorneys, class action lawsuits against plans can easily deliver attorneys’ fees that are six or seven figures. 87 Even better for these attorneys, it is also relatively easy to research potential fiduciary malfeasance prior to initiating litigation by comparing plan fees and investments to those otherwise available in the market. From participants’ perspective, even relatively small differences in fee levels (whether administrative or asset-based) can drive substantial differences in retirement savings when compounded over decades. 88 From an employer perspective, the relative attractiveness of retirement
for the Storm, NEW ENG J. HIGHER EDUC May 2017; José M. Jara, Thou Shall Not Pay Excessive Fees!, Amer. Bar Ass’n Real Property , Trust, and Estate Law Section Winter 2019 Report, https://www.americanbar.org/groups/real_property_trust_estate/publications/ereport/rpte-ereportwinter-2019/erisa thou-shall-not-pay-excessive-fees-/.
82 See, e.g., Smith v. CommonSpirit Health, 37 F.4th 1160 (6th Cir. 2022).
83 See, e.g., id.
84 See, e.g., Forman v. TriHealth, 40 F.4th 443 (6th Cir. 2022).
85 See, e.g., Smith v. CommonSpirit Health, 37 F.4th 1160 (6th Cir. 2022).
86 Wille, supra note 81. See also Beagan Wilcox Volz & Emily Laermer, Legal Settlements Squeeze Fees for U.S. Employee Retirement Plans, FINANCIAL TIMES, May 21, 2017; Jara, supra note 81.
87 See, e.g., Munro v. Univ. of S. Cal., No. 2:16-cv-06191 (C.D. Cal. Feb. 23, 2023) (motion for preliminary settlement approval requesting $4.3 million in attorneys’ fees as part of retirement plan class action settlement); Jacklyn Wille, Lawyers Seek Fees for $2.6 million Aurora Health Retirement Deal, BLOOMBERG LAW, Feb. 24, 2023 (lawyers seeking $900,000 in fees and litigation costs as part of retirement plan class action settlement agreement).
88 See, e.g., DEP’T OF LABOR, A LOOK AT 401(K) PLAN FEES 2 (2019), https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-center/publications/a-
plan fiduciary litigation is likely to drive increased attention to fiduciary duties and extra care in decisionmaking.
ii. Efficiencies Achieved
There is substantial evidence that regulatory guidance and its vigorous enforcement have both improved fiduciary decisionmaking in the retirement plan context and thereby increased the value of retirement benefits. For example, a few years ago administrative fee lawsuits against plans were typically brought where recordkeeping fees exceeded $35 per participant per year, and are now often brought against plans with fees above $20 per participant per year. 89 Similarly, one survey found that the average asset-weighted administrative fee declined from 57 basis point to 46 basis points between 2006 and 2016. 90 There is also some evidence that plan fiduciaries have shifted toward lower-cost passively-managed funds, and have become more selective about including specialty asset classes within a plan’s investment menu. 91 While participant-level investment decisions within 401(k) plans often appear sub-optimal, 92 investment menus in such plans encourage participants to achieve efficient and diversified portfolios, 93 making plans with investment options superior to non-plan options or chance. 94
Anecdotal evidence also supports the hypothesis that regulation and litigation have driven improvements in proactive fiduciary compliance. Several publications, with titles such as “The War on Retirement Fees: Is Anyone Safe?” offer guidance to plan fiduciaries, advising them to put in place sound governance structures, review plan investments and fee arrangements regularly, and negotiate fees “early and often.” 95 While plan fiduciaries are understandably unenthusiastic
look-at-401k-plan-fees.pdf (explaining that a 1% increase in retirement plan fees will reduce retirement savings by 28% over 35 years). The Supreme Court has held that, in actions involving a breach of fiduciary duty in an individual account plan, the losses suffered can be credited to an individual’s account and do not need to be credit to the plan as a whole. LaRue v. DeWolff, Boberg & Associates, 552 U.S. 248 (2008). The result is that individual plaintiffs may directly benefit where a breach of fiduciary duty and corresponding loss have been established.
89 Wille, supra note 81
90 Mellman & Sanzenbacher, supra note 81, at 5-6.
91 Id. at 4-5. But see Ian Ayres & Quinn Curtis, Beyond Diversification: The Pervasive Problem of Excessive Fees and “Dominated Funds” in 401(k) Plans, 124 YALE L.J. 1476 (2015) (providing empirical evidence of suboptimal investment menus and high fees in 401(k) plans).
92 See, e.g., ALICIA H. MUNNELL & ANNIKA SUNDEN, COMING UP SHORT: THE CHALLENGE OF 401(K) PLANS (2005); Gary R. Motola & Stephen P. Utkus, Red, Yellow, and Green: Measuring the Quality of 401(k) Portfolio Choices, in OVERCOMING THE SAVINGS SLUMP: HOW TO INCREASE THE EFFECTIVENESS OF FINANCIAL EDUCATION AND SAVINGS PROGRAMS 119 (Annamaria Lusardi, ed., 2009).
93 Ning Tang et al., The Efficiency of Sponsor and Participant Portfolio Choices in 401(k) Plans, 94 J. PUB ECON 1073 (2010).
94 Keith C. Brown & W. VanHarlow, How Good are the Investment Options Provided by Defined Contribution Plan Sponsors, 1 PORTFOLIO ANALYSIS & MGMT. 3 (2012).
95 Steven J. Friedman et al., Steps Every 401(k) Fiduciary Should Take to Avoid Participant Lawsuits, J. RET PLAN Sept.-Oct. 2008 at 15. See also Fisher Phillips, Reducing Your 401(k)
about the prevalence of litigation in this area, the consensus appears to be that vigorous enforcement of fiduciary standards have driven real improvements for retirement plan participants. 96
C.ERISA’s Failure to Regulate or Enforce Health Plan Fiduciary Duties
While ERISA’s fiduciary duties appear to have meaningfully improved retirement plan quality and value, there is no indication that the same has been true for health plans. Indeed, there is little indication that the relevant legal standards are given any type of serious consideration by either employers or regulators. Although there may be reasonable historical explanations for the lack of attention given to this area of law, the statute’s plain meaning and intent was to protect employee-earned compensation that came in the form of benefits. Since American employers are custodians to more annual health insurance dollars than retirement dollars, the failure to apply ERISA protections to health benefits is a critical failure. Before detailing the development of the law as it applies to health plan fiduciary duties, we first provide a brief overview of the employer health plan decisionmaking process, and the points at which ERISA’s existing fiduciary duties apply (even if not currently enforced)
An employer’s decision to offer health benefits to its employees is generally driven by labor market considerations. 97 For example, an employer would evaluate whether it needs to offer health benefits to be competitive with its peers and, relatedly, evaluate whether the employer’s workforce value health benefits over an
Litigation Risks – 10 Questions Employers Need to Ask ASAP, https://www.fisherphillips.com/newsinsights/reducing-401k-litigation-risks-10-questions- employers-ask-asap.html (suggesting employers should verify, among other things, that the fiduciary committee confirm that it is using the lowest fee alternative for each investment option); Alison L. Martin & Lars C. Golumbic, The War on Retirement Fees: Is Anyone Safe?, https://www.chubb.com/content/dam/chubb-sites/chubb-com/usen/global/global/documents/pdf/2020-05.06-17-01-0271-war-on-retirement-plan-fees.pdf (offering various tips to reduce the likelihood of facing an excessive fee claim, such as retaining qualified independent experts to advise on fee levels).
96 But see Mellman & Sanzenbacher, supra note 81, at 6 (expressing concern that fiduciary duty litigation may result in fiduciaries becoming suboptimally conservative in their decisionmaking, potentially resulting in a loss of gains from innovation); Ayres & Curtis, supra note 91 (making several arguments regarding the ineffectiveness of ERISA’s fiduciary standards and resulting litigation); Webber, supra note 56 (making the case for a broader interpretation of retirement plan fiduciary duties).
97 See, e.g., Jon B. Christianson & Sally Trude, Managing Costs, Managing Benefits: Employer Decisions in Local Health Care Markets , 38 HEALTH SERV RES. 357 (2003); AMERICA’S HEALTH INSURANCE PLANS, THE VALUE OF EMPLOYER-PROVIDED COVERAGE (2018) (reporting results of employee survey where 46% stated that their employer’s health plan played a role in recruiting them, and 56% reported that the health plan has an impact on the employee’s choice to stay in their current job).
equal amount of cash wages. This initial decision regarding plan sponsorship is purely a business decision and is not subject to any fiduciary obligations. 98
Once the decision to offer a health plan has been made, the employer must decide how to finance those benefits. The two primary choices are purchasing a group insurance contract, where the financial risk associated with paying claims is transferred to an insurance company, or self-insuring benefits, where the employer pays claims out of its own assets. Employers are again free to make this financing decision based on business criteria not fiduciary obligation.
Once the financing mechanism is chosen, the employer must select an insurer (if purchasing an insurance contract) or a third party administrator (TPA) (if selfinsuring) to operate the plan. The TPA is generally an insurance company that is willing to provide the administrative services for the health plan without taking on the risk-shifting function of insuring the benefits itself. TPAs typically charge a fixed per member per month fee for their services, 99 while the employer retains liability for paying the underlying claims expenses. For ease of reference, we refer to these roles collectively as that of a “health plan administrator” or simply “administrator” and intend such term to capture both insured and self-insured plans. The choice of a health plan administrator is the selection of a plan service provider, and therefore is clearly subject to ERISA’s fiduciary duties. 100 The employer must select the service provider solely in the best interests of plan participants, and must seek out and consider all information relevant to the decision. Once selected, the employer has a continuing fiduciary duty to monitor the performance of the service provider. 101
The impact that an employer’s selection of an administrator has on the ability of a health plan to achieve its core purposes is underappreciated. When an employer selects a health plan administrator, one of the primary services the employer is purchasing is the administrator’s network of medical providers and, with it, the reimbursement rates the administrator has negotiated with these providers 102 Nearly all health plans today either limit coverage to providers who
98 See Curtiss-Wright Corp. v. Schoonejongen, 514 U.S. 73, 78 (1995) (recognizing that, under ERISA, an employer is generally free to “adopt, modify, or terminate” a plan at any time and for any reason).
99 See Manoj Athavale & Stephen M. Avila, The Selection of Competing Third Party Administrators, COMPENSATION & BENEFITS REV , Vol. 37, May/June 2005, at 51, 54.
100 U.S. DEPT. OF LABOR, UNDERSTANDING YOUR FIDUCIARY RESPONSIBILITIES UNDER A GROUP HEALTH PLAN 1-2, 4-5 (2023), https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/ouractivities/resource-center/publications/understanding-your-fiduciary-responsibilities-under-a-grouphealth-plan.pdf; U.S. Dept. of Labor, Information Letter from Bette J. Briggs to Diana O. Ceresi (Feb. 19, 1998) (hereinafter “DOL Information Letter”)
101 U.S. DEPT OF LABOR, supra note 100, at 6.
102 The choice of an administrator also implicates important compliance and customer service functions. The administrator is responsible for accurately communicating information about the plan to participants and must process claims promptly and accurately. The administrator should also
are “in-network” or provide higher levels of coverage for in-network versus out-ofnetwork providers. 103 Gone are the days when a health plan simply paid for any medically necessary care from any licensed provider. 104
The result is that provider networks have a significant impact on nearly all facets of a health plan’s operation. There are the obvious patient-facing considerations: the provider network will influence or determine where a patient can receive care, the timeliness of that care, and the quality of care. But there are also enormous financial implications associated with the structure and makeup of a provider network. In general, the broader a network is, the higher its reimbursement rates will be, based on the assumption that providers in a broader network will see lower patient volume and therefore must charge higher rates. 105 Conversely, narrow networks typically have lower reimbursement rates because providers can be assured or a greater patient volume, and are willing to agree to lower reimbursement rates as a result. 106
Provider quality is also an important network component. While some networks seek to maximize quality of care, others seek to maximize value by including providers who deliver the best clinical outcomes at the lowest cost. 107 A prudent fiduciary, then, should carefully consider the provider network when selecting a service provider, and should understand how the network was constructed and review its adequacy and clinical quality. There is a clear analog between network choice for a health plan and an employer’s selection of a retirement plan investment menu. Just as the underlying investments offered by a retirement plan determine the plan’s ability to achieve its core purposes, so, too, does the selection of an administrator determine the ability of a health plan to achieve its core purpose of financing medical care.
i. Little Guidance, Little Enforcement, Little Action
Even though the selection of a health plan service provider is functionally no different than the selection of a retirement plan custodian or retirement plan
have audit procedures in place to ensure oversight of major functions. While these functions are each important, we focus on provider network given its unique systemic effects.
103 See KAISER FAM FOUND., supra note 27, at 84, 85 fig. 5.1 (2023) (finding that only one-percent of covered employees are enrolled in a “conventional” or indemnity plan that does not rely on a preferred network of providers).
104 See generally Amy B. Monahan & Daniel Schwarcz, Rules of Medical Necessity, 107 IOWA LAW REVIEW 423 (2022) (documenting the various methods by which health plans limit or otherwise control coverage terms).
105 See Leemore S. Dafny et al., Narrow Networks on the Health Insurance Marketplaces: Prevalence, Pricing, and the Cost of Network Breadth, 36 HEALTH AFF 1606, 1607 (2017).
106 See id. at 1610-11.
107 JAMES T. O’CONNOR & JULIET M. SPECTOR, HIGH-VALUE HEALTHCARE PROVIDER NETWORKS 4-5 (2014).
investment options, the Department of Labor has not engaged in any rulemaking addressing health plan fiduciary duties, instead issuing just a single information letter 108 and a single employer pamphlet 109 describing the application of ERISA’s fiduciary duties to health plans. The clearest statement from the Department of Labor on health plan fiduciary duties comes from a 1998 information letter, which was issued in response to a question from a union regarding whether it would be appropriate for a trustee of an ERISA health plan to “consider quality in the selection of health care services.” 110 Specifically, the union was interested in determining whether it was permissible to give quality priority over cost when contracting with or making a choice from among various providers or plans. 111 In response, the Department first clarified that when the “selection of a health care provider” involves a disposition of plan assets (i.e., paying the provider with plan assets) the selection is indeed a fiduciary act subject to fiduciary duties. 112 From there, the Department emphasized the importance of an “objective process” designed to carefully review the provider’s qualifications, including the “quality of services offered, and the reasonableness of the fees charged on light of the services provided.” 113 The letter emphasized that plans do not need to accept the lowest bidder for health services, and explicitly stated that “a plan fiduciary’s failure to take quality of [health care] services into account” in selecting a health service provider “would constitute a breach of the fiduciary’s duty under ERISA.” 114
This 1998 guidance has been reinforced in the ensuing years, but has not been promulgated more formally. For example, in 2019 and again in 2023, the Department of Labor published a compliance document for employers, Understanding Your Fiduciary Responsibilities Under a Group Health Plan. 115 The document explicitly states that fiduciary duties attach to the selection of any plan service provider, and further that employers are required to monitor the ongoing performance of any service provider “at reasonable intervals” through a formal
108 See DOL Information Letter., supra note 100
109 See U.S. DEPT OF LABOR, supra note 100
110 DOL Information Letter, supra note 100 See also 75 Fed. Reg. 41603 (July 16, 2010) (Department of Labor states in preamble to retirement plan fee regulations that, while the regulations do not address health plans, ERISA §404(a) “continues to obligate” health plan fiduciaries to “obtain and consider information relating to the cost of plan services and potential conflicts of interest”).
111 DOL Information Letter., supra note 100
112 Id
113 Id
114 Id.
115 U.S. DEP’T OF LABOR, supra note 100 (2019 version has been removed from the Department of Labor’s website, but is on file with authors).
review process. 116 The employer is also instructed to ensure that any fees charged by plan service providers are reasonable. 117
With respect to selecting a health plan service provider such as a plan administrator, the compliance document focuses on the need for uniform evaluation criteria and on documenting the selection process. 118 Employers are advised to provide potential service providers with identical information about the plan and the services sought, and in return the service providers should each be asked to provide identical types of information 119 The employer should, among other things, evaluate the quality of each firm’s services, including the identity, experience, and qualifications of professionals who will be handling the plan or providing medical services. 120 Yet this guidance, coming as it does in an informal publication, lacks the force of law that comes with properly promulgated regulations.
Perhaps not surprisingly given the lack of formal rulemaking in this area, there is little enforcement activity and little evidence that employers rigorously abide by their fiduciary duties. In particular, our research discovered almost no enforcement of the Department of Labor’s stated position that employers must consider both cost and quality in selecting health plan providers. It is likely several factors drive this lack of compliance and enforcement.
On the compliance side, even well-meaning employers are likely to struggle with how to abide by the duty of prudence in the health plan context without specific guidance from the Department of Labor. The selection of a health plan administrator is a highly complex decision that involves weighing multiple factors that often push in different directions. Without guidance on which factors to measure and appropriate data sources for such metrics, even large, sophisticated employers may struggle to gather all relevant information and give it appropriate consideration. Employers may also have preferences that diverge from employee preferences, a topic we explore in greater detail in Part II.
When it comes to ex-post enforcement of fiduciary standards, further barriers impede the normal mechanism of litigation. Plan participants, who have a private cause of action for breach of fiduciary duty under ERISA, are unlikely to be in a position to evaluate the merits of a potential case prior to initiating litigation and discovery Unlike retirement plan actions, where it is relatively simple to examine a plan’s investment offerings and fees compared to what is available on the market, health plan fees are generally subject to an individualized bidding process. In part,
116 Id. at 6.
117 Id. at 5.
118 See id. at 4-5.
119 Id.
120 Id
this is because insurers treat negotiated provider reimbursement rates as confidential, 121 and because the size and composition of an employer’s workforce typically affects pricing. A potential litigant cannot simply look up what competing insurers or administrators would have offered the employer plan. This issue is further exacerbated by the fact that there is no formal guidance on the information employers should consider, nor guidance on how employers should weigh cost and quality, along with the fact that the duty of prudence is largely process-based. The result is that a potential plaintiff may need to spend significant funds to determine if a viable claim exists. And ERISA’s remedial limitations may make that type of investment unattractive for plan participants and even plaintiffs’ counsel. 122
Regardless of precise cause, we have found only a single case where a plan participant has attempted to challenge their employer’s selection of a health plan administrator, and that case was filed mere days before this Article was submitted for publication. 123 There have been unsuccessful lawsuits by health plan participants challenging aspects of plan design, 124 and unsuccessful lawsuits by employers challenging administrator negotiations of provider rates 125 and
121 Michael Batty & Benedict Ippolito, Mystery of the Chargemaster: Examining the Role of Hospital List Prices in What Patients Actually Pay, 36 HEALTH AFF. 689, 694 (2017).
122 While ERISA’s remedial provisions are notoriously complex, it is sufficient for our purposes to note that are two avenues of relief available for health plan participants. In the first, relief is sought under section 502(a)(2), where any recovery goes to the plan itself, not individual participants. Relief under this section could still benefit plan participants in the form of lowered premia going forward, but such relief would not be automatic or direct. Plaintiffs’ attorneys could, however, recover their fees in most cases if the action is successful, but such fee shifting is not automatic. See 29 U.S.C. §1132(g). Participants could also seek relief under section 502(a)(3), but that section allows only those types of remedies that were typically available in a court of equity, such as injunction, mandamus, and restitution. Traditional money damages are therefore not available. Harris Trust & Sav. Bank v. Salomon Smith Barney, Inc., 530 U.S. 238 (2000).
123 Lewandowski v. Johnson & Johnson, Case 1:24-cv-00671 (D. N.J. filed Feb. 5, 2024), discussed in Part III.A, infra
124 For example, a lawsuit brought by plan participants who were charged a prescription drug copay that exceeded the actual cost of the drug was unsuccessful because they were complaining about plan design, a settlor function, not a fiduciary action. Alves v. Harvard Pilgrim Health Care Inc., 204 F. Supp. 2d 198, 210 (D. Mass. 2002), aff'd, 316 F.3d 290 (1st Cir. 2003) (finding no breach of fiduciary duty where prescription drug copays sometimes exceeded the drug’s cost, because “there can be no breach of fiduciary duty where an ERISA plan is implemented according to its written, nondiscretionary terms”). Similarly, kickbacks paid out of health plan premiums to a local chamber of commerce were not governed by fiduciary rules because the premiums were agreed to in an arm’s length transaction and what the insurance company chose to do with those premiums was not governed by ERISA’s fiduciary duties. Depot, Inc. v. Caring for Montanans, 915 F.3d 643 (9th Cir. 2019).
125 DeLuca v. Blue Cross Blue Shield of Michigan, 628 F.3d 743 (6th Cir. 2010) (holding that an insurer’s rate negotiations where not fiduciary in nature because they were not specific to the individual employer’s plan, but were instead applicable to insurer’s entire book of business. While acknowledging that an individual is acting as a fiduciary when they engage in plan “management” or “administration” the court held that rate negotiation is “a business decision that has an effect on an ERISA plan [and is therefore] not subject to fiduciary standards”).
fraudulent billing practices, 126 but no significant participant-led attempts to hold employers accountable for their underlying selection of the administrator. We review the existing litigation in more detail in Part III, below.
Even if participants bring a suboptimal amount of health plan fiduciary litigation, ERISA also authorizes the Department of Labor to enforce fiduciary duties. In practice, however, while the Department of Labor does regularly initiate actions that fall broadly within health plan fiduciary duties, 127 we have located only a single case in which the Department of Labor pursued a breach of fiduciary duty claim challenging the selection of a health plan service provider. 128 In 2015, the Department of Labor initiated litigation alleging, among other things, that health plan fiduciaries paid excessive fees to the health plan’s third party administrator and broker and failed to loyally and prudently administer the plan. 129 The court ruled against the Department of Labor on both issues, finding that the employer had “monitored the effectiveness of the TPA, regularly reviewing and evaluating options and alternatives.” 130 Before selecting their TPA, the employer “engaged in an adequate investigative process, including contacting other organizations in similar circumstances and being informed that [the TPA] was a reputable, credible, and effective health and welfare plan manager.” 131 The employer also periodically contacted peer organizations “to gauge whether the value they were receiving was reasonable in comparison to the fees they were paying.” 132 The Department of Labor presented evidence showing that the plan’s administrative expenses exceeded those of relevant benchmarks in the years at issue. 133 However, the defendant’s expert used a different benchmarking methodology, which found that the plan’s fees were within the 60 to 90% range of peers, and the court ultimately found the defense expert more persuasive. 134 The court noted that “ERISA does not require a fiduciary
126 Peters v. Aetna, 2 F.4th 199 (4th Cir. 2021) (alleging that self-insured plan’s third party administrator set up a dummy billing code to impermissibly pass administrative costs along to plan participants).
127 For example, the Department of Labor regularly pursues action against health plan fiduciaries that have withheld health plan premiums from employee wages but failed to use the collected funds to actually pay for health plan coverage. See, e.g., Perez v. Harris, 88 F. Supp. 1049 (D. Minn. 2015); Acosta v. Air LLC, 2019 WL 4670189 (W.D. Wisc. 2019); Scalia v. Marzett, 2020 WL 4365535 (E.D. Va. 2020).
128 The Department of Labor has, however, brought breach of fiduciary duty claims against other types of welfare plans. See, e.g., Secretary v. United Transportation Union, 2020 WL 1611789 (N.D. Ohio 2020) (alleging disability plan trustees breached their fiduciary duty and engaged in prohibited self-dealing transactions).
129 Acosta v. Chimes, 2019 WL 931710 (D. Md. 2019).
130 Id. at *6.
131 Id
132 Id. at *7.
133 Id. at *11.
134 Id at *12.
to ‘scour the market’ to find and offer the cheapest possible deal for participants” 135 and concluded that, compared to a prudent plan administrator under the same circumstances, the defendants acted prudently.
136
ii. ERISA Preemption and Its Restraints on States to Improve Employer Health Plans
One key complication in ERISA’s statutory structure is its broad preemption of state law, which effectively makes the federal government the only actor that can implement employer plan reforms Part of ERISA’s grand legislative bargain was broad preemption of any state law that “relates to” an employee benefit plan. 137 The practical result is that states are essentially powerless to compel employers to be better stewards of employee health plan dollars 138 As a result, the current lack of federal rulemaking or enforcement around health plan fiduciary duties, combined with preemption of any state efforts to address the lack of federal action, has created what is commonly referred to in ERISA jurisprudence as a regulatory vacuum.
139
While ERISA allows states to regulate insurance, 140 that authority has its limits. States can (and do) regulate which insurance products may be offered for sale, specify contractual terms required to be included in insurance contracts, impose network adequacy standards, and regulate premiums and certain aspects of claims procedures. A state could not, however, place any legal requirements on employers when it comes to health plan design or the selection of an administrator, even when the administrator is also acting as an insurer. 141 Such actions are clearly and completely preempted by ERISA.
In addition, even if a state could cleverly devise an insurance regulation aimed at improving employer health plans that survives ERISA preemption, employers can easily avoid any such regulation by electing to self-insure their
135 Id. at *19.
136 Id. The Depart of Labor also charged the defendants with self-dealing, alleging that the thirdparty administrator had made charitable contributions to the plan sponsor in return for being awarded the contract. The court found in favor of the defendants on this issue as well. Id. at *10-11.
137 See Leon E. Irish & Harrison J. Cohen, ERISA Preemption: Judicial Flexibility and Statutory Rigidity, 19 U. MICH J.L. REFORM 109, 148-56 (1985).
138 See, e.g. Erin C. Fuse Brown & Elizabeth Y. McCuskey, Federalism, ERISA, and State SinglePayer Health Care, 168 U. PA. L. REV. 389 (2020) (explaining the various ways in which ERISA preemption stands as an obstacle to state single-payer systems).
139 See, e.g., Aetna Health v. Davila, 542 U.S. 200, 222 (Ginsburg, J., concurring) (internal citation omitted).
140 29 U.S.C. §1144(b)(2)(A).
141 New York State Conf. of Blue Cross & Blue Shield Plans v. Travelers Ins. Co., 514 U.S. 645, 658 (1995) (ERISA preempts state laws that mandate “employee benefit structures or their administration”).
health plans. 142 ERISA explicitly provides that self-insured plans may not be regulated through state insurance regulation. 143 And while self-insurance may appear too large or volatile a risk for many employers to absorb, there is stop-loss insurance coverage easily available in most states that allows an employer to remain technically self-insured, while protecting itself from large medical plan losses. 144 In fact, the vast majority of large employers prefer self-insuring, and a majority of all employees with ESI have self-insured plans. 145
The end result is that, even if a state had the political will to provide greater consumer protections to employer health plan participants – for example by allowing insurers to only offer provider networks that met certain minimum standards for quality or value – they would risk employers simply exiting the insured market and shifting to self-insurance. 146 The only governmental actor with the ability to effectively regulate employer health plans is the federal government.
II. THE REGULATION AND PERFORMANCE OF EMPLOYER HEALTH PLANS
Employer-provided health plans are the primary financier of American healthcare, making its provision and regulation a central part of the nation’s social policy. Although the link between employment and health insurance is now part of the nation’s economic fabric, it came about from what has been called an accident of history. 147 World War II employers started offering health insurance to their workers as a way to evade wage controls, and an IRS ruling shortly afterwards deemed that amounts paid for employer-provided health insurance were not subject to income tax. 148 Thereafter, employer-provided health plans enjoyed a hefty tax
142 29 U.S.C. §1144(b)(2)(B) (preventing states from regulating self-insured plans under the guise of state insurance law). Sixty-five percent of all workers covered by an employer plan are covered by a self-insured plan. KAISER FAM. FOUND., supra note 27, at 168. Nearly all large firms (93%) selfinsure their health benefits, while rates of self-insurance among the smallest firms have increased somewhat from 13% in 1999 to 18% in 2023 Id. at 152.
143 See Russell Korobkin, The Battle Over Self-Insured Health Plans, or “One Good Loophole Deserves Another”, 5 YALE J. HEALTH POL’Y L. & ETHICS 89 (2005).
144 See Timothy Stoltzfus Jost & Mark A. Hall, Self Insurance for Small Employers Under the Affordable Care Act: Federal and State Regulatory Options, 68 NYU ANN. SURV. AM. L. 539, 546-550 (2013) (documenting the growing availability and feasibility of stop loss coverage for even small employers).
145 Frank Diamond, As Large Employers Back Away from Self-Insurance, Small- and Medium-Sized Ones Embrace It: EBRI, FIERCE HEALTHCARE. (Aug. 31, 2023).
146 See Amy B. Monahan, Federalism, Federal Regulation, or Free Market? An Examination of Mandated Health Benefit Reform, 2007 U. ILL. L. REV. 1361, 1371-74 (2007) (discussing the phenomenon of employers electing to self-insure in order to evade state regulatory requirements).
147 Regina Herzlinger & Barak Richman, Give Employees Cash to Purchase Their Own Insurance, HARV BUS REV , Dec. 9, 2020, https://hbr.org/2020/12/give-employees-cash-to-purchase-their-owninsurance.
148 CONGRESSIONAL RSCH. SERV., THE TAX EXCLUSION FOR EMPLOYER-PROVIDED HEALTH INSURANCE 5 (2011). Such amounts are similarly excluded from state income and payroll taxes. Id
subsidy, 149 and HR managers were suddenly thrust into becoming purchasers of healthcare for a heterogeneous workforce.
While the federal government currently forgoes $221 billion per year in tax revenue to subsidize such coverage, 150 few regulations supervise the substance or quality of such benefits 151 The lack of regulatory oversight is premised, in part, on the theory that employers act as effective agents for their employees, thereby blunting the need for much market intervention, but the reality is that employee health dollars are not necessarily being spent as those employees would want them spent. Premiums for employer health plans have risen substantially faster than both inflation and wages, and their offerings have become both more limited and subject to higher rates of cost-sharing over time. 152 Further evidence suggests that these cost increases are not just inevitable consequences of market pressures. To the contrary, research into how firms finance and construct their health plans suggest they expend little effort into conserving employee healthcare dollars and invest few resources into tailoring healthcare benefits to meet employee needs and preferences. 153 In other words, evidence from healthcare markets and from internal
149 I.R.C. §§106 (exempting contributions toward employer-provided health insurance from income taxation) and 125 (allowing employees a mechanism to pay their share of health insurance premiums on a pre-tax basis). States that impose an income tax uniformly follow this federal tax treatment.
150 The estimated cost of the federal tax expenditure for employer-provided health plans is $221 billion in the current year, with additional revenue losses at the state level. U.S. DEPT TREAS., TAX EXPENDITURES FY2023, https://home.treasury.gov/system/files/131/Tax-Expenditures-FY2023.pdf. While few estimates can be found regarding the nationwide cost of state income tax exclusions for employer-provided health benefits, one estimated that, in 2009, the value of such state exclusions was over $30 billion. Jonathan Gruber, The Tax Exclusion for Employer-Sponsored Health Insurance, NBER Working Paper Series (Feb. 2010). Not surprisingly, in states that produce their own tax expenditure reports, the exclusion for employer-provided health care is among the most expensive preference. See, e.g., CAL. DEPT. OF FIN., TAX EXPENDITURE REPORT 2021- 22 8 (2023), https://dof.ca.gov/wp-content/uploads/Forecasting/Economics/Documents/2021- 22-Tax-ExpenditureReport.pdf (exclusion for employer contributions to health plans estimated to cost $9 billion in 202223, the second-highest personal income tax expenditure); GA DEPT OF AUDITS & ACCOUNTS, GEORGIA TAX EXPENDITURE REPORT FOR FY 2025 9 (2023) (exclusion for employer-provided health plans has an estimated cost of $1.45 billion, the second-highest individual income tax expenditure); MINN. DEPT. OF REVENUE, STATE OF MINNESOTA TAX EXPENDITURE BUDGET FISCAL YEARS 2022-25 32 (2002), https://www.revenue.state.mn.us/sites/default/files/202202/2022%20Tax%20Expenditure%20Budget_0.pdf ($1.5 billion forgone revenue for employerprovided health plans in 2023, also the second-highest individual income tax expenditure)
151 Substantive health plan requirements have been added to ERISA since its passage in 1974, but remain modest in scope. See 29 USC §§1161- 1191c. More significant requirements were implemented by the Affordable Care Act, such as the requirement to cover preventive services without cost sharing. IRC §4980H. However, even the Affordable Care Act exempted large employer plans from much of its health insurance regulation. See Amy Monahan & Daniel Schwarcz, Will Employers Undermine Health Care Reform by Dumping Sick Employees?, 97 VA L. REV. 125, 146- 152 (2011).
152 KAISER FAMILY FOUND, supra note 27, at 41-42, 112.
153 See, e.g., id. at 217 (reporting that employers most commonly plan on addressing high plan costs by “increasing workers’ premium contributions” and “increasing cost-sharing,” rather than changes
firm deliberations suggest that many employers do not satisfy ERISA’s requirement to act prudently and solely in their employees’ best interest when managing their health benefit plans.
This Part provides a brief introduction to the current state, and the pervasive disappointments, of employer-provided health coverage We highlight the impact that rising health plan costs have on worker take-home pay, and the lack of effective cost containment in employer plans. We then examine the mismatch between the task of selecting and managing a health plan administrator and the core competencies of human resources departments, along with various agency costs that impact employer health plan decisionmaking.
A. The Current State of Employer-Provided Health Coverage
Employer-provided health plans cover nearly 155 million people, or 58% of the nonelderly population, 154 and it has remained the dominant form of health insurance coverage even as health insurance exchanges, individual coverage, and Medicaid expansion have caused the market share of employer-based plans to decline since 2000. 155 By comparison, Medicaid programs cover approximately 83 million people and Medicare covers 64 million. 156
Many consider employer-provided coverage to be the best-functioning piece of our dysfunctional system of health care finance, 157 but that perception might only be due to historically widespread dysfunction in other private health insurance markets and the fact that ESI hides its true costs. On paper, ESI is paid for by a combination of employer and employee contributions. 158 For example, an employer might require an employee to contribute $150 per month for health plan coverage, with the employer contributing the remaining $500 cost each month. The employee might think of her cost as limited to the $150 that is taken out of her paycheck each month But there is widespread agreement among economists that the full cost of that make the plan itself less expensive); Yiyan Liu & Ginger Zhe Jin, Employer Contribution and Premium Growth in Health Insurance, 39 J. HEALTH ECON 228 (2015) (finding that employers have an incentive to keep employees’ share of premiums low, while increasing the “employer’s share,” which in turn contributes to employer health plan premium growth).
154 KAISER FAMILY FOUND., HEALTH INSURANCE COVERAGE OF THE NONELDERLY 0-64 (2022), https://www.kff.org/other/state-indicator/nonelderly-064/?currentTimeframe=0&sortModel=%7B%22colId%22:%22Location%22,%22sort%22:%22asc%22% 7D (employer plans cover 58% of the U.S. nonelderly population; Medicaid is the second-largest source of coverage, at 21% of the nonelderly population).
155 Thomas C. Buchmueller & Robert G. Valletta, Work, Health, and Insurance: A Shifting Landscape for Employers and Workers Alike, 36 HEALTH AFF 214, 217 (2017) (In 2000, 65.1% of all workers were covered by employer-sponsored insurance).
156 KAISER FAMILY FOUND., supra note 154
157 See, e.g., Allison K. Hoffman, Howell E. Jackson, & Amy B. Monahan, A Public Option for Employer Health Plans, 20 YALE J. HEALTH POL’Y L. & ETHICS 299, 311 (2021).
158 See KAISER FAMILY FOUND., supra note 27, at 88
ESI – in our example $650 per month – is a compensation expense that reduces wages accordingly. 159 Assume that an employee in our example earns $3,600 per month before taxes. If that employee was not offered health insurance, we would expect her wages to increase by $500 per month, the amount currently contributed by her employer for health insurance, so that she would be paid $4,100 per month before tax. In other words, total health insurance cost is part of an employee’s earned compensation even though the dollars that finance it never fall into the employee’s possession. And because the “employer contribution” to such coverage is largely invisible to employees, they are unaware of its impact, including the price of the health insurance they indirectly purchase and its effect on their cash wages. 160
Perhaps precisely because the true cost of ESI is hidden from employees, the costs and affordability of such coverage impose enormous challenges for employers and employees alike. 161 In 2023, the average annual premium for employer plans for family coverage was $23,968 (equal to more than 25% of the median family household income of $95,450) and $8,435 for individual coverage (equal to nearly 19% of median non-family household income of $45,440). 162 These premium prices are not inevitable consequences of healthcare cost inflation. Medicare payments to hospitals, which are calculated based on an accounting of costs, have remained much more stable over the past twenty years, whereas prices paid by private health insurers have rocketed upward. From 1996-2001, private insurers paid hospitals approximately 10% more than Medicare, but in 2012 private plans paid 75% more, 163 and the most recent data suggests that private plans now pay 224% of what Medicare pays hospitals for identical services. 164 The health insurers hired to insure and administer employer health plans have done a very poor job of
159 See, e.g., Gruber, supra note 25; MARK V. PAULY, HEALTH BENEFITS AT WORK: AN ECONOMIC AND POLITICAL ANALYSIS OF EMPLOYMENT-BASED HEALTH INSURANCE 2 (1999) (“employer payments for health insurance premiums ultimately come out of what would otherwise have been money wages for workers”).
160 Some have argued that, if employees did know the true cost of their health insurance, many would decide to forgo it altogether. See Clark Havighurst & Barak Richman, Who Pays for Health Insurance?, WALL ST J., Sept. 6, 2007, https://www.wsj.com/articles/SB118904358759518916. The Affordable Care Act required employers to report the cost of health insurance to employees in their annual W-2 forms, in Box DD. Despite its well intentions, there is little evidence that this end-ofyear report on the employee tax form makes employees more knowledgeable or cost-conscious of their health benefits.
161 Among those firms that do not offer health coverage, cost is most often cited as the most important reason for not offering coverage. KAISER FAMILY FOUND., supra note 27, at 62.
162 Health insurance premium data available at KAISER FAMILY FOUND., supra note 27, at 33. Household median income data available at The Census Bureau, https://www.census.gov/content/dam/Census/library/publications/2022/demo/p60-276.pdf
163 Thomas M. Selden et al., The Growing Difference Between Public and Private Payment Rates for Inpatient Hospital Care, 34 HEALTH AFF 2147 (2015).
164 CHRISTOPHER M. WHALEY ET AL., PRICES PAID TO HOSPITALS BY EMPLOYER HEALTH PLANS (2022), https://www.rand.org/content/dam/rand/pubs/research_reports/RRA1100/RRA11441/RAND_RRA1144-1.pdf
negotiating prices that track actual costs of service, and employers thus far have not been effective in changing that result. 165
The prices that health plans pay hospitals (which constitute the majority of medical spending – twice the amount spent on physicians and over three times the amount spent on pharmaceuticals 166) and other providers determines the ultimate price of such plans, so the upward trend in prices paid to hospitals has caused average premiums to grow significantly over the past twenty years, outpacing both inflation and wage growth. 167 For example, from 2016 to 2021, average premiums for family coverage increased 22%, while inflation was 11% and wage growth was 18%. In earlier periods, the difference was even more stark. From 2001 to 2006, average family premiums increased 63%, compared to 13% inflation and 15% wage growth. 168
Despite the rising cost of health coverage, most employer plans offer a diminishing degree of financial protection. After paying more for premiums, employees are also assuming heavier cost sharing burdens through copayments, coinsurance, and deductibles. 169 Most workers with employer coverage are currently in a plan with an annual deductible, which on average is $1,735 and for thirty-one percent of covered workers is greater than $2,000. 170 Both the percentage of workers in plans with an annual deductible and the average dollar amount of such deductibles have grown significantly in recent years. From 2006 to 2022, deductibles have increased 162%, whereas inflation was 20% and workers’ earnings grew by 26%. 171
165 There are, of course, complicated factors at play that affect an employer’s ability to negotiate prices, including provider consolidation. For example, corporate giants Amazon, Berkshire Hathaway, and JPMorgan Chase joined forces in 2018 to try to lower health care prices, but the venture ultimately folded in 2021, unable to successfully achieve its aims despite representing over 1.5 million employees. Sebastian Herrera & Kimberly Chin, Amazon, Berkshire Hathaway, JPMorgan End Health-Care Venture Haven, WALL ST. J. (Jan. 4, 2021), https://www.wsj.com/articles/amazon-berkshire-hathaway-jpmorgan-end-health-care-venture-haven11609784367.
166 AMERICAN MED ASSOC., TRENDS IN HEALTHCARE SPENDING (2022), https://www.amaassn.org/about/research/trends-health-care-spending
167 KAISER FAMILY FOUND., supra note 27, at 40.
168 Id. In addition to premium growth, underlying spending on health care for enrollees in employer plans has also grown. Over a ten-year period from 2007-16, total per enrollee spending in employer plans on health care increased by 44%, nearly twice the increase of inflation. Amanda Frost et al., Health Care Spending Under Employer-Sponsored Insurance: A 10-Year Retrospective, 37 HEALTH AFF 1623, 1623 (2018).
169 KAISER FAMILY FOUND., supra note 27, at 106-123. Where coinsurance is charged on such services, participants typically must pay 20% of the cost. Id. at 125
170 Id at 114 fig. 7.10, 116 fig. 7.14
171 KAISER FAMILY FOUND., EMPLOYER HEALTH BENEFITS 2022 ANNUAL SURVEY 95 (2002) (In 2022, 88% of ESI enrollees faced an annual deductible, compared to 55% in 2006; the average amount of such deductibles was $584 in 2006, compared to $1,763 in 2022).
The appropriate market response to the pervasiveness of expensive health plans would be to encourage the availability of lower-cost alternatives, which could economize on care or coverage in various ways. 172 But workers’ options are constrained by what their employers make available, 173 and most enjoy very limited choice. In 2023, only 21% of covered workers in all firms had a choice of more than two plan options, while 39% were offered only a single plan. 174 Among firms that only offer one type of health plan, the most common offering is a higher-cost PPO plan rather than a more affordable plan such as an HMO. 175
The burden of ESI’s poor cost-containment falls disproportionately on lowerincome workers. The diversion of employee money to pay for health insurance is a little-discussed factor in stagnant wages among wage-earning employees, but it is among the most important. 176 Because health insurance premiums are charged on a per employee or per family basis, and not adjusted for income level, such premia effectively function as a “head tax.” 177 The result is that lower-income employees
172 See, e.g., Clark C. Havighurst, Contract Failure in the Market for Health Services, 29 WAKE FOREST L. REV 47 (1994) (exploring the failure of the market to deliver lower-cost health insurance options).
173 While it is true that employees could forgo the coverage offered by their employer and seek coverage on the individual market, it generally would be financially disadvantageous to do so. First, an employee who purchases an individual health insurance policy must pay for such coverage with after-tax dollars, because the tax exclusion for health insurance premia applies only to employerprovided coverage or coverage purchased by a self-employed individual. See IRC §§106, 162(l). In addition, an employee who is offered coverage by their employer has had their cash wages reduced to account for the “employer contribution” to such coverage. As a result, an employee who forgoes such coverage is losing the economic value of the employer contribution.
174 KAISER FAMILY FOUND., supra note 27, at 80, fig. 4.2. Lack of choice is especially prominent at small firms; three-quarters of firms offering health benefits offer only a single health plan option Among firms that offer only a single health plan option, PPO plans are the most commonly offered, followed by high-deductible plans. Id. at 82, fig. 4.5. Some employers express the worry that increasing choice also increases administrative costs, but substantial research indicates that expanding the selection of plans and insurers increases employee welfare and controls costs. Jonathan Gruber & Robin McKnight, Controlling Health Care Costs through Limited Network Insurance Plans: Evidence from Massachusetts State Employees, 8 AM J. ECON POL’Y 219 (2016), https://www.jstor.org/stable/24739222?seq=1.
175 KAISER FAMILY FOUND., supra note 27, at 82, fig.4.5. (among firms that offer only a single health plan option, PPO plans are the most commonly offered, followed by high-deductible plans).
176 See, e.g., Drew Desilver, For Most U.S. Workers, Real Wages Have Barely Budged in Decades, Pew Rsch. Ctr. (Aug. 7, 2018), https://www.pewresearch.org/short-reads/2018/08/07/for-most-us-workersreal-wages-have-barely-budged-for-decades/ (discussing the theory that “rising benefit costs –particularly employer-provided health insurance – may be constraining employers’ ability or willingness to raise cash wages”); JAY SHAMBAUGH, RYAN NUNN, PATRICK LIU, & GREG NANTZ, THIRTEEN FACTS ABOUT WAGE GROWTH iv (2017), https://www.hamiltonproject.org/wpcontent/uploads/2023/01/thirteen_facts_wage_growth.pdf (noting that benefit cost increases have outpaced wage growth; between 1991 and 2017, real wages have increased 15.71%, while the percentage of total compensation attributable to benefit plan costs has risen by 36.33%).
177 Clark C. Havighurst & Barak D. Richman, Distributive Injustice(s) in American Health Care, 69 LAW & CONTEMP PROBS 7, 28 (2006).
have been hit especially hard, exacerbating income inequality. Heightened costshifting also disproportionally affects the finances and behavior of lower-income individuals. 178 The burdens and disappointments of ESI have led to a considerable decrease in lower-income employees’ accepting employers’ health insurance altogether, which hardly is the preferred outcome for a polity aiming to achieve full coverage. 179 And even where such workers manage to find a way to afford premium payments, high cost-sharing requirements often result in such workers postponing necessary medical care or facing medical bankruptcy when care is received. 180 The plight of low-income workers illustrates the important role employer-provided coverage has to play in achieving effective social policy.
B. Explaining the Shortcomings of Employer-Sponsored Health Plans
ESI’s shortcomings present something of a puzzle. A competitive labor market would suggest that employers would offer high-value health benefits to attract a talented workforce, and surveys consistently report that employers believe employer-provided health benefits are important in recruiting and retaining valued employees. 181 Moreover, employees also report in surveys that health benefits constitute the most important benefit that employers offer, far outranking retirement or other benefits. 182 Such evidence, along with rudimentary economics, indicates a mutual interest to have plan managers exercise fastidiousness and demand efficiencies in spending the very substantial sums dedicated to health benefits. This should be even more true given that employer-provided health care is part of a worker’s total compensation, such that the amount spent on health benefits are borne by employees through lower wages. 183
Perhaps this thinking is why employers have been subject to minimal regulatory oversight in their provision of employee health benefits. If a competitive labor market and other price pressures would discipline an employer that uses employee benefit dollars inefficiently, then stringent regulation is unnecessary to
178 See Collins et al., supra note 19.
179 PETERSON-KFF HEALTH SYSTEMS TRACKER, LONG-TERM TRENDS IN EMPLOYER-BASED COVERAGE (2020), https://www.healthsystemtracker.org/brief/long-term-trends-in-employer-basedcoverage/#Percent%20of%20Nonelderly%20Population%20Enrolled%20in%20EmployerSponsored%20Coverage,%201998-2018 (reporting that, among full-time workers, 88% of those with income at or above 400% of the federal poverty level were enrolled in employer health coverage, while only 48% of those with income between 100% and 250% of the federal poverty level elected such coverage).
180 See Saad, supra note 19; Himmelstein et al., supra note 19
181 See, e.g., Heidi Whitmore et al., Employers’ Views on Incremental Measures to Expand Health Coverage, 25 HEALTH AFF 1668, 1670 (2006).
182 Salisbury & Ostrew, Value of Benefits Constant in a Changing Job Environment: The 1999 World at Work/EBRI Value of Benefits Survey, EBRI Notes 21:5-6 (2000).
183 See supra text accompanying notes 158-162
monitor those employers. 184 An employer that fails to act as an effect agent for its employees will either have to increase total compensation to account for their lessthan-ideal health benefits or face higher employee turnover than any competitors that properly account for employee preferences. 185
The poor performance of ESI suggests, de facto, that this prevailing theory is problematic (would anyone think that employers who agree to prices that are more than twice that of Medicare are acting in accordance with their employees’ wishes?), and some recent research has explored reasons why employers act as ineffective purchasing agents for their employees. One reason is derived from the political economy of the firm. In most firms, health benefits are overseen by the human resources (HR) department, whose primary role and core responsibility is to attend to employee needs, not conserve financial resources. This delegation not only means that benefits expenditures escape the typical scrutiny a company applies to its finances (in HR departments, accountability is often measured in terms of recruitment and retention, not the value of expenditures), but it also means that HR policies are not factored into a company’s central business decisions. One former human resources executive put it starkly:
[B]usiness leaders have not treated health care costs as a core business issue. They delegate the responsibility to their human resources department, which is measured on employee satisfaction and has no accountability for the company’s financial performance. This makes little sense. HR professionals rely on insurance brokers to provide expertise. Brokers are rarely equipped to help employers develop effective health care strategies. Many states do not require a college degree for licensure, and brokers get commissions and hefty fees from the very health suppliers that employers hire them to select and manage.
186
The above quote suggests additional inefficiencies that accrue from a delegation to HR departments. First, most HR executives lack the training and background necessary to scrutinize the purchasing of healthcare. They therefore outsource the job of selecting insurers/administrators to insurance brokers or benefit consultants. 187 And second, HR executives are generally poorly suited to
184 Gregory Acs & Eugene Steuerle, The Corporation as Dispenser of Welfare and Security, in THE AMERICAN CORPORATION TODAY: EXAMINING THE QUESTIONS OF POWER AND EFFICIENCY AT CENTURY’S END (Carl Kaysen ed., 1996).
185 See Peele et al., supra note 43, at 7.
186 Robert S. Galvin, To Improve Your Company’s Health Care, Get the CEO Involved, HARV BUS REV , May 29, 2019, https://hbr.org/2019/05/to-improve-your-companys-health-care-get-the-ceoinvolved
187 M. Susan Marquis & Stephen H. Long, Who Helps Employers Design Their Health Insurance Benefits?, 19 HEALTH AFF. 133, 135 (2000) (finding that 54% of all surveyed employer use external consultants to advise them on health benefits, a figure that rises with employer size); Pinar Karaca-
monitor the wisdom of the brokers’ or consultants’ recommendations, who in turn and consequently are not held to terribly high professional standards. A series of agency costs therefore accrue in the purchasing of healthcare benefits simply because HR departments are ill-equipped to demand value from their healthcare purchasing. Evidence suggests that when employers feel health plan cost pressure, they respond by shifting an increasing percentage of those costs to workers, rather than address the drivers of those costs. 188
Some scholars, examining why these intra-firm agency costs pervade employee benefits policies, ask the simple question of whether employers can accurately identify their employees’ preferences for health benefits. One study by Peele, et al., separately surveyed employees and health plan decisionmakers at various companies to see if the health plan decisionmakers accurately understood their own employees’ health plan preferences. 189 The authors found mixed results. Employers correctly perceived that access to specific providers was among the most important factors for their employees, but they underestimated how much employees identified the quality of care as a priority. 190
The Peele, et al., study has several severe limitations. While the study authors gave employers relatively high marks for discerning employee preferences, 191 it engaged in only a very high-level preference matching. For example, in evaluating how well employers did in incorporating employee preferences into plan design, employers were found to have responded to employee preferences for quality and access to specific providers because the employer plans offered broad networks of providers. 192 Yet there was no indication that employers made any attempt to evaluate provider quality on behalf of their employees, or made sure that the specific providers desired by the employees were included, instead simply opting for a broad provider network. Indeed, none of the employers in the study provided their employees with any information on plan or provider quality, even though such information was available in the regions studied. 193 Mandic, Roger Feldman, & Peter Graven, The Role of Agents and Brokers in the Market for Health Insurance, 85 J. RISK & INS 7, 7-9 (2018) (summarizing the literature on the heavy use of insurance brokers by small firms purchasing health insurance contracts).
188 See, e.g., Jill R. Horwitz et al., Wellness Incentives in the Workplace: Cost Savings Through Cost Shifting to Unhealthy Workers, 32 HEALTH AFF. 468 (2013); Hughes et al., supra note 26 (explaining that some employers address high costs by shifting those costs from premiums to workers’ out-ofpocket expenses).
189 Peele et al., supra note 43
190 Id at 13.
191 Id.
192 Id. at 14.
193 Id at 15.
The failure to assure or measure quality is unfortunately a common feature of employee health plans. 194 Employees routinely report that quality care is among their highest priorities, yet evidence suggest that clinical quality is not a key metric used by employers in selecting plan administrators through whom provider networks are made available. 195 For example, in one large 2019 survey, 36% of employers stated that “quality” was the most important factor in selecting a health plan. 196 In follow-up focus group interviews, however, employer health plan decisionmakers “were generally unable to identify any quality information available to them.” 197 Similarly, a 2020 survey by the National Committee for Quality Assurance found that employers were not generally aware of how to compare health plan quality. 198
As the above studies suggest, even large, sophisticated employers appear to have difficulty evaluating the ex-ante quality of their health plan structure and its providers, and most likely do not have either the data or expertise to adequately analyze quality ex post. 199 At least one study found that employers often equate plan quality with the customer service quality – for example, call wait times, patient satisfaction, and claims processing accuracy – not the underlying quality of the medical care provided by the plan’s network. 200 Evaluating customer service
194 Robert S. Galvin, An Employer’s View of the U.S. Health Care Market, 6 HEALTH AFF. 166, 167 (1999) (noting that employers do not routinely engage their employees on issues of quality and value – keeping such tradeoffs obscured). See McKinsey & Co., Employers Look to Expand Health Benefits While Managing Medical Costs, May 25, 2022, https://www.mckinsey.com/industries/healthcaresystems-and-services/our-insights/employers-look-to-expand-health-benefits-while-managingmedical-costs (quality was not among the top five most important factors reported by employers).
195 While there are many ways to define quality of care, the Institute of Medicine uses six parameters – quality care is safe, effective, patient-centered, timely, efficient, and equitable. INSTITUTE OF MEDICINE, CROSSING THE QUALITY CHASM: A NEW HEALTH SYSTEM FOR THE 21ST CENTURY 39-40 (2001).
196 Gary Claxton et al., Employer Strategies to Reduce Health Costs and Improve Quality through Network Configuration, Peterson-KFF Health System Tracker, Sept. 25, 2019, https://www.healthsystemtracker.org/brief/employer-strategies-to-reduce-health-costs-and-improvequality-through-network-configuration/.
197 Id
198 Kelsey Waddill, Employers Unaware of How to Compare Health Plan Quality Measures, HEALTH PAYER INTELLIGENCE, Sept. 2, 2020, https://healthpayerintelligence.com/news/employers-unaware-ofhow-to-compare-health-plan-quality-measures.
199 See Robert K. McLellan, Work, Health, and Worker Well-Being: Roles and Opportunities for Employers, 36 HEALTH AFF 206, 211 (2017); Ron Z. Goetzel et al, Do Workplace Health Promotion (Wellness) Programs Work?, 56 J. OCCUP ENVIRON MED 927 (2014). Robert S. Galvin & Suzanne Delbanco, between a Rock and a Hard Place: Understanding the Employer Mind-Set, 25 HEALTH AFF 1548, 1553 (2006) (noting that many employers simply “do not have a deep understanding of health care”).
200 Christianson & Trude, supra note 97, at 364.
quality is both easier to observe and more in line with the core functions of an HR department, but it is not the clinical quality that employees prioritize. 201
The Peele, et al., study also provides circumstantial evidence of how the hidden nature of true employer health plan costs impacts stated employee preferences and employers’ responses thereto. As was noted above, 202 employees neither know how much their health benefits cost nor recognize that whatever amounts they cost directly reduce their take home pay. It therefore is not surprising that employee responses in the Peele, et al., study indicated little concern about either the costs of care or the availability of low-cost insurance products. A better indication of how individuals view health insurance tradeoffs is provided by Ginsburg, et al., whose study asked individuals to reveal their preferences for health benefits, but within a limited budget. 203 In sharp contrast to the findings in Peele, et al., respondents in the Ginsburg study placed a low priority on choice of provider, instead readily tolerating tight restrictions on provider choice in exchange for comprehensive coverage and reduced cost sharing. 204 They also supported limiting benefits in accordance with practice guidelines and standards of effectiveness, excluding high-cost and low-value interventions. 205
These studies not only suggest that employers do poor jobs of representing their employees’ preferences, but they also begin to explain why. Employees have the errant belief that health benefits are a perk, rather than a displacement of wages and other compensation, and they therefore inadequately demand value from their employer health plans, as they would if they were purchasing the benefits directly. Employers, in turn, place health benefits within the domain of human resources, where the skills and priorities of HR departments encourage an emphasis on broad networks and customer service, rather than clinical quality and value. But the emphasis on broad networks, which employers errantly believe responds to employees’ desire for quality care, merely shifts “responsibility for selecting ‘quality providers’ back to their employees” 206 and fails to control costs. Industry experts, in contrast, find that active benefits management, through
201 Id
202 See supra text accompanying notes 158-160.
203 Marjorie Ginsburg et al., (De)constructing ‘Basic’ Benefits: Citizens Define the Limits of Coverage, 25 HEALTH AFF. 1648 (2006).
204 Id. at 1652-53.
205 Id. at 1650-52. See also Marjorie Ginsburg & Kathy Glasmire, Designing Coverage: Uninsured Californians Weigh the Options, California Health Care Foundation Issue Brief, https://www.chcf.org/wp-content/uploads/2017/12/PDF-DesignCoverageForUninsured.pdf (reporting the results of a study with similar findings).
206 Christianson & Trude, supra note 97, at 365.
narrow or tiered networks that explicitly consider quality while restricting choice, are far more effective in controlling costs and serving employee interests. 207
None of this poor performance is irreversible. To the contrary, researchers regularly confirm that employers have an intense and genuine interest in promoting their employees’ health, but the perceived barrier is simply a feeling of powerlessness in advancing their employees’ health interests. One study concludes that “most companies and their senior leaders fail[] to appreciate their ability to intervene in ways that would improve the health of their employees.” 208 Although prevailing mechanisms in providing employee health benefits suffer from a sequence of agency costs and misaligned priorities, the status quo is simply due to employers lacking both the imagination to craft the health benefits their employees crave and the legal requirements that they do so.
III. USING ERISA’S FIDUCIARY DUTIES TO IMPROVE EMPLOYER HEALTH PLANS
Section I establishes that ERISA requires employers to abide by fiduciary standards when administering their health plans, and Section II illustrates the enormous need to hold employers to that standard. Together, the two Sections suggest that there is both a way and a will to bring relief to employees whose health benefits are being mismanaged.
The path forward offers both immediate and long-term implementation strategies. Some employees and employers are already pursuing immediate relief through litigation – this perhaps reveals both the broader recognition that ERISA imposes legal duties regarding health benefits and impatience with widespread mismanagement of health benefit dollars. However, despite the immediate need to demand more from ESI managers, imposing fiduciary duties to economic activity as large as the entire French economy should be done deliberately. We offer a roadmap for how to apply ERISA’s fiduciary obligations though a prudent rulemaking process led by the Department of Labor, which has the rulemaking authority under current law to issue vast regulations that compel employers to improve the quality and reduce the wastefulness of their health plans. This includes a regulatory safe harbor that would not only result in employers being better
207 See, e.g., Nicole Rapfogel & Emily Gee, Employer- and Worker-Led Efforts to Lower Health Insurance Costs, Center for American Progress, July 28, 2022, https://www.americanprogress.org/article/employer-and-worker-led-efforts-to-lower-healthinsurance-costs/; United Healthcare, Network Configurations May Help Improve Care Quality While Reducing Costs, https://www.uhc.com/content/dam/uhcdotcom/en/BrokersAndConsultants/Tri1Tiered-Network-article.pdf.
208 Jeffrey Pfeffer, et al., Employers’ Role in Employee Health: Why They Do What They Do, 62 J. OCCUPATIONAL & ENV’T MED E601 (2020)
custodians of their employees’ money, but would generate a more competitive healthcare market that would benefit all citizens.
A. Novel Litigation to Enforce Longstanding Fiduciary Duties
The secret is out. After more than forty years of ERISA litigation that almost exclusively hewed to enforcing fiduciary duties over retirement benefits, at least one employee was sufficiently exasperated with her employer’s healthcare benefits to sue under ERISA to claim that her employer failed to fulfill its fiduciary duties when selecting a plan administrator. 209 On February 5, 2024, Ann Lewandowski sued Johnson & Johnson, her employer, for selecting a health plan administrator (specifically, the pharmacy benefits manager) that charged the plan prices for prescription drugs that greatly exceeded market norms, a fiduciary decision that “cost[] their ERISA plans and their employees millions of dollars in the form of higher payments for prescription drugs, higher premiums, higher deductibles, higher coinsurance, higher copays, and lower wages or limited wage growth.” 210 To illustrate her complaint, Lewandowski alleged that the pharmacy benefits manager selected by Johnson & Johnson was charging an 800.72% mark-up on a generic HIV antiviral drug (the cash pay price for the drug ranged from $123.82 to $210.20 for a 90-day supply, while the plan agreed to pay $1,629.40). 211 One longtime observer of employee health plans remarked, “This is the first suit of its kind … It definitely will not be the last.” 212
A victory for Lewandowski and her class of fellow employees would represent a sea change in the $1.5 trillion health benefits market and is precisely the litigation predicted in Parts I and II. While the Lewandowski lawsuit is the first of its kind because it has been brought by a participant challenging the employer’s selection of a plan administrator, it builds on a still nascent but growing trend of litigation that is broadly exploring ERISA’s application to health benefits management. In just the past few years, a small but important number of cases have been brought by employers against the very plan administrators the employers have contracted with, claiming that those administrators had breached their fiduciary duties to the relevant plans by, among other things, overpaying claims, approving fraudulent and improper claims, and failing to disclose plan
209 Lewandowski v. Johnson & Johnson, Case 1:24-cv-00671 (D. N.J. filed Feb. 5, 2024). See also Melanie Evans & Anna Wilde Mathews, J&J Accused of Mismanaging Its Employees’ Drug Benefits, Wall St. J., Feb. 5, 2024 (reporting on the novel nature of the case); Sara Hansard, Johnson & Johnson Case Signals Employee Drug Price Suits to Come, BLOOMBERG LAW DAILY LABOR REPORT, Feb. 9, 2024 (noting that the case “appears to be the first case brought by an employee…alleging breach of ERISA fiduciary duty over mismanagement of health plan funds”).
210 Lewandowski v. Johnson & Johnson, Case 1:24-cv-00671 (D. N.J. filed Feb. 5, 2024).
211 Id. at 33-34.
212 Evans & Mathews, supra note 209
information. 213 While it is undoubtedly a positive development that employers are beginning to question, on their employees’ behalf, some of the financial behavior of their plan administrators, it obviously would be more productive to ensure that employers make better decisions in the first place.
These pioneering lawsuits do, however, offer some early lessons. The first is that they reflect deep dissatisfaction in both the structure and the administration of employer-sponsored health benefits. It is telling that so many of these early actions were brought by employers dissatisfied with the plan administrators they themselves had selected. Both the employers and the plan administrators they hire are subject to fiduciary duties under ERISA, but resorting to lawsuits reflects an incapacity or unwillingness among employers to effectively screen and monitor administrators or replace them; they instead reflect an exasperation that employers and the public have with an industry that is unaccustomed to being held accountable for its fees and quality of service. Somewhat cynically, one might also observe that the suits suggest that employers recognize that the failure of their plan administrators might expose them to liability as well. However, it is unlikely that an employer meets its fiduciary duties under ERISA merely by suing the insurer that it hired for breaching ERISA’s duties, and equally unlikely that an employer is excused if the administrator is deemed liable.
The second lesson is that recent medical price transparency requirements have enhanced the ability to enforce ERISA’s health plan fiduciary duties. The most notable of these requirements is the “transparency in coverage” final rule, issued in October 2020 under the authority of the Affordable Care Act. 214 The rule requires health plans and insurers to disclose, among other figures, negotiated rates for in-network providers, historical out-of-network allowed amounts and billed charges, and drug pricing information. 215 Also important are the hospital price transparency rules 216 that require hospitals to disclose the payer-specific negotiated charge for items and services. 217 The result is that, for the first time, employers selecting a plan administrator can compare carriers’ negotiated hospital rates, a key
213 See, e.g., Clancy v. United Healthcare Ins. Co., Civil 3:21cv535(DJN) (E.D. Va. Nov. 30, 2022); Trustees of the Int’l Union of Bricklayers & Allied Craftworkers Local 1 Connecticut Health Fund v. Elevance, Inc., 3:22-cv-01541 (D. Ct. Dec. 5, 2022); Kraft Heinz Co. Emp. Benefits Admin. Bd. v. Aetna Life Ins. Co., No. 2:23-cv-00317 (E.D. Tex. June 30, 2023)
214 Tran sparency in Coverage, 85 Fed. Reg. 72158 (Nov. 12, 2020) (to be codified at 26 C.F.R. pt. 54).
215 26 C.F.R. §54.9815-2715A1(b).
216 See 42 U.S.C. §300gg-18(e) (hospital price transparency requirements).
217 See 45 CFR §180.50(b)(3). In addition to making such information available in a machinereadable format, hospitals must also make such information available in a consumer-friendly format for certain “shoppable” hospital services. Id §180.60(b)(3). There have, however, been indications that hospitals have failed to fully comply with these new requirements as of their effective date. See Anthony T. LoSasso, Kevin Toczydlowski, & Yanchao Yang, Insurer Market Power and Hospital Prices in the US, 42 HEALTH AFF 615 (2023).
driver of health plan costs. The disclosure of negotiated prices has revealed to employees, plan administrators, and others whether certain ERISA fiduciaries are paying more than what a prudent purchaser should.
The third lesson is that the lawsuits are marching toward some new enforcement realities to vindicate employee rights. Most of the suits have survived initial challenges and have settled, which suggests both that the claims have merit and that clear law is unlikely to emerge from the stream of lawsuits. And significantly, those within the industry sense that much more is to come. A longtime former Department of Labor attorney succinctly described the state of ERISA law:
Fiduciaries and service providers to employee benefit plans [should] prepare now for what could be a new wave of class action ERISA fee and expense litigation this one crashing down on health care plans. In the last two decades, hundreds of class action lawsuits have been filed against fiduciaries of ERISA retirement plans alleging their imprudence and lack of oversight of plan finances caused their plans to pay too much for investments and plan administration. … Some of the attorneys who spearheaded this retirement plan litigation tsunami may now be turning their attention to health care plans. 218
One such attorney is already issuing advertisements on LinkedIn with a simple message: “Are you a current ______ employee who has participated in the company’s healthcare plan? You may have a legal claim and we’d like to speak with you.” 219 The company employees being targeted include Anthem, State Farm, PetSmart, and many more. 220
The fourth lesson, and certainly the most important, is that these initial legal actions, whatever their outcome, illustrate the need for the Department of Labor to issue ex-ante regulations. Most lawsuits will result in settlements, which do nothing to clarify obligations for other employers, and even those that result in rulings will be hard to translate into rules of general applicability. For example, the plaintiff’s success in Lewandowski may or may not have implications outside the domain of pharmaceutical benefits and whether an out-of-pocket payment is the only metric to determine plan overspending. Answering these questions, which have vital industry-wide importance and would meaningfully enhance needed
218 Joanne Roskey, Are You Ready for Class Action Health Care Plan Fee Litigation?, Plan Adviser, Sept. 1, 2023, https://www.planadviser.com/exclusives/ready-class-action-health-care-plan-feelitigation/
220 Nat’l Assoc. of Plan Advisors, Schlichter Widens Net for Fiduciary Claims, Aug. 9, 2023, https://www.napa-net.org/news-info/daily-news/schlichter-widens-net-fiduciary-claims
accountability, predictability, and efficiency to the health benefits sector, requires the Department of Labor to exercise its authority under ERISA to issue regulations.
This is a common feature of lawmaking, as both scholars and legal authorities broadly agree that rules and rulemaking are generally superior over piecemeal adjudication, especially when a new wave of litigation raises industrywide questions. Academic icons such as Merton Bernstein and David Shapiro, in the early years of administrative law scholarship, wrote conclusively about the general merits of rulemaking over adjudication, 221 and the U.S. Supreme Court has embraced it as a truism in multiple rulings. 222 Moreover, the Supreme Court on more than one occasion has criticized agencies that have delayed or refused to issue rules. 223
In short, the recent filing of Lewandowski v. Johnson & Johnson may be a harbinger of a new litigation wave, one that will squarely address the substantive fiduciary obligations that employers have to their employees. It is unclear where these cases will lead and what rules they will generate, but the current trend will force courts to establish the parameters for ERISA’s fiduciary duties. This puts the Department of Labor in a unique position and presents it with a unique opportunity. Rather than watching a morass of case law develop, the Department could preemptively issue regulations that bring the clarity, farsightedness, and expertise that the industry requires.
B. Regulatory Clarity and a Safe Harbor
ERISA’s role in safeguarding employee retirement benefits has always relied on guidance from the Department of Labor. In giving the Department both rulemaking and enforcement authority, it was clearly Congress’ intent to have the Department play an active role in ensuring compliance with ERISA. Moreover, in basing ERISA liability on the law of fiduciary duties, the statute contains significant ambiguities that Congress intended rulemaking by the Department of Labor to fill in.
221 Merton C. Bernstein, The NLRB’s Adjudication-Rule Making Dilemma Under the Administrative Procedures Act, 79 YALE L. J. 517 (1970); David L. Shapiro, The Choice of Rulemaking and Adjudication in the Development of Administrative Policy, 78 HARV. L. REV. 921 (1965). See also Kristen E. Hickman & Richard J. Pierce, Jr., ADMINISTRATIVE LAW TREATISE – HICKMAN AND PIERCE, §4.8 (reviewing the literature and listing “at least nine different advantages of rulemaking over adjudication as a source of generally applicable rules”).
222 See, e.g., Mohawk Industries, Inc. v. Carpenter, 558 U.S. 100, 113- 14 (2009) (“Indeed, the rulemaking process has important virtues. It draws on the collective experience of bench and bar, and it facilitates the adoption of measured, practical solutions.”)
223 See, e.g., Allentown Mack Sales & Service, Inc. v. National Labor Relations Board, 522 U.S. 359 (1998)
As noted in Part I, the Department of Labor has embraced this responsibility issuing regulations regarding how employers should comply with their fiduciary duties in administering retirement benefits, but it has been virtually silent in doing the same for health benefits. Now, however, both the sector’s enormous wastefulness (see Part II) and the recent emergence of litigation (see Part III.A) demand action by the Department.
In this Part, we offer a roadmap for how to apply ERISA’s fiduciary obligations though a prudent rulemaking process led by the Department of Labor We begin by offering suggestions for immediate steps the Department of Labor could take within their existing rulemaking authority to improve the quality of employer health plans. We then propose a regulatory safe harbor focused on health plan value that would cause employers to be better custodians of their employees’ money and, consequently, would generate a more competitive healthcare market.
i. High-Return/Low-Risk Regulatory Actions to Improve Employer Health Plans
The obvious place to start in health plan fiduciary rulemaking is to specify the factors that an employer must consider when selecting a health plan administrator in order to comply with the duty of prudence. While precise details should be arrived at as part of a deliberative rulemaking process, at a minimum employers should be required to evaluate cost, clinical quality, network adequacy, claims processing accuracy and timeliness, and customer service functions. Cost considerations should include not simply administrative fees or premiums, but should require employers to evaluate the provider reimbursement rates that will apply to covered medical services. Some of these factors (such as claims accuracy or customer service) require little explication and appear to receive appropriate attention from employers even in the absence of fiduciary rulemaking. We therefore limit our discussion below to those factors we have reason to believe receive a suboptimal level of consideration under the status quo and about which regulatory guidance could drive real improvement in employer health plans.
a. Medical Costs
When an employer selects a health plan administrator it is purchasing access to that entity’s provider network, along with the reimbursement rates that have been negotiated with those providers. Given that these reimbursement rates largely determine the plan’s medical costs, which are far and away the most significant driver of overall plan expenses, the choice of an administrator has a profound impact on plan premiums and those out-of-pocket expenses that are determined based on charged costs. Fiduciaries have a clear duty when selecting a plan administrator to determine if the administrator’s negotiated provider rates are
reasonable in light of the services provided, and rulemaking should make this requirement explicit.
Negotiated provider rates vary tremendously among payers. To begin with, private payers such as employer plans face rates that are significantly higher than the rates paid by public programs. The Medicare Payment Advisory Commissions has estimated that private payers face rates that are 50% higher than what Medicare pays. 224 But even when we focus solely on rates faced by private payers, we see substantial variation not only between geographic regions, but also within geographic regions. For example, the costs for a common surgical procedure in a given metropolitan area might vary by tens of thousands of dollars among various hospitals, 225 in a manner that is not correlated with quality. 226 There is even evidence that, in some cases, the “negotiated” rates for services exceed self-pay cash prices for those same services. 227 While the causes of these disparate rates are complex, the important fact for our purposes is that prudent fiduciaries would inform themselves about these price differences as well as relevant market averages, and be prepared to justify the selection of any plan administrator that charges above-average prices.
Historically, employers have had limited ability to determine or compare negotiated reimbursement rates prior to entering into a contract with an insurer (and, in certain circumstances, even after entering into such a contract). Prior to the recent implementation of price transparency requirements, insurers and administrators treated negotiated rates as confidential and proprietary. While employers were able to request certain information about rates during the bidding
224 MEDICARE PAYMENT ADVISORY COMMISSION, REPORT TO THE CONGRESS: MEDICARE PAYMENT POLICY (2017), http://medpac.gov/docs/ default-source/reports/mar17_ entirereport.pdf. See also Mark Katz Meiselbach et al., Hospital Prices for Commercial Plans are Twice Those for Medicare Advantage Plans When Negotiated by the Same Insurer, 42 HEALTH AFF. 1110, 1114-15 (2023) (finding that insurer-negotiated medical hospital prices for private health plans were more than twice their Medicare Advantage prices in the same hospital for the same service).
225 See, e.g., Nisha Kurani et al., Price Transparency and Variation in U.S. Health Services, PetersonKFF Health System Tracker (Jan. 13, 2021), https://www.healthsystemtracker.org/brief/pricetransparency-and-variation-in-u-s-health-services/#Average%20allowed%20charges%20for%20officebased%20lower%20back%20MRIs%20in%20large%20employer%20plans,%20by%20MSA,%202018 (finding that, in the San Diego metropolitan area, the average allowed charge for knee replacement surgery was $33,554, but the 25th percentile of the range was $20,305 and the 75th percentile was $51,995).
226 For a summary of the existing literature on this complex topic, see Michael E. Chernew & Richard G.Frank, What Do We Know About Prices and Hospital Quality?, Health Affairs Forefront, July 29, 2019, https://www.healthaffairs.org/content/forefront/do-we-know-prices-and-hospital-quality.
227 Gerardo Ruiz Sánchez, Variation in Reported Hospital Cash Prices Across the United States and How They Compare to Reported Payer-Specific Negotiated Rates, 211 ECON LTRS 110226 (2021).
process, that information was incomplete and was of course limited to those who submitted bids. 228
Given the recently enacted price transparency requirements, plan fiduciaries now have much better information on reimbursement rates available to them, and they should be explicitly required to use this information when selecting a plan administrator. To use hospital prices as an example, a prudent fiduciary should be required to examine plan administrators’ hospital reimbursement rates as part of the plan administrator selection process, particularly given the highly significant role hospital expenses play in overall health plan costs. Because there are innumerable types of hospital charges, it may be helpful to limit the required analysis to some manageable basket of services, such as the top-five hospital-based cost drivers for the plan. In reviewing potential plan administrators, the employer would be expected to compare hospital prices (among those hospitals most frequently used by plan participants) for those five services not only as compared to other bidders, but as compared to all payers. If Company A’s negotiated rates for knee replacement surgery are on average two times higher than all other private payers, a prudent fiduciary would take that into account in evaluating Company A’s bid. Obviously hospital rates are only one piece of a complex decision, but hospital rates significantly above competitors should at the very least require further consideration (and, hopefully, negotiation).
Regardless of the particular form the rulemaking might take, we believe that explicitly requiring employers to consider negotiated provider reimbursement rates and compare hospital reimbursement rates in selecting a plan administrator is one of the highest return actions the Department of Labor could undertake.
b. Administrative Expenses
In addition to payments for plan participants’ underlying medical expenses, plans face administrative expenses that cover what is characterized as overhead costs, such as payments for claim administration and call centers, as well as marketing and profits. Recent research has estimated administrative costs to consume 25% to 31% of total health care expenditures in the United States, 229 a
228 For examples of the types of rate information requested by employers as part of the bidding process, see Pierce County Washington, Request for Proposal: Third Party Administrator for Self Insurance Medical Plan and Stop Loss, May 20, 2015; State of North Carolina, The North Carolina State Health Plan for Teachers and State Employees Request for Proposal #270-20220830TPAS Third Party Administrative Services, Aug. 30, 2022, at 83 (both on file with authors).
229 Tseng P, Kaplan RS, Richman BD, Shah MA, Schulman KA. Administrative Costs Associated With Physician Billing and Insurance-Related Activities at an Academic Health Care System. JAMA. 2018;319(7):691–697. doi:10.1001/jama.2017.19148; Jiwani A, Himmelstein D, Woolhandler S, Kahn JG. Billing and insurance-related administrative costs in United States’ health care: synthesis of micro-costing evidence. BMC Health Serv Res. 2014;14(1):556; Himmelstein DU,
proportion twice that found in Canada and significantly greater than in all other OECD member nations. 230 The rate of growth in administrative costs in the United States has outpaced overall healthcare expenditures, 231 and these costs themselves have been blamed for contributing to excess health spending in the U.S. 232
Escalating administrative costs has likewise burdened ESI, though its impact has been hidden from most observers. The culprit is the medical loss ratio (MLR), which is the share of total health care premiums spent on medical claims, with overhead expenses constituting the remainder. 233 The Affordable Care Act (ACA), in an effort to limit the profits and administrative costs of health insurers, established floors for the MLR, thereby limiting administrative expenses. 234 For fully insured plans, these administrative expenses are capped under federal law as a percentage of premiums. Administrative expenses may not exceed 15% of total premium for large group plans or 20% for small group plans. 235 If the insurer spends less than 85% or 80%, respectively, on medical expenses (including health improvement efforts), the carrier must refund the excess premium to keep administrative expenses below the permitted maximum. 236
The problem is that the MLR is a ratio, so a health plan’s profits – which are included in the 15% that excludes medical costs – can be increased if total expenditures increase. 237 This explains the several actions employers brought under ERISA against their plan administrators with allegations that those plans overpaid claims and approved unnecessary expenditures. 238 In one case, an employer accused its administrator of approved claims for its self-funded plan that it did not approve for its fully-insured plans, i.e., plans in which medical expenses
Jun M, Busse R, et al. A comparison of hospital administrative costs in eight nations: US costs exceed all others by far. Health Aff (Millwood). 2014;33(9):1586-1594.
230 Barak Richman, et al., Billing and Insurance-Related Administrative Costs: A Cross-National Analysis, Health Affairs, vol.41 no.8 (2022) https://doi.org/10.1377/hlthaff.2022.00241; Morra D, Nicholson S, Levinson W, Gans DN, Hammons T, Casalino LP. US physician practices versus Canadians: spending nearly four times as much money interacting with payers. Health Affairs, 2011;30(8):1443-1450; Woolhandler S, Campbell T, Himmelstein DU. Costs of health care administration in the United States and Canada. N Engl J Med. 2003;349(8):768-775.
231 Himmelstein, et al., (2014), supra note 229
232 Laura Tollen, et al., How Administrative Spending Contributes to Excess US Health Spending, Health Affairs Forefront (February 12, 2020).
233 See 45 CFR § 158.130, 45 CFR § 158.140, and 45 CFR § 158.150, for definitions of the medical loss ratios, applicable premiums, medical claims, and other factors.
234 42 U.S.C. §300gg-18(b).
235 Id. §300gg-18(b)(ii).
236 Id. §300gg-18(b)(i).
237 David Scheinker, et al., The Dysfunctional Health Benefits Market and Implications for US Employers and Employees, J. American Med. Assoc. 327(4):323-324. (2022). (“regardless of whether an insurer is managing or assuming financial risk for employee health benefits spending, … lower spending for health care may weaken insurer financial performance.”)
238 See supra, note 213, citing cases.
reduce, not increase, the administrator’s profits. 239 In another suit, a union accuses its TPA of deliberately overpaying providers. 240
As with medical expenses discussed above, explicitly requiring employers to consider administrative expenses – for both insured and self-insured plans – could help strengthen price competition. Moreover, efficient management of medical expenses is inherently connected both to the amount paid in administrative expenses and to how administrative expenses are calculated. Although there are clear problems with calculating administrative expenses, including plan fees and profits, as a percentage of the overall spend, few employers scrutinize how plans are paid. Currently, employers with fully insured plans are often quoted premiums that represent an all-in price, but employers should, as part of their fiduciary duties, pay attention to the administrative expenses embedded in premiums.
Of course, administrative expenses hold the particular feature of not adding any value health care delivery, and even as the health sector frets over 15% caps, other industries manage financial transactions at far lower costs (for example, paying for services with a commercial credit card adds only 2 percent to the cost of the transaction). 241 Though an employer is not obligated to select the administrator with the lowest administrative fees, fiduciaries of health plans like those of retirement plans should be expected to reduce these expenses, and the key test is whether the fees charged be reasonable in light of the services provided. Specifying in rulemaking that employers explicitly consider these fee levels should not create an uncritical race to the bottom, but instead result in employers documenting the factors that support a higher administrative fee level where lower cost options were available.
c. Network Adequacy
In addition to evaluating costs, health plan fiduciaries should also be explicitly required to evaluate network adequacy when selecting a plan administrator (except in the truly rare case where the health plan is offered on an indemnity basis and does not rely on a network of providers). This requirement is not proposed as a means to require plans to adopt a broad network, but is simply to ensure that employers are informed of the network structure they are purchasing when they select an administrator.
239 Jacklyn Wille, “Kraft Panel Sues Aetna for Health Plan Missteps, Claims Data,” Bloomberg News (February 23, 2023).
240 Emily Brill, “Union Fund Trustees Say Anthem Should Face ERISA Suit,” Law360 (May 16, 2023).
241 Daly L. Average credit card processing fees and costs in 2021. The Ascent (April 13, 2021). https://www.fool.com/the-ascent/research/average-credit-card-processing-fees-costs-america/
There are no agreed upon standards for network adequacy, nor consensus on how best to measure such adequacy. In part, the lack of standards and consensus in this area reflects the trade-offs between network size and price. In general, the broader the network, the less leverage an administrator has to negotiate on price, and therefore the higher the cost. 242 So while the effectiveness of coverage obviously depends on the ability of participants to access care, it is often difficult to determine the ideal network scope given price trade-offs. 243
There are, however, federal regulations addressing network adequacy for individual marketplace plans 244 and private Medicare Advantage plans 245 that are helpful in illustrating various methods of evaluating network adequacy that might be borrowed in ERISA fiduciary rulemaking. These requirements include time and distance standards, 246 minimum provider-to-enrollee ratios, 247 and maximum appointment wait times. 248 To be clear, we are not suggesting that these standards
242 See Paul B. Ginsburg & L. Gregory Pawlson, Seeking Lower Prices Where Providers are Consolidated: An Examination of Market and Policy Strategies, 33 HEALTH AFF 1067, 1069 (2014).
243 There are also well documented challenges in measuring network adequacy, such as the problem of “phantom networks” – where providers are listed as members of a network but those providers are not actually accepting patients. See Howard H. Goldman, How Phantom Networks and Other Barriers Impede Progress on Mental Health Insurance Reform, 41 HEALTH AFF. 1023 (2022); Susan H. Busch & Kelly A. Kyanko, Incorrect Provider Directories Associated with Out-of-Network Mental Health Care and Outpatient Surprise Bills, 39 HEALTH AFF. 975 (2020); Simon F. Haeder, David L. Weimer, & Dana B. Mukamel, Secret Shoppers Find Access to Providers and Network Adequacy Lacking for those in Marketplace and Commercial Plans, 35 HEALTH AFF. 1160 (2016).
244 The ACA has been interpreted to require individually-purchased marketplace plans to have networks that are “sufficient in number and types of providers…to assure that all services will be accessible without unreasonable delay.” 45 C.F.R. §156.230. For a study of the breadth of marketplace plan networks, see Simon F. Haeder, David Weimer, & Dana B. Mukamel, A ConsumerCentric Approach to Network Adequacy: Access to Four Specialties in California’s Marketplace, 38 HEALTH AFF. 1918, 1921 (2019); Aditi P. Sen, Lena M. Chen, Donald F. Cox, & Arnold M. Epstein, Most Marketplace Plans Included At least 25 Percent of Local-Area Physicians, But Enrollment Disparities Remained, 36 HEALTH AFF 1615 (2017); Leemore S. Dafny, Igal Hendel, Victoria Marone, & Christopher Ody, Narrow Networks on the Health Insurance Marketplaces: Prevalence, Pricing, and the Cost of Network Breadth, 36 HEALTH AFF. 1606 (2017).
245 42 C.F.R. §422.116.
246 45 C.F.R. §156.230(a)(2)(i); Dept. of Health & Human Serv., Ctr. for Consumer Info. & Ins. Oversight, Ctrs. for Medicare & Medicaid Servs., 2023 Final Letter to Issues in the FederallyFacilitated Exchanges, April 28. 2022, at 10-14, https://www.cms.gov/CCIIO/Resources/Regulationsand-Guidance/Downloads/Final-2023- Letter-to-Issuers.pdf (requiring that at least ninety percent of enrollees live within the maximum time and distance to at least one provider of each type). These maximum time and distance thresholds vary based on type of service and geographic location. For example, when it comes to primary care, the maximum time and distance is ten minutes or five miles in a large metro area, while it is forty minutes or thirty miles in rural locations Id
247 DEPT OF HEALTH & HUMAN SERV., CTRS FOR MEDICARE & MEDICAID SERVS., MEDICARE ADVANTAGE NETWORK ADEQUACY CRITERIA GUIDANCE (2017).
248 Dept. of Health & Human Serv., supra note 246, at 13 (for example, carriers need to attest that their contracted providers can meet wait time standards of ten calendar days for behavioral health, fifteen calendar days for primary care, and thirty calendar days for non-urgent specialty care).
be imposed on employer plans – only that these existing standards can be helpful in identifying data employers might gather for purposes of fiduciary network evaluation.
d. Medical Care Quality
It should be self-evident that a prudent fiduciary would evaluate quality when selecting a health plan administrator. But it is important to specify that this means not only administrative quality (i.e., customer service and claims processing accuracy), but also the quality of the medical care delivered by the administrator’s network of providers. Evidence suggests that employers routinely consider administrative quality, but often overlook clinical quality or are unaware of how it can be measured. 249 To respond to employee preferences for quality care, employers often simply provide broad provider networks, and leave it to employees to determine which providers are delivering quality outcomes. 250
To a certain extent, employers’ discomfort measuring quality is understandable. Measuring the quality of medical care is difficult even for experts, let alone human resources professionals. But human resources professionals have much better resources available to them to evaluate quality than do individual plan participants. In fact, it is remarkable that the quality of health benefits, which arguably is much harder for the layperson to assess than financial instruments, was never subject to ERISA scrutiny while retirement benefits consistently are. There is a strong case for an explicit requirement that health plan fiduciaries evaluate medical quality when selecting a plan administrator.
The primary challenge of requiring consideration of clinical quality is determining the appropriate method or methods to use in such evaluation. We suggest, as a starting point, that fiduciaries be required to consult the pre-existing Healthcare Effectiveness Data and Information Set (HEDIS) when selecting a plan administrator, which provides quality ratings for over 90% of health plans. 251
Health plan quality ratings such as HEDIS are a relatively new tool, having been developed beginning in the 1990s following the rise of managed care plans. When indemnity plans were the norm, there was no need to rate the quality of a plan’s network because there was no network – covered individuals could go to any provider of their choosing. But in a managed care environment, where the
249 See Claxton et al., supra note 196; Waddill, supra note 198.
250 Peele et al, supra note 33, at 14-15.
251 U.S. Dept. of Health & Human Servs., Off. of Disease Prevention & Health Promotion, Healthcare Data and Information Set (HEDIS), https://health.gov/healthypeople/objectives-and-data/datasources-and-methods/data-sources/healthcare-effectiveness-data-and-information-sethedis#:~:text=The%20Healthcare%20Effectiveness%20Data%20and,report%20quality%20results%2 0using%20HEDIS (last visited Feb. 14, 2024).
administrator’s provider network exerts a significant influence on how and where enrollees access care, quality ratings were and are thought necessary. 252 Today, health plan quality is typically evaluated using a combination of measures that take into account patient safety, clinical effectiveness, member satisfaction, and the timeliness of care. 253 HEDIS, the leading quality measurement set, produces scores that are based on data reporting that is subject to external audit. 254 The overall HEDIS performance score is based on an aggregation of compliance scores across six domains of care and includes over ninety individual measures of quality. 255 For example, one measured domain is the effectiveness of care. Within that domain, HEDIS measures whether certain care targets for specific patient populations have been met, such as whether women 50-74 years of age have had at least one mammogram within the past two years, 256 whether adults who have suffered acute myocardial infarction receive persistent beta blocker treatment for six months after hospital discharge, 257 and whether adults diagnosed with major depression were prescribed an antidepressant and remained on that medication. 258
While HEDIS may not be a perfect measure, its current availability and general acceptance make it a good first choice for health plan fiduciary rulemaking. Moreover, the objective in ERISA quality assurance is not to guarantee beneficiaries receive the highest quality care but merely are not steered towards negligent caregivers. To be sure, the burgeoning industry of healthcare quality metrics will continue to produce new measures, and regulations may account for innovations in measurement or data availability, but the ERISA fiduciary duty requires attention and deliberation, not perfection.
252 U.S. Dept. of Health & Human Servs., Agency for Healthcare Rsch. & Quality, Measuring the Quality of Health Plans, https://www.ahrq.gov/talkingquality/measures/setting/healthplan/index.html (last visited Feb. 14, 2024)
253 Dept. of Health & Human Servs., Agency for Healthcare Rsch. & Quality, Examples of Health Plan Quality Measures for Consumers, https://www.ahrq.gov/talkingquality/measures/setting/healthplan/examples.html (last visited Feb. 14, 2024).
254 Dept. of Health & Human Servs., Agency for Healthcare Rsch. & Quality, Major Health Plan Quality Measurement Sets, https://www.ahrq.gov/talkingquality/measures/setting/healthplan/measurement-sets.html (last visited Feb. 14, 2024)
255 Id.
256 Nat’l Committee for Quality Assurance, Breast Cancer Screening (BCS, BCS- E), https://www.ncqa.org/hedis/measures/breast-cancer- screening/ (last visited Feb. 14, 2024).
257 Nat’l Committee for Quality Assurance, Persistence of Beta-Blocker Treatment After a Heart Attack (PBH), https://www.ncqa.org/hedis/measures/persistence-of-beta-blocker-treatment-after-aheart-attack/ (last visited Feb. 14, 2024).
After examining relevant costs and quality, we believe a prudent fiduciary should combine those measures to evaluate the value offered by prospective plan administrators. Metrics of quality tend to be independent from price, and thus the value offered by a particular administrator refers to assessing quality and efficiency of care given a particular price. 259
The structure of ERISA’s fiduciary duties precludes the Department of Labor from mandating selection of the highest-value administrator, but gains are likely to result from simply requiring plan fiduciaries to measure and consider value in selecting alternatives. An employer might rationally desire the highest quality plan available, irrespective of price, and such a choice is clearly permitted under ERISA as a business decision. But by requiring consideration of value, the employer might be better able to distinguish between two equally high-quality administrators. They might also become more open to tradeoffs that would otherwise be opaque without value information. For example, if choosing between Administrator A, with a quality score of 99 and a cost of $5 million and Administrator B, with a quality score of 98 and a cost of $3 million, the employer might re-think its best-at-any-cost approach.
f. Disclosure to Participants
The last element in our high-return/low-risk proposal may be the most controversial, which is to require employers, as part of their fiduciary duties, to disclose to participants the relative cost, quality, and value of bidders, including the insurer or administrator ultimately selected. The goal of this requirement is to increase transparency to workers, so that they can better understand the trade-offs that their employer is making on their behalf and lobby for desired changes.
Recall that health plan expenses represent a significant percentage of employee wages and that, unlike the typical retirement plan scenario, employees have relatively little choice (if any) in the type of health coverage they receive from their employer. Ideally, an employer would be responsive to employee preferences and structure their health plans accordingly. But requiring disclosure may help improve responsiveness to employee preferences.
For example, assume the employer received bids from three separate health plan administrators, Companies A, B, and C. After reviewing the factors identified above (and any others included in rulemaking), the employer selects Company C to administer the plan. The final step would be a “Notice of Health Plan Service Provider Selection” that would contain basic information about the bid process, 259
including how many companies responded to the request for proposals. It would then list each bidder – and this could be done anonymously for those companies not selected – along with the HEDIS scores, network adequacy assessments, and quoted costs. The employer would then state a brief rationale for selecting Company C.
In many cases, the disclosed information would show an easy case for selecting Company C. Company C might have by far the best quality scores and a cost that does not exceed the other bidders. Or Company C might have the only adequate network. But the idea is that by making the employer’s trade-offs transparent, employees can better communicate their desires to their employer, helping the employer to act as a more effective fiduciary. Such disclosure would have the added benefit in aiding both participants and regulators in ensuring employer compliance with health plan fiduciary duties. 260
ii. A Modest Safe Harbor Proposal to Reward Value
While required consideration of specified factors is a good place to start, we believe even more could be achieved by encouraging employers to maximize value when selecting an administrator, and that this could be effectively accomplished through the use of a regulatory safe harbor Such safe harbors are common in employee benefits rulemaking, 261 and seek to give employers comfort where they might otherwise face compliance uncertainty – as is frequently the case with fiduciary duties that inherently involve fact-specific determinations. They are by their very nature voluntary, and employers are free to take advantage of the protection they provide or simply proceed under the general legal standard.
We propose a regulatory safe harbor that deems an employer to have satisfied the duty of prudence in selecting a plan administrator if the employer has
260 A helpful example is provided by the implementation of the Mental Health Parity and Addiction Equity Act (MHPAEA), which broadly prohibits employer health plans from covering mental health and substance use disorder benefits in a manner that is more restrictive than the plan’s coverage for medical or surgical benefits. See ERISA §712. Several years after its passage, at least partly in response to concerns about a lack of compliance with the parity requirements, Congress amended the MHPAEA to require employers to undertake and document their analyses of the parity between mental health and substance use disorder benefits and medical/surgical benefits. Pub. L. No. 116260, Div. BB, Title II, §203, 134 Stat. 1182 (2020). The ability to track and review employer compliance through these analyses has created a helpful enforcement tool. See DEPTS OF TREASURY, LABOR, & HEALTH & HUMAN SERVICES, MHPAEA COMPARATIVE ANALYSIS REPORT TO CONGRESS 2633 (2023).
261 See, e.g., Dept. of Labor, Emp. Benefits Security Admin., Field Assistance Bull. 2015-02 (2015) (providing a safe harbor related to the selection of an annuity provider); 29 C.F.R. §2510.3-1(b)-(k) (providing a safe harbor that deems certain types of “payroll practices” to be exempt from ERISA’s requirements); 42 C.F.R. §2510.3-2(b); (providing a safe harbor for certain severance plans to be considered welfare plans rather than pension plans); 29 C.F.R. §2510.3-2(h) (providing a safe harbor for state auto-IRA savings arrangements); 29 C.F.R. §2590.715-2715 (providing a safe harbor for the electronic distribution of health plan summaries of benefits and coverage); 29 C.F.R. §104b-31 (providing a safe harbor for compliance with certain retirement plan notice requirements)
selected a high-value network option, even if other plan options continue to be offered alongside the high-value choice. To be eligible for the safe harbor, the employer would need to document selection of an administrator whose care network delivers the highest clinical quality at the lowest price, provided certain minimum standards are satisfied on the other relevant factors, such as network adequacy, claims processing accuracy, and customer service quality. In addition, in order to prevent the employer from undermining the purpose of a high-value option, where an employer offers multiple health plan options and seeks protection under our proposed value-based safe harbor, the employer’s contribution to premiums must be an equal percentage of the cost of coverage across all options. In other words, the employee’s required contribution for the high-value option must be the same percentage of total cost as it is for all other health plan options offered by the employer, allowing the employee to enjoy the financial benefits of opting into a highvalue network.
This safe harbor could be made even more effective by requiring employers taking advantage of the safe harbor to disclose relevant information to participants. Specifically, employers could be required to notify participants of the selection of a “Safe Harbor High-Value Health Plan Option.” This notice should provide a brief explanation of high-value health plans and, if other options are offered in addition to the high-value plan, provide comparative cost and quality metrics for each option.
Because this is merely a safe harbor, employers are under no obligation to provide a high-value option, but will simply receive a modest benefit – in the form of reduced fiduciary risk – if they choose to do so. We believe that the significant value in this proposal comes not from strong-arming employers into structuring their plans in a particular way, but by raising awareness of an effective cost control mechanism. Creating this regulatory incentive is likely to result in a reduction in health plan premiums, given that few employers currently offer high-value options, a benefit of particular value to low- and moderate-income workers for whom health plan premiums represent a significant percentage of total compensation. In addition, by creating a market-wide incentive for administrators to compete on the basis of value, the nature of competition in the employer market should begin to shift in favor of constructing provider networks that deliver the highest quality care at the lowest cost, rather than the current trend of broad networks at high prices, with the consumer left to attempt to ascertain quality.
CONCLUSION
Those immersed in American health policy intimately familiar with the shortcomings of our current healthcare system and are rightly frustrated by escalating costs that have not translated into improvements in population health. The good news is that many of the system’s deficiencies are attributable to the poor
performance of ESI managers, and that existing law under ERISA can force them to do better. It is increasingly evident that many managers of employer sponsored health plans are likely in violation of their ERISA fiduciary duties, and a growing wave of private litigation will soon target them. Although this new scrutiny is welcome after many decades of nonfeasance, a better solution is to encourage the Department of Labor to do for the health benefits sector what it has done for the retirement benefits sector, which is to promulgating regulations that articulate the basic obligations that employers must fulfill in their capacity as fiduciaries. Their employees expect, and the law properly requires, employers to act as responsible custodians to the benefits their employees have already earned.
It is worth emphasizing the enormity of the gains that this regulatory guidance could generate for the entire U.S. economy. Employee benefits in the United States approximate the world’s 7th largest economy, and employers purchase health care for a majority of Americans. Both the nation’s economy and the nation’s ailing health sector would experience widespread gains from even modest efficiencies. Even relatively modest guidance and regulatory attention could drive such efficiencies. It is not often that large problems have simple solutions, but ERISA – no longer hiding in plain sight – offers a powerful, albeit partial, remedy.
Submitted for consideration for the ERISA 50th Symposium
Executive Summary
The Employee Retirement Income Security Act of 1974, henceforth referred to as Erisa, marked a significant milestone in safeguarding the retirement prospects of American workers. Its primary aim was to establish minimum standards for pension plans in the private industry and to provide protections for individuals in these plans. However, the evolving landscape of retirement planning, especially the shift from defined-benefit, or DB, to defined-contribution, or DC, plans has had profound implications for retirement-income adequacy. This paper explores these changes and their impacts, presenting a comprehensive analysis using the Morningstar Model of US Retirement Outcomes.
Key Findings
Generational Disparities: Generation X is more likely to face retirement-income shortfalls compared with younger generations. Specifically, 47% of Gen Xers are projected to experience shortfalls, in contrast with 37% for Gen Z and 44% for millennials.
Income-Level Influence: Lower-income households are at a greater risk of running short of money in retirement, despite Social Security.
Demographic Di erences: Single females, Hispanic Americans, and non-Hispanic Black Americans are at higher risk of retirement shortfalls compared with their counterparts.
Defined-Contribution Plan Participation: Individuals with prolonged participation in DC plans are better positioned to avoid retirement shortfalls. For instance, those with 20 or more years of future DC-plan participation are significantly less likely to face retirement-income inadequacy.
Counterfactual Simulations: The elimination of DC participation and savings would drastically reduce the probability of a successful retirement, particularly for middle-income groups, as they heavily rely on these plans.
Automatic Enrollment and Escalation: Transitioning from voluntary to automatic enrollment in DC plans, coupled with auto-escalation features, can significantly enhance retirement savings. For example, a shift to automatic enrollment with a 15% auto-escalation cap could increase average wealth ratios—defined as the ratio of projected wealth at retirement under a hypothetical scenario over projected wealth at retirement under our baseline scenario (which assumes status quo)—by 28.8%.
Policy Proposals: The Automatic IRA Act of 2024, proposing automatic enrollment into IRAs with opt-out features and auto-escalation, could substantially improve retirement outcomes, with an aggregate average wealth ratio increase of 23.8%.
The findings highlight the critical importance of sustained participation in DC plans and the potential benefits of automatic enrollment and escalation features. Policy proposals like the Automatic IRA Act of 2024 could play a significant role in enhancing retirement security for a broader segment of the population. Addressing disparities in retirement readiness across di erent demographic groups and industries is essential for promoting retirement-income adequacy for all Americans.
This comprehensive analysis provides valuable insights for policymakers, plan sponsors, and individuals, emphasizing the need for thoughtful policy interventions and robust retirement plan designs to secure better retirement outcomes.
Introduction
The Employee Retirement Income Security Act of 1974 was a landmark piece of legislation aimed at protecting the interests of employees who participate in qualified retirement plans. While Erisa was instrumental in improving the security of retirement benefits, its impact on overall retirementincome adequacy is complex. Erisa established minimum standards for participation, vesting, benefit accrual, and funding of defined-benefit plans, thus enhancing the likelihood of workers receiving promised benefits. However, it has been argued that the regulatory burden and increased costs1 (including premiums to the Pension Benefit Guaranty Corporation for plan termination insurance2) associated with these plans led to a shift toward defined-contribution plans.3
The increasing prevalence of defined-contribution plans (such as 401(k) plans) shifts the onus of retirement planning onto individuals and has caused some critics to suggest that this has contributed to a type of“retirement crisis.”4
While Erisa did not explicitly promote defined-contribution plans, the environment it created, combined with accounting and subsequent legislative changes,5 as well as demographic pressures,6 made these type of plans a more attractive option for many employers. This shift has had significant implications for retirement savings and income adequacy for American workers.
This paper starts with a review of retirement-income adequacy prospects for US workers by summarizing their likely probability of a successful retirement using the Morningstar Model of US Retirement Outcomes. We show how this is related to age cohort, career average income quartiles, gender and family status, race and ethnicity, industry, and future years in a defined-contribution plan. We then turn to the question of how di erent the prospects for retirement-income adequacy
1 Refer to Hustead (undated).
2 This is true even though it has been argued by some that the true cost to the system is much larger than the cost under the variable-rate premium system. See VanDerhei (1990) for additional detail.
3 In 1975, one third of all private pension plans filing the Form 5500 were defined-benefit plans. By 2000, this share fell to about 7%. Since then, the defined-benefit plan share has remained relatively stable. United States Department of Labor (2023). For a time-series analysis of these trends see VanDerhei and Olsen (1997). Note, however, that the number of defined-benefit plans relative to defined-contribution plans masks the importance of a relatively recent trend to freeze accruals for some or all of the participants. See Copeland and VanDerhei (2010) for additional information.
4 However, several simulation studies have shown that when realistic job turnover is considered, 401(k) plans produce superior results compared with final average defined-benefit plans for a majority of the sample population (see VanDerhei June 2013, VanDerhei December 2013, VanDerhei 2015, and VanDerhei February 2019).
5 For an analysis of defined-benefit plan sponsors’ reaction to the Pension Protection Act of 2006 (PPA) and Financial Accounting Standards Statement No. 158, see VanDerhei (July 2007). For an analysis of the impact of PPA on retirement income for 401(k) participants, see VanDerhei and Copeland (2008).
6 For an example of how some defined-benefit plan sponsors reacted to the perceived need to provide a retirement plan format that was more responsive to a younger workforce, see VanDerhei (1989).
would be for today’s workers if individual account plans (defined-contribution and IRAs) did not exist. The counterfactual simulations we run show a massive decrease in the probability of a successful retirement, especially for the youngest cohort and those in the second- and third-career average income quartiles.
Moving back to the status quo, we then look at how much improvement US workers in aggregate would experience if the industry were able to deal with the vexing problem of incomplete coverage via the Automatic IRA Act of 2024. We find that the overall average increase in wealth ratios with a 30% opt-out is 23.8% with a median increase of 3.2%.
The final portion of the simulation analysis in the paper focuses on a further evolution of 401(k)plan design that has been in place at least since the Pension Protection Act of 2006: the move from voluntary to automatic enrollment. We analyze the impact of the remaining voluntary-enrollment plans converting to automatic enrollment as well as a universal adoption of auto-escalation among these plans. We find that simulating a transition from voluntary to automatic enrollment leads to an aggregate average wealth ratio increase of 16.3% (median: 0.5%) without escalation and a more substantial 28.8% increase (median: 8.0%) when escalation is factored in.
The final section of the paper focuses on future analysis on this topic using the Morningstar Model of US Retirement Outcomes.
A Review of the Status Quo
The Morningstar Model of US Retirement Outcomes is a sophisticated tool used to predict the financial outcomes of American households in retirement. By utilizing detailed data from a variety of sources, including the Survey of Consumer Finances, the model simulates various factors such as income, expenses, investments, and health to project retirement adequacy.
Key features of the model include:7
Comprehensive data input: Incorporates a wide range of household characteristics and financial information.
Stochastic modeling: Utilizes probability-based simulations for both the accumulation and decumulation periods.
Realistic behavior: Models household behavior, including savings rates, withdrawal patterns, and job turnover.
Longevity and health risks: Accounts for the impact of long-term-care expenses on retirement finances.
Tax implications: Calculates federal and state income taxes on retirement income.
Housing wealth: Considers the role of home equity in retirement planning.
The Model uses a retirement-funded ratio metric to assess financial su iciency in retirement. This is calculated for each of 1,000 simulated life paths for each household. The numerator is the sum of real (that is, inflation-adjusted) income across all retirement years plus any leftover assets at the time of death, if applicable. The denominator is the sum of real expenses (also across all retirement years). This metric shows the magnitude of the shortfalls, with retirement-funded ratios that are well below 1, indicating significant shortfalls.
Using the Morningstar Model of US Retirement Outcomes in a previous publication,8 we found that baby boomers and Gen Xers are more likely to experience retirement shortfalls than other generations of today’s workers, assuming status quo for Social Security.9 We focused our analysis on cases wherein the retirement-funded ratio was less than 1 (as these are, by definition, a shortfall) and found that baby boomers and Gen Xers are more likely to run short of money than those in other generations. In particular, we found that 47% of Gen Xers, compared with 37% for Gen Z and 44% for millennials, are simulated to run short of money in retirement.
In Exhibit 1, we break those results down further by constructing age-specific average indexed monthly earnings, or AIME,10 quartiles as a proxy for preretirement career earnings. As expected, percentage of households with a retirement-funding ratio less than 1 decreases as the AIME value increases. For example, 66% of Gen Z households in the lowest income category are simulated to
7 Please see the technical appendix of this paper for additional detail.
8 Look and VanDerhei (2024).
9 The Model also has the ability to run sensitivity analysis on Social Security reform scenarios, but this will be addressed in a future publication.
10 Average indexed monthly earnings refer to a worker’s average earnings, wherein wages are adjusted to account for differences in the standard of living over time. Social Security benefits are typically calculated using average indexed monthly earnings. Refer to https://www.ssa.gov/oact/cola/Benefits.html
run short of money, but the percentage decreases to 43% for those in the second income category, 27% for those in the third income category, and only 14% for those in the highest income category.
The disparities by income category are more pronounced for millennials, with 78% of households in the lowest income category simulated to run short of money, 54% for those in the second income category, 32% for those in the third income category, and only 12% for those in the highest income category.
However, the gaps in retirement-income adequacy by income categories are largest for Gen X households, because workers in this age group are closer to retirement, meaning that existing savings gaps between income cohorts are a big driver of results. In this case, 86% of households in the lowest income category are simulated to run short of money compared with 53% for those in the second income category, 37% for those in the third income category, and only 11% for those in the highest income category.
In our previous publication, we also found that the probability of running short of money in retirement varied by:11
Family status: For those between the ages of 20 and 64, about 55% of single females are projected to be at risk in retirement, compared with just 41% for couples and 40% for single males.
Race and ethnicity: For those between the ages of 20 and 64, approximately 61% of Hispanic Americans and 59% of non-Hispanic Black Americans are projected to run short of money in retirement. The results for non-Hispanic white Americans and non-Hispanic other Americans (which include Asian Americans) are significantly better, with only approximately 40% of both groups experiencing retirement shortfalls.
Industry: For those between the ages of 20 and 64, we found that the public sector is the most prepared for retirement, with only about 29% of workers in this industry projected to experience retirement shortfalls. The public sector is followed by the finance, insurance, and real estate industry, the miscellaneous services industry, and the manufacturing industry.12
Future years in a defined-contribution plan: For those between the ages of 20 and 64, we found that retirement-funding ratios were dramatically better for those who are simulated to participate in a DC plan for 20 or more years in the future. Specifically, we found that 57% of those not participating at all in a DC plan in the future may run short of money, compared with only 21% for those with 20 or more years of future participation in a DC plan.13
11 We also analyzed how the probability of running short of money in retirement varied by educational level. For those between the ages of 20 and 64, 79% of those with no high school diploma were simulated to fall short, but the percentage decreased to 58% for those with a high school diploma or GED, and 51% for those with some college or associate’s degree. The probability fell to 25% for those with a bachelor’s degree or higher.
12 See Exhibit 7 in Look and VanDerhei (2024) for more detail.
13 Even people with 20 or more years of future participation in a DC plan may undermine their retirement by, for example, taking preretirement withdrawals or cashing out upon job termination. This will be explored in more detail in future Morningstar Center for Retirement and Policy Studies publications analyzing (1) emergency savings arrangements and (2) auto-portability.
Counterfactual Evidence: What Would Happen
If There Were No Individual Account Retirement Plans Available?
We employed a counterfactual simulation in an attempt to generate a first-order approximation of how much the results in the previous section would change in the absence of individual account retirement plans (defined-contribution plans and IRAs). The analysis began by eliminating all defined-contribution participation and savings. For households with a DC account in the simulation that lacked an existing post-tax balance, imputed post-tax balances were utilized. If an existing post-tax balance did exist, the larger of the existing and imputed amounts was applied. Both DC and Individual Retirement Account balances were set to zero for the entire simulation period. The probability of saving to an IRA was fixed at zero percent. However, post-tax contributions were modeled based on IRA contribution probabilities and IRA contribution amounts (which we assume are the IRS limits), simulating potential savings behavior in the absence of other retirement accounts. Preretirement withdrawals from post-tax accounts were modeled using IRA withdrawal probabilities.14
When the results from this counterfactual simulation were compared with the status quo results in the previous section, we find that there are very significant di erences in the simulated probability of running short of money in retirement by age cohort along with very interesting disparities by AIME quartile. Exhibit 2 shows the impact of individual account retirement plans by graphing the increase in the probability of running short of money for each of the three generations as a function of AIME quartile. We see the same overall trend for each of the three generations, with those in the lowest income quartile having the smallest impact, presumably since they rely more on Social Security than their higher-income counterparts (this portion of the overall retirement income was not modified in the counterfactual simulation). Likewise, those in the highest income quartile experience less of an impact than those in the middle 50%, since a larger portion of their overall retirement-income resources would come from other sources in addition to individual account retirement plans, such as post-tax brokerage accounts.
Exhibit 2 also shows that Gen X households would have the smallest impact for each of the four income categories compared with their younger counterparts. Gen X households in the lowest income category would only su er a 6% increase in the probability of running short of money compared with 15% for millennials and 26% for Gen Z households. Similarly, Gen X households in the second income category would have a 15% increase in the probability of running short of money in retirement compared with 27% for millennials and 38% for Gen Z households. A similar phenomenon is observed for both the third income quartiles (15% for Gen X households versus 32% for millennials and 39% for Gen Z households) and fourth income quartiles (11% for Gen X households versus 25% for millennials and 37% for Gen Z households).
When aggregated across all four income categories, the probability of Gen X households running short of money in retirement would increase from 47% under the status quo to 59% in the counterfactual simulation with no individual account retirement plans. Millennials would have a
14 An expense adjustment factor, a proxy for the baseline run's expenses, was incorporated into the analysis.
worse situation with the aggregate probability increasing from 44% to 69%, while the Gen Z households would be faced with the prospect of an increase from 37% in today’s environment to a devastating 72% without individual account retirement plans.
Exhibit 3 shows the impact of assuming no defined-contribution plans or IRAs on the probability of running short of money in retirement by education. We see that the loss of these individual account plans would have the smallest impact on those with no high school diploma (an increase of only 6% in the probability). However, the impact increases with the level of education, and for those with a bachelor's degree or higher, the probability of running short of money in retirement increases by 19%.
Exhibit 4 shows the impact by industry.15 Households in the agricultural sector would only experience a 7% increase in the probability of running short of money in the absence of definedcontribution plans and IRAs, whereas all other industries would have an increase of at least 17%, with the manufacturing industry having the largest impact at 23%.
The impact by gender and family status is more uniform. Exhibit 5 shows an impact of 17% for males who are single at retirement as well as for couples. However, females who are single at retirement would only have a 13% increase in the probability of running short of money in retirement.
Exhibit 6 shows the impact of assuming no defined-contribution plans or IRAs on the probability of running short of money in retirement by race and ethnicity. Both non-Hispanic whites and Hispanics would have an increase of 16%, and those in the non-Hispanic “other” category would have an increase of 17%. However, non-Hispanic Blacks would only have an increase of 13%.
Overall, the results of the counterfactual analysis indicate that American workers would be significantly less prepared for retirement if individual account plans were not available.
15 We are not modeling public-sector plans in this analysis.
Automatic IRA Act of 2024
In February of 2024, House Ways and Means Committee Ranking Member Richard E. Neal (D-MA) introduced the Automatic IRA Act of 202416 to dramatically expand retirement coverage for millions of workers. The bill would require companies with more than 10 workers to automatically enroll employees in IRAs or similar plans unless they already provide a retirement plan.17
To more accurately model retirement outcomes, Roth IRA balances were transferred to pretax accounts within the account information file. This adjustment was necessary to accommodate the auto-IRA modeling process. With the exception of workers at an employer with fewer than 10 employees (based on Survey of Consumer Finances data), it was assumed that individuals without access to a DC plan would automatically enroll in a Roth IRA. To account for potential pretax IRA contributions in the absence of an auto-IRA, participants were modeled as continuing to contribute to pretax IRAs while adhering to overall IRA contribution limits. A default enrollment rate of 6% for the auto-IRA was established, with an escalation to 10% over time. Due to data constraints, it was assumed that all participants who did not opt out would increase their contribution by 1% annually until reaching the 10% cap. Opt-out rates of 30%, 45%, and 15% were tested. To simulate realworld behavior, preretirement withdrawals from the auto-IRA were modeled using 401(k) preretirement withdrawal probabilities and severities.18
Instead of showing the changes in the probability of running short of money in retirement as we did in the previous section, in this case we calculated pairwise wealth ratios at retirement age (assumed to be 65 in the baseline scenario). The first panel in Exhibit 7 shows the aggregated results of the auto-IRA proposal for Gen X and younger assuming a 30% opt-out rate. The results are categorized by future years in a defined-contribution plan and displayed as wealth ratio means and medians.19
As expected, those simulated to have no future years in a defined-contribution plans have the largest increase in the wealth ratios with a mean increase of 53.7% and a median increase of 11.0%. Both the mean and median wealth ratios are monotonically decreasing as future years in a defined-contribution plan increase. Those who are simulated to have one to nine future years in a defined-contribution plan would have an average increase of 26.3% (with a median increase of 6.2%). For those with 20 or more future years in a defined-contribution plan, there would be little opportunity to benefit from the auto-IRA proposal, which is reflected in their wealth ratios with a mean increase of only 3.1% and a median increase of 0.8%.20 The overall average increase in wealth ratios with a 30% opt-out is 23.8% with a median increase of 3.2%.
17 A previous version of this bill was analyzed by VanDerhei (2022).
18 The expense adjustment factor was applied to approximate spending patterns observed in the baseline analysis.
19 The ratios were filtered at the 99th percentile when computing the means.
20 Those with 10 to 19 future years in a defined-contribution plan would have a mean increase of 8.9% and a median increase of 2.2%.
There is considerable debate as to the appropriate opt-out assumption for these types of plans.21 Therefore, we ran a sensitivity analysis by including results for both a 45% opt-out rate (second panel in Exhibit 7) as well as a 15% opt-out rate (third panel in Exhibit 7). As expected, increasing the opt-out rate significantly decreases the wealth ratios for the households. For example, those with no future simulated years in a defined-contribution plan would have a mean increase of only 40.6%, as opposed to the 53.7% under the baseline assumption from a 30% opt-out. The overall average increase in wealth ratios with a 45% opt-out is 18.1% with a median increase of 1.1%.
If the opt-out-rate assumption is decreased to only 15 percent, the wealth ratios are significantly increased. In this case, those with no future simulated years in a defined-contribution plan would have a mean increase of 68.2%. The overall average increase in wealth ratios with a 15% opt-out is 29.5% with a median increase of 5.8%.
Exhibit 8 presents wealth ratio increases at retirement under varying opt-out-rate scenarios by gender and family status. For single males, the mean (median) increase is 29.2% (2.7%) at a 30% opt-out rate, rising to 32.0% (5.6%) at a 15% rate and decreasing to 22.3% (0.6%) at a 45% rate. Single females experience similar trends, with mean (median) increases of 27.9% (3.4%), 32.3% (7.2%), and 21.2% (0.8%), respectively. Couples show a mean (median) increase of 17.4% (3.4%) at a 30% opt-out rate, rising to 27.8% (5.2%) at a 15% rate, and declining to 13.2% (1.5%) at a 45% rate.
Exhibit 9 compares wealth ratio increases at retirement for di erent racial and ethnic groups across varying opt-out rates. Hispanics see average (median) wealth ratio gains of 25.8% (2.9%) at a 30% opt-out rate, ranging from 19.6% (0.7%) to 32.0% (5.6%) for higher and lower opt-out rates. NonHispanic Black individuals exhibit similar patterns, with average (median) increases of 26.3% (4.0%) at a 30% opt-out rate. Non-Hispanic whites have lower average (median) increases, starting at 22.9% (3.1%) for a 30% opt-out rate.
Exhibit 10 illustrates the impact of varying opt-out rates on wealth ratio increases at retirement for di erent generations. Gen Z households experience average (median) wealth ratio gains of 18.4% (6.1%) at a 30% opt-out rate, with this figure ranging from 14.1% (3.9%) to 22.7% (8.4%) under the 45% opt-out rate and 15% opt-out-rate scenarios, respectively. Millennials demonstrate similar trends, with average (median) increases of 24.2% (5.6%) at a 30% opt-out rate. Gen X households exhibit average (median) wealth ratio growth commencing at 20.7% (0.8%) for a 30% opt-out rate.
Exhibit 11 compares wealth ratio gains at retirement across industries under a 30% opt-out rate. Results vary significantly, with the finance, insurance, and real estate industry showing the smallest average (median) increase at 19.2% (1.9%), while the wholesale and retail trade industry had the largest increase at 33.5% (9.8%).
21 See VanDerhei (2022) for additional information.
Impact of Automatic Enrollment and Auto-Escalation
One of the major problems with the original 401(k) plan designs was that they generally required eligible employees to opt in to coverage. A small number of plan sponsors started to experiment with a fundamental change in plan design in which most, if not all, of the eligible employees would be automatically enrolled in a 401(k) plan with an option to opt out if they so desired.22 While this drastically improved the participation percentages,23 there was still a problem with relatively low deferral percentages that plan sponsors chose as a default. The concept of auto-escalation where the participant’s deferral rate would automatically increase by a set percentage (typically 1%) per year was adopted by some plan sponsors as a way to gradually increase the employee-contribution rate that was closer to a level thought to be necessary to provide adequate retirement income.24
Even though several studies were conducted to show the likely impact of a change from the voluntary enrollment, or VE, to automatic enrollment,25 or AE, it was not until the Pension Protection Act of 2006 removed certain obstacles (such as wage-garnishment restrictions) that this practice began to flourish.
However, this practice is still not universal,26 even though Secure 2.0 will require new 401(k) plans to adopt this design. This section analyzes the potential impact of all current 401(k) VE plans moving to an AE plan design. We also include an analysis in which we assume that all AE plans use auto-escalation to 15%.27
For all analyses, an expense adjustment factor,28 representing a proxy for the baseline run's expenses, was applied. In the first scenario, all VE plans were converted to AE plans. This involved adjusting plan-type probabilities used in contribution regressions by setting VE plan probabilities to zero and proportionally distributing the probability to AE plan types. In the second scenario, all VE plans were transformed into AE plans with an auto-escalation feature capping at 15%. Plan-type probabilities were modified as in the previous scenario. To ensure a minimum contribution rate, predicted contribution rates below 6% in the initial year were adjusted upward. Subsequently, contribution rates were compared with the auto-escalated rate in each year, with adjustments made as necessary to maintain the escalating contribution pattern.
Simulating a transition from voluntary to automatic enrollment indicates an aggregate average wealth ratio increase of 16.3% (median: 0.5%) without escalation and a more substantial 28.8% increase (median: 8.0%) when escalation is factored in. This change has no e ect on individuals
22 See Madrian and Shea (2000) for early analysis of the potential benefits of this change in plan design.
23 According to Vanguard, the participant-weighted participation rate was 82% in 2023. Refer to Figure 24 of Vanguard’s "How America Saves 2024" report: https://institutional.vanguard.com/content/dam/inst/iigtransformation/insights/pdf/2024/has/how_america_saves_report_2024.pdf
24 See Thaler and Benartzi (2004) for a groundbreaking study on this plan design and various EBRI simulation analyses on the likely impact on the general 401(k) population (VanDerhei 2007 and VanDerhei 2012).
25 See Holden and VanDerhei (2005) for a simulation analysis of the likely winners and losers under several different scenarios.
26 According to Vanguard’s “How America Saves 2024” report, 59% of plans have adopted an automatic-enrollment feature. Refer to link in footnote 23.
27 See VanDerhei (2010) for earlier EBRI research on this topic.
28 This adjustment factor varies by household in the sample.
projected to leave the workforce before contributing to a defined-contribution plan. Exhibit 12 illustrates that those expected to participate in a plan for one to nine years would experience an average wealth ratio increase of 14.6% (median: 0.3%) without auto-escalation and 24.9% (5.5%) with auto-escalation to 15%. Participants with a projected 20 or more years of plan participation stand to benefit more significantly from plan design changes, resulting in average wealth ratio increases of 24.2% (median: 9.1%) without auto-escalation and 46.5% (29.3%) with autoescalation.
Exhibit 13 shows the impact of these plan design changes by gender and family status. For single males, average (median) wealth increases by 19.5% (0.3%) without auto-escalation and 33.7% (7.5%) with it. Single females see similar gains: 16.7% (0.2%) without, 30.0% (6.8%) with. Couples experience average (median) increases of 14.1% (0.8%) and 25.2% (9.3%), respectively.
Exhibit 14 presents the di erential e ects of plan design changes on households of various racial and ethnic backgrounds. Hispanic households, for example, experience a notable increase in average (median) wealth from 16.5% (0.4%) without auto-escalation to 30.2% (8.5%) with it. Similar gains are observed for non-Hispanic Black and non-Hispanic white households, with respective average (median) increases of 17.1% (0.5%) to 30.5% (8.9%) and 16.1% (0.5%) to 28.3% (7.8%).
Exhibit 15 illustrates the varying impact of plan design changes across di erent age groups. For instance, auto-escalation significantly boosts wealth accumulation for Gen Z households, increasing average (median) wealth from 18% (4%) to 35% (19%). Millennials and Gen X also benefit, with average (median) wealth rising from 17% (2%) to 31% (13%) and from 13% (0.1%) to 22% (3%), respectively.
Exhibit 16 highlights the diverse e ects of plan design changes across di erent industries. For example, auto-escalation has a minimal impact on the agriculture industry, increasing average (median) wealth modestly from 5% (less than 1%) to 10% (less than 1%). In contrast, manufacturing experiences the most substantial gains, with average (median) wealth soaring from 19% (1%) to 34% (13%).
Summary
The landscape of retirement-income adequacy in the United States is undergoing significant transformation, and our analysis underscores the importance of understanding these shifts. Using the Morningstar Model of US Retirement Outcomes, we explored the status quo, identified disparities among various demographic groups, and examined potential changes to retirementsavings plans.
Our findings indicate that baby boomers and Gen Xers are more likely to face retirement shortfalls than younger generations. The percentage of households with a retirement-funded ratio less than 1, a clear indicator of shortfalls, varies significantly by generation and income level. For instance, 47% of Gen Xers are projected to experience shortfalls compared with 37% for Gen Z and 44% for millennials. These disparities are even more pronounced when broken down by income categories. Lower-income households are at a greater risk of running short of money, highlighting the critical role of preretirement earnings in determining retirement adequacy.
The analysis also revealed stark di erences in retirement readiness based on family status, race and ethnicity, industry, and participation in defined-contribution plans. Single females, Hispanic Americans, and non-Hispanic Black Americans are at a higher risk of retirement shortfalls. Furthermore, the public sector shows the highest preparedness for retirement, while industries like finance, insurance, real estate, and manufacturing display varying levels of readiness.
Our research underscores the significant impact of DC plans on retirement outcomes. Individuals with longer participation in DC plans are better positioned to avoid retirement shortfalls. For example, those with 20 or more years of future DC-plan participation are much less likely to run short of money compared with those with no future participation. This finding emphasizes the importance of sustained contributions to DC plans.
To better understand the role of individual account retirement plans, we employed a counterfactual simulation. This simulation aimed to approximate the impact of eliminating individual account retirement plans (DC plans and IRAs). The results showed significant di erences in the probability of running short of money in retirement, particularly among middle-income groups who rely heavily on DC plans for their retirement savings.
We also examined the potential e ects of the Automatic IRA Act of 2024 proposal. This proposal aims to automatically enroll individuals without access to a DC plan into IRAs, with an opt-out feature and auto-escalation. The simulation of this proposal showed significant increases in wealth ratios for participants, particularly for those simulated to have no future years in a DC plan. This suggests that such policy changes could significantly improve retirement outcomes for a broad segment of the population.
Finally, we explored the potential benefits of transitioning from voluntary-enrollment plans to automatic-enrollment plans with auto-escalation features. Such changes could lead to substantial increases in wealth ratios at retirement. For example, transitioning to AE plans with a 15% autoescalation cap could increase average wealth ratios by 28.8% (median: 8.0%). This demonstrates the powerful impact that thoughtful plan design can have on enhancing retirement security.
In conclusion, our analysis highlights the importance of continued participation in DC plans, the potential benefits of automatic enrollment and auto-escalation features, and the positive impact of policy proposals like the Automatic IRA Act of 2024. Addressing the disparities in retirement readiness across di erent demographic groups and industries is crucial for improving retirement outcomes for all Americans. As we look to the future, it is essential to consider these findings in shaping policies and plan designs that promote retirement-income adequacy and financial security.
By understanding and addressing these issues, we can help ensure that more Americans achieve a comfortable retirement, regardless of their income level, family status, race, or industry. The path forward requires thoughtful policy interventions, robust retirement plan designs, and a commitment to improving retirement outcomes for all.
Appendix: Future Analysis From the Model
In future research, we will explore the impact of broader economic factors and policy changes on retirement outcomes, focusing on topics such as:
The impact of various proposals to reduce/eliminate the tax incentives for 401(k) plans.
The impact of the Saver’s Match on all households (whether or not they are eligible to participate in an employer-sponsored defined-contribution plan).
The impact of auto-portability to reduce leakage.
How net housing equity can be used to increase retirement-income adequacy.
The impact of annuities and the possibility of providing them as a default option in definedcontribution plans.
Social Security reform and the impact of potential benefit reductions on retirement-income adequacy.
Mandatory Rothification of employee 401(k) contributions.
The impact of alternative plan design modifications (including managed accounts).
The impact of needing long-term services and supports on retirement-income adequacy with and without long-term-care insurance.
Morningstar Model of US Retirement Outcomes: Technical Appendix
Model Methodology
The Morningstar Model of US Retirement Outcomes, henceforth referred to as the Model, is a quantitative framework to evaluate retirement-income adequacy in the United States. The Model produces a distribution of financial outcomes in retirement for each household (focusing on the main respondent and their spouse, if applicable) in the Survey of Consumer Finances, or SCF. The Model uses SCF data as inputs for each household, such as age, gender, race and ethnicity, balances in financial accounts, salary and other job-related information.
The Model projects retirement outcomes for each household across 1,000 independent scenarios with the projection going to age 120. To be clear, household members are not assumed to pass away at a specific age. Instead, death ages are modeled stochastically. Before retirement starts, the Model simulates whether death occurs based on Social Security cohort life tables. In retirement, the Model uses a health state transition model. The possible states include 1) good health, 2) poor health, 3) in home health care, 4) in a nursing home, or 5) dead. The Model has specific states for long-term services and supports, or LTSS, because requiring paid LTSS is one of the biggest risks for retirees.
The health state transition model was built based on longitudinal data from the Health and Retirement Study, or HRS. In particular, a series of generalized linear models were fit to the data based on the approach of Fong et. al (2015).29 The health state transition model considers age, gender, marital status, race and ethnicity, and income level when predicting probabilities. Also, the probability of transitioning from one state to the next is informed by the current state that an individual is in. For example, under this framework, the probability that an individual passes away is much higher if they are currently in a nursing home than if they are in good health. Note that rates of incidence and continuance from the health state transition model are broadly consistent with the observations of Johnson (2019).30 Further, life expectancy statistics following from this model are generally consistent with those from applicable Social Security cohort life tables and the Society of Actuaries Pri-2012 Private Retirement Plan Mortality table with generational mortality improvement applied.
The Model leverages Morningstar salary curve methodology to estimate both forward- and backward-looking real wages. Forward-looking salaries are used in the accumulation period in the projection, and the full wage history is used to estimate Social Security benefits.
29 Fong J., Shao A., & Sherris M. 2015. “Multistate Actuarial Models of Functional Disability.” https://doi.org/10.1080/10920277.2014.978025
30 Johnson, R. (April 3, 2019). “What Is the Lifetime Risk of Needing and Receiving Long-Term Services and Supports?”O ice of the Assistant Secretary for Planning and Evaluation. Retrieved June 17, 2024, from https://aspe.hhs.gov/reports/what-lifetime-risk-needing-receiving-long-term-services-supports-0
Before retirement, the Model simulates job change for each household member based on the individual’s characteristics, such as age, gender, job tenure, and salary. The likelihood of job change is also informed by whether the individual has access to a defined contribution, or DC, plan.
Upon a job change, the Model simulates whether the individual has a defined benefit, or DB, plan with their new employer and the accrual rate if a DB plan exists. Both the likelihood of an individual joining a DB plan and the accrual rate vary based on job information, such as industry, salary, and employer size and individual characteristics, such as age and gender.
The Model also simulates (at job change) whether the individual has access to a DC retirement plan and whether they participate. Furthermore, the Model simulates what plan features are applicable, such as whether the plan has auto-enrollment or voluntary enrollment, whether the plan has auto escalation, what the default contribution rate is if auto-escalation is present, and what the plan match formula is. Note that the assumptions underlying this process are based on record kept data.
The Model does not assume a deterministic or static contribution rate in the projection. Instead, the Model estimates employer and employee contribution rates based on the features of the DC plan and relevant information about the individual, such as age, salary, and job tenure. Note that the contribution prediction model is based on record kept data. The Model also simulates whether contributions are made to an Individual Retirement Account, or IRA, based on SCF data.
Note that the Model reflects investor behaviors that lead to less retirement savings, such as DC plan cashouts (simulated upon job change), DC plan hardship withdrawals, DC plan loans, and IRA preretirement withdrawals. The assumptions underlying these processes are based on record kept data or SCF data.
The Model forecasts assets within investment accounts to grow based on stochastic portfolio returns from Morningstar Investment Management’s Time Varying Model. Refer to the next section of this technical appendix for more information on the Time Varying Model.
In terms of asset allocation, the Model uses a glide path that represents the industry consensus. It is calculated as the average of the target strategic equity allocation weights for the fund families (both CITs and mutual funds) available in Morningstar Direct. Linear interpolation is used to populate the equity weights for points in between the five-year increments. Every year in the projection, the liquid investment portfolio is rebalanced according to the glide path. The fund fee used in the analysis is 0.39%, which is based on the median fee for mega plans according to a Morningstar report on the retirement plan landscape.31 This assumption is also generally consistent with the findings in the Investment Company Institute’s 2024 analysis of mutual fund fees.32
Once retirement commences, the Model estimates the household’s retirement expenses. The expenses consist of two elements: 1) standard expenses assuming no LTSS costs and 2) LTSS expenses. The standard expenses are based on the 2019 RAND CAMS dataset supplement to the
31 Mitchell, L., & Szapiro, A. (March 2022). “Retirement Plan Landscape Report.” Morningstar. https://www.morningstar.com/lp/retirement-plan-landscape
32 Duvall, J. & Johnson, A. 2024. “Trends in the Expenses and Fees of Funds, 2023.” ICI Research Perspective 30, no. 2 (March). Available at https://www.ici.org/system/files/2024-03/per30-02.pdf
HRS. The standard expenses vary by age, marital status, and income level, with predicted expenses decreasing at higher attained ages. LTSS expenses are stochastic and only occur in cases wherein a household member is in either home health care or a nursing home (per the health state transition model described above). LTSS expenses are based on national median costs from Genworth’s Cost of Care Survey.33
Social Security benefits are estimated separately for each member of the household. Specifically, the Model uses the estimated historical wages along with the individual’s birth year, claim age (which is used to calculate the adjustment to the benefits if the individual is claiming before or after normal retirement age), and other Social Security data to calculate Social Security benefits. Note that the Model does calculate spousal benefits when processing claims. Further, the Model calculates survivor benefits, meaning that the surviving spouse can claim 100% or some portion of their former spouse’s benefits.
Every year in retirement, the Model adds up the guaranteed income from Social Security and pensions and deducts it from the simulated expenses. The household’s investments (which include any assets in pretax and Roth IRAs, pretax, post-tax, and Roth 401(k)s, and a post-tax account) are used to fund any leftover amount. Note that the model does calculate both state34 and federal income taxes, which are added to the next year’s required expenses. The Model also calculates required minimum distributions, taxing, and then reinvesting any excess withdrawals that are not needed to fund expenses into the post-tax account (which is assumed to follow the same glide path as described earlier).
If the household is unable to fully fund its projected expenses, any net housing equity (which is estimated at the start of retirement) is assumed to be liquidated and added to the post-tax investment account in the form of a lump-sum payment. Note that rental costs are added to the projected retirement expenses if this situation occurs in the Model.
The projected income, wealth, and expense cash flows are converted from a nominal basis to an inflation-adjusted, or real, basis. The Model uses this data to calculate two main metrics.
1)Retirement funded ratio: The Model calculates the funded ratio for each of the 1,000 trials. The numerator is the sum of real (that is, inflation-adjusted) income across all retirement years plus any leftover assets at the time of death,35 if applicable. The denominator is the sum of real expenses (also across all retirement years). Note this metric shows the magnitude of the shortfalls, with retirement funded ratios that are well below 1 indicating significant shortfalls.
2)Probability of success: this metric is calculated as the percentage of trials in which the household did not run short of money. While the binary success definition does not capture the magnitude of failure, note that the Model’s estimation of retirement expenses explicitly incorporates the household’s ability to pay such expenses. In other words, the expenses are already dynamic in the projection, with the household adjusting expenses downward as wealth balances decrease.
33 Cost of Care Report | Genworth. From https://www.genworth.com/aging-and-you/finances/cost-of-care.html
34 The state of Virginia is used for the analysis.
35 For households with two members, the time of the death refers to the second death.
The Model has the ability to calculate many other metrics. Additional information is available from the authors upon request.
Capital Market Assumptions and Time-Varying Model
Interest rates and portfolio returns are based on forward-looking assumptions and modeled stochastically using Morningstar Investment Management’s Time Varying Model. Equity returns are based on a combination of US large cap, US mid-cap, US small cap, and international equity asset classes. Bond fund returns are based on US aggregate bond, international government bond, and US Treasury-Inflation Protected Securities asset classes.
The Time Varying Model forecasts returns for many global asset classes over a long time horizon. The model incorporates current market conditions in its forecast (for example, valuations and interest rates), which influence returns in the first 20 years of the projection. After that, the model’s forecasts are based on unconditional, long-run return assumptions.
Inflation is modeled with a stochastic regime-switching Ornstein-Uhlenbeck model, inspired by Ahlgrim and D’Arcy (2012).36 The“normal inflation”regime corresponds to a period where inflation is relatively stable and stays near the Federal Reserve’s target. The“high inflation”regime represents periods of high inflation, well above the Fed’s target. We use a 2% inflation target for the “normal”inflation regime in our analysis. Other model parameters are calibrated based on historical data.
Additional information on the projected interest rates, fund returns, and inflation rates are available from the authors upon request.
36 Ahlgrim, K. C., & D’Arcy, S. P. (2012). “A User’s Guide to the Inflation Generator. Society of Actuaries. Retrieved April 22, 2022, from https://www.soa.org/globalassets/assets/Files/Research/Projects/research-2012-02-effectdeflation-user-guide.pdf
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About The Morningstar Center for Retirement and Policy Studies
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The information, data, analyses, and opinions presented herein do not constitute investment advice; are provided as of the date written and solely for informational purposes only and therefore are not an o er to buy or sell a security; and are not warranted to be correct, complete or accurate. Past performance is not indicative and not a guarantee of future results.
This white paper contains certain forward-looking statements. We use words such as“expects”, “anticipates”,“believes”,“estimates”,“forecasts”, and similar expressions to identify forward looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results to di er materially and/ or substantially from any future results, performance or achievements expressed or implied by those projected in the forward-looking statements for any reason.
Monte Carlo is an analytical method used to simulate random returns of uncertain variables to obtain a range of possible outcomes. Such probabilistic simulation does not analyze specific security holdings, but instead analyzes the identified asset classes. The simulation generated is not a guarantee or projection of future results, but rather, a tool to identify a range of potential outcomes. The Monte Carlo simulation is hypothetical in nature and for illustrative purposes only. Results may vary with each use and over time. The results from the simulations described within are hypothetical in nature and not actual investment results or guarantees of future results.
This should not be considered financial planning advice. Please consult a financial professional for advice specific to your individual circumstances.
Exhibit 1: Percentage of Americans Ages 20+ With Retirement-Funding Ratio Less Than Displayed Value by Generation and Age-Specific AIME Quartile
RFRs by AIME - Gen Z
RFRs by AIME - Millennials
Funded
RFRs by AIME - Gen x
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age. Note that the funded ratio 1.5 category includes results in which the funded ratio is above 1.5.
Exhibit 3: Impact of Assuming no Defined-Contribution Plans or IRAs on the Probability of Running Short of Money in Retirement by Education
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 4: Impact of Assuming no Defined-Contribution Plans or IRAs on the Probability of Running Short of Money In Retirement by Industry
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 5: Impact of Assuming no Defined-Contribution Plans or IRAs on the Probability of Running Short of Money in Retirement by Gender and Family Status
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 6: Impact of Assuming no Defined-Contribution Plans or IRAs on the Probability of Running Short of Money in Retirement by Race and Ethnicity
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 7: Aggregated Wealth Ratio Results of the Auto IRA Proposal for Gen X and Younger by Future Years in a Defined-Contribution Plan
Opt-out rate = 30%
Opt-out rate = 45%
= 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 8: Aggregated Wealth Ratio Results of the Auto IRA Proposal for Gen X and Younger by Gender and Family Status
MaleFemaleMarried
Opt-out rate = 30%
Opt-out rate = 45%
Opt-out rate = 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 9: Aggregated Wealth Ratio Results of the Auto IRA Proposal for Gen X and Younger by Race and Ethnicity
Opt-out rate = 30%
Opt-out rate = 45%
Opt-out rate = 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 10: Aggregated Wealth Ratio Results of the Auto IRA Proposal for Gen X and Younger by Generation
Opt-out rate = 30%
Opt-out rate = 45%
Opt-out rate = 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 11: Aggregated Results of the Auto IRA Proposal for Gen X and Younger by Industry
Opt-out rate = 30%
Opt-out rate = 45%
Opt-out rate = 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 12: Aggregated Results--Gen X and Younger--Means and Medians for Switch From VE to AE by Future Years in a Defined-Contribution Plan Without auto-escalation to 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 13: Aggregated Results--Gen X and Younger--Means and Medians for Switch From VE to AE by Gender and Family Status
Without auto-escalation to 15%
With auto-escalation to 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 14: Aggregated Results--Gen X and Younger--Means and Medians for Switch From VE to AE by Race and Ethnicity
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 15: Aggregated Results--Gen X and Younger--Means and Medians for
Without auto-escalation to 15% With auto-escalation to 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
Exhibit 16: Aggregated Results--Gen X and Younger--Means and Medians for Switch From VE to AE by Industry
auto-escalation to 15%
Source: Authors' calculations using v1.0 of the Morningstar Model of US Retirement Outcomes under the assumption that household members retire at 65. Household members are assumed to claim Social Security at retirement age.
The success of defined contribution plans and the road ahead
In the Spotlight August 2024
Key Insights
Defined contribution (DC) plans have expanded retirement plan access for U.S. workers and offered them diversified investments at costs that have declined over time.
— As the main workplace retirement plan option, DC plans could adequately replace career earnings for all Americans when combined with Social Security benefits.
Fixing Social Security, encouraging default participation, age-based default contributions, and promoting emergency savings could improve the retirement system.
The Employee Retirement Income Security Act of 1974 (ERISA) was enacted to establish the guardrails for workplace retirement plans in the private sector. Since then, the world of workplace retirement plans has evolved significantly to expand access to retirement plan benefits to workers across all income groups, encourage higher participation and increase retirement savings through automated features, and improve age-appropriate asset allocation through the adoption of default investment arrangements. These plans have become
a vital force behind a more secure retirement for many Americans, allowing them to share in the prosperity of capital markets.
According to data from the Department of Labor (DOL), defined benefit (DB) plans covered roughly three times the employees covered by defined contribution (DC) plans in 1975. By 1991, DC plans covered more workers than DB plans for the first time, and the trend continues to grow (Figure 1). In 2021, DC plans covered nearly 115 million private sector workers
Sudipto Banerjee, Ph.D. Director of Retirement Thought Leadership
...workplace retirement plans... have become a vital force behind a more secure retirement for many Americans....
The number of workers covered by DC plans continues to grow (Fig. 1) Number of participants in pension plans by type of plan, 1975–2021 (thousands)
Source: Private Pension Plan Bulletin Historical Tables and Graphs 1975–2021 (Page 5). Department of Labor, Employee Benefits Security Administration, Department of Labor. September 2023.
compared with 32 million workers covered by DB plans.
Data from the Investment Company Institute (ICI) show that at the end of 2023, DC plans and individual retirement accounts (IRAs) held $24.1 trillion in assets compared with $3.2 trillion held in private sector DB plans.1
This dramatic shift from DB to DC plans has been welcomed by many, but there are some critics of the DC system as well. Their criticisms, for the most part, ignore the progress made by the DC system
and compare it with an illusory past, which seems rosier in the rearview mirror. Generally, the concerns raised fall into several buckets—limited DC plan coverage, ill-equipped participants left on their own to make complex decisions, inadequacy of savings generated by DC plans, lack of guaranteed income in retirement, and the fact that DC plans only help affluent (not middle-class and low-income) Americans.
This paper will outline how DC plans have improved retirement saving and investing; it will also address some of these criticisms and offer suggestions to help enhance
DC plans in ways that aim to improve retirement outcomes for all Americans.
Coverage and contributions have improved with DC plans
Coverage of workplace retirement plans in the U.S. (also known as access to a retirement plan) has been steadily improving in the last 40 years thanks to DC plans. A recent Congressional Research Service report from 2021 indicated that nearly two-thirds (65%) of private sector workers had access to DC plans and 47% of
DC plans cover more private sector workers than DB plans ever did, even at their peak (Fig. 2) Percentage of private sector wage and salary workers participating in an employer-based retirement plan by plan type, 1979–2021
Source: Employee Benefit Research Institute (EBRI), Fast Facts #485, November 2023.
1 Quarterly Retirement Market Data, Investment Company Institute, Washington D.C., 2024.
workers were actively contributing to their plans. For full-time private sector workers, access was 74% and the participation rate2 was 57%.3
According to data from the Employee Benefit Research Institute (EBRI), the high watermark for DB plan participation in the private sector was 39% in 1980 (Figure 2). In comparison, the participation rate for DC plans was 50% for private sector workers in 2021.4
Like many things of the past, nostalgia about DB plans tends to ignore their realities. The truth is that when DB plans were more dominant, not only was coverage lower, but coverage also didn’t mean the same thing under these plans. Many DB plans were designed as workforce management tools, so the vesting schedules were very steep and the benefit formulas (such as final average pay) meant that those who changed jobs often ended up with meager pensions. This highlights a benefit of the transition from DB to DC plans that is rarely discussed—job mobility and increased earnings potential.
DB plans often compelled workers to forgo higher earnings by switching jobs in the hope of earning a decent pension someday. Schrager (2008) studied the relative risks of DB and DC plans accounting for job turnover and wage variability in the context of a life cycle model and found that as wages become more variable and the probability of job turnover increases, DC plans generate higher welfare for workers than DB plans.5
In 1983, the median tenure of a worker between ages 55 and 64 was 15.3 years, which went down to 10.2 years in 2018.6 DC plans have indeed induced more job changes among late-career workers. However, according to the Bureau of Labor Statistics (BLS), median tenure for the entire workforce inched up slightly in the last four decades, from 3.5 years in 1983 to 4.1 years in 2020.7 This data indicates that the average worker never worked long enough for a single employer to accrue any meaningful DB benefits.
There is also a limitation of looking at coverage from a cross-sectional or point-in-time view. Many workers who are currently not covered by a retirement plan might gain coverage in the future, and others might lose such coverage when they change jobs (for example, moving from a full-time to a part-time job). As a result, it becomes unclear what share of the workforce accumulates savings in a workplace retirement plan during the span of an entire career. Analyzing data from the Federal Reserve Board’s Survey of Consumer Finances (SCF), ICI (2024) found that more than three-quarters (77%) of near-retiree households had DB plan accumulations, DC plan or IRA assets, or both.8 This means that, during their entire careers, three in four households accumulate retirement savings in a workplace retirement plan or an IRA.
Brady and Bass (2023)9 also addressed this issue by analyzing tax filing information to estimate the share of retirees who draw retirement income from
2 Participation rate refers to the total share of the workforce (with or without access) who participate in a DC plan. For DB plans, participation was automatic. Contributions to both DB and DC plans refer to the amount of benefits that participants receive or accrue.
3 “Worker Participation in Employer-Sponsored Pensions: Data in Brief”, Congressional Research Service, R43439, November 2021. https://crsreports.congress.gov/product/pdf/R/R43439
4 “The Retirement Landscape for Private-Sector Workers: How It Has Changed 1979–2021,” EBRI Fast Fact # 485, November 9, 2023.
5 Allison Schrager “The Decline of Defined Benefit Plans and Job Tenure.” Journal of Pension Economics and Finance. 2009;8(3):259–290. doi:10.1017/S1474747208003570.
6 Craig Copeland. “Trends in Employee Tenure, 1983–2018.” EBRI Issue Brief, no. 474, February 28, 2019.
7 U.S. Bureau of Labor Statistics https://www.bls.gov/opub/ted/2020/median-tenure-with-currentemployer-was-4-point-1-years-in-january-2020.htm
8 See Figure 8.4 in Investment Company Institute, 2024 Investment Company Fact Book: A Review of Trends and Activities in the Investment Company Industry (Investment Company Institute, Washington D.C., May 2024); available at https://www.icifactbook.org/pdf/2024-factbook.pdf
9 Peter J. Brady & Steven Bass, “When I’m 64 (or Thereabouts): Changes in Income from Middle Age to Old Age,” Investment Company Institute, May 2023.
Like many things of the past, nostalgia about DB plans tends to ignore their realities.
Small DC plans have consistently reported higher contributions than small DB plans over the past 50 years (Fig. 3) Pension plan contributions to plans with fewer than 100 participants by type of plan, 1975–2021 (millions)
Source: Private Pension Plan Bulletin Historical Tables and Graphs 1975–2021 (Table E14, Page 19). Department of Labor, Employee Benefits Security Administration, September 2023. Contributions are defined as employer and employee contributions.
DB plans, DC plans, IRAs, or annuities. They report that by age 72, 67% of individual tax filers and 75% of joint tax filers report drawing retirement income from these sources.
Moving on to contributions, they also follow a pattern that mirrors coverage. Going back to 1975, DB plans took in more total contribution dollars than DC plans.10 The order flipped in 1985 when DC plans took in higher contributions than DB plans for the first time and never looked back.
A closer look at the coverage and contribution data provides an interesting observation. A common criticism of DC plans has been that they don’t help enough people who work for small employers. However, according to DOL data, DC plans with fewer than 100 participants have always covered more participants and taken in more total contribution dollars than similar DB plans at any point in the past 50 years going back to 1975 (Figure 3). For example, these smaller DC plans covered 2.5 million participants in 1975 compared with 1.6 million participants
covered by similar DB plans. In 2021, the gap expanded to 13.1 million (DC plans) versus 0.5 million (DB plans).11 So, contrary to common belief, DC plans have always been the plan of choice for small private sector employers who wanted to provide a retirement savings plan to their employees.
DC plans have improved investing
The adoption of automatic features and default investment arrangements in DC plans has relieved workers of making complex decisions and positively influenced their savings and investments. Remember, DC or 401(k) plans were originally designed to supplement DB plan benefits; they were not the primary workplace retirement investing vehicle that they are today. At their inception, individuals shared the responsibility of their supplemental savings. But as DC plans became the primary retirement savings plan for millions of workers, it became evident that many employees were either ill-equipped to make investment decisions or had no interest in
doing so, and many plan sponsors were poorly prepared to assist them.
The retirement industry, regulators, and academics came together with solutions that have largely eased the decision-making burden from individual workers, at least for the working or saving phase. Now, the focus is shifting toward retirement or the decumulation phase, which we will discuss in a later section.
The adoption of auto-features, such as auto-enrollment with default contributions and auto-escalation, has removed the need for participants to actively decide whether to save or how much to save.
The only remaining hurdle for individual workers was investment decision inertia, which has been solved by the adoption of qualified default investment alternatives (QDIAs) such as target date solutions.
According to the EBRI/ICI 401(k) database, at the end of 2022, 88% of participants in 401(k) plans were offered target date investments and 68% of participants were invested in target date strategies.12
10 Private Pension Plan Bulletin Historical Tables and Graphs 1975–2021 (Table E5, Page 7). Employee Benefits Security Administration, Department of Labor. September 2023.
11 Private Pension Plan Bulletin Historical Tables and Graphs 1975–2021 (Table E14, Page 19). Employee Benefits Security Administration, Department of Labor. September 2023.
12 Sarah Holden, Steven Bass, and Craig Copeland, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2022,” EBRI Issue Brief, no. 606, and ICI Research Perspective, vol. 30, no. 3 (April 2024).
Source: EBRI/ICI Participant-Directed Retirement Plan Data Collection Project, 2024.
The widespread adoption of target date investments has improved the asset allocations for participants. More workers are now invested in age-appropriate allocations than 15 years ago (Figure 4). According to the EBRI/ICI 401(k) database, at year-end 2022, 3% of 401(k) plan participants held no equities,13 down from 13% at year-end 2007. More than 90% of 401(k) plan participants in their 20s had more than 80% of their account balances invested in equities at year-end 2022 compared with less than half at year-end 2007. Furthermore, 13% of 401(k) plan participants in their sixties had more than 80% of their account balances invested in equities at year-end 2022 compared with 30% of 401(k) plan participants in their sixties at year-end 2007. The importance of such improvement in asset allocation for the retirement nest egg of workers cannot be overstated.
Another benefit of defaulting participants into a diversified investment, such as a target date portfolio, has been that they are less likely to change these investments by trying to time the market. Data from T. Rowe Price’s recordkeeping platform14 show that, in 2023, only 0.8% of participants who were fully invested in target date strategies made an exchange compared with 20.7% of participants who were not
invested in target date strategies at all. Therefore, not only are accounts more diversified,15 but participants are also less likely to try to time the market or engage in risky investing behavior that might erode the returns they have amassed.
The holistic outlook on retirement adequacy is positive
Do Americans have enough retirement savings? A deeper look reveals some surprises.
When it comes to the adequacy of retirement savings, workplace retirement savings plans are not supposed to be viewed in isolation. But DC plans are often viewed in isolation and criticized for not helping workers save enough for retirement. Faulty data such as crosssectional average account balances are often cited as the marker of a “retirement crisis.” But cross-sectional data only show the balance from the current job for workers who also have different ages and tenure. For example, T. Rowe Price’s recordkeeping data show that, at year-end 2023, the average 401(k) account balance was $115,000. But on a closer look, participants younger than 30 with a tenure of two to five years had an average balance
of $15,900, and participants between ages 60 and 64 who were close to retirement and had a tenure over 20 years had an average balance of $463,200. Looking at a single average for the entire participant population produces a distorted image of retirement savings, and we should refrain from using it. In addition, these balances typically don’t include account balances from prior jobs or rollover IRAs.
Still, the larger issue is that this criticism undermines the structure of the U.S. retirement saving system, which consists of multiple layers, including Social Security; homeownership; and tax-advantaged savings such as 401(k)s, IRAs, and other private savings. The foundation of our retirement savings system is Social Security, a government-mandated social insurance program. Like other social insurance programs, it prevents people from running out of income in their old age by guaranteeing a stream of inflation-protected income for life based on earnings during their working years. According to the Social Security Administration (SSA), the average monthly retired worker benefit for Social Security recipients was $1,907 in January 2024.16
Social Security also has a progressive benefit structure, which means it replaces
13 This includes any direct investment in equities as well as the equity portion in target date strategies or other balanced portfolios.
14 All data from the T. Rowe Price recordkeeping platform are based on the large-market, full-service universe—T. Rowe Price total—of T. Rowe Price Retirement Plan Services, Inc., retirement plans (401(k) and 457 plans) consisting of 660 plans and over 2 million participants.
15 Diversification cannot assure a profit or protect against loss in a declining market.
a higher share of preretirement earnings for low earners. These individuals would only need to replace a smaller share of their earnings from other sources.
Bee and Mitchell (2017) showed that people above age 65 in the second income decile (from the bottom) received 83% of their income from Social Security (the bottom income decile received less from Social Security as they receive a large part of their income from Supplemental Security Income, or SSI), whereas people in the ninth income decile (or second decile from top) received only 24% of their income from Social Security.17 This shows that higher-income people need to replace a larger share of their income from private savings such as employer-sponsored retirement plans. To complicate things further, marginal tax rates change differently for people across the income distribution as they move into retirement. We can only judge the effectiveness of the U.S. retirement savings system once we consider how all these different sources of retirement income and associated tax rates change for people across the income distribution.
Unlike coverage, it is tricky to judge the issue of adequacy because there is no single objective way to measure adequacy of savings. The verdict on a “retirement crisis” appears split. However, the differences in findings can be traced to the difference in the methodologies used in some of these studies. For example, Munnell, Chen, and Yin (2024) use historical data on wealth-to-income ratios to estimate predicted income replacement rates and compare them with a target income replacement rate needed to maintain the preretirement standard of living.18 They
predict that 39% of U.S. households could be at risk in retirement. On the other hand, Brady and Bass (2023) use tax return data from the Internal Revenue Service (IRS) to estimate actual post-tax income replacement rates, i.e., how much of late-career spendable income is replaced early in retirement. They find that a typical individual replaced 90% of their age 55–59 post-tax income through age 72. And people in the bottom 25% of the age 55–59 income distribution typically replaced more than 100% of their post-tax income.
It should also be noted that the assumption of maintaining a preretirement standard of living or a preretirement level of consumption throughout retirement as the marker of a successful retirement ignores actual spending patterns of retirees. It also vastly overestimates the amount of savings required in retirement. Our research has shown that, on average, real spending declines at an annual rate of 2% throughout retirement.19 Hurd and Rohwedder (2023) report similar findings.20 The common question that arises when looking at this spending decline is whether this decline is voluntary or forced by lack of savings. To answer this, Hurd and Rohwedder (2023) share two interesting observations: (1) spending declined across the entire wealth distribution (i.e., wealthy households who face no risk of running out of money also decreased their spending), and (2) the budget share of gifts and donations increased as households aged. If people were lowering their spending due to lack of savings, we don’t expect them to spend a higher share on gifts and donations.
These findings also underscore the need for using empirical consumption-based measures rather than income replacement
17Charles Adam Bee and Joshua Mitchell, “Do Older Americans Have More Income Than We Think?” (July 25, 2017). SESHD Working Paper #2017-39, Available at SSRN: https://ssrn.com/ abstract=3015870 or http://dx.doi.org/10.2139/ssrn.3015870
18Yimeng Yin, Anqi Chen, and Alicia H. Munnell. 2024. “The National Retirement Risk Index: An Update from the 2022 SCF” Issue in Brief 24-5. Chestnut Hill, MA: Center for Retirement Research at Boston College.
19Sudipto Banerjee, “Decoding Retirement Spending” T. Rowe Price Insights, March 2021.
20Michael D. Hurd, Susann Rohwedder, “Spending trajectories after age 65 variation by initial wealth,” The Journal of the Economics of Ageing, Volume 26, 2023, 100468, ISSN 2212-828X, https:// doi.org/10.1016/j.jeoa.2023.100468. (https://www.sciencedirect.com/science/article/pii/ S2212828X23000282)
...there is no single objective way to measure adequacy of savings.
Source: Survey of Consumer Finances, Board of Governors of the Federal Reserve System, 1989–2022.
1 Middle income includes families between the 40th percentile and 60th percentile of the family income distribution.
rates to study adequacy of lifetime savings. In a comparison of these two types of measures, Hurd and Rohwedder (2015) found that the vast majority of households were adequately prepared for retirement when consumption-based measures were used, but the majority fall short when typical income replacement rates were used.21
Who benefits from DC plans?
The notion that only high earners benefit from DC plans is flawed. This argument primarily claims that higher earners with higher marginal tax rates get a higher tax relief for their contributions. But traditional DC plan contributions are tax-deferred, not tax-free. And future tax rates are highly uncertain.22
This narrow argument around tax benefits misses the larger benefits of DC plans that are enjoyed by workers across the income spectrum. It is often forgotten that DC plans have increased stock market participation and provided easy and cost-effective access to professional
money management for middle-class workers. Historically, stocks have provided the highest returns relative to most asset classes over the long term, which means they are essential for long-term investing goals such as saving for retirement (higher returns, however, come with higher risk).23 But stock ownership was low for middle-class workers because of significant barriers of owning stocks.
According to data from SCF, stock ownership for middle-income families has more than doubled between 1989 and 2022, from 28.9% to 60.1% (Figure 5). This includes families holding individual shares directly or indirectly (e.g., through mutual funds in retirement accounts). During the same period, direct ownership of stocks only increased from 12.5% to 17.0%, but indirect ownership through retirement accounts increased from 38.2% to 56.4%. It is safe to say that retirement accounts have been a key driver of stock ownership for middle-income families—an upshot that has allowed them to share in the prosperity of capital markets.
As a result, a large share of Americans’ financial portfolios are invested in equities. According to data from the Organization for Economic Cooperation and Development (OECD), 39.2% of financial assets of Americans were invested in equities, far ahead of many other western industrialized nations. For example, the comparable number for the United Kingdom and Germany was 11.9%.24
As DC plans have grown, the share of retirement balances in total financial assets has grown as well, albeit at a much faster rate for middle-income families than high-income families (Figure 6). SCF data show that between 1989 and 2022, this share increased from 26% to 32% for the top 10% of earners. But for the middle 20% (40th to 60th percentiles) of earners, this share has increased from 46% to 76%.
Therefore, less than one-third of total financial assets of the top 10% of earners are invested in retirement accounts. But more than three-quarters of total financial assets of middle-income families are invested in retirement accounts. So, when
21 Michael D. Hurd and Susann Rohwedder. 2015. “Measuring Economic Preparation for Retirement: Income Versus Consumption.” Michigan Retirement Research Center Research Paper no. WP 2015–332. Available at https://mrdrc.isr.umich.edu/publications/papers/pdf/wp332.pdf.
22 David C. Brown, Scott Cederburg, Michael S. O’Doherty, Tax uncertainty and retirement savings diversification, Journal of Financial Economics, Volume 126, Issue 3, 2017, Pages 689-712, ISSN 0304-405X, https://doi.org/10.1016/j.jfineco.2017.10.001
23 Jim Reid, Nick Burns, Luke Templeman, Henry Allen, Karthik Nagalingam, “The Age of Disorder,” Deutsche Bank, September 8, 2020. 24 OECD Data, 2019–2022. https://data.oecd.org/hha/household-financial-assets.htm
Retirement balances make up a significant share of total financial assets for middle-income families (Fig. 6) Share of retirement balance in total financial assets for middle-income1 and high-income families between 1989 and 2022
Source: Survey of Consumer Finances, Board of Governors of the Federal Reserve System, 1989–2022.
1 Middle income includes families between the 40th percentile and 60th percentile of the family income distribution.
measured by the share of their financial portfolio, middle-income families have benefited greatly from the advances in DC plans.
These advances include easy access to professional money management, lower fees, access to financial planning tools, and so on. For instance, an analysis of 401(k) mutual fund fees reveals that they have fallen dramatically in recent years. According to ICI, equity mutual fund expense ratios in 401(k)s are down 57% and bond mutual fund expense ratios are down 63% since 2000.25 These advances help middle-class workers to save more and invest better.
The road ahead for DC Plans: First stop, retirement income
Could DC plans deliver retirement income? Yes.
DC plans have been an innovation lab. They have revolutionized voluntary participation through auto-enrollment and investing through QDIAs such as target date solutions, which offer both diversification and portfolio rebalancing. Retirement income is the next wave of DC innovation.
While traditional DB plans generally leaned toward providing participants an annuity income for life, DC plans are increasingly providing a greater set of income options, including annuities.
Currently, the retirement income discussion revolves around a discussion of lifetime income, i.e., income guaranteed for life or annuities. But the universe of retirement income products is larger and expanding. A key reason behind the interest in annuities is the decline of DB plans in the private sector. Proponents of annuities point out that they provide a monthly paycheck in retirement, which certainly seems like a good thing. But we have limited understanding of whether people have the same preference for a regular paycheck if it comes at the expense of their savings rather than from their labor. This problem gets compounded when we add Social Security—which provides a guaranteed inflation-indexed paycheck for life—into the mix. The question then becomes, how much additional annuity income might people need? In other words, are retirees under-annuitized, and should they consider additional annuities?
According to a 2020 report from ICI,26 the majority of U.S. households nearing
retirement are highly annuitized through annuities or annuity equivalents, including Social Security, DB wealth, and homeownership.27 For example, when future income streams are included in a comprehensive measure of wealth in present discounted form, households in the bottom quintile (20%) of the wealth distribution hold 94% of their wealth in annuitized form. The middle quintile holds about three-quarters (76%) of their wealth in annuitized form. Households in the top quintile of the wealth distribution hold half of their wealth in annuitized form. So, there could be a demand for additional annuity income, particularly, among the wealthier households. But it is not clear if everyone, particularly less wealthy households, could benefit from a nudge toward additional annuities.
Apart from a steady income stream, the other key benefit of an annuity is that it provides longevity protection, usually at the expense of some liquidity and an additional cost. Whether a person chooses the annuity payment or not also depends on where they fall on the liquidity/longevity hedge trade-off. Risk and potential benefits vary depending on the type of annuity, and they can be subject to higher costs and are typically more complex. It is, therefore,
25 ICI Research Perspective, “The Economics of Providing 401(k) Plans: Services, Fees, and Expenses, 2022.” Investment Company Institute, July 2023, Vol. 29, No. 6. https://www.ici.org/system/files/2023-07/per29-06.pdf
26“The Myth of Under-Annuitization: Managing Income and Assets in Retirement,” Whitepaper, Investment Company Institute, April 2020, https://www.ici.org/doc-server/pdf%3A20_ppr_annuitization.pdf
27 In the absence of an owned home, households need to pay rent. Owner-occupied housing provides imputed rental income, which reduces the need for regular income from other sources.
not obvious that annuities would meet everyone’s needs (besides needing to take into account an individual’s own situation), and a closer look at DB plan outcomes confirms that. Banerjee (2013) has shown that when DB plans offered participants a choice between a lump sum and an annuity, only a small share of participants (27.3%) chose to annuitize.28 Mottola and Utkus (2007) also reported similar annuitization rates in DB plans.29 The current evidence from DC plans also points toward this trend. Brown, Poterba, and Richardson (2022) analyzed retirement income choices made by participants in a large DC plan with multiple withdrawal options, between 2000 and 2018. They found that the share of life annuitants fell from 52% in 2008 to 31% in 2018.30 Interestingly, they also found that about one-fifth of participants used more than one withdrawal option, often combining a life annuity with another withdrawal option. This speaks to the need of providing participants a range of retirement income options that meets their personal needs.
The larger DC market is in a nascent stage when it comes to retirement income. But more and more retirement income products—such as managed payouts, systematic withdrawals, target date strategies with embedded annuities, managed accounts, and annuity marketplaces—are coming to DC plans. Different employers have different workforce demographics and having access to a suite of retirement income solutions will help them choose what makes the most sense for their employees.
...more needs to be done to boost saving rates and limit leakage.
Still, the retirement income problem cannot be solved by products alone. Most workers are unlikely to figure out the workings of each of these retirement income products on their own, let alone understand how or which of these products are best suited to help with their personal situation. They will need help to do that, and DC plans should offer that help. Help can come in many forms, including education on retirement income planning, tools that let participants compare different in-plan income options, and help with Social Security claiming or tax-aware withdrawals. Most importantly, for any of these offerings to be successful, participants need to be confident in their decisions or choices. This is where the services of financial professionals, a trusted human professional such as an advisor, or a managed account solution could prove beneficial.
DC plans should address savings challenges of all workers
One of the well-documented facts that has garnered more attention in recent years
is the racial wealth disparity in the U.S. Aladangady et al. (2023) reported that the typical white family had six times as much wealth as the typical Black family and five times as much wealth as the typical Hispanic family.31 To be clear, these inequities were not created by DC plans. They are a cumulative result of various socioeconomic issues that have existed for centuries. If anything, these gaps are narrower among those who participate in DC plans; however, there are still large gaps. Banerjee (2024) shows that among DC participants, a typical Black family had 36% of the net worth of a typical white family and a typical Hispanic family had 58% of the net worth of a typical white family.32 Retirement accounts are the largest component of financial assets for American families,33 and data suggest that DC plans have the potential to narrow some of these savings’ inequities by providing access to tax-advantaged savings vehicles with professionally managed investment options.
Once someone starts participating in a plan, there are three factors that determine their final savings—saving rate, investment allocation, and leakage or early withdrawals. QDIAs such as target date solutions have gone a long way to address the issue of investment allocation. But more needs to be done to boost saving rates and limit leakage. Some leakages such as loans are not necessarily bad, so we need to be careful on how we limit them.
Choukhmane et al. (2023) show that the average contribution of Black and Hispanic workers is 40% lower than that
28 Sudipto Banerjee, “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” EBRI Issue Brief, no. 381 (January 2013).
29 Gary R. Mottola, and Stephen P. Utkus. 2007. “Lump Sum or Annuity? An Analysis of Choice in DB Pension Payouts.” Vanguard Center for Retirement Research, Vol. 30.
30 J.R. Brown, J.M. Poterba, and D.P. Richardson. “Trends in retirement and retirement income choices by TIAA participants: 2000–2018.” Journal of Pension Economics and Finance. Published online 2023:1-22. doi:10.1017/S1474747223000070
31 Aditya Aladangady, Andrew C. Chang, and Jacob Krimmel (2023). “Greater Wealth, Greater Uncertainty: Changes in Racial Inequality in the Survey of Consumer Finances,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, October 18, 2023, https://doi.org/10.17016/23807172.3405
32 Sudipto Banerjee, “Race, Retirement, and the Savings Gap,” T. Rowe Price Insights on Retirement, 2024. https://www.troweprice.com/content/dam/ retirement-plan-services/pdfs/insights/race-retirement-and-savings-gap/Race-Retirement-Savings_Gap_Insights.pdf
33 Survey of Consumer Finances, Historical Tables, Excel based on Public Data, Table 5, October 202
of white workers.34 They attribute this mostly to the differences in earnings— their own earnings and earnings of their parents —and show that the tax and employer matching subsidies further amplify the gap in saving rates by subsidizing higher savers at a higher rate. To break this cycle, they suggest that both employer contributions and tax subsidies are proportional to earnings and disconnected from employee contributions. Such a move that redistributes the existing pool of matching dollars has the potential to narrow the racial savings gap significantly. But employers often have different reasons— such as offering competitive benefits or retention of top talent—for designing their plans in a particular way and might have limited room to change their plan design. In that case, they might take a closer look at their overall compensation policies to make sure that those are in line with the company’s values and objectives.
SECURE 2.0 has created a new Saver’s Match program that will go into effect in 2027. The program will offer a 50% match on the first $2,000 of retirement savings contributions for a participant, subject to certain income eligibility conditions. VanDerhei (2024) shows that the program has the potential to improve the retirement savings outcomes significantly for most race-gender subgroups.35 He shows that if participants increase their contributions to receive the full Saver’s Match, then every race-gender group
will have a significantly higher account balance to salary ratio at age 65 with Black females and Hispanic females reporting the highest potential gains, compared with what they are currently projected to have. However, Ramnath (2013) has shown that the past iteration of Saver’s Credit had little effect on retirement contributions.36 The challenge for DC plans will be to ensure that those who become eligible to be part of the program take full advantage of it.
Early withdrawals from retirement plans are the other key reason why many minority workers fall behind on their retirement savings. VanDerhei (2024) shows that Black and Hispanic workers are much more likely to take early withdrawals, and Black workers are more likely to have outstanding loans from their retirement plans compared with their white counterparts.37 He shows that eliminating these early withdrawals would mitigate the racial gaps in retirement savings. However, the counterargument for eliminating early withdrawals is that some of these workers might lower their contributions or stop participating in their retirement accounts if they have no ability to access these funds before retirement. Beshears et al. (2010) show that the net effect of loans on savings is small and could be either positive or negative.38 But this points toward a larger issue. Lack of emergency savings is contributing to lower retirement savings and needs to be addressed.
How to address the lack of emergency savings?
In our latest Retirement Savings and Spending (RSS) Study,39 we asked retirement plan participants if they thought they were saving enough, and if not, what prevented them from doing so. Among the respondents, 38% said that they were not saving enough (another 22% were not sure), and among those not saving enough, 25% said they were prioritizing an emergency savings fund and 18% didn’t want to tie up their money in their 401(k). This indicates that many participants don’t have the financial cushion needed to put money toward long-term goals such as retirement. As a result, many end up taking loans or hardship withdrawals from their retirement accounts.
Data from T. Rowe Price’s recordkeeping platform show that nearly one in five (19.4%) participants had an outstanding loan balance and another 1.6% of eligible participants had taken a hardship withdrawal in 2023.40 Furthermore, our analysis revealed that the deferral rate for participants who took multiple small loans per year was lower, on average, by 2.3 percentage points. Frequent and/or unpaid loans and hardship withdrawals increase leakage from retirement accounts and often end up eroding some of the long-term compounding and potential tax benefits due to the tax-penalty imposed on early withdrawals.
34 Taha Choukhmane, Jorge Colmenares, Cormac O’Dea, Jonathan Rothbaum, and Lawrence D.W. Schimdt, “Who Benefits from Retirement Savings Incentives in the U.S.? Evidence from Racial Gaps in Retirement Wealth Accumulation,” Working Paper, November 2023, https://mitsloan.mit.edu/ shared/ods/documents?PublicationDocumentID=10074
35 Jack VanDerhei, “How Effective Might the Saver’s Match Be in Mitigating Race/Gender Disparities in 401(k) Plans: Evidence from the Collaborative for Equitable Retirement Savings Project,” The Collaborative for Equitable Retirement Savings Report, May 2024.
36 Taxpayers’ responses to tax-based incentives for retirement savings: Evidence from the Saver’s Credit notch, Journal of Public Economics, Volume 101, 2013, Pages 77–93, ISSN 0047–2727, https://doi.org/10.1016/j.jpubeco.2013.02.010 (https://www.sciencedirect.com/science/article/pii/ S0047272713000479)
37 Jack VanDerhei, “How Large are Racial and Gender Disparities in 401(k) Account Balances and What is Causing Them: Initial Findings from the Collaborative for Equitable Retirement Savings,” The Collaborative for Equitable Retirement Savings Report, March 2024.
38John Beshears, James J. Choi, David Laibson, and Brigitte C. Madrian. “The Impact of 401(k) Loans on Saving.” Retirement Research Consortium and NBER, September 2010.
39 The 2023 RSS was conducted between July 24, 2023, and August 13, 2023. It included 3,041 401(k) participants, full-time or part-time workers who never retired, currently age 18 or older, and either contributing to a 401(k) plan or eligible to contribute and have a balance of $1,000+. The survey also included 1,176 retirees who have retired with a Rollover IRA or a left-in-plan 401(k) balance.
40 Reference Point Annual Report, T. Rowe Price, Baltimore MD, April 2024. https://www.troweprice.com/content/dam/retirement-plan-services/pdfs/ insights/savings-insights/ReferencePoint_2024.pdf
Participants need adequate emergency savings to prevent leakage and the tax penalty. SECURE 2.0 has created two in-plan emergency savings options—an emergency withdrawal of up to $1,000 a year and a pension-linked emergency savings account (PLESA). While the emergency withdrawal option is gaining traction among plan sponsors due to its relative simplicity regarding implementation, PLESAs are not generating as much interest due to their perceived complexity. However, out-of-plan emergency savings accounts, which are relatively simple to implement and offer much more flexibility, could be an attractive option for employers who want to provide an emergency savings option to their participants. They could provide incentives to their employees to set up a payroll deduction into these emergency savings accounts. A small contribution of 1% to 2% of salary into these accounts could create the financial cushion that prevents participants from taking early withdrawals to address unexpected expenses, and it may encourage them to invest for long-term goals such as retirement.
Legislative opportunities
Fix the long-term outlook for Social Security: Social Security is the foundation of the U.S. retirement savings system. As previously stated, the combination of Social Security and private savings replaces a large share of earnings for most workers, with lower earners replacing a higher share of their earnings with Social Security and higher earners replacing more of their earnings with private savings such as retirement accounts. But according to the latest Social Security Trustees Report,41 the Old-Age and Survivors Insurance (OASI) Trust Fund, commonly known as the Social Security Trust Fund, is projected to exhaust its reserves by 2033, after which Social Security will be able to pay
...the combination of Social Security and private savings replaces a large share of earnings for most workers...
only 79% of scheduled benefits. In other words, if Congress doesn’t take any action, there will be a roughly 20% cut in Social Security benefits.
Congress should address this as soon as possible. Any delay narrows the set of options to fix the program. Certainty over the future of Social Security could restore confidence in the U.S. retirement system including the DC system. But whatever fix Congress comes up with, it should try to protect the self-funded status of Social Security, i.e., it should not be funded through general revenue. Tying Social Security to the often contentious budgetary process would only add tremendous uncertainty to the program.
Encourage auto-enrollment for all plans: Auto-enrollment (AE) increases participation rates dramatically. In 2023, AE plans recordkept by T. Rowe Price had a participation rate of 83% as opposed to a participation rate of only 36% for plans without AE. SECURE 2.0 has mandated AE for all plans established after the passing of the law with some exceptions for small and new businesses. Extending the mandate to all plans irrespective of their date of
establishment, but keeping the exceptions, will give many more American workers the opportunity to save in a workplace retirement plan.
Encourage auto-reenrollment: Even when AE is mandated, participants have the opportunity to opt out. People have various needs at any given point in time, and that might require them to focus on other financial priorities. But priorities can change with time. Therefore, plans should be encouraged to auto-reenroll workers who opt out at a regular frequency of their choosing. If some workers still prefer to opt out, they should have the chance to do so.
Introduce age-based default contribution rates: Most, if not all, retirement plans have a single default contribution rate. The addition of auto-escalation slowly builds up the contribution rates of participants over time. But as participants change jobs, they are more likely to start contributions again at a default rate, which could be lower than what they were saving earlier. If they take a career break, which is more common with women, they need to save at a higher rate to make up the ground. People should not save less by default if they switch jobs or return to the labor force. In doing so, they can lose valuable time and the benefits of compounding. Having some legislative clarification to allow age-based default contribution rates might address some of these issues.
Reform health savings: Declining health and the associated costs are a constant worry for retirees. If future retirees live longer, they will likely need to save more for health care. The Health Savings Account (HSA) with its “triple tax” advantage42 is an excellent vehicle for that, but only if people invest the money in these accounts. But utilization of investments in HSAs has been lagging. There are several factors behind this, including the fact that people generally don’t use what is called a “savings account”
41 “The 2024 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds,” Social Security Administration, May 6, 2024. https://www.ssa.gov/oact/TR/2024/tr2024.pdf
42 Contributions to HSA’s are tax-deductible, any earnings are tax-free, and withdrawals are tax-free when used for qualified medical expenses (may, in whole or part, still be subject to state taxes). Withdrawals prior to age 65 for nonqualified expenses is subject to taxes and penalties. An individual must be covered by a high-deductible health plan to be eligible for an HSA.
for investing. Flexible Spending Accounts (FSAs) complicate matters further. The difference between a “savings account” and a “spending account” might not be clear to most workers, which hurts proper usage of these accounts.43 Renaming HSAs to Health Investment Account (HIA) might be helpful.
Also, HSAs have proliferated rapidly as more and more employers have switched to high-deductible health plans. As a result, workers are starting to accumulate several HSAs. This trend could grow over time. It might be beneficial to create a framework that helps workers to easily roll over their HSA balances and consolidate. Otherwise, many of them will likely lose track of some of these accounts, particularly those with small balances.
Opportunities for plan sponsors
Rethink retirement: Our current understanding of retirement is outdated. The vast majority don’t retire on their 65th birthday and go out of the labor force permanently. Yet, somehow, we are still making decisions assuming that this is the case. Retirement will be a transitional phase for American workers, if it isn’t already, and we need to prepare for that.
Employers need to think about how and when they can move their full-time workers into a “transitioning to retirement” workforce. Compensation and benefits need to adjust to that. Some people might want to reduce their hours but keep their health coverage. Others might be willing to give up benefits altogether but continue with reduced hours. People might want to switch roles and work on a limited capacity. Employers need to decide if and how they are going to create this transitional workforce, and how they are going to design the benefits for this group. Easier said than done.
Nudge participants to save for emergencies: Leakages can be a drag on
retirement savings. But in the absence of any dedicated emergency savings, some participants might have no other choice but to withdraw money from their retirement accounts if a sudden need for cash arises. SECURE 2.0 tried to address this by creating two in-plan solutions—emergency withdrawals and the PLESA. But the PLESA appears too complicated for many plan sponsors, and the emergency withdrawal option could potentially add to leakages.
Another alternative is to offer out-of-plan emergency savings options to participants. Plan sponsors have a lot of flexibility in setting up these accounts, and participants can easily access the money. But most importantly, this money is earmarked for emergencies and could potentially stop some leakages from retirement accounts. Plan sponsors can also nudge participants into contributing a small portion of their salaries into these accounts.
Think beyond products to address retirement income: As discussed above, the next wave of DC innovations will happen in the retirement income product space. In fact, it’s already happening. But while products are necessary, they are not sufficient to solve the retirement income needs of participants. The decision to use a retirement income product is linked to a series of other decisions such as when to retire, when to claim Social Security, or whether to relocate. Unless participants see how each product can help them execute their plans, they are not likely to use them. Therefore, if the retirement income problem has to be solved in plan, then participants will need help on how to choose the right retirement income product.
Final thoughts
The U.S. retirement savings system is a mix of social insurance (Social Security) and private savings (workplace plans, personal savings, and investments). By design, social insurance provides more
support for workers with lower lifetime earnings, while higher earners depend more on private savings. But when the two are combined, most workers can replace their preretirement income adequately.
On the private savings front, DC plans have been the driving force for the last few decades. However, there is room for improvement, particularly, when it comes to coverage. Although, coverage of workplace retirement plans has never been higher, there might be limits to the voluntary system.
In recent times, some experts have suggested that the U.S. should move to a mandatory private savings structure where employers are mandated to offer or contribute to retirement plans. By definition, a mandate will improve coverage; however, there could be other perils apart from the political feasibility of a mandate. While researchers or policymakers might look at income and retirement benefits separately, for most employers, they are just different components of compensation. If they can’t increase overall compensation and are forced to increase one component— retirement benefits—the result could be a decrease in the other components of compensation, such as salary or income. After all, there is no free lunch.
DC plans are not perfect, but they have helped American workers to build secure retirements for themselves. They have also addressed the unfunded liability challenges faced by DB plans, made it easier for middle-class Americans to invest in well-diversified and professionally managed investments, and they are constantly innovating and improving. Expense ratios on equity and fixed income funds in 401(k)s have also declined meaningfully over the past two-plus decades. The DC system is a success story but with far more potential. We should all work together to build on its success.
43 Employees cannot invest their money in FSAs. Investments are not FDIC insured and are subject to possible loss of principal.
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T. Rowe Price focuses on delivering investment excellence and retirement services that institutional, intermediary, and individual investors can rely on—now and over the long term.
To learn more, please visit troweprice.com/retirementUS
Risks
Annuities risk: Guarantees are subject to the claims paying ability of the insurer. Riders may be available to help customize policies and provide additional benefits. Riders are optional and available at an additional cost. There is no guarantee that the benefits received under the terms of rider may not exceed the cost to include the rider on a policy. All withdrawals or partial surrenders will reduce the death benefit. Additionally, once in the income phase, excess withdrawals will reduce subsequent future payments. An annuity is a contract between you and an insurance company. You should read contract(s) carefully before purchasing to review the terms, fees, and charges that apply. An annuity isn’t intended to replace emergency funds or to fund short-term savings goal. There may be a 10% federal tax penalty on withdrawals before age 59½.
Target Date Investing Risks:
The principal value of target date strategies is not guaranteed at any time, including at or after the target date, which is the approximate date when investors plan to retire (assumed to be age 65). A particular level of income is not guaranteed. Diversification cannot assure a profit or protect against loss in a declining market.
Important Information
This material is provided for general and educational purposes only and is not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you.
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T. Rowe Price Investment Services, Inc., distributor, and T. Rowe Price Associates, Inc., investment adviser.
Addressing barriers to retirement savings for women.
KEY INSIGHTS
While there is no gender gap in access to retirement plans, women lag far behind men in terms of contributions, savings, and retirement confidence.
Typically lower incomes, higher debt loads—especially student loans—and shorter job tenures are some of the factors contributing to the gender savings gap.
Employers and the retirement industry can help narrow this gap by ensuring that benefits programs, overall, can meet the needs of the female workforce.
For many employers, diversity and inclusion is an important area of focus, and inequities in their own retirement savings plans have gained renewed attention. To this end, some of the recent research, including ours, has focused on the racial gaps in retirement savings. But an equally important dimension of the retirement savings gap is gender.1 In 2022, our T. Rowe Price Retirement Savings
and Spending Study, which surveys a nationally representative group of 401(k) participants, focused on the gender gap in retirement savings—and the disparities are striking.
Our analysis showed that women were contributing less annually to their workplace retirement accounts, and as a result, they had significantly lower retirement account balances (Figure 1).
The Gender Gap in Retirement Savings
(Fig. 1) For women, lower contributions mean less savings
Source: T. Rowe Price Retirement Savings and Spending Study, 2022.
*Estimated annual 401(k) contribution (median expected contribution % x median personal income).
† Median 401(k) balance.
‡ How confident are you about retirement (on a scale of 0 to 10)? Percentages based on top 3 boxes, those who rated their confidence levels at 8, 9, and 10.
1 Participants in the survey self‑identified their gender. For the purposes of this research, we use the term woman to refer to an adult who lives and identifies as a female and the term man to refer to an adult who lives and identifies as a male.
Sudipto Banerjee, Ph.D. Vice President, Retirement Thought Leadership March 2023
...women’s confidence levels in attaining retirement goals were also lower.
No Gender Gap in Access to Retirement Plans
(Fig. 2) Retirement plan participation among 21–64 year old wage or salaried workers in the private sector.
Source: Author’s calculations from the Annual Social and Economic (ASEC) supplement of the Current Population Survey (CPS), 2022. IPUMS CPS, University of Minnesota.
Participation Rate = Share of total private sector workforce (with or without access to a retirement plan) who participate in a retirement plan.
Notably, the median 401(k) account balance for women was 65% lower than for men. Therefore, it is understandable that women’s confidence levels in attaining retirement goals were also lower.
The gender gap in retirement savings is a challenge for women who are preparing for retirement. We understand that there are various social and economic factors that significantly affect women’s ability to save. For the purposes of our paper, we only focus on factors that can be addressed by employers and other retirement industry stakeholders.
In our research, we examined how traditionally lower incomes, along with factors such as access to and participation in retirement plans, debt, and job tenure, may be contributing to the gender retirement savings gap. We believe that stakeholders in the retirement industry—including employers, recordkeepers, financial professionals, and policymakers—can learn from similar research to help narrow the gap.
No Gap in Retirement Plan Access and Participation
Interestingly, we found that there were no overall gaps in access to retirement plans between men and women. In fact, retirement plan participation appears
consistent among private sector wage and salaried workers (Figure 2).
However, this apparent gender equality in participation masks disparities and wide variations in the level of participation across different industries (Figure 3). For example, wholesale and retail trade and business and personal services industries employ men and women equally. Despite this, the retirement plan participation rate is significantly lower among women in those industries.
Even in industries that employ significantly more women than men—such as health care and professional services—women still lag in their rate of retirement plan participation. This disparity in participation further exacerbates the gender savings gap, given the large population of women who work in these industries.
There are, however, some bright spots for women highlighted in the research. Although fewer women work in manufacturing and in transportation and communication, their retirement plan participation in these sectors is on par with that of their male peers. Compared with these industries, women in the finance, insurance, and real estate industries make up a larger share of the overall workforce, and the data show that their participation rate is close to that of their male colleagues.
Women in Several Industries Lag in Retirement
Plan
Participation (Fig. 3) Retirement plan participation among 21–64 year old wage or salaried workers in the private sector across different industries
Source: Author’s calculations from the Annual Social and Economic (ASEC) supplement of the Current Population Survey (CPS), 2022. IPUMS CPS, University of Minnesota.
Participation Rate (PR) = Share of total private sector workforce (with or without access to a retirement plan) who participate in a retirement plan.
Lower Income Means Lower Contributions
Although many employers have made progress in addressing the gender pay gap, national averages reflect that women typically earn less than men. In our survey of plan participants, the median income of women was two‑thirds that of men (Figure 4). While the various factors behind this disparity are the subject of debate, the effect is unambiguous— women are less likely to be prepared for a secure retirement because lower income limits their ability to save.
But interestingly, our study found that at any given level of income, women are more likely to participate in retirement plans than men (Figure 5). In other words, absent any income disparities, women would, in fact, be more likely to save.
However, women’s rate of saving is lower. The expected median contribution rate for women, including both the employer and employee contribution, is 11%, compared with 13% for men. The 2% difference in the contribution rate seems
Women Typically Earn Less Than Men
(Fig. 4) Despite some progress, a gender income gap still persists
Across Different Income Groups, Women Are More Likely to Save
(Fig. 5) Retirement plan participation among 21–64 year old wage or salaried workers in the private sector across different income groups
Source: Author’s calculations from the Annual Social and Economic (ASEC) supplement of the Current Population Survey (CPS), 2022. IPUMS CPS, University of Minne sota.
Participation Rate (PR) = Share of total private sector workforce (with or without access to a retirement plan) who participate in a retirement plan.
marginal, but when coupled with a lower income base, the long‑term compounded effect can result in dramatically lower retirement account balances for women. In our study, the approximate median contribution for women was 43% less than for men and women’s median 401(k) balances were roughly one‑third of those of men.
Women are more likely to take time out of the workforce when starting a family or for caregiving responsibilities. To manage competing priorities and gain flexibility, they may also alter their career paths or work reduced hours. This loss of income and retirement benefits— such as employer match contributions— and the disruption in plan participation can contribute to the gender retirement savings gap.
Lower Income Has Lead to Lower Contributions and, Eventually, to Lower Balances
(Fig. 6) The compounding impact of lower contributions is significant.
Source: T. Rowe Price
and Spending Study, 2022. Numbers shown are the medians.
Women Generally Have Shorter Job Tenures Than Men
Shorter Job Tenures Can be an Impediment for Women
Relatedly, our research also shows that female participants have shorter job tenures (median of six years) than their male counterparts (median of eight years). In addition, only 10% of male participants have a tenure of one year or less compared with 17% of female participants.
Shorter tenures can result in lower retirement savings in a number of ways. Plans have varying vesting rules, and those without immediate vesting can deny some portion of employer contributions to employees with shorter
More Women Held Debt in Almost Every Category
tenures. Also, participants who change jobs after a short stint with an employer usually have smaller balances and might be more inclined to cash out their savings, even if that incurs a penalty. Additional research is needed to see if female participants are more likely to cash out.
Women Carry a Higher Debt Burden
For many participants, paying off debt is a high financial priority that competes with retirement saving. This is particularly true for women. Our analysis found that more women than men held debt across all categories except for home equity loans (Figure 8).
Women Men
Source: T. Rowe Price Retirement Savings and Spending Study, 2022.
Source: T. Rowe Price Retirement Savings and Spending Study, 2022.
Women Had Higher Outstanding Student Loans
(Fig. 9) Student loan debt could be hampering women’s ability to save
Source: T. Rowe Price Retirement Savings and Spending Study, 2022.
The disparity in student loan debt, in particular, is staggering. Among the surveyed participants, 14% of men and 23% of women reported that they had student loan debt—a difference of 60%.
Our analysis found that, except for those in Gen Z, women have higher outstanding student loan balances than their male peers (Figure 9). The outstanding balance increases progressively for millennials and Gen Xers before dropping for baby boomers. This could be partly because women tend to take out more in student loans and pay back less due to lower incomes.
The smaller payments and compounding interest charges on outstanding loan balances can increase loan balances over time, highlighting the need for assistance to those who are struggling with student loan debt. The recently passed SECURE 2.0 Act of 2022 (SECURE 2.0) legislation allows plan sponsors to adopt provisions
that match student loan payments in terms of retirement contributions and could give a boost to retirement savers, particularly women.
Less Savings Results in Less Wealth
Given these trends, it is not surprising that women on average are also less wealthy than men. Indeed, our analysis found that roughly one in four female retirement plan participants has a negative net worth, as calculated by total investable assets plus home equity less debt. In comparison, just over one in 10 men reported a negative net worth (Figure 10).
Additional research is also needed to understand the impact of caregiving and child‑care costs on retirement savings, particularly for women. Generally, women are disproportionately responsible for unpaid caregiving of loved ones, often prioritizing those responsibilities ahead of their careers.
Vast Gender Gaps Remain in Overall Wealth
(Fig. 10) One in four female participants reported a negative net worth versus one in 10 men
Source: T. Rowe Price Retirement Savings and Spending Study, 2022.
An estimated 59% of women provide 20 hours or less of unpaid care per week compared with 41% of men. The difference between male and female caregivers providing more hours of unpaid care is much greater: 62% of women provide more than 20 hours of weekly care compared with 38% of men.2
In addition, according to the latest Census (2021),3 single parents make up more than one‑quarter of all American family groups raising children under the age of 18, and 80% of these single‑parent households are led by mothers. It is therefore reasonable to assume that the steep costs of raising children are making it even harder for women in this demographic to adequately save for retirement.
How Can We Move the Needle?
To understand how we can help women close the savings gap, we asked them
Are Less Comfortable Making Investment Decisions
what challenges they face when it comes to saving and investing. While women are almost as comfortable as men making daily financial decisions, they are less comfortable making longer‑term financial planning decisions, particularly investment choices (Figure 11).
The disparity in women’s comfort level when selecting investments in a retirement plan account and determining how much to save for retirement was notable. This lack of confidence is problematic and could lead to actions that hamper successful retirement outcomes, such as under‑saving, untimely withdrawals, investing too conservatively, or other mistakes.
Some past studies have suggested that men and women might have different levels of risk tolerance and might invest differently. But to understand the differences in investing patterns of men and women in the age of auto‑enrollment
2 Amy Barger and Christina Best, “The State of Women and Caregiving.” https://www.caregiving.com/posts/women‑and caregiving‑2021
3 United States Census Bureau. 2021. America’s Families and Living Arrangements: 2021.
and qualified default investment alternatives (QDIAs), we need more careful analysis of participant investment behavior. All stakeholders—including plan sponsors, recordkeepers, and financial professionals—could then help female investors work toward their retirement goals.
Our research also found that women, particularly those with fewer assets, are less likely to hire or interact with a financial professional for help navigating their retirement journey. The least wealthy female participants—those with under $50,000 in household investable assets—were also less inclined to leverage workplace advice resources and mostly relied on guidance from friends and family (Figure 12). This could be an opportunity for plan sponsors and recordkeepers to promote the financial tools and resources. Promotional messages can help with participant engagement by making the tools and
Women Engaged Less With Plan‑Provided Resources
resources accessible, user‑friendly, and less intimidating.
We also found that the financial needs of women are not uniform, and they value different employer‑provided products and services (Figure 13). Generally, women earning less than $40,000 had a higher need for products and services that help them with building emergency savings, investment education, and student loan repayment. At higher income levels, the preference for these employer‑provided tools and services did not vary significantly between genders.
Overall, the workplace remains an important source of advice for retirement savers. We believe that this provides a great opportunity for employers and recordkeepers to engage with women and provide guidance that can help to improve the financial wellness for female participants who may be reticent about seeking guidance.
(Fig. 12) The least wealthy women were less likely to leverage workplace financial tools and resources
Men
of Participants Who Rely on Each Source “Somewhat” to “Great Deal”
Source: T. Rowe Price Retirement Savings and Spending Study, 2022.
Women
Women’s Financial Needs Are Not Uniform
(Fig. 13) Income influenced what products and services women wanted from their employers
% of Participants Who Think Services Offered Through Employer Are “Somewhat” to “Very Important”
Source: T. Rowe Price Retirement Savings and Spending Study, 2022.
What Can Employers and Financial Professionals Do to Close the Gap?
To be sure, the savings gap between men and women is attributable to various complex factors, which may not be completely addressed by employers or financial professionals. But these stakeholders can help narrow the gap by addressing the unique needs of the female workforce.
Statistically, women are more likely to live longer than their male counterparts, more likely to take on unpaid caregiving, and they typically share more responsibilities of child rearing. By understanding these unique needs, recordkeepers, plan sponsors, and financial professionals can help women become more comfortable with financial decisions and take actions to help to close the gender savings gap.
Design Benefit Programs to “Lift All Boats”
Adoption of auto‑features such as auto‑enrollment, auto‑reenrollment, auto‑escalation, and QDIAs could nudge all employees into saving more and help women, in particular, increase contribution rates and gain comfort in their investment decisions. Innovations such as out‑of‑plan emergency savings or debt management programs could help boost retirement savings for women. Similar in‑plan innovations such as matching retirement contributions for student loan debt repayments or setting up an emergency savings program to prevent untimely withdrawal of retirement savings are also now possible due to the recently passed SECURE 2.0 legislation.
Bolster Financial IQ to Improve Behavior
Our research shows that the workplace remains the primary source for accessing educational tools and financial guidance. Employers enjoy a unique trust, which could be utilized to deliver personalized communications or interventions that help employees understand the consequences of their actions, such as lowering or stopping contributions or taking loans, while encouraging them to build up emergency savings, pay down high‑interest loans, and start saving early for retirement.
Use Plan Data and Research to Improve Outcomes
Employers should focus more on analyzing plan data to understand their participants’ behavior and who is falling behind. If the data are available, this could include analyzing the savings behavior of different segments of participants, such as women, racial minorities, different income groups, and so on. Employers could also compare their participants’ savings with industry or national benchmarks. This will not
only give them a better idea about where their participants stand but could also provide some guidance about their competitiveness as an employer.
Utilize Platforms Outside of Retirement Plans to Foster Organic Discussions
These days, many companies, particularly the larger ones, have business resource groups (BRGs) formed around employees’ personal interests or characteristics. Moreover, many firms have BRGs focused on challenges facing women in the workplace. Having retirement preparation conversations under the umbrella of BRGs could be very useful. BRGs can drive less formal and more personal discussions, which can often give employers ideas about what their employees are struggling with and how to help them. They can also be used to promote the underutilized financial tools and services that the employers provide as voluntary benefits. Suggestions coming from fellow coworkers could make an impactful difference.
Retirement Savings and Spending Study
The Retirement Savings and Spending Study is a nationally representative online survey of 401(k) plan participants and retirees. The survey has been fielded annually since 2014. The 2022 survey was conducted between June 24 and July 22. It included 3,895 401(k) participants, full‑time or part‑time workers who never retired, currently age 18 or older, and either contributing to a 401(k) plan or eligible to contribute and have a balance of $1,000+. The survey also included 1,136 retirees who have retired with a Rollover IRA or left‑in‑plan 401(k) balance. NMG Consulting conducts this annual survey on behalf of T. Rowe Price.
This research is a continuation of the first theme of Access and Adequacy that is discussed in our 2023 Retirement Market Outlook. This theme focuses on who under‑saves and why, as well as who can help and how. For more details, our retirement market outlook can be accessed here: https://www.troweprice.com/retirement plan services/en/insights/retirement market outlook.html
T. Rowe Price focuses on delivering investment excellence and retirement services that institutional, intermediary, and individual investors can rely on—now and over the long term.
To learn more, please visit troweprice.com/retirementUS.
Important Information
This material is provided for general and educational purposes only and is not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision‑making.
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The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
Kobby Aboagye is an investment quantitative analyst in the Multi-Asset Division. He is an assistant vice president of T. Rowe Price Associates, Inc.
Kobby has been with T. Rowe Price since 2021, beginning in the Multi-Asset Division. Prior to this, Kobby was employed by American Air Liquide, a global industrial gas company, as a senior research scientist in the Computational and Data Science Group. In this role, Kobby explored and developed new algorithms for Air Liquide to procure energy (electricity and natural gas) efficiently and optimally, in both the physical and financial markets. Kobby also modeled the health impact of COVID-19 in the Americas and, collaborating with researchers from the University of Washington, built a statistical model to predict the excess demand in oxygen for ventilators. Kobby also was employed by PricewaterhouseCoopers as an accountant in the auditing line of business, where he led medium-risk audit projects in a variety of sectors including banking, energy and mining, and telecommunications.
Kobby earned a B.Sc. in statistics and actuarial science from KNUST in Ghana and an M.Sc. and a Ph.D. in operations research from Princeton University.
Sébastien Page, CFA
Sébastien Page is Head of Global Multi-Asset and Chief Investment Officer. He oversees a team of investment professionals dedicated to actively managing a broad set of multi-asset portfolios representing more than $485 billion1 in assets, including the firm’s target date franchise. He is a member of the Asset Allocation Committee, which is responsible for tactical investment decisions across asset allocation portfolios, and a member of the Management Committee of T. Rowe Price Group, Inc.
Sébastien’s investment experience began in 2000, and he has been with T. Rowe Price since 2015. Prior to this, Sébastien was employed by PIMCO as an executive vice president where he led a team focused on research and development of multi-asset solutions. Prior to joining PIMCO in 2010, he was employed by State Street Global Markets as a senior managing director.
Sébastien earned a Master of Science degree in finance and a bachelor’s degree in business administration from Sherbrooke University in Quebec, Canada. He also has earned the Chartered Financial Analyst® designation.
Sébastien coauthored award-winning research papers for The Journal of Portfolio Management in 2003, 2010, 2011 and 2022 and the Financial Analysts Journal in 2010 and 2014. He is the author of the book “Beyond Diversification: What Every Investor Needs to Know About Asset Allocation” (McGraw Hill, 2020) and the coauthor of the book “Factor Investing and
Asset Allocation” (CFA Institute Research Foundation®, 2016). Sébastien is a member of the editorial boards of The Journal of Portfolio Management and the Financial Analysts Journal, and he is a member of the Board of Directors of the Institute for Quantitative Research in Finance (Q Group). He regularly appears in the financial media, including Bloomberg TV and CNBC and was recently named amongst the 15 Top Voices in Finance for 2022 by LinkedIn.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
Louisa Schafer, CFA, Ph.D.
Louisa Schafer is a quantitative analyst in the Multi-Asset Division.
Louisa has been with T. Rowe Price since 2016, beginning in the Investment Fellowship Program.
Louisa earned a B.A. in economics and business administration from American University in Bulgaria and a Ph.D. in economics from Louisiana State University. Louisa also has earned the Chartered Financial Analyst® designation.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
James Tzitzouris, Ph.D.
James Tzitzouris is the director of Research, Retirement in the Multi-Asset Division. He is a member of the Multi-Asset Steering Committee and a vice president of both the Retirement Funds and Target Funds series. Jim is a vice president of T. Rowe Price Group, Inc., and T. Rowe Price Associates, Inc.
Jim’s investment experience began in 1999 when he joined T. Rowe Price, beginning in the Fixed Income Division. He has been actively involved with the Investment Fellowship program at T. Rowe Price since its inception in 2006, serving as a rotational manager, interviewer, and key advisor.
Jim earned an S.B. in mathematics from the Massachusetts Institute of Technology and an M.S.E. and a Ph.D. in mathematical sciences from Johns Hopkins University. In addition to his responsibilities at T. Rowe Price, he held an appointment as lecturer in the Department of Applied Math and Statistics in the Whiting School of Engineering at Johns Hopkins University, where he regularly taught classes in mathematical finance and quantitative investments. He also helped to design the curriculum and degree requirements for the master’s degree in mathematical finance offered by that department.
Kobby Aboagye is a quantitative investment analyst at T. Rowe Price in Baltimore, MD. kobby.aboagye@troweprice .com
Sébastien Page is head of global multiasset and chief investment officer at T. Rowe Price in Baltimore, MD. sebastien.page@ troweprice.com
Louisa Schafer is a senior quantitative investment analyst at T. Rowe Price in Baltimore, MD. louisa.schafer@troweprice .com
James Tzitzouris is director of research, retirement at T. Rowe Price in Baltimore, MD. jim.tzitzouris@troweprice .com
Personalized Target-Date Funds
Kobby Aboagye, Sébastien Page, Louisa Schafer, and James Tzitzouris
KEY FINDINGS
n The authors argue in defense of target-date funds and suggest several ways to improve upon them now that recordkeeping technology has evolved.
n A utility-based model expands upon traditional target-date funds, making the life-cycle investing strategy more dynamic and personalized.
n Analysis supports a substantial potential gain in risk-adjusted retirement spending from the suggested improvements, especially when including dynamic spending rules.
ABSTRACT
The simplicity and regulatory protection (when used as a default investment) of target-date funds (TDFs) offer advantages to both employers and employees saving for retirement in defined-contribution plans. But despite their commercial success, TDFs have faced criticism. The authors review the attacks on TDFs, argue in defense of them, and build a model to accommodate important extensions to traditional TDFs: further personalization and dynamic allocations and spending. They estimate that the benefits of these improvements average an additional 5%–6% in annual, risk-adjusted spending.
Target-date funds (TDFs) may be the most successful investment product of all time. While many academics and practitioners love to hate them, there is no doubt that their simplicity and regulatory protection provide advantages to employers (plan sponsors) and employees who are saving for retirement (plan participants). In 2000, total assets under management (AUM) invested in TDFs stood at $5 billion. As of 2021, TDF AUM had reached a staggering $3.27 trillion.1
In the United States, as defined-contribution plans have grown, we have given individuals responsibility for portfolio construction. Individuals are presented with a menu of investment options, and they must choose how much to allocate to stocks versus bonds. Then, within each asset class, they must choose how much to allocate between different strategies and subasset classes. These choices aren’t easy to make for noninvestment professionals. Most people do not have the expertise required to make these investment choices. Would your surgeon ask you to perform surgery on yourself?
Most individuals do not make a choice. Those involved with defined-contribution plans in the United States know that inertia seems to be the most powerful force that
1 This number includes trusts (CITs). Source: Morningstar, “2023 Target-Date Funds and CITs Landscape,” repor t: https://assets.contentstack.io/v3/assets/blt4eb669caa7dc65b2/blt879461b1430db de5/6442b988398bc14b3cffe380/Target_Date_Landscape.2023.pdf
drives portfolio construction. The do-nothing, default option drives how individuals invest because they do not engage in the process.
For many years, the default was cash. But this default led to poor returns. If an individual has a long time horizon before retirement, it is hard to argue that cash is a good investment. In fact, it may be the worst choice. It is not even the “risk-free” choice, because cash needs to be reinvested along the way, at uncertain rates.2 We cannot predict the cumulative return for cash over multi-year horizons. In theory, the “safest choice” is a long, inflation-protected bond that delivers cash flows that match what we want to spend in retirement. Such an asset does not exist, but long bonds are typically used as a proxy. Long bonds are also a suboptimal choice, however, when individuals are underfunded (and they cannot afford risk-free).
Stocks can deliver a higher compound rate of return over time, but they also expose investors to significant short-term losses. How much should individuals allocate to stocks throughout their life cycle? This key portfolio construction decision affects investment outcomes perhaps more than any other decision.
Following the Pension Protection Act of 2006 (PPA), plan sponsors can automatically enroll employees for monthly contributions to their retirement plan. They can use a multi-asset fund as the default option. These measures make inertia work in favor of employees. They can opt-out or change their asset allocation, but if they do nothing (which is often the case), they automatically get exposure to a diversified portfolio with a healthy allocation to stocks. TDFs are a popular default option in great part because they are designated by the Department of Labor as one of the so-called qualified default investment alternatives (QDIAs). TDFs starts with a high allocation to stocks when the employee (or “plan participant” in defined-contribution jargon) is early in their career and gradually shift from stocks to bonds as they approach retirement (the glide path). Participants are assigned a TDF vintage based on their retirement date.
TDFS HAVE DETRACTORS
Despite (or perhaps because of) their commercial success, arrows have been shot at TDFs. The four most common critiques are the following:
1. The downward glide path is not optimal.
2. TDFs are not well diversified.
3. Adaptive strategies deliver better outcomes.
4. TDFs are not personalized.
The Downward Glide Path Is Not Optimal
Detractors across academia and industry argue that there are better ways than a TDF to invest across one’s life cycle. Credible research suggests that an inverse glide path—in which the allocation to stocks rises rather than decreases as the employee approaches retirement—produces better outcomes than traditional, downward-sloping glide paths (see Arnott, Sherrerd, and Wu 2013; Estrada 2014). Other research suggests that glide paths should have flexible shapes, including a peak, with rising then declining allocation to stocks (Mindlin 2016); a trough, with declining then rising allocation to stocks in retirement (Pfau and Kitces 2013; Pfau 2017); or a flat section in retirement (Cohen 2010). In an article with the provocative title “The False Promise
2 For an intuitive description of how to think about the risk-free rate as a function of your time horizon, see Allison Schrager’s book An Economist Walks Into a Brothel and Other Unexpected Places to Understand Risk (Penguin Random House, 2019).
of Target Date Funds,” Esch and Michaud (2014) even suggest that maintaining a fixed stock/bond allocation throughout the life cycle may be a superior to any glide path. The limit appears to be one’s imagination when it comes evaluating glide path success and ipso facto what an optimal glide path should look like.
TDFs Are Not Well Diversified
Others maintain that most TDFs deliver too much equity risk (Dhillon, Ilmanen, and Liew 2016). Private equity firms continue to lobby to get into 401(k) plans, arguing they can provide the needed diversification (Schoeff 2020; Ramsey 2022), although some might take issue with this claim (see, for example, Page 2020). Detractors often shoot this “too much equity risk” arrow at TDFs following market crashes. Following the financial crisis of 2008–2009, the SEC held public hearings on TDFs, asking, essentially, whether they were too risky.3 Zvi Bodie (2021) argues that stocks are riskier in the long run than most people think. He claims that the “fallacy” of time diversification has led to excessive risk-taking in defined-contribution and defined-benefit plans. Bodie has even gone so far as to suggest that most individuals should ignore the siren call of high stock returns and instead invest 100% of their retirement savings in a TIPS portfolio, to safely match their retirement spending goal. For unfunded individuals who would otherwise rely on stock returns for wealth accumulation, this type of advice must lead to larger contributions or lower expectations.
Adaptive Strategies Deliver Better Outcomes
The third critique targets the precooked—that is, deterministic—nature of the glide path. Shouldn’t we adjust the glide path to the market environment?4 Or, a related question, shouldn’t asset allocation change as a function of the individual’s financial position? Yoon (2010) suggests a dynamic strategy that responds to prevailing market risks. Sharpe (2010) proposes an adaptive strategy that reacts to the relative size of the stock and bond markets in the market portfolio. Basu, Byrne, and Drew (2011) adjust the asset mix based on cumulative portfolio performance relative to a set target. They conclude that “the dynamic allocation strategies exhibit almost stochastic dominance over strategies that unidirectionally switch assets without consideration of portfolio performance.” Kobor and Muralidhar (2020) propose an extension of this strategy, focusing on funded status relative to a retirement income goal. Similarly, Forsyth and Vetzal (2018) introduce adaptive strategies that consider the individual’s accumulated wealth and argue that “investors are not being well served by the strategies currently dominating the marketplace.”
TDFs Are Not Personalized (Enough)
While they automatically adjust portfolio risk exposure based on the individual’s age (or more precisely, the individual’s time to and since retirement), detractors argue that within a given age cohort, TDFs should be further personalized (see, for example, Tang and Lin 2015; Janssen, Kramer, and Boender 2013; Drew and West 2021; Duarte et al. 2022). It is common knowledge that an individual’s risk tolerance depends on a lot more than their age. Turner and Klein (2021) provide a succinct review of the
4 To clarify, TDFs are “dynamic” in that the stock/bond mix changes over time. Also, many TDF managers implement tactical asset allocation around the glide path to take advantage of transitory relative valuation opportunities. But tactical decisions rarely deviate more than 5% or 10% from the target glide path.
literature on the importance of such factors as wealth, income, education, race, gender, and personality. There is even a strand of research that correlates hormone levels, such as testosterone and cortisol, to risk tolerance (Nofsinger, Patterson, and Shank 2018). But much of the needed data for personalization are not readily available. Individuals may find blood tests and personality tests somewhat invasive. More practically, Li and Webb (2012) focus on the participant data that are available to the employer. They introduce three additional data fields, beyond an individual’s retirement date: salary, savings rate, and plan balance. The recordkeeper can provide these data; hence, engagement from the individual is not required. They conclude that such “semi-personalized TDFs generally outperform the one-size-fits-all fund by more closely matching an optimal portfolio.”
Such arrows have been shot at TDFs from the ivory tower for over a decade, yet the giant is still standing. Detractors have been asking the following question: “Your product works in practice, but does it work in theory?” In the real world, one in which employees are not investment professionals and employers prefer to focus on their core business, simplicity confers tremendous advantages to TDFs.
IN DEFENSE OF TDFS
The benefits of TDFs become more obvious if we compare them with the real-world alternative of self-allocated portfolios in 401(k) plans, rather than theoretically superior alternatives. Mitchell and Utkus (2022) explain that the adoption of TDFs has led individuals to hold more age-appropriate portfolios. They show that many non-TDF investors hold too little in stocks when they start their career or too much at retirement. There is a debate on the optimal shape of the glide path, but it is hard to argue that an 80% or higher allocation to cash for someone in their early 20s or an 80% or higher stocks allocation for someone near retirement are appropriate allocations. Yet one recordkeeper confirmed that such allocations are surprisingly frequent for individuals who do not use TDFs. The same recordkeeper also explained that non-TDF investors are more likely to panic and sell stocks at the bottom rather than stay the course during a crisis.5 Mitchell and Utkus add that TDFs have “curtailed cash and company stock holdings and reduced idiosyncratic risk” and conclude that “the adoption of low-cost target-date funds enhance retirement wealth by as much as 50% over a 30-year horizon.”
Regarding the debate on the shape of the glide path, it’s common sense that individuals become more risk-averse as they approach retirement. With decades to go until retirement, most young professionals are willing to tolerate the month-to-month volatility of stocks in exchange for a higher long-term expected return. But as they approach retirement, they become less willing to put money at risk. Large losses could mean a delayed retirement. Besides, those approaching retirement have larger account balances, such that a given percentage loss means a larger dollar loss than earlier in their life cycle.
Beyond common sense, the downward-sloping glide path stands on solid theoretical foundations. Decades of research on utility theory and hundreds of articles on life-cycle investing support the downward-slop glide path, going as far back as Samuelson (1969) and Merton (1969). The implications of Samuelson (1969) are reinforced two decades later in Samuelson (1989):
The capitalized (present discounted) value of [my] human capital declines as I age and as my time to retirement shrinks. Therefore, if I hold equities in constant fraction of my total wealth—defined as portfolio wealth plus
5 Source: T. Rowe Price. Data available upon request.
human capital—my observed fraction in equities will be seen to decline rationally with age.
Merton (1971) also concludes that the allocation to stocks should be high when human capital is abundant (i.e., early in life) and that it should decrease over time. Here, the assumption is that human capital is bond-like rather than equity-like, which can be debated (Page and Tzitzouris 2016). But ultimately, almost all serious life-cycle research points to the downward-sloping glide path. Researchers have kicked the tires on its theoretical foundations in a variety of ways, for example, introducing nuances such as habit formation (Lax 2002), flexible labor supply (Gomes, Kotlikoff, and Viciera 2008), international evidence from 17 countries (Pfau 2011), advances in stochastic optimal control (Konicz, Karolina, and Weissensteiner 2016), investor behavior (Fagereng, Gottlieb, and Guiso 2017), and the inclusion of annuities (Shoven and Walton 2023). Despite all this tire-kicking, the downward-sloping glide path still stands as theoretically superior to alternative strategies proposed by TDF detractors, such as the upward-sloping glide path. And, as mentioned, it dominates all other alternatives in terms of adoption by plan sponsors. One might argue that most plan sponsors adopt a downward-sloping glide path merely because of regulatory considerations. Plan sponsors do not want to stray from regulatory guidance and standard industry practice because they fear lawsuits from participants. However, recent research shows self-directed participants’ risk aversion increases with age as well (Egan, MacKay, and Yang 2023). Hence, the downward-sloping glide path occurs naturally, “in the wild.”
As for the argument that TDFs aren’t well diversified, it depends on the provider, but a quick look at publicly available information from various TDF managers reveals that these portfolio are indeed well diversified across domestic and international markets, style and size (value and growth, small and large), and credit asset classes (core bonds, high yield, international bonds).The only asset classes that are not typically included are illiquid alternatives, such as private equity, due to liquidity constraints on the defined-contribution plan platforms.
The related question as to whether equity risk is too high in TDFs is more difficult to debate because it also relates to risk tolerance and, ultimately, to how the life-cycle investing model is constructed. The credible research that supports a downward-sloping glide path also generally supports a high allocation to stocks or the “risky asset,” especially early in one’s career. The reality of capital markets is that equity risk is difficult to diversify away (see, for example, Page 2020). And the reality of life-cycle investing is that most individuals need a healthy compound rate of return because they either do not earn or save enough (or both) to meet their retirement goals.
OUR CONTRIBUTION: AN ADAPTIVE AND PERSONALIZED TDF STRATEGY
While the optimality of the downward glide path and the level of diversification in TDFs can be debated, prior research offers more of a consensus that adaptive and personalized strategies can improve the investor’s lifetime experience. We propose to extend TDFs by adding these two features and thereby address critiques #3 and #4 from the earlier discussion. Recent advances in personalized accounts—so-called managed accounts—on 401k platforms make these improvements possible.
Like Li and Webb (2012), our model uses data from the recordkeeper, thereby eliminating the need for the individual to engage in the process (401(k) participants have extremely low engagement levels). Our personalized TDFs can be used as a
qualified default, like traditional TDFs. And for participants willing to engage, our model accepts detailed user inputs, for example, on their risk tolerance and any assets they might own outside of the 401(k), including their spouse’s assets.
Our key contribution is to introduce a novel, multi-attribute utility function that incorporates the individual’s aversion to deplete wealth. To set the stage, let us ask the most basic of questions: What goal are we trying to achieve when we design a TDF strategy?
The answer is far from obvious. “To make the most money” ignores risk. “To maximize my pot of money at retirement, while controlling for risk” ignores what happens after the investor retires. Besides, how should we define “risk”? Is it the month-to-month volatility of the investment portfolio? Or is it the uncertainty around the size of the pot of money the individual can retire with? Or, perhaps, should it be the probability of not achieving the desired consumption level in retirement? But then, how do we account for consumption during the accumulation phase? No wonder Nobel laureate William Sharpe described life-cycle investing as the “nastiest, hardest problem in finance.”6
Ultimately, most investors want to maximize risk-adjusted consumption over their life cycle, from accumulation to decumulation … to death. Most of the studies we mentioned previously focus on this goal, starting with Merton (1969). In such classical utility functions, wealth is represented by a terminal value, what’s “leftover” for bequest motives. Our innovation is to also account for the fact that most individuals also derive utility (or satisfaction or security) merely from holding wealth along their journey. Consider how most retirees want to live off the income generated by their retirement savings, without touching the principal. Their desire to hold on to wealth often goes beyond lifetime consumption considerations, or the desire to leave an inheritance. They display an explicit reluctance to deplete wealth, even if that means consuming less. Hence, in our model, wealth provides intrinsic utility, beyond its traditional interpretation as the present value of future consumption.
What Is The Individual’s Goal?
Our study involves a set of models and simulations. To generate an adaptive and personalized glide path, we solve for the optimal allocation to stocks and bonds that the individual should hold at any point in time. We simultaneously optimize consumption decisions, which allows us to provide spending advice, should it be needed. Here, we begin with our answer to the question: What goal is the individual is trying to achieve? In any period indexed by t = 1, …, T, we denote an investor’s investment balance by bt, current period income by y t, consumption by ct, and allocation to equity by w t. We use a multi-attribute utility function. We optimize the individual’s lifetime experience based on these basic preferences:
1. The individual wants more lifetime consumption,
2. She wants to hold more wealth along the way,
3. She wants less risk around each of these objectives.
For some relative risk aversion coefficient γ> 1 and depletion aversion coefficient δ∈ (0,1), our single-period utility function is given by the following:7
7 This utility function was originally derived by James A. Tzitzouris; see SSRN: https://papers.ssrn .com/sol3/papers.cfm?abstract_id=4693176
This function is a composition of a constant relative risk aversion utility function (CRRA) and a Cobb–Douglas production function.
Our goal is to maximize the discounted expected aggregate utility over the investor’s lifetime. To that end, we seek to maximize
where
bt+1 = Rt · (bt + y t ct), y t+1 = Gt · y t,
subject to the following constraints:
0 ≤ wt, No short sales w t ≤ 1, No leverage
0 ≤ ct, Consumption is a positive number ct ≤ bt + y t Individual cannot consume more than their account balance
We include the discount factor β∈ [0,1] and the probability of being alive at the beginning of period t, denoted by pt ∈ [0,1]. We use standard mortality probabilities from the Society of Actuaries.8 T is the last year on the mortality tables (120th year).
It is important to distinguish the behavioral discount factor β from a traditional financial discount factor. The behavioral discount factor reflects an individual’s preference to consume more in the present rather than defer consumption to the future. In this sense, it reflects an investor’s impatience. In contrast, a financial discount factor reflects the interest or growth rate of an alternative investment. In this case, we are not discounting future cash flows but, rather, expected utility—future satisfaction. We assume stochastic processes denoted by Rtb ,and Rts describe the real returns of investment-grade bonds and the broad stock market, respectively, with ; y t denotes the real income (salary) received at the beginning of the period; and Gt is the stochastic real growth factor that governs the evolution of income between the current time period and the next.
The subscripts ct and w t under the Max operator indicate that we are solving for the asset allocation and consumption decisions simultaneously. Our framework applies to the individual’s entire lifetime, across their working years (accumulation) and retirement (decumulation). The challenge is that asset allocation and consumption are multi-stage decisions. The decisions the individual makes now will have an impact on their future decisions. Such problems must be solved by working backwards, from the future to the present. Hence, we use the Bellman equation to solve Equation (2), as shown in Appendix A.
While computationally intensive, this framework is straightforward: The individual earns a salary, saves part of it, and spends the rest. Their retirement account balance grows with accumulated savings and market returns. In retirement, the individual enters the so-called “decumulation” phase. Their salary goes to zero, but they earn other sources of income, such as pensions and Social Security. From a mathematical modeling point of view, there is nothing special about reaching retirement age.
8 This mortality information is available online: www.soa.org/resources/experience-studies/2014/ research-2014-rp/
The framework is the same, except that net savings typically turn negative.9 Such is the game of life.
Simulations
Because the individual invests in the face of risk and uncertainty, we must generate scenarios over which to maximize utility. Our scenarios represent 10,000 lifetime experiences for each participant. Our personalized asset allocation and consumption decisions represent the best risk-adjusted strategy at any point in time, given these scenarios and given the individual’s preferences as represented by the utility function. We combine the following three simulation models (data sources are given in Appendix B):
1. Economic scenario model. We generate scenarios for growth, inflation, and asset returns (stocks and bonds) using a standard Monte Carlo model. Each scenario is a random multi-period event, resulting from the realization of a sequence of stochastic shocks, propagated through time. The mathematical structure of the model enforces consistency between the variables. This simulation is calibrated to generate realistic forward-looking scenarios.
2. Salary model. Recordkeeping data reveal an individual’s current salary. From there, we simulate the future evolution of her salary. There are two components to this model. First, we project aggregate wages for the entire economy. We use the latest data available on the Aggregate Wage Index (AWI), published by the Social Security Administration, and generate the forward path, (3) where γ, ϕ, and π, are year-over-year rates for real economic growth, workforce growth, and inflation, respectively. Economic growth and inflation are imported from the economic scenario model simulation. We assume work force growth rate, ϕt, of 1% a year.10 Second, we add an idiosyncratic component (
(from recordkeeping and the salary model12), assumed retirement age, and starting age for Social Security benefits. The model replicates the intricacies of the Social Security Administration methodology. We model, in detail, how the cost of living adjustment (COLA), wage base, bend points, average indexed earnings, and ultimately, primary insurance amounts are calculated.13 As for taxes, we assume flat state and local combined effective tax rates. We account for FICA taxes and capital gains taxes. Of note, income taxes matter in the simulation, but for optimization purposes, a constant effective tax rate simplifies the computation.
The Experiment
Our goal is to evaluate the percentage utility gained from our personalized target-date strategy, compared with the industry standard glide path. We focus on the default approach, which means that we assume that the individual does not engage in the process. Our methodology expands easily to a wider range of inputs that could be provided by the individual, but for this experiment, we use recordkeeping data only.
We select 75,168 individuals with clean data from the recordkeeping database. By “clean,” we mean that all required data for the individual are available and their account balances are within a reasonable range. After switching jobs, many individuals have a very small account balance in their new 401(k). This situation occurs when the individual does not consolidate their old 401(k) from their prior employer. We can adjust small account balances to be more reasonable using population data and statistical shrinkage methodologies, but this topic is beyond the scope of this analysis. The information about each participant in the dataset is current age, employee deferral rate, employer match rate, current salary, and current account balance.
Using a managed account platform, the individual can input this information directly. The current ages of participants in the dataset span 25 to 70, and we further assume a default retirement age of 65 unless the individual is currently 65 or older, in which case we assume retirement age is their current age plus one (for example the retirement age will be assumed to be 67 for a 66-year-old participant). By default, we assume individuals take Social Security starting at retirement and abide by the required minimum distributions (RMDs), although these parameters can be modified. The choice of default retirement and Social Security ages in our simulation experiment is for simplicity, but if necessary, our model can accommodate nondefault ages.
For each of the 75,168 individuals, we simulate the personalized strategy along 10,000 multi-year paths (10,000 possible lifetime scenarios). We update the asset allocation or glide path once a month; hence, the strategy adapts to changes in account balance.14
RESULTS
Does personalization make a difference in the individual’s asset allocation, compared with a standard glide path? The following exhibits compare the distribution of
12 The salary model provides a simulation of historical salaries for each individual because these data are generally not available from recordkeepers, and many individuals switch companies, and thus recordkeepers, throughout their career.
13 For more details, see https://www.ssa.gov/oact/cola/Benefits.html. Part of the calculation for Social Security benefits requires the historical average salary over 35 years.
14 Note that we do not calculate a full glide path but, rather, an adaptive equity allocation given a state value. The state here is the ratio of wealth to income. The model generates a function that maps this ratio to an equity allocation for a given age cohort. Because the future state is stochastic, we never know with certainty what the allocation recommendations will be in the future.
EXHIBIT 1
Equity Allocations as a Function of Age
S&P Target-Date Glidepath
the percentage stocks allocations (versus bonds) across individuals, by age cohort (in increments of five years), with the industry-average glide path represented by the S&P Target-Date Glidepath, as of December 2022.
The boxplots graphically represent the distribution of stock allocation for participants in each age cohort. In Exhibit 1, we assume a medium risk aversion level, coupled with a low depletion aversion level for all participants. The spread in stock allocation at each age (while holding both risk aversion and depletion aversion fixed) highlights the fact that our model does indeed provide personalized allocation solutions based on each participant’s specific financial situation (current salary, current balance, deferral rate, and employer match).
In Exhibit 2, we fix the depletion aversion level at medium and rerun the simulation at three different risk aversion levels for participants: low (blue distribution), medium (red distribution), and high (green) distribution). This char t shows how the model provides personalization based on participants’ choice of preference parameters, in addition to and different from the personalization obtained from participants’ financial situation. The dispersion of the results for each level of risk aversion is narrower than in the prior chart, because here we use “centroids,” which we define as a cluster of statistically similar participants near the typical or “average” participant. We make this adjustment to avoid overlap in the distributions and illustrate the impact of risk aversion specifically.
EXHIBIT 2
Equity Allocations Using Centroids, as a Function of Age and Risk Aversion
Risk Aversion: Low, Medium High (wealth depletion aversion: medium)
25303540455055606570
Does Personalization Lead to Superior Outcomes?
Measuring the impact of personalization is not straightforward. If a custom suit fits you better, how do you quantify “better”? Thankfully, our utility model already defines “better” for each participant. In the following, we quantify the benefit of personalization compared with an off-the-shelf industry solution of using the S&P Target-Date Index glide path with a 4% spending rule. We also introduce an equity-matched glide path as a second benchmark, to control for the benefits of merely increasing allocations to stocks via personalization.
We call our figure of merit the equivalent supplemental pension (ESP), which we define as follows:
The hypothetical amount of nominal annual pension that would have to be granted to a participant so that the participant would be indifferent between the personalized solution (including dynamic spending rules) and the static alternative.
Indifference is achieved by choosing the level of pension such that the expected utility is equal for both the personalized solution and the alternative. The level of ESP is expressed as a multiple of the average of the participant’s salary over the final five years before retirement. In other words, ESP is the “risk-adjusted” extra annual spending that personalization provides.
For the benchmarks, the 4% rule means the retiree spends, throughout retirement, 4% of their balance at the beginning of retirement. This dollar amount is increased by inflation each subsequent year. In the event the targeted withdrawal amount is greater than the balance, the withdrawal is capped at the balance, and the balance is set to zero. Total consumption in a year is the withdrawn amount plus any permanent income (e.g., Social Security benefits).
EXHIBIT 3
Current Salaries
Panel B: Equity-Matched Glide Path with “4% Rule”
Our results hold broadly across a wide range of participants. However, for transparency and to make our results easier to interpret, our ESP simulations use a specific, common persona:
We assume the individual is currently 50 years old and expects to retire and take Social Security at 65.
The simulations are run until age 119 (the far end of the mortality table).
Age 85 is the planning horizon: We assume the probability of living until age 85 is 100%, with the mortality table governing the probabilities thereafter (conditional on living to 85).
The individual defers 9% of their compensation, and their employer match is 3%.
Their risk aversion is medium, and their depletion aversion is low.
Exhibit 3 shows substantial benefi ts to personalization compared with the S&P Glide Path and the equity-matched glide path with the 4% rule. Additional risk-adjusted spending (ESP) from personalization ranges from +3% to +9%, depending on the size of the participant’s balance and their salary. As an example, for a participant earning $90,000 with a balance of five times their salary at age 50, expected additional spending versus using the S&P Glide Path and the 4% rule is 7.3% of the average of their final 5 years of salary. The average benefit across assumed balances and salaries is 5%–6%.
CONCLUSIONS
Despite criticism, TDFs remain a popular choice among plan sponsors. Regulatory guidance supports their use as default (QDIA) in 401(k) pensions plans, and the downward-sloping glide path aligns with the natural risk aversion observed in self-directed participants as they age. We believe the next stage of evolution for TDFs will be to introduce further personalization beyond age only, including dynamic allocation and spending capabilities. To introduce these expanded capabilities, our model starts with same theoretical foundations used to develop popular TDFs. We expand the framework from age-based allocation to a broader range of participant data, including salary, balance, contribution and match rates, Social Security, risk tolerance, and more.
To measure the impact of personalization, we introduce the equivalent supplemental pension as a figure of merit, representing the hypothetical additional annual spending that personalization provides compared with industry benchmarks, such as the S&P Target-Date glide path with a 4% spending rule. Our results show that the benefit of a personalized target-date strategy over conventional industry practice could be substantial.
The next step in this evolution of TDFs will be to introduce retirement income solutions, including guarantees as needed. We believe our model is a stepping stone toward making retirement income solutions viable in defi ned-contribution plans.
Investment firms and insurance companies have tried for more than a decade to introduce annuities in-plan, often embedding them in awkward ways into TDFs, with limited success. The missing piece may be to first personalize TDFs, as suggested here. Further research should expand our utility framework to include annuities.
APPENDIX A
SOLVING THE UTILITY MAXIMIZATION PROBLEM
To solve the utility maximization problem from Equation (2), we convert the general concave nonlinear optimization problem to a dynamic program via the recursive Bellman equation. Before we proceed, let us simplify notation by defining
so that we have the Bellman equation and constraints given by
bt+1 = Rt · (bt + y t ct), y t+1 = Gt · y t, 0 ≤ w t, w t ≤ 1, 0 ≤ ct, ct ≤ bt + y t, and the following terminal value conditions are known: cT = bT + yT, vT (bT, yT) = uT (cT, bT + yT),
The functions v t (bt, y t) are the so-called value functions and are defined recursively through the Bellman equation. There is no terminal value for wT because there are no assets remaining to be allocated after consumption. Note that bt and y t are the state variables and ct and w t are both decision or control variables. So, for each choice of bt and y t we solve the optimization problem for ct and w t, thus obtaining the optimal policy functions cb y tt t * (, ) and wb y tt t * (, )
Model Variable
APPENDIX B DATA SOURCES
Start Date
End Date
Economics Scenario Model (data used for calibration of Monte Carlo simulation)
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Disclaimer
The views expressed are the authors’, are subject to change without notice, and may differ from those of other T. Rowe Price associates. Information and opinions are derived from sources deemed reliable; their accuracy is not guaranteed. This material does not constitute a distribution, offer, invitation, recommendation, or solicitation to sell or buy any securities; it does not constitute investment advice and should not be relied upon as such. Investors should seek independent legal and financial advice before making investment decisions. There can be no assurance that the projected or simulated results will be achieved or sustained. All investments involve risk.
ERISA Preemption: Foundation of Success
and Linchpin of
Future Innovation
Aline G. Haffner*
Since its enactment, the Employee Retirement Income Security Act of 1974 (ERISA)1 has enabled private employers to deliver valuable and innovative benefits to employees and their families.
ERISA’s authors had the wisdom and foresight to imbue the legislation with both protections and incentives 2 The linchpin of its success in preserving and promoting the employer-sponsored benefits system in this country has been ERISA’s preemption of state law. Its broad preemptive reach is fundamental to the survival and advancement of employer-sponsored retirement and welfare benefits. As the conference committee drafting the final bill recognized, and as has become increasingly apparent over the past fifty years, enabling employers to design and administer benefits tailored to their workforce needs, free from a patchwork of state regulation, affords a level of certainty that enables employers not only to maintain the status quo but also to design new benefits and implement them in novel ways that meet evolving business and workforce needs
Outside the collective bargaining context, employer-sponsored benefits are largely voluntary. Employers are not required to provide, or to continue providing, contributions to or benefit accruals under defined contribution or defined benefit retirement plans for their employees. Even under the Affordable Care Act,3 employer-sponsored health coverage is not required.
It can be easy to forget that, in a system grounded on employers’ voluntary provision of employee benefits, simply adding more rules for benefit plan design and administration does not necessarily protect workers or improve their benefits. Rather, incentivizing employers to innovate, to deliver benefits their employees will value and that are administrable by the employer and its service providers, is what sustains and advances our system of workplace benefits.
This paper (i) examines ERISA’s legislative history as a timely reminder of Congressional intent; (ii) considers the extent to which judicial decisions have delivered on ERISA’s goal of uniformity for multi-state employers; and (iii) cautions that a narrowing of ERISA’s preemptive reach will impair employers’ ability to maintain and improve the employee benefits American workers and their families have come to rely upon.
* Ali Haffner is Associate General Counsel, Senior, at Elevance Health, Inc. She received her J.D. from Cornell Law School and her B.A., magna cum laude, from Alfred University. Ms. Haffner has practiced, written about, and taught employee benefits law in multiple settings for nearly three decades. The views and opinions expressed herein are the author’s own and do not necessarily reflect those of Elevance Health or its affiliates. The author gratefully acknowledges Ira H. Goldman for inspiring her career in employee benefits law.
1 Employee Retirement Income Security Act of 1974, Pub. L. No. 93-406, 88 Stat. 829 (1974) (codified at 29 USC §§ 10011461).
2 Senator Harrison A. Williams, Jr., Foreword to the Legislative History of ERISA (page III) (“The new rules reflect a careful balance of incentives and controls designed by Congress to improve the equitable character of private plans while encouraging their future growth and development”).
3 Patient Protection and Affordable Care Act, Pub. L. No. 111-148 (2010) and Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152 (2010) [hereinafter, collectively, Affordable Care Act] (adding employer shared responsibility penalty for large employers that fail to offer medical coverage with minimum value and affordability standards to a requisite portion of their workforce, certain limited coverage mandates for group health plans, and additional mandates for insured coverage).
Congressional Intent
ERISA’s preemption of state law has its foundation in the Supremacy Clause of the United States Constitution.4 Pursuant to the Supremacy Clause, federal law will supersede, or preempt, state and local law, in three circumstances where an explicit statement by Congress so provides, where Congress has regulated so broadly over an entire subject matter as to leave no room for state regulation, and where state law conflicts with federal law 5 Both the statutory language of Section 514 of ERISA6 and its legislative history7 make clear that Congress intended to fully preempt the “field” of employee benefits, subject only to the narrowly stated exceptions set forth in Section 514(b) 8
ERISA’s policy objectives, which included uniformity for multi-state employers, did not arise in a vacuum. The Senate Committee on Labor and Public Welfare recognized that Congress’s previous foray into the employee benefits field, the Welfare and Pension Disclosure Act of 1958 (WPPDA),9 with its limited federal oversight and reliance on employee initiative and state regulation, had failed in its goals of protecting workers’benefits.10 With the benefit of hindsight, Congress worked for years on a new approach,11 culminating in a bill that addressed a broad range of substantive protections for pension benefits and fiduciary, reporting, disclosure, and enforcement provisions for
4 U.S. CONST. art. VI (“This Constitution, and the laws of the United States which shall be made in pursuance thereof shall be the supreme law of the land; and the judges in every state shall be bound thereby, anything in the Constitution or laws of any State to the contrary notwithstanding.”).
5 See, e.g., Jones v. Rath Packing Co., 430 U.S. 519, 525-526 (1977); Florida Lime & Avocado Growers, Inc. v. Paul, 373 U.S. 132, 142 (1963).
6 "[T]he provisions of this subchapter . . . shall supersede any and all State laws insofar as they may now or hereafter relate to any employee benefit plan described in section 1003 (a) of this title and not exempt under section 1003 (b) of this title." 29 U. S. C. § 1144 (a).
7 See, e.g., 120 Cong. Rec. 29,933 (1977) (statement of Sen. Williams) (explaining intent to “preempt the field for Federal regulations, thus eliminating the threat of conflicting or inconsistent State and local regulation of employee benefit plans”).
8 These exceptions are limited to laws that regulate insurance [see infra note 28 and accompanying text], banking, or securities; generally applicable criminal laws; the Hawaii Prepaid Health Care Act; insurance laws as applied to multiple employer welfare arrangements; qualified domestic relations orders as defined in ERISA; and certain actions in connection with state Medicaid plans. 29 U.S.C. §1144(b).
9 Welfare and Pension Plans Disclosure Act, Pub Law No. 85-836 (August 28, 2958).
10 See James D. Hutchinson & David M. Ifshin, Federal Preemption of State Law Under the Employee Retirement Income Security Act of 1974, 46 U. CHI. L. REV. 23, 29030 (WPPDA “plac[ed] primary responsibility for the policing and improved operations of these plans upon the participants and beneficiaries themselves, with a minimum of interference in the natural development and operation of such plans, reserving to the States the detailed regulations relating to insurance and trusts, and other phases of their operations” and was “weak in its limited disclosure requirements and wholly lacking in substantive fiduciary standards . . . rel[ying] upon the initiative of the individual employee to police the management of his plan”) (quoting H.R. Rep. No. 2283 (1958), as reprinted in 1958 U.S.C.C.A.N. 4181, 4189; S. Rep. No. 1150 (1972)).
11 The bill that ultimately became ERISA was a later iteration of bill sent to Congress by the DOL in 1967. JAMES A. WOOTEN, THE EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974: A POLITICAL HISTORY 118 (2004)
both pension and welfare benefits 12 But its “crowning achievement,”13 the means by which ERISA would succeed, and has in fact done so for the past fifty years, is its preemption provision.
This was by no means an accident ERISA’s legislative history is replete with statements evidencing the intended breadth of its preemption of state law and the recognition of its importance to the success of the overall statutory scheme. As described by Senator Harrison Williams, Jr., Chair of the Senate Committee on Labor and Public Welfare, “[t]his principle is intended to apply in its broadest sense to all actions of State or local governments, or any instrumentality thereof, which have the force or effect of law.”14
Support for a broad preemption provision was bipartisan. The Committee’s ranking Republican member, Senator Jacob Javits, explained why the Conference Report intentionally rejected narrower articulations of preemption (contained in the House and Senate bills and the Administration’s recommendations15), articulations that would have limited preemption to the explicit substantive areas regulated in ERISA:
Such a formulation raised the possibility of endless litigation over the validity of State action that might impinge on Federal regulation, as well as opening the door to multiple and potentially conflicting State laws hastily contrived to deal with some particular aspect of private welfare or pension benefit plans not clearly connected to the Federal regulatory scheme.16
Instead, Javits explained, the approach adopted in the Conference Report recognized that “a comprehensive and pervasive Federal interest and the interests of uniformity with respect to interstate plans required but for certain exceptions the displacement of State action in the field of private employee benefit programs.”17
In addition, perhaps as a means to reconfirm the Conference Committee’s approach, ERISA expressly called for post-enactment Congressional study of the effects and desirability of its preemption of state law.18 That study, in which “the ERISA experience to date was carefully and extensively explored,” including via multiple days of subcommittee hearings, culminated in a 1977
12 See H. REP. NO. 93-1280 (1974) (Conf. Rep.), reprinted in 3 SUBCOMM. ON LABOR OF THE S. COMM. ON LABOR AND PUBLIC WELFARE, 94TH CONG , LEGISLATIVE HISTORY OF THE EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974, at 4277-4654 (1976) [hereinafter LEGISLATIVE HISTORY OF ERISA].
13 120 Cong. Rec. 29,197 (1974) (statement of Rep. Dent), reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 4670. 14 120 Cong. Rec. 29,993 (1974), reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 4745-4746.
15 U.S. DEP’T OF THE TREASURY & U.S. DEP’T OF LABOR, ADMINISTRATION RECOMMENDATIONS TO THE HOUSE AND SENATE CONFEREES OF H.R. 2 TO PROVIDE FOR PENSION REFORM 107 (1974), reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 5047, 5145.
16 120 Cong. Rec. 29,933 (1974), reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 4770-4771. See also Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 98 (1983) (noting the House bill would have limited preemption to state laws “relat[ing] to the reporting and disclosure responsibilities, and fiduciary responsibilities, of persons acting on behalf of any employee benefit plan to which part 1 applies,” and the Senate bill, to those “relat[ing] to the subject matters regulated by this Act or the [WPPDA].”).
17 120 Cong. Rec. 29,942 (1974), reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 4670.
18 ERISA §§ 3022(a)(5), 3022(b); see also 120 Cong. Rec. 29,942 (1974) (statement of Sen. Williams), reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 4771
report,19 which expressly reconfirmed Congressional intent to broadly preempt state law and praising the outcome:
It is our understanding of this language that, with respect to regulation of the activities of certain employee benefit plans (those subject to ERISA jurisdiction), federal authority has been expressly extended to occupy the field to the exclusion of state authority, subject to certain exceptions Based on our examination of the effects of Section 514, it is our judgment that the legislative scheme of ERISA is sufficiently broad to leave no room for effective state regulation within the field preempted. Similarly[,] it is our finding that the Federal interest and the need for national uniformity are so great that enforcement of state regulation should be precluded.20
The report noted that litigation involving other provisions of ERISA was beginning to make its way to the courts.21 The preemption provision would soon face its reckoning in the courts as well.
U.S. Supreme Court ERISA Preemption Decisions Pre-Travelers
Early in its ERISA preemption jurisprudence, the U.S. Supreme Court recognized that the broad preemptive sweep of Section 514(a) was not limited to laws specifically directed at benefit plans 22 Although federal preemption “is not lightly to be presumed,”23 the Court was “assisted by an explicit congressional statement.”24 Concluding that ERISA preempted a New Jersey workers’ compensation law seeking to prohibit employers from reducing pension plan benefits by workers’ compensation payments, the Court reasoned that it was “of no moment that New Jersey intrudes indirectly, through a workers' compensation law, rather than directly, through a statute called ‘pension regulation,’” since the preemption provision applies to “a State, any political subdivision thereof, or any agency or instrumentality of either, which purports to regulate, directly or indirectly, the terms and conditions of employee benefit plans covered by this subchapter.”25
The Court echoed and expanded on this reasoning two years later in Shaw v. Delta Air Lines, Inc., turning again to ERISA’s statutory text and legislative history:
Congress used the words "relate to" in § 514(a) in their broad sense. To interpret § 514(a) to pre-empt only state laws specifically designed to affect employee benefit plans would be to ignore the remainder of § 514. It would have been unnecessary to exempt generally applicable state criminal statutes from pre-emption in § 514(b), for example, if § 514(a) applied only to state laws dealing specifically with ERISA plans. Nor, given the legislative history, can § 514(a) be interpreted to pre-empt only state
19 H. COMM ON EDUCATION AND LABOR, 94TH CONG., ERISA OVERSIGHT REPORT OF THE PENSION TASK FORCE OF THE SUBCOMMITTEE ON LABOR STANDARDS (Comm. Print 1977).
20 Id. at 9
21 Id. at 2.
22 See Alessi v. Raybestos-Manhattan, Inc., 451 U.S. 504 (1981)
23 Id. at 522 (quoting New York Dept. of Social Services v. Dublino, 413 U. S. 405, 413 (1973).
24 Id. (citing ERISA § 514(a), 29 U. S. C. § 1144(a)).
25 Id 525 (quoting, with added emphasis, ERISA § 514(c)(2), 29 U. S. C. § 1144(c)(2))
laws dealing with the subject matters covered by ERISA—reporting, disclosure, fiduciary responsibility, and the like.26
In Shaw, the Court also invoked the importance of ERISA’s goal of uniformity and the clarity of Congressional intent to support that goal. The Court outlined a dreary future for employersponsored benefit plans if employers were forced to navigate the legal frameworks of multiple states in the administration of their employee benefit plans:
[T]he inefficiency of such a system presumably would be paid for by lowering benefit levels reduc[ing] wages or eliminat[ing] those benefits not required by any State . . . [or] eliminating classes of benefits that are subject to state requirements. . . . ERISA's comprehensive pre-emption of state law was meant to minimize this sort of interference with the administration of employee benefit plans.27
In 1985, the Supreme Court tackled another preemption question, the answer to which may seem obvious today whether state law can require ERISA welfare benefit plans to provide particular benefits 28 This case required the Court to work through the (then) lesser-known subclauses of ERISA preemption, the “savings” clause29 and the “deemer” clause.30 The Court began with the threshold question of whether preemption was even appropriate in the welfare plan context, given that ERISA imposed various administrative and fiduciary requirements on both welfare and retirement plans but did not (at that time) regulate the substantive content of welfare plans 31 The Court concluded this presented no impediment to preemption. The Massachusetts law in question, requiring plans to cover certain mental health benefits, fell within the scope of ERISA § 514(a)’s preemption clause because Congress had “intended to displace all state laws that fall within its sphere, even including state laws that are consistent with ERISA's substantive requirements.”32
Having concluded the law Massachusetts fell within Section 514(a) of ERISA, the Court then considered whether it was “saved” from preemption under Section 514(b)(2)(A) as a law that regulates insurance. Noting a dearth of helpful legislative history on ERISA’s savings clause, the Court reasoned that the savings clause allowed the law’s application to insured plans, but the “deemer” clause preempted its application to self-funded ERISA plans:
We are aware that our decision results in a distinction between insured and uninsured plans, leaving the former open to indirect [state] regulation while the latter are not. By so doing we
26 Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 98 (1983) (citing H.R. 2, 93d Cong., 2d Sess., § 514(a) (1974), reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 4057-4058 (1976) (House-passed bill); H.R. 2 93d Cong., 2d Sess., § 699(a) (1974) reprinted in 3 LEGISLATIVE HISTORY OF ERISA at 4057-4058 (1976) at 3820 (Senate-passed bill)).
27 Id. at 105 n.25
28 Metro. Life Ins. Co. v. Mass., 471 U.S. 724 (1985).
29 ERISA § 514(b)(2)(A)
30 ERISA § 514(b)(2)(B).
31 Metro. Life Ins. Co. v. Mass., 471 U.S. at 732.
32 Id. at 740 (citing Shaw, 463 U.S. at 98-99)
merely give life to a distinction created by Congress in the "deemer clause," a distinction Congress is aware of and one it has chosen not to alter.33
Following its Metropolitan Life decision, the Court held that ERISA preempted a Georgia law intended to protect employees’ ERISA welfare plan benefits from state garnishment proceedings, holding that the law’s specific reference to ERISA plans brought it squarely within Section 514(a).34 The state’s motives were of no import; that Georgia’s intent aligned with ERISA’s goal of protecting and preserving employees’ benefits did not spare the law from preemption.35
ERISA’s preemption of state law thus enjoyed a wave of success, rounded out by decisions preempting state law where it would have prohibited a plan from enforcing subrogation provisions or provided litigants an alternative causes of action. The Court reasoned that allowing Pennsylvania to prohibit employee benefit plans from enforcing subrogation rights against ERISA plan participants located there would require plans to “calculate benefits based on expected liability conditions” that differ by state, thereby "frustrat[ing] plan administrators' continuing obligation to calculate uniform benefit levels nationwide."
36 ERISA preemption also precluded Texas from recognizing a state-law cause of action for wrongful termination based on allegations that the termination was motivated by the employer’s desire to avoid paying pension benefits a circumstance for which ERISA explicitly provides a cause of action.
37
Travelers and Its Progeny
Over time, distilling the Supreme Court’s growing body of ERISA preemption decisions into a discernable standard began to present a challenge, even for the Court itself. In 1995, the Court revisited its earlier articulation of ERISA preemption analysis, explaining that because its prior attempts to interpret the statute’s “relate to” phrase would prove unhelpful to any further linedrawing,38 the Court would“look instead to the objectives of the ERISA statute as a guide to the scope of the state law that Congress understood would survive.”39
33 Id. at 747.
34 Mackey v. Lanier Collection Agency & Serv., Inc., 486 U. S. 825 (1988). See also D.C. v. Greater Washington Bd. of Trade, 506 U.S. 125, 130 (1992) (striking down D.C. law that "specifically refers to welfare benefit plans regulated by ERISA and on that basis alone is pre-empted").
35 The Court simultaneously concluded that ERISA did not preempt the overall enforcement of state-law garnishment proceedings against ERISA welfare plan benefits. 486 U.S. at 829. Notably, however, the reasoning in this portion of the opinion differed from the Court’s usual preemption ERISA analysis because the Court discerned Congressional intent based largely on ERISA’s statutory text beyond the preemption provision: Congress’s explicit protection of pension plan benefits in ERISA’s “anti-alienation” provision (ERISA § 206(d), 29 U.S.C. § 1056(d)), coupled with the omission of such a provision for welfare benefits, evidenced an intent to allow state garnishment proceedings to apply to ERISA welfare benefits. 486 U.S. at 836-838.
36 FMC Corp. v. Holliday, 498 U. S. 52, 60 (1990).
37 Ingersoll-Rand Co. v. McClendon, 498 U.S. 133 (1990). See ERISA § 510, 29 U.S. Code § 1140). The Court noted its similar reasoning in Pilot Life Ins. Co. v. Dedeaux, 481 U.S. 41 (1987) (preempting claim based on state contract or tort law for improper processing of benefit claim under ERISA plan) and distinguished its holding in Fort Halifax Packing Co. v. Coyne, 482 U.S. 1 (1987) (upholding state law requiring severance payment because it did not require establishment of a plan and thus did not “relate to” an ERISA plan).
38 New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Ins. Co., 514 U.S. 645, 655 (1995).
39 Id. at 656.
The New York law at issue imposed a surcharge on hospital bills for patients covered by commercial insurance or self-funded plans, but not for patients with Blue Cross/Blue Shield coverage or Medicaid coverage. Commercial insurers and plan fiduciaries sought preemption of the surcharge law, and the Second Circuit agreed, finding it“interfered with the choices that ERISA plans make for health care coverage” in a way that had "an impermissible impact on ERISA plan structure and administration.”40
The Supreme Court, however, disagreed. The Court shared its analysis of ERISA’s legislative history, concluding “[t]he basic thrust”of ERISA’s preemption provision was “to permit the nationally uniform administration of employee benefit plans.”41 Against that backdrop, the Court summed up its earlier decisions as preempting state laws that sought to mandate particular benefit structures or administration or to provide alternatives to ERISA’s enforcement mechanisms. It drew a sharp contrast between those types of consequences and what it described as an “indirect economic influence”42 presented by New York’s surcharge law An indirect economic influence, the Court explained, does not force an ERISA plan to a particular coverage or purchasing decision, nor preclude uniformity in plan administration which the Court distinguished from cost uniformity.43 The Court conceded that Congress had indeed intended ERISA’s preemption to extend beyond those aspects of benefit plan design and administration directly addressed in ERISA, but nonetheless concluded that “nothing in the language of the Act or the context of its passage indicates that Congress chose to displace general health care regulation, which historically has been a matter of local concern.”44 Moreover, the Court cited its decision in Mackey as confirming this conclusion,45 notwithstanding that the Court’s upholding of Georgia’s garnishment regime in Mackey had been based largely on the specific context and presence of ERISA’s anti-alienation provision.46 But despite the Court’s holding, Travelers explicitly left open the possibility that, in a future case, a state law’s indirect economic effects might be so “acute as to force an ERISA plan to adopt a certain scheme of substantive coverage or effectively restrict its choice of insurers, and that such a state law might indeed be preempted under § 514.”47
At some point in the post-Travelers string of preemption cases, tedium must have settled in. The opening line of the Court’s 1997 opinion in DeBuono reads simply: “This is another Employee Retirement Income Security Act of 1974 (ERISA) pre-emption case.”48 The utter lack of enthusiasm is palpable.
40 Travelers Ins. Co. v. Cuomo, 14 F. 3d 708 at 719, 721 (2d Cir. 1994), rev’d, 514 U.S. 645 (1995)
41 Travelers, 514 U.S. at 657 (citing 120 Cong. Rec. 29,197 (1974) (comments of Rep. Dent) and 120 Cong. Rec. 29,933 (1974) (comments of Sen. Williams); see supra notes 13 & 16
42 Id at 659.
43 Id. at 662 (“In sum, cost uniformity was almost certainly not an object of pre-emption, just as laws with only an indirect economic effect on the relative costs of various health insurance packages in a given State are a far cry from those ‘conflicting directives’ from which Congress meant to insulate ERISA plans”) (citing IngersollRand Co. v. McClendon, 498 U.S. 133, 142 (1990))
44 Id. at 661 (citing Hillsborough County v. Automated Medical Laboratories, Inc., 471 U. S. 707, 719).
45 Id. at 662.
46 Mackey v. Lanier Collection Agency & Serv., Inc., 486 U. S. 825 (1988); see supra note 35.
47 Travelers, 514 U.S. at 668.
48 De Buono v. NYSA-ILA Medical & Clinical Servs. Fund, 520 U.S. 806 (1997)
Like Travelers, DeBuono involved financial measures adopted by New York—this time a gross-receipts tax on hospitals that had an effect on ERISA plans but did not specifically refer to them. Trustees of a multiemployer welfare fund that administers an ERISA welfare plan and owned and operated hospitals in the state sought preemption of the law, as applied to hospitals owned by ERISA plans. The Second Circuit had taken care to distinguish Travelers, reasoning that the tax (unlike the surcharge in that case) directly depleted the assets of the ERISA welfare fund and thus was a law that related to ERISA plans 49 The Supreme Court disagreed, however, describing its opinion in Travelers as having “unequivocally concluded” that ERISA’s "relates to" phrase was not intended to modify "the starting presumption that Congress does not intend to supplant state law."50 The Court explained the gross-receipts tax was a law of general applicability in an area traditionally regulated by the states and the Second Circuit had erred in making a false distinction between direct and indirect effects: The tax’s effect on the ERISA plan only appeared to be direct because the plan had chosen to deliver benefits by operating its own hospitals; had it chosen instead (as most plans do) to simply reimburse for services its participants obtained from third-party hospitals, the tax’s effect would have been indirect.51 The Court thus concluded the hospital tax was not preempted. Similarly, in a case challenging the apprenticeship provisions of a state prevailing-wage law, the Court held that the provisions “merely [provided] some measure of economic incentive” and thus were not preempted from applying to an ERISA-governed apprenticeship program.52
Despite Travelers’ rearticulation and arguable narrowing of the “relates to” language, the Court continued to recognize the preemption of state laws involving what it recognized as ERISA’s core areas of ERISA concern even when they butted up against traditional spheres of state authority. In Boggs v. Boggs, the Court considered an issue “at the intersection of ERISA pension law and state community property law.”53 Acknowledging the “ancient lineage” of such laws and their
49 NYSA-ILA Medical and Clinical Services Fund v. Axelrod, M. D., 74 F. 3d 28, 30 (2d Cir. 1996), rev’d sub nom. De Buono v. NYSA-ILA Medical & Clinical Servs. Fund, 520 U.S. 806 (1997)
50 De Buono, 520 U.S. at 813 (citing Travelers, 514 U.S. at 654).
51 Id. at 817.
52 Cal Div. of Labor Standards Enforcement v. Dillingham Constr., N. A., Inc., 519 U. S. 316 (1997)
53 Boggs v. Boggs, 520 U. S. 833 (1997). This one gets interesting. Just parsing the vote count presents a challenge: “Justice Kennedy delivered the opinion of the Court, in which Justices Stevens, Scalia, Souter and Thomas joined and in which Chief Justice Rehnquist and Justice Ginsberg joined only as to Part III. And Justice Breyer filed a dissenting opinion, in which Justice O’Connor joined, and in which Chief Justice Rehnquist and Justice Ginsberg joined.” To translate, seven Justices held that ERISA preempted Louisiana’s community property law from reaching a survivor annuity being paid from the deceased participant’s defined benefit pension plan to his surviving (second) wife, to whom he was married when the annuity commenced. The context was an attempted testamentary transfer by the participant’s (predeceased) first wife to their sons, of her purported community property interest in the participant’s benefits. The Court reasoned that recognizing the interest asserted by the sons would directly conflict with both the text and purpose of ERISA § 205 (29 U.S.C. § 1055), which requires such benefits to be paid as a qualified joint and survivor annuity to the participant and then-spouse, unless the spouse otherwise consented in writing to the plan. Five of the seven held that ERISA also preempted the sons’ similar claims to an interest in ERISA retirement benefit payments their father had received during his lifetime, but after their mother’s death. Since these payments included defined contribution plan benefits to which ERISA § 205 does not apply, this narrow majority reasoned, under the Court’s “relates to” analysis, that ERISA’s anti-assignment language and express exception for “qualified domestic relations orders”(QDROs) evidenced Congress’s intent to establish ERISA’s QDRO process as the sole means to transfer an interest in ERISA benefits. (Among the four dissenting justices, two agreed with the ERISA § 205 analysis as to the survivor annuity, and two would have held that that ERISA did not preempt even that claim because the
role in “implement[ing] policies and values lying within the traditional domain of the States,” the Court nonetheless concluded that, to the extent these regimes would permit the transfer of an interest in a spouse’s ERISA pension plan benefits, they conflicted with ERISA and thus were preempted 54
Similarly, Egelhoff v. Egelhoff55 addressed a Washington state law requiring pension, life insurance, and other ERISA plans to automatically revoke a spousal beneficiary designation upon divorce Despite its foundation in two traditional areas of state regulation family law and probate law 56 the law bore an impermissible connection to ERISA plans. By dictating to whom a plan fiduciary must pay plan benefits, the law both implicated a “core ERISA concern” and interfered with nationally uniform plan administration.57 As applied to ERISA plans, it thus fell squarely within Section 514(a)’s preemptive reach.
Recent Cases Involving State Regulation and Plan Service Providers
The struggle between state regulation and ERISA preemption has made its way to third-party service providers of ERISA plans. In the health plan context, a third-party administrator (TPA) or pharmacy benefit manager (PBM) is often contractually engaged as an agent of the ERISA plan administrator, to implement plan design and carry out designated functions of plan administration for a self-funded ERISA welfare benefit plan. The question is whether Section 514(a) of ERISA preempts the application of state laws seeking to regulate these third-party entities in connection with the services they provide to ERISA plans
In Gobeille, 58 the Court held that ERISA preempted, with respect to TPAs servicing selffunded ERISA health plans, the application of a Vermont law requiring the reporting of certain health care claim payment information to a state database The Vermont law imposed these reporting requirements on health insurers, health care providers, health care facilities, and governmental agencies, and it defined “health insurers” to include administrators of self-funded health plans.59 Even though the law invoked the state’s traditional power of public health regulation, the Court ruled it was preempted with respect to self-funded ERISA plans 60 As in Egelhoff, 61 the law’s implications for reporting and recordkeeping intruded upon “a central matter of plan administration” and “interfere[d] with nationally uniform plan administration.”62 The Court made clear that because the sons’ request for an “accounting” of their mother’s purported community property interest in the survivor annuity should have been granted if Louisiana law would permit the claimed interest to be settled via other assets of the estate.)
54 Id. at 840-841.
55 Egelhoff v. Egelhoff, 532 U.S. 141 (2001).
56 Id at 151.
57 Id. at 147.
58 Gobeille v. Liberty Mut. Ins. Co., 577 U.S. 312 (2016).
59 Vt. Stat. Ann., Tit. 18, §§ 9410(c), 9402(8) (2015 Cum. Supp.) (V. S. A.). Although the employer challenging the law had fewer plan participants in Vermont than the law’s 200-person threshold to trigger reporting, its TPA far exceeded the threshold due to servicing other plans and individuals in the state, and thus would be required to report the information it held about the employer’s plan participants in Vermont. 577 U.S. at 317.
60 Gobeille, 577 U.S. at 325 (“ERISA pre-empts a state law that regulates a key facet of plan administration even if the state law exercises a traditional state power.” (citing Egelhoff, 532 U.S. at 148)).
61 See supra notes 55-57 and accompany text.
62 Gobeille, 577 U.S. at 323.
notion of reporting is simply one of those long-recognized, core areas of ERISA concern, it did not matter whether Vermont’s reporting law addressed a different objective than ERISA’s reporting regime, whether the datapoints to be reported paralleled, overlapped, or conflicted with those of ERISA, or whether complying with the law would actually result in any economic burden for ERISA plans.63
Four years later, the Court decided a case that, in terms of its ultimate impact on ERISA plans, might seem difficult to reconcile with Gobeille But the Court did not depart from Gobeille, Egelhoff, or Shaw; it acknowledged these earlier holdings, including its statement in Gobeille that ERISA will preempt state law where “acute, albeit indirect, economic effects of the state law force an ERISA plan to adopt a certain scheme of substantive coverage.”64 On the specific facts at issue in Rutledge, however, the Court held that such acute effects did not exist and thus an Arkansas law imposing certain financially targeted restrictions on a PBM’s interactions with dispensing pharmacies was not preempted as applied to PBMs servicing ERISA health plans The Arkansas law at issue: (i) required PBMs to reimburse pharmacies in an amount at least equal to the pharmacy’s acquisition cost of the dispensed drug, (ii) established an appeal process for pharmacies to challenge PBM reimbursements, and (iii) permitted a pharmacy to decline to fill a prescription if the expected PBM reimbursement would be below the pharmacy’s acquisition cost. The Court reasoned that because the law’s imposition of these requirements on PBMs was“merely a form of cost regulation,” Travelers dictated the outcome.65
The Rutledge Court reached this result after characterizing PBMs as “intermediaries” between health plans and the pharmacies their plan participants use to fill prescriptions, where the amount the PBM pays a dispensing pharmacy for a prescription fill is set by contract between the PBM and the pharmacy and the amount a health plan pays the PBM is likewise set by contract between the PBM and the plan, such that“[t]hat difference generates a profit for the PBM.”66 Focusing on these financial implications, the Court thus rejected arguments that the law’s potential consequences reprocessed reimbursements and declined prescriptions would create uncertainty in plan expenses and jeopardize participants’ access to benefits, thereby intruding on plan administration and disrupting national uniformity. Rather, the Court explained, if a pharmacy refused to fill a plan participant’s prescription, fault would lie with the PBM for having failed to assure the pharmacy of adequate financial reimbursement; and if ERISA plans suffered any “operational inefficiencies” as a result of reprocessed payments, such merely financial consequences would be insufficient, under Travelers and Mackey, to warrant preemption.67
63 Id at 323-325.
64 Rutledge v. Pharm. Care Mgmt. Ass'n, 592 U.S. 80, 87 (2020) (citing Gobeille v. Liberty Mut. Ins. Co., 577 U.S. 312, (2016), Egelhoff v. Egelhoff, 532 U.S. 141, and Shaw v. Delta Air Lines, Inc., 463 U.S. 85 (1983)).
65 Id. at 88 (citing New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Ins. Co , 514 U.S. 645 (1995)).
66 Id at 83-84. Such an oversimplification, however, overlooks the fact that nearly all ERISA plans engage PBMs to implement various aspects of plan design and administration. See, e.g., Pharm. Care Mgmt. Ass'n v. Mulready, 78 F.4th 1183 (10th Cir. 2023). See also infra notes 68-75 and accompany text.
67 592 U.S. at 91 (citing Mackey v. Lanier Collection Agency & Serv., Inc., 486 U. S. 825 (1988) (ERISA did not preempt state garnishment despite claims that plans would face “substantial administrative burdens and costs”)); see supra note 35.
On the heels of Rutledge, another PBM case might be headed to the U.S. Supreme Court. In Mulready, 68 the Pharmaceutical Care Management Association (PCMA) challenged Oklahoma’s Patient's Right to Pharmacy Choice Act for its inclusion of provisions that would (i) impose geographic access standards on PBM networks, which standards by their nature could not be satisfied by mailorder only networks; (ii) prohibit insurers and PBMs from using cost-sharing discounts to incentivize individuals to use particular pharmacies; (iii) require PBMs to include any willing pharmacy (“AWP”) in a preferred network; and (iv) prohibit PBMs from terminating a pharmacy’s contract for employing a pharmacist on probation with the state’s pharmacy board. 69
The Tenth Circuit explained that health plans design their prescription drug benefits including features such as which drugs are covered, how the plan and participants will share costs for covered drugs, and the network of pharmacies where participants can purchase covered drugs and engage PBMs to manage these designs because of the “economic efficiencies and administrative savvy” PBMs afford.70 Moreover, “[b]ecause a plan's choice between selfadministering its benefits and using a PBM ‘is in reality no choice at all,’ regulating PBMs ‘function[s] as a regulation of an ERISA plan itself.’”71 The Tenth Circuit respected but distinguished Rutledge on its facts,72 concluding that because the Oklahoma law’s geographic access restrictions, prohibition on cost-sharing incentivization, and AWP provision restricted health plans’ network designs in ways that would "prohibit[] employers from structuring their employee benefit plans in a [certain] manner,"73 these provisions must be preempted as applied to ERISA plans. The law’s fourth challenged provision was also preempted with respect to ERISA plans because limiting the accreditation requirements a PBM may impose "affect[s] the benefits available by increasing the potential providers," and "eliminates the choice of one method of structuring benefits."
74 In so holding, the Tenth Circuit invoked Egelhoff, Gobeille, and Shaw (all having been cited approvingly by the Supreme Court in Rutledge75), while it distinguished Travelers and its progeny on their facts:“[O]f course, ‘ERISA does not pre-empt a state law that merely increases costs.’ [But] [t]he Act's network restrictions say nothing about PBM costs; they instead target network design. Thus, Travelers, Dillingham, and De Buono offer little support for Oklahoma's position.”76
68 Pharm. Care Mgmt. Ass'n v. Mulready, 78 F.4th 1183 (10th Cir. 2023), reh’ing denied; petition for cert. filed, 92 U.S.L.W. 3314 (May 10, 2024) (No. 23-1213).
69 Okla. Stat. tit. 36, §§ 6958-6968.
70 Id. at 1188-89 (“The parties estimate that PBMs manage the drug benefits for over 2.4 million Oklahomans. Nationally, PBMs are ubiquitous, administering the drug benefits for around 270 million people '[n]early everyone with a prescription drug benefit.’”) (internal citations omitted)
71 Id. at 1195-96 (quoting Pharm. Care Mgmt. Ass'n v. D C , 613 F.3d 179, 188 (D.C. Cir. 2010))
72 Mulready, 78 F.4th at 1200 (“Our holding today adheres to Rutledge. Unlike Arkansas's reimbursement-rate regulations, Oklahoma's network restrictions do more than increase costs.”).
73 Id. at 1198, 1201 (citing Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 97 (1983)).
74 Id at 1203-1204 (quoting Ky. Ass'n of Health Plans, Inc. v. Nichols, 227 F.3d 352, 363 (6th Cir. 2000) and CIGNA Healthplan of La., Inc. v. La. ex rel. Ieyoub, 82 F.3d 642, 648 (5th Cir. 1996)).
75 Id. at 1193-94, 1197-98 (citing Egelhoff v. Egelhoff, 532 U.S. 141, 147 (2001), Gobeille v. Liberty Mut. Ins. Co., 577 U.S. 312, 320 (2016), and Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 97 (1983)). See Rutledge, 592 U.S. at 87 (citing Egelhoff, Gobeille, and Shaw).
76 Id at 1201 (quoting Rutledge, 592 U.S. at 91).
Considerations for the Future of ERISA Preemption
Jurisprudence
Since Travelers, the Supreme Court has increasingly framed its preemption analysis as a dichotomy between laws that“merely increase costs” and those that implicate what the Court views as ERISA’s core areas of concern (benefit design, administration, reporting, and disclosure). But as plan design and administration evolve and integrate with increasingly complex third-party relationships and technological advancements, it will be even more critical to ensure the Court’s analysis continues to preserve all aspects of benefit design and administration as falling within ERISA’s preemptive protection. Moreover, it is unclear whether the Court’s analysis to date has thoroughly considered the extent to which ERISA’s fiduciary provisions an equally “core”area of the statutory regime are implicated by laws seeking to regulate the engagement and activities of thirdparty service providers contracted to implement plan design and effect plan administration. As the Court recognized in Gobeille, “ERISA does not guarantee substantive benefits. The statute, instead, seeks to make the benefits promised by an employer more secure by mandating certain oversight systems .”77 Chief among these “oversight systems” are the fiduciary responsibilities ERISA imposes on those responsible for plan administration.
ERISA requires plan fiduciaries to exercise prudence and loyalty in the selection, monitoring, and compensation of plan service providers 78 These aspects of a fiduciary’s responsibilities interrelate with ERISA’s disclosure provisions (old, new, and continually evolving79) that require, inter alia, service providers to inform plans about their practices and compensation and plans to inform participants and beneficiaries. Congress designed ERISA’s fiduciary duties and disclosure obligations as the means to ensure oversight of service provider practices and compensation, recognizing that the “core areas” of plan design and plan administration are very often carried out by a plan’s third-party service providers
The Supreme Court’s decision in Rutledge did not directly address (perhaps because the parties did not raise) whether the Arkansas law’s regulation of PBMs servicing self-funded ERISA plans would intrude upon ERISA plan fiduciaries’ obligations to adhere to the terms of the written plan documents, act solely in the interest of plan participants and beneficiaries, to prudently engage and monitor plan service providers, and to determine that a service provider’s compensation including direct and indirect sources of compensation is reasonable. To prevent a slide down the slippery slope of “mere” cost increases (after all, could not any administrative burden ultimately be characterized as a cost?), it may be worth considering whether Congress intended the oversight responsibilities it had carefully designed and placed on ERISA plan fiduciaries to be overtaken by state regulation
77 Gobeille, 577 U.S. at 320-321 (citing New York State Conference of Blue Cross & Blue Shield Plans v. Travelers Ins. Co , 514 U.S. 645, 651 (1995)).
78 ERISA § 404(a)(1); 29 U.S.C. § 1104(a)(1). See also ERISA § 406(a)(1)(C), 29 U.S.C. § 1106(a)(1)(C); and ERISA § 408(b)(2), 29 U.S.C. § 1108(b)(2).
79 See, e.g., Consolidated Appropriations Act, 2021, Public Law 116-260 (2021) (amending ERISA § 408(b)(2) (29 U.S.C. § 1108(b)(2)) to add compensation disclosure requirements applicable to those providing“brokerage services” or “consulting” to group health plans).
ERISA Preemption Is Essential to Benefit Protection and Design Innovation
In addition to ERISA’s statutory language and legislative history, strong policy arguments support a broad reading of its preemption provision.
The Supreme Court hypothesized in Shaw80 that multi-state employers faced with tracking, reconciling, and adhering to a multitude of state laws relating to employee benefit plans would likely reduce or eliminate benefits as a means to manage an overwhelming compliance burden. Fortunately, the past fifty years have evidenced relatively strong recognition of ERISA’s broad preemptive reach, enabling employers not only to maintain but also to enhance benefit plan design and administration across their multi-state workforces, as ERISA’s authors intended.
Employers on the whole are proactive and generous, offering both retirement and welfare benefits beyond legal requirements. And employees’ expectations continue to increase.81 To narrow ERISA’s preemptive effect would be to jeopardize employers’ ability to maintain the status quo and advance further innovation. ERISA’s preemption of state law supports innovation both directly, by enabling plan administration and benefit provisions that state law otherwise may have restricted, and indirectly, by relieving multi-state employers of the economic burden of constantly tracking, and adjusting their practices to comply with, evolving legal requirements across the fifty states.
Retirement Plan Design and Administration
A striking example is the introduction and proliferation of automatic enrollment features in 401(k) retirement plans, the prevalence of which has skyrocketed82 since the Internal Revenue Service approved the design from a tax perspective in 1998.83 Many state wage laws restrict employers’ ability to withhold amounts from an employee’s wages, for example, by requiring the employee’s affirmative written consent.84 Even before the Pension Protection Act of 2006 (PPA)85 amended ERISA to specifically confirm the preemption of such state laws with respect to“automatic
80 Shaw v. Delta Air Lines, Inc., 463 U.S. 85, 105 n.25 (1983).
81 See, e.g., ELLYN SHOOK & DAVID RODRIGUEZ, ACCENTURE, CARE TO DO BETTER 14 (2020), https://www.accenture.com/content/dam/accenture/final/a-com-migration/thought-leadershipassets/accenture-care-to-do-better-report.pdf (reporting increase in percentage of workers who expected their employer to be responsible for helping them become “net better off” (measured through six metrics, at least three of which physical, emotional, and financial well-being implicated employee benefits offerings), from 67% before the COVID-19 pandemic to 78% thereafter).
82 See, e.g., RICHARD HINZ & EUNJU, AMERICAN BENEFITS INSTITUTE, AMERICAN BENEFITS LEGACY: THE UNIQUE VALUE OF EMPLOYER SPONSORSHIP LEGACY 64 (2018), https://www.americanbenefitscouncil.org/publications-andresources/research-and-policy-reports/ [hereinafter AMERICAN BENEFITS LEGACY] (reporting approximately onethird of larger 401(k) plans adopted automatic enrollment before enactment of the Pension Protection Act of 2006); JEFFREY W. CLARK, THE VANGUARD GROUP, INC., HOW AMERICA SAVES 2024 26-28 (2024), https://institutional.vanguard.com/content/dam/inst/iigtransformation/insights/pdf/2024/has/how_america_saves_report_2024.pdf [hereinafter VANGUARD] (reporting 74% of larger plans offering automatic enrollment in 2023).
83 Rev Rul 98-30 1998-25 I.R.B. 8, amplified and superseded by Rev. Rul. 2000-8, 2000-7 I.R.B. 617.
84 See, e.g., Ky. Rev. Stat. § 337.060(1) (“No employer shall withhold from any employee any part of the wage agreed upon [except as] expressly authorized in writing by the employee to cover insurance premiums, hospital and medical dues, or other deductions”); Wis. Stat. § 241.09 (2001) (anti-assignment statute requiring spousal consent and limiting duration to six months).
85 Pension Protection Act of 2006, Pub. L. No. 109-280, § 902(g) (2006).
contribution arrangements,”
86 ERISA’s existing preemption language in Section 514(a) paved the way for automatic enrollment designs; the U.S. Department of Labor acknowledged ERISA’s preemptive effect in a series of advisory opinions87 predating the PPA, and the Fourth Circuit adopted the same interpretation in the context of a claim involving insurance premium withholdings 88
For many employer plan sponsors, implementing 401(k) automatic enrollment embodied both innovation and generosity because for employers that provide matching contributions on employees’ 401(k) deferral contributions, automatic enrollment costs more 89 Although employees can opt-out, in some circumstances even retroactively,90 most do not; they continue deferring91 and receiving employer matching contributions. ERISA’s many employee protections (e.g., vesting standards and fiduciary rules) protect the employees who participate and their beneficiaries but it is ERISA’s preemption provisions that enable employers to provide these benefits without fear of penalty under state law or the burden of tracking and administering wage-withholding consent requirements everywhere their employees reside And plans that couple automatic enrollment with an automatic escalation feature (under which a participant’s deferral contribution rate automatically increases annually, without the participant’s express consent, up to a stated maximum) build even more savings for employees and their families.92
Within the retirement plan landscape, ERISA plan sponsors are able to offer their plan participants access to plan-based financial advice,93 and design features geared to their workforce’s needs and goals, such as programs targeted to encourage and reward student loan repayment,94
86 ERISA § 514(e), 29 US Code § 1144(e). Although Section 514(e) imposes annual notice requirements for “automatic contribution arrangements,” the implementing regulations confirm ERISA preempts any state law “that would directly or indirectly prohibit or restrict” an automatic enrollment feature regardless of whether it satisfies those requirements. 29 C.F.R. § 2550.404c-5(f)(2). The addition of § 514(e) was not superfluous, however, because, for example, § 514(a) alone would not have preempted any criminal penalties for violation of state wage withholding laws.
87 See, e.g., U.S. Dep’t of Labor, Advisory Opinions 1994-27A (July 14, 1994) (concluding ERISA preempted NY written consent requirement to the extent it would prohibit employers from accepting employees’ salaryreduction elections for ERISA plans via telephone), 1996-01A (Feb. 8, 1996), 1994-27A (July 14, 1994), and 2008-02A (Feb. 8, 2008) (“In the Departments [sic] view, the Kentucky state law at issue here has a prohibited connection with ERISA plans because it prohibits automatic enrollment arrangements in such plans...”).
88 Jackson v. Wal-Mart Stores, Inc., 24 Fed. Appx. 132 (4th Cir. 2001) (ERISA preempted employee’s South Carolina Payment of Wages Act claim that employer over-withheld contributions for coverage under employer’s ERISA plan).
89 See, e.g., James J. Choi et al., For Better or Worse: Default Effects and 401(k) Savings Behavior, in PERSPECTIVES ON THE ECONOMICS OF AGING 121 (David A. Wise ed., 2004) (“High default savings rates may increase [employer] matching costs.”)
90 See 26 U.S. Code § 414(w).
91 See Choi, supra note 88, at 120 (inclusion of automatic enrollment design in employer plans increased participation “to around 90 percent”).
92 See, e.g., Richard H. Thaler & Schlomo Benartzi, Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving, J. POLIT ECON 164 (2004) (reporting that, over 40 months, automatic increase feature increased average participant savings rate from 3.5% to 13.6%).
93 See, e.g., VANGUARD at 82 (reporting 43% of Vanguard 401(k) plan sponsor clients, and 80% of those with larger plans, offered participants a plan-based “managed account advice” feature in 2023).
94 See, e.g., I.R.S. Priv. Ltr. Rul. 201833012 (May 22, 2018) (ruling favorably on employer’s program to provide non-elective employer contributions to retirement plan accounts of employees making student loan
without fear of reprisal under potentially conflicting state laws. ERISA preemption enables employers to design retirement plan features that provide extra savings help as employees approach retirement age, for example, age-based or age- and service-based contribution tiers, without risk of running afoul of state or local laws that, unlike the federal Age Discrimination in Employment Act,95 also prohibit “reverse” age discrimination against younger employees.96 And ERISA’s preemption of state escheat laws provides uniformity for plan administrators while protecting participants and beneficiaries from the loss of benefits.97
Health and Welfare Plan Design and Administration
Prior to the Affordable Care Act (ACA),98 federal law did not dictate the terms of ERISA health and welfare plans, with few and rather restrained exceptions. For example, Congress’s foray into promoting coverage of mental health services by employer sponsored plans, the Mental Health Parity and Addition Equity Act,99 does not require plans to cover services for mental health or substance use disorders. Rather, a plan sponsor that voluntary chooses to design its plan to cover such services must not impose quantitative or non-quantitative limitations on such coverage that are more restrictive than limitations the plan imposes on its coverage of medical and surgical services not for the treatment of mental health or substance abuse disorders.
Even in the years since the ACA’s enactment, large employers subject to its shared responsibility provisions continue to offer employees and their families more generous health care benefits than the Act requires.100 Of course, employers are motivated by tax advantages and labor market competitiveness, but it is ERISA’s preemption of state law that enables plan sponsors to manage the needs of their employees, rising health care costs, and their resources efficiently; subjecting employer plan sponsors to potentially exponential increases in compliance expense and repayments); VANGUARD at 58 (describing program under which employer makes taxable loan repayments, on employees’ behalf, directly to creditors of employees repaying student loans).
95 Age Discrimination in Employment Act of 1967, 29 U.S.C. §§ 621-634
96 See, e.g., NYC COMM’N ON HUMAN RIGHTS, LEGAL ENFORCEMENT GUIDANCE ON EMPLOYMENT DISCRIMINATION ON THE BASIS OF AGE 2 (2020), https://www.nyc.gov/assets/cchr/downloads/pdf/AgeDiscriminationGuide-2020.pdf (“Since 1977, the New York City Human Rights Law has included protections against age discrimination for all workers, regardless of one’s age, unlike federal law that only protects older workers who are at least the age of forty.”)
97 See, e.g., U.S. Dep’t of Labor, Advisory Opinion 94-41A (Dec. 7, 1994); Commonwealth Edison Co. v. Vega, 174 F.3d 870 (7th Cir. 1999); Mfrs. Life Ins. Co. v. East Bay Rest. & Tavern Ret. Plan, 57 F. Supp. 2d 921 (N.D. Cal. 1999).
98 See supra note 3
99 Mental Health Parity and Addiction Equity Act of 2008, Pub. L. No. 110-343 (2008), as amended by Pub. L. No. 110-460 (Dec. 23, 2008) (amending mental health parity provisions originally added to ERISA § 712 (29 U.S.C. 1185a) by the Departments of Veterans Affairs and Housing and Urban Development, and Independent Agencies Appropriations Act, Pub. L. No. 104-204 (1996)).
100 See, e.g., Paul Fronstin et al., The More Things Change, the More They Stay the Same: An Analysis of the Generosity of Employment-Based Health Insurance, 2013–2019, EBRI ISSUE BRIEF NO. 545 (Oct. 28, 2021), available at ebri_ib_545_av-28oct21.pdf (concluding that actuarial value of employer-based health did not decline in response to the ACA but in fact improved slightly, that employer-based coverage is more generous than individual coverage, and that the percentage of Americans with employer-based coverage increased from 70.5 percent to 72.7 percent between 2013 and 2019).
risk would jeopardize this balance Employer-sponsored insurance covers almost 153 million nonelderly people.101
Even plan design features intended to help self-funded employer health plans manage claims expense are simultaneously designed to promote employees’ access to quality care and improve overall wellness. For example, incorporating value-based “narrow” or “tiered” networks102 and surgical centers of excellence103 into medical plan design aligns quality of care with costmanagement strategies benefitting employers and employees. Disease management programs (typically focused on a chronic condition such as diabetes, asthma, or hypertension)104 and wellness programs (such as those encouraging smoking cessation, exercise, or weight management)105 promote employee engagement in health improvement. Telehealth coverage106 and on-site clinics107 (often incorporated as part of an employer’s self-funded ERISA medical plan) provide ready access to basic care in settings convenient to employees and their families. And employers continue to innovate developing and expanding their ERISA health and welfare benefit offerings to add features such as allowances for nutrition tied to medical plan enrollment108 and coverage of doula services 109 Indeed, ERISA preemption has proven so successful in preserving and promoting this country’s
101 KAISER FAMILY FOUNDATION, 2023 EMPLOYER HEALTH BENEFITS SURVEY (2023) (Summary of Findings), available at https://www.kff.org/report-section/ehbs-2023-summary-of-findings/.
102 See, e.g., Anna D. Sinaiko et al., Enrollment In A Health Plan With A Tiered Provider Network Decreased Medical Spending By 5 Percent, 36 HEALTH AFF 870 (2017) (“suggest[ing] the potential for tiered-network plans as a tool for providers to improve value” and “add[ing] to the evidence that tiered-network benefit designs have the potential to deliver higher value and be a tool that employers and other payers can use to decrease spending in the U.S. health care system”).
103 AMERICAN BENEFITS LEGACY at 52 (reporting about 67% of employers with 500 or more employees and about 80% of those with 20,000 or more employees offer health plans that include access to a surgical center of excellence).
104 See, e.g., KAISER FAMILY FOUNDATION, 2023 EMPLOYER HEALTH BENEFITS SURVEY (2023) § 12, available at https://www.kff.org/report-section/ehbs-2023-section-12-health-screening-and-health-promotion-andwellness-programs-and-disease-management/ (reporting that 64% of employers with 200 or more employees, and 85% of those with 5,000 or more, offered a disease management program).
105 Id. (reporting that 80% of employers with 200 or more employees offered a wellness program in 2023 designed to help employees stop smoking, lose weight, and/or engage in some other lifestyle or behavioral coaching, including 46% that offered employees incentives to complete the program).
106 See, e.g., KAISER FAMILY FOUNDATION, 2023 EMPLOYER HEALTH BENEFITS SURVEY (2023) § 13, available at https://www.kff.org/report-section/ehbs-2023-section-13-employer-practices-telehealth-provider-networkscoverage-limits-and-coverage-for-abortion/ (reporting that 91% of employers with 50 or more employees cover the provision of some health care services through telehealth in their largest health plan).
107 See, e.g., MERCER & NAT’L ASS’N OF WORKSITE HEALTH CTRS., WORKSITE HEALTH CENTERS 2021 SURVEY REPORT 5 (2021) (reporting nearly 33% of employers with at least 5,000 employees, and 38% of those with at least 20,000 employees, offer a primary care clinic to their employees), available at https://www.mercer.com/assets/us/en_us/shared-assets/local/attachments/pdf-2021-worksite-healthcenters-report.pdf
108 Daniel Cullen et al., Supporting Low-Income Workers to Address Nutritional Needs NEJM CATALYST INNOVATIONS IN CARE DELIVERY, Aug. 2023, https://catalyst.nejm.org/doi/full/10.1056/CAT.22.0405 (reporting early success in improving ability of low-income employees to afford and secure nutritious food through a narrow-network health plan combined with in-kind assistance)
109 See. e.g., Kathryn Mayer, Walmart Expands Doula Coverage for Employees, SOC. FOR HUM. RESOURCE MGMT., Nov. 1, 2023, https://www.shrm.org/topics-tools/news/benefits-compensation/walmart-expands-doulacoverage-for-employees
employer-sponsored benefits regime that it may provide a useful template for solving the oft bemoaned “patchwork” of state laws addressing paid leave from work in connection with an employee’s or a family member’s medical condition or family circumstances.110
Looking ahead, the need to protect national uniformity in benefit plan operation will only intensify as employers and employees leverage technology and mobility advancements to expand multi-state presence. Perhaps ERISA’s authors could not have imagined the ways in which the intricacies of today’s global economy would affect employer-sponsored benefit plans, but fortunately they had the foresight to incorporate the broadest of preemption provisions to pave the way for innovation.
110 For a thoughtful discussion, see Evan Sumner, A Fork in the Road: Paid Sick Leave Plans as a Payroll Practice and ERISA Preemption of State Laws Regulating Paid Sick Leave, 51 CAP U L REV 27 (2023).
Pension Committee
Grace Lattyak, MAAA, EA, FCA, FSA— Chairperson
Lloyd Katz, MAAA, EA, FCA, FSA— Vice Chairperson
Michael Antoine, MAAA, EA, FSA
Michael Bain, MAAA, ASA, EA, FCA, MSPA
Rachel Barnes, MAAA, FSA
Margaret Berger, MAAA, EA, FCA, FSA
James Burke, MAAA, EA, FCA, FSA
Maria Carnovale, MAAA, FSA
Tristan Christ, MAAA, EA, FSA
Jonathan de Lutio, MAAA, EA
David Gustafson, CMAAA, EA
Scott Hittner, MAAA, EA, FCA, FSA
Maria Kirilenko, MAAA, EA
Gerard Mingione, MAAA, EA, FSA
Maria Moliterno, MAAA, ASA, EA
Nadine Orloff, MAAA, EA, FCA, FSA
Mary Stone, MAAA, EA, FCA, FSA
Hal Tepfer, MAAA, EA, FCA, FSA, MSPA
Carolyn Zimmerman, MAAA, EA, FCA, FSA
Geralyn Trujillo— Senior Director, Public Policy
Linda K. Stone, MAAA, FSA— Senior Retirement Fellow
The Pension Committee would like to gratefully acknowledge the contributions of Ellen Kleinstuber for her assistance with peer review of this document, along with the following primary contributors:
Mike Antoine, Rachel Barnes, Michael Bain, Margaret Berger, Elena Black, James Burke, Bruce Cadenhead, Jonathan de Lutio, Scott Hittner, Lloyd Katz, Maria Kirilenko, Maria Moliterno, Melody Prangley, Mark Shemtob, Mary Stone, Hal Tepfer, and Carol Zimmerman.
The American Academy of Actuaries is a 20,000-member professional association whose mission is to serve the public and the U.S. actuarial profession. For more than 50 years, the Academy has assisted public policymakers on all levels by providing leadership, objective expertise, and actuarial advice on risk and financial security issues. The Academy also sets qualification, practice, and professionalism standards for actuaries in the United States.
AMERICAN ACADEMY OF ACTUARIES 1850 M STREET NW, SUITE 300, WASHINGTON, D.C. 20036 202-223-8196 | WWW.ACTUARY.ORG
Any references to current laws, regulations, or practice guidelines are correct as of the date of publication.
ERISA: 50 Years of Shaping the Single-Employer
Defined Benefit Landscape
An Issue Paper
American Academy of Actuaries
Key Points:
1. The level of underfunding across defined benefit plans has declined during the past 50 years.
2. Participant benefits are better protected than before ERISA via PBGC insurance and expanded rights.
3. Defined contribution plans have supplanted defined benefit plans as the main source of retirement savings, resulting in fewer participants having annuity income from their retirement plans.
4. Overall, employer-provided defined benefit retirement plan coverage has declined, due in part to the complex and rigorous legal and regulatory requirements combined with significant changes in the economic landscape since 1974.
Introduction
On Labor Day in 1974, President Gerald Ford signed into law groundbreaking legislation that dramatically changed the retirement landscape in the United States. The Employee Retirement Income Security Act of 1974, commonly referred to as ERISA, provides a broad framework for regulation and governance of most privately sponsored defined benefit (DB) and defined contribution (DC) plans. While ERISA has been amended and augmented many times over the past 50 years, it remains the foundation of U.S. retirement plan regulation.
ERISA filled a significant void confronting DB plan participants. Previously, the lack of strong minimum funding standards and the absence of a guarantor in the event of employer insolvency put private sector pensioners at significant risk. Several prominent bankruptcies brought these risks to the public’s attention.
Prior to ERISA, a sponsor of a tax-qualified DB plan was not required to fund promised plan benefits, as they were earned by participants. ERISA changed that, however, by requiring DB plans to pay a minimum annual contribution. Additionally, the federal government established the Pension Benefit Guaranty Corporation (PBGC) as the insurer of last resort, ensuring that DB plan participants would receive all, or a significant portion of, their promised benefits.
The law and the vast majority of subsequent acts have helped protect covered workers’ benefits through more equitable plan access, enhancements in employee rights, and DB plan solvency requirements. ERISA introduced stronger vesting rules, which greatly increased the portability of plan benefits and protected plan participants from losing valuable benefits when terminating employment after a significant period of service. The law also required most DB plans to provide death benefits to the surviving spouses of plan participants. ERISA added Section 415 to the Internal Revenue Code (Code), which imposed new limits on the amount of benefits that could be paid from a tax-qualified DB plan and the amount of contributions that could be made to a tax-qualified DC plan.
As with any complex piece of legislation, ERISA’s requirements have resulted in a significant number of unintended or unanticipated outcomes over the years. Although ERISA has clearly mitigated many significant gaps in retirement security, progress has been uneven.
Most private sector, single-employer DB plans are well funded today. However, DB plans now cover a much smaller portion of the workforce than 50 years ago, with an even smaller proportion of employees in these plans still accruing pension benefits. In fact, many private sector DB plans are now “frozen” and employees do not accrue additional pension benefits. The most common approach for private employers providing retirement plans has shifted from a DB model to a DC model. This change from DB to DC shifts most of the risk related to retirement savings from the employer to the employee, which has resulted in a lower percentage of employees having access to secure lifetime income.
This paper discusses ERISA’s impact, focusing specifically on single-employer plans. The paper generally treats ERISA and the related Code sections interchangeably.
History
When President Ford signed ERISA into law on the symbolic date of Labor Day in 1974, DB pension coverage had been gradually increasing in the United States over many decades. In fact, some DB pension plans existed as far back as the time of the Revolutionary War. By the mid-1870s and early 1880s, several major employers had adopted DB plans, including American Express, the Baltimore and Ohio Railroad, and the Pennsylvania Railroad.1 DB pension coverage greatly increased during the boom years immediately following World War II. By the time of ERISA’s enactment, DB pension coverage had become increasingly commonplace for employees of major corporations in the United States.
Before ERISA, DB pension plans were largely unregulated. The Internal Revenue Code of 1954 limited the maximum amount of contributions that plan sponsors could deduct from taxable income and contained several other basic requirements concerning plan coverage and nondiscrimination. The regulatory framework for DB pension plans consisted of a variety of rather weak federal and state disclosure rules, such as the 1947 Taft-Hartley Act, which attempted to limit some of the worst historic abuses in multiemployer plans. In general, DB plan sponsors had great latitude regarding how much to fund the plan, who could participate, how to structure vesting rules, and even whether to pay promised benefits. There was no requirement that employers receive actuarial guidance in funding their pension plans and there were no restrictions on who could call themselves a “pension actuary.”
1 Evolution of employer-provided defined benefit pensions; Bureau of Labor Statistics; December 1991.
During the 1960s and early 1970s, legislators grew increasingly concerned about the security of DB plans following several high-profile DB failures. In 1963, the Studebaker Corporation discontinued production of automobiles in the United States and subsequently reduced or canceled the DB pension benefits it had promised to its approximately 4,000 workers. An August 16, 1964, story in the New York Times ran under the headline “Workers Finding Pensions Empty—When Plants Close, Funds Are Often Inadequate.” In 1972, NBC News ran a documentary: “Pensions: The Broken Promise.” That same year, consumer activist Ralph Nader said the private pension system represented “one of the most comprehensive consumer frauds that many Americans will encounter in their lifetime.”2
At the same time, anger spread among the general public about the perceived excessive benefits paid to some corporations’ senior executives. For example, when Penn Central Transportation Company filed for bankruptcy in 1970, the public learned that Penn Central’s retired president was receiving an annual pension benefit of $114,000 (about $925,000 in 2024 dollars). In a series of congressional hearings in 1972, the panel heard about shortcomings in pension plans. One example was the story of George Allen, who had worked 32 years for Baldwin-Lima-Hamilton in Philadelphia but lost his entire pension benefit when his plant closed five months before he reached the plan’s vesting age of 60.3
Many of ERISA’s provisions can be directly traced to abuses like these. Its enactment was the culmination of nearly a decade of work, study, and negotiation among members of Congress of both parties and several presidential administrations.
Change in the Number and Type of Plans
In the decade following ERISA’s enactment, DB plan coverage continued to increase. Before the number of plans began to drop in 1986, the number of single-employer DB pension plans had increased nearly 70% since 1974.4 Many factors contributed to the decline, including new financial disclosure requirements that went into effect in 1986 under Financial Accounting Standards Board (FASB) Statement No. 87, as well as stricter funding requirements under the Omnibus Budget Reconciliation Act of 1987 (OBRA ’87). In addition, as companies matured, the size of the typical pension obligation relative to the size of the
2 “Great Pension Issue”; The New York Times; August 10, 1972.
3 Hearings before the Subcommittee on Labor, United States Senate Committee on Labor and Public Welfare, Ninety-Second Congress, Second Session; July 17, 1972; Philadelphia.
4 Employee Benefits Security Administration; United States Department of Labor; Private Pension Plan Bulletin Historical Tables and Graphs 1975–2021; Table E1.
sponsor presented an increased risk. Sponsors of underfunded plans in certain industries found it difficult to compete with both U.S. and foreign companies that didn’t have these significant legacy obligations. These changes resulted in a greater understanding and appreciation of the potential risks associated with significant pension obligations.
Over time, and especially since the Pension Protection Act of 2006 (PPA) took effect in 2008, PBGC premiums have increased dramatically. In 1985, plans paid a flat-rate premium of $2.60 per participant. By 1991, the flat-rate premium had jumped to $19 per participant and less well-funded plans were subject to an additional variable rate premium of 0.9% of unfunded vested liability. In the decades since, further changes to funding rules and significant increases in PBGC premiums have accelerated the decline in DB pension plan coverage.
DC plans were common even before the codification of 401(k) plans. In fact, at the time ERISA was enacted, there were already about twice as many DC plans as DB plans, and the number of DC plans continued to increase dramatically in subsequent years. Internal Revenue Code Section 401(k) was enacted in 1978, explicitly permitting cash or deferred arrangements inside DC plans as long as specific requirements were met. In subsequent years, DC plans continued to grow. Despite this, DC plans usually remained supplementary to DB plans and the adoption of plans with 401(k) features was still limited. This differs from the experience today, as many employers, particularly large and mid-sized employers, have adopted a “DC-only” approach. The vast majority of current DC plans contain a 401(k) feature, as shown in Figure 1:5
1 5 Employee Benefits Security Administration; United States Department of Labor; Private Pension Plan Bulletin Historical Tables and Graphs 1975–2021; Tables E1 and E19.
Figure
Figure 2
Figure 3
Figure 2 shows the number of plans by type since 1975, including the noticeable increase in the number of DC plans.6
Number of U.S. Single-Employer Plans—1975–2021
Single-Employer DB Plans Single-Employer DC Plans
The change in the number of DB plans corresponds to a rapid decrease in percentage of actively employed private sector workers in the U.S. covered by single-employer DB plans over 20 years, from 29% in 1980 to 7% in 20207 (Figure 3).
The designs of DB plans have also changed over the past 50 years. Traditionally, employers designed DB plans to provide a monthly benefit, defined as a percentage of final pay related to service at retirement or a fixed dollar amount for every year of service. In the 2000s, hybrid plans, where the benefit is defined as a lump sum account, became popular. By 2020, 40% of PBGC-insured plans were hybrid plans.8
6 Employee Benefits Security Administration; United States Department of Labor; Private Pension Plan
1975–2021; Table E1. 7 “Pension
One Area of Growth for DB Plans— Small Employer-Sponsored Plans
The number of single-employer DB plans sponsored by small employers (i.e., fewer than 25 participants) decreased in number consistently with those sponsored by larger employers for much of the post-enactment period. However, the pattern has diverged in recent years, as the number of DB plans sponsored by small employers has begun to increase. These plans were strongly affected by several ERISA provisions, including the family aggregation rules and Code Section 415(e), which combined DB/DC limitations. The elimination of these requirements by the Small Business Job Protection Act of 1996 (SBJPA), and the increase in Code Section 415 limits under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), played a part in stemming the decline in the number of DB plans sponsored by small employers. The number of such plans covered by the PBGC is up more than a third from 2014 to 2022, as shown in Figure 4.9
Number of PBGC-Covered DB Plans—Fewer Than 25 Participants—2000–2022
One of the most significant contributing drivers of ERISA’s enactment was the default of several pension plans, including the previously noted Studebaker plan. To enhance benefit security, ERISA established a minimum funding requirement for single-employer pension plans and created the PBGC to backstop the pension benefits from plans that cannot meet their benefit commitments.
Before ERISA’s enactment, benefits were not guaranteed when plans terminated with insufficient funds. ERISA created the PBGC to:
• Encourage the continuation and maintenance of voluntary private pension plans for the benefit of their participants;
• Provide for the timely and uninterrupted payment of pension benefits to participants and beneficiaries under covered plans; and
• Maintain premiums at the lowest level consistent with carrying out its obligations.10
PBGC termination insurance markedly strengthened participant benefit security. One significant impact has been increased confidence in pension promise sustainability. According to the 2023 PBGC Annual Report, the PBGC’s single-employer program protects about 20.6 million participants in approximately 23,500 plans. Nearly 1.4 million current and future retirees rely on the PBGC for their pension benefits. The multiemployer program protects an additional 11.0 million workers and retirees in approximately 1,360 pension plans.
Since PBGC’s inception, single-employer and multiemployer plans have separate premium structures and benefit guarantees. Initially, single-employer plans paid a premium of $1.00 per participant. Premium rates have increased dramatically over the past 50 years, to $101 per participant in 2024. (For reference, $1 in 1974 equates to approximately $6.29 in 2024.)
The Consolidated Omnibus Budget Reconciliation Act of 1985 established an additional single-employer premium, based on a plan’s unfunded vested benefits (UVB). This additional variable-rate premium was initially set at 0.6% of UVB in 1988. By 2024, that amount had risen to 5.2% of a plan’s UVB, capped at $686 per participant.
Some economists note that the termination insurance concept creates moral hazards that may weaken pension funding discipline over time. Research suggests the presence of a backstop guarantee may encourage plan sponsors to take greater portfolio risks, knowing that the PBGC will step in if substantial losses occur.11 Several high-profile corporate bankruptcies and insufficient funding on the part of some sponsors saddled the PBGC with liabilities exceeding premium revenues. In the early 2000s, seven large organizations terminated their single-employer DB pension plans and the PBGC took them over. The claims from these seven plans represent 43% of the PBGC’s total single-employer claims12 and caused the PBGC single-employer program’s net financial position to decline from a $9.7 billion surplus in 2000 to a $22.8 billion deficit by 2005. The deficit peaked at $29.1 billion in 2012.13 This rapid decline in the net financial position of the PBGC insurance program led to sharp premium increases in an effort to return the PBGC to a secure financial position. It is important to note that not all of the subsequent increases have been tied to the PBGC’s financial position.
In response to the plan terminations, the PPA was enacted to significantly overhaul pension funding rules. The PPA instituted new funding requirements for underfunded pensions, intending to force sponsors to pay down funding shortfalls at an accelerated pace. It also implemented stricter liability measurement assumptions to curb rising underfunding. PBGC employer premiums rose considerably, despite the introduction of a per-person variable rate premium cap. Together, these reforms aimed to improve DB system solvency while addressing moral hazard concerns. In the decade following the PPA, rates of new claims on the insurance fund stabilized, as shown in Figure 5.14
Figure 5
PBGC Single-Employer Trusteed Terminations
Today, the PBGC single-employer program’s net financial position has improved to reflect a $44.6 billion surplus at the end of fiscal year 2023. Many employers pay contributions exceeding minimum funding requirements to limit the PBGC premiums, avoid fundingbased benefit restrictions, or limit the unfunded pension liability reported in their accounting statements, thus reducing the likelihood their plans will need future financial support from the PBGC. For employers where the additional funding to avoid these requirements are too large, or the premium is limited by the variable rate premium cap, there is less incentive to fund in excess of minimum requirements. The flat rate premium provides an incentive for all employers to reduce participant counts, and that incentive is amplified for employers for which the variable rate premium is limited by the per-person variable rate premium cap.
While the PBGC has had a positive impact for participants in covered plans, the cost of coverage—particularly in the context of the PBGC’s current surplus position—has contributed both to the decrease in the number of single-employer DB plans and the rising trend toward DC plans. More information on the impact of PBGC premiums can be found in the Academy’s issue brief PBGC Single-Employer Premiums and Their Impact on Plan Sponsorship Although the sharp increase in variable premium rates led some plan sponsors to better fund their plans, others lowered liabilities by reducing benefit accruals, closing their plans to new hires, and reducing the number of covered participants through lump sum cashouts, annuity purchases, and plan terminations. These actions are arguably at odds with the PBGC’s fundamental purpose. The Academy’s issue brief Aligning the PBGC’s SingleEmployer Premium Structure With Its Objectives discusses ways to address these concerns.
Funding History Post-ERISA
ERISA’s funding rules require ongoing funding of accruals earned each year and include a maximum amortization period for paying the plan’s unfunded liability. DB plans must employ enrolled actuaries15 to perform certain required services, including certifying the plan’s minimum required contribution and the PBGC variable rate premium. The statute requires actuaries to use reasonable assumptions to measure the plan’s liabilities.
Early on, ERISA gave plan sponsors lengthy amortization periods to fund even significant benefit increases due to plan amendments or other events triggering highly subsidized benefits, such as plant shutdowns. However, this buildup of unfunded liabilities made pension plans and their sponsors vulnerable to changes in economic conditions, such as interest rates and competition from employers, without the legacy liabilities. Eventually, this led to some significantly underfunded pension plans being transferred to the PBGC, straining the insurance system.
The funding rules in place led to a large divergence of funded levels. In 1985, when the discount rate used to measure plan liabilities was about 9.75%, the aggregate funding ratio of underfunded plans’ vested benefits insured by the PBGC was 72%, while the aggregate funding ratio of overfunded plans’ vested benefits was 176%.16 The underfunded plans likely improved benefits along the way and had not fully funded those improvements. At the other end of the spectrum were pay-based plans, mostly final-pay plans, where the funding approach considered benefits not yet vested and were generally well-funded on this basis.
In the 1980s, some employers with well-funded plans terminated those plans and stripped out excess assets for various reasons,17 such as financing corporate takeovers.18 These actions reduced financial security for plan participants if the pension plan was not replaced. At ERISA’s outset, assets that exceeded a terminated plan’s liability and reverted to the plan sponsor were subject only to income tax, making this strategy possible.
In response, Congress made numerous changes to strengthen the funding rules from the mid-1980s through the mid-1990s. These changes included reducing the amortization period for unfunded liabilities, implementing additional funding requirements for
15 As defined by the IRS, an enrolled actuary is any individual who has satisfied the qualifications set forth in the regulations of the Joint Board for the Enrollment of Actuaries and who has been approved by the Joint Board to perform actuarial services under the Employee Retirement Income Security Act (ERISA) of 1974.
16 “Pension Insurance Data”; Pension Benefit Guaranty Corporation; 2021; tables S-44 and S-45. For purposes of this measure, liabilities reflect vested accrued benefits, while funding rules generally targeted a liability measured on projected increases in future pay, which would lead many plans to appear overfunded on this basis.
17 Pension Plans—Termination of Plans With Excess Assets; U.S. Government Accountability Office; April 1986.
18 For example, the purchase of the A&P supermarket chain by Tengelmann Group in 1979 using the surplus in the A&P pension plan.
6
underfunded plans based on prescribed assumptions, and creating a liquidity contribution requirement that generally requires a reserve of liquid assets to cover three years of benefit payments. Congress also made changes that indirectly affected plan funding, including the imposition of a reversion tax intended to curb the practice of stripping excess pension assets. The unintended consequence was that the potential to incur the reversion excise tax if a plan becomes substantially overfunded made some employers hesitant to fund pension plans at too high a level.
A long period of steady declines in interest rates began in the 1990s and continued until 2022, as shown in Figure 6.19 For much of that period, pension plan funded ratios fell in lockstep with discount rates. Overfunding as a percentage of all liabilities in the singleemployer system dropped from 44% in 1990 to 1% in 2010.20 However, in the mid-2010s, plan sponsors began to aggressively employ liability-hedging strategies, reduced or froze benefit accruals, and made significant catch-up contributions to plans. These tactics stabilized funding ratios even as discount rates continued to fall.
The magnitude of liabilities and assets in the single-employer system has increased substantially, even as the number of plans has decreased by 75%21 and the number of participants covered by single-employer plans has decreased by 20%22 from 1980 to 2022. Aggregate liabilities in 1980 were $212 billion with $260 billion in assets supporting those liabilities. Aggregate liabilities in 2020 were $3.1 trillion with $2.6 trillion in assets supporting those liabilities, a 10-fold increase in 40 years.23
Figure
Pension Protection Act of 2006
The PPA represented the largest overhaul in pension funding rules for single-employer plans after ERISA’s enactment. This act intended to put single-employer pension funding on a mark-to-market basis by requiring the use of a funding method based directly on participants’ accrued benefits, interest rate assumptions based on current bond rates, and the current market value of assets.24 The PPA also required amortization of past service liabilities over a period of seven years and limited employer flexibility to reduce required contributions by using credit balances, amounts that arose from making excess contributions in prior years. Additionally, poorly funded plans were subject to accelerated funding requirements.
The PPA also imposed broad funding-based benefit restrictions on underfunded plans to limit further deterioration in funded status. These included restrictions on payments of lump sums, annuity purchases, and other accelerated forms of payment; amendments increasing benefits; and unpredictable contingent events benefits, such as plant-shutdown benefits.25
Challenging economic conditions, beginning with the financial crisis in late 2008, made the transition to the PPA single-employer funding rules onerous for many plan sponsors. Stock prices fell almost 50% from October 2007 to March 2009.26 As stock prices collapsed, the Federal Reserve initiated its quantitative easing program, purchasing securities in the open market and cutting interest rates. Medium- and long-term interest rates declined dramatically, which led to a decrease in the interest rates used to measure pension liabilities and a corresponding increase in those liabilities and minimum funding requirements, all at a time when many plan sponsors were suffering from financial difficulties.
Congress responded with a series of laws, each of which was intended to provide sponsors with temporary funding relief. The Pension Relief Act of 2010 gave sponsors additional time to amortize losses arising from the 2008 financial crisis. In 2012, the Moving Ahead for Progress in the 21st Century Act stabilized interest rates by applying a corridor around them based on a 25-year average of corporate bond rates. This relief was extended several times afterward, most recently by the American Rescue Plan Act of 2021, which also lengthened
the amortization period for unfunded liabilities from seven to 15 years. Thus, what was originally intended as temporary relief has become a longer-term modification that provides more flexibility, especially in times of rapidly changing economic conditions.
Many sponsors have found the PPA rules, particularly the complex rules around managing the credit balances that arise from past overpayments and the funding-based restrictions on plan benefits, to be inflexible, creating considerable administrative challenges and discouraging ongoing plan sponsorship.
The Academy’s Pension Committee sent a comment letter to the U.S. Department of Treasury and the Internal Revenue Service on increasing flexibility relating to maintenance and application of funding balances, identifying several ways the credit balance rules could be improved. The committee also sent a separate comment letter addressing potential improvements to the rules around benefit restrictions.
The Academy issue brief The Pension Protection Act: Successes, Shortcomings, and Opportunities for Improvement provides a more in-depth assessment of the PPA’s successes and failures.
Limitations of Current Funding Rules
As the retirement landscape continues to evolve, additional plan types are emerging to better satisfy the needs of a mobile workforce and mitigate employer risk related to a traditional pension plans’ financial volatility. In particular, there is growing interest among both employers and employee representatives in risk-sharing designs, such as market-return cash balance plans and variable annuity designs. Both reduce plan sponsor risk while allowing for effective long-term investment strategies. These designs retain some of the key advantages of DB plans, such as lifetime retirement income and pooling of longevity risk. However, the DB funding rules have not yet been clarified to fit the underlying economics of these plans. Ensuring that the legal and regulatory framework for DB plans supports these hybrid, risksharing plan designs is essential to encouraging the continuation of DB plans and fulfilling ERISA’s primary goal of protecting access to an efficient source of lifetime income benefits for workers.
Participant Benefit Security and Fairness
ERISA and subsequent laws introduced additional rules specifically intended to protect participants. The protections include strict vesting provisions, prohibitions against retroactive benefit changes, and disclosure requirements that allow participants to make informed decisions about their benefits. Rules preventing plans from excessively favoring highly compensated employees were also expanded.
Participation & Vesting
ERISA set minimum participation and vesting requirements for pension plans. The law defines the maximum age and service conditions a plan can use in order to determine an employee’s eligibility to begin participating in a pension plan, as well as the time until benefits vest. Plans can apply more generous participation and vesting requirements but may not apply stricter rules.
Participation Requirements
Before ERISA, corporate pension plans imposed a wide variety of participation requirements based on age and service. These ranged from one year of service to more stringent requirements, such as entry at age 30. ERISA specified that tax-qualified plans must generally allow participation no later than completion of one year of service and attainment of age 25. The Retirement Equity Act of 1984 later changed this condition to age 21, with one year of service.
DC plans are generally subject to the same minimum participation requirements as DB plans. However, many DC plans apply more liberal participation requirements, particularly for employee deferrals. Many plans automatically enroll newly hired employees at a moderate level of employee deferrals, with a choice to opt out. Going forward, the SECURE 2.0 Act of 2022 (SECURE 2.0) requires most new 401(k) plans to have an auto-enrollment feature.
Vesting
Vesting provisions provide a pension plan participant with a nonforfeitable right to the benefits funded by the employer’s contribution after a minimum period of service. A participant vests in benefits funded by their own contributions immediately.
Prior to ERISA, most plans provided some sort of vesting schedule for participants who terminated prior to normal retirement age. However, those vesting provisions often required many years of service and/or termination at an age close to retirement. A small percentage of participants were in plans that provided no vesting at all, prior to age 65. ERISA initially prescribed a maximum vesting period of 15 years and, over time, the maximum vesting periods have been shortened to five years for cliff-vesting schedules for traditional DB plans (three for DC plans and hybrid DB plans) and to three- to seven-year graded vesting schedules for traditional DB plans (two- to six-year graded vesting schedule for DC plans).
Benefit Accruals
Pre-ERISA nondiscrimination requirements limited the extent to which tax-qualified retirement plans could provide highly compensated employees with more generous benefits than those given to non-highly compensated workers. These rules initially had two goals: “1) to eliminate pension plan tax avoidance schemes, and 2) increase pension and retirement coverage of rank-and-file workers.”27 These requirements encourage more equity between the tax-favored benefits that highly and non-highly compensated employees receive. Since the enactment of ERISA, the nondiscrimination requirements have been made more detailed and strengthened on several occasions.
Before ERISA, tax-qualified pension plans could provide unlimited benefits. To limit deductions for funding benefits to highly compensated employees, ERISA limited the annual pension provided by a pension plan to $75,000 per year at age 55 and the annual contribution to DC plans to $25,000 per year. Since then, the limitations have been tightened by reducing the dollar amounts, raising the payment age for DB plans, and suspending inflation indexation for a time in the 1980s. Despite inflationary indexing, this resulted in a significant reduction in the maximum benefit that can be paid by a qualified retirement plan. A comparison of 1975 to 2024 limits is provided in Figure 7.
27 Benefits, Rights and Features Nondiscrimination Testing and Phased Retirement Programs; Georgetown University Law Center; 2010.
An additional limitation was added in the mid-1980s to limit the amount of compensation that can be considered in pension formulas. ERISA allows employers to provide benefits that exceed these limits, but those benefits must be provided through a nonqualified plan and are not eligible for PBGC guarantees. The people most affected by the limitations of qualified plans are often the executives who decide whether to support the continued sponsorship of a DB plan in their organization. Today, many of them lack a connection to the value of the DB plan because they are not participating in or accruing a benefit in the plan.
Benefit and Contribution Limits for Tax-Qualified Plans
Annual Pension from DB (Equivalent Amount at Age 62)
Annual DC Contribution
ERISA implemented “anti-cutback” protections, which prevent plan sponsors from retroactively reducing a participant’s accrued benefit. These rules also protect certain other plan features, such as early retirement subsidies, optional form subsidies, and the availability of different optional forms. ERISA also strengthened the rules regarding how benefits can accrue over a participant’s career, requiring relatively even accruals throughout a participant’s career. Previously, some plans had significantly “backloaded” formulas, where much of the benefit accrued at the end of a participant’s career. This meant that participants leaving employment before normal retirement age might receive only a small portion of the full-career benefit. Later changes to ERISA prohibited plans from reducing benefit accrual rates due to a participant’s attainment of a certain age. 28 1975 DB limits adjusted from age 55 to 62 using 5% and the 2024 417(e) mortality table.
Survivor Benefits Under ERISA
ERISA introduced the requirement that DB and money purchase plans must offer a qualified joint and survivor annuity (QJSA) to married participants upon their retirement. The QJSA provides a benefit payable to the surviving spouse of at least 50% of the benefit payable during the joint lives of the participant and the spouse. Generally, it must also be no less than the actuarial equivalent of a single life annuity payable to the participant.
The Retirement Equity Act of 1984 (REA) tightened the QJSA requirement by requiring spousal consent for a form of payment other than the required QJSA or a joint and survivor annuity with a higher survivorship percentage. The law also required plans to provide qualified pre-retirement survivor annuities (QPSAs) to pay death benefits to surviving spouses of vested participants who die before retirement. REA also added Section 414(p) to the Internal Revenue Code, creating qualified domestic relations orders (QDROs) to provide spousal rights to retirement benefits in the event of divorce.
Although DC plans must pay the vested account balance to the spouse upon the death of the participant unless spousal consent for another beneficiary is obtained, those plans generally are not required to obtain spousal consent to a participant’s distribution request upon termination from employment or retirement.
Optional Forms of Benefit
Pension plan benefits define a “normal form” of benefit as a monthly payment for the participant’s lifetime. Plans must offer certain optional forms to cover spouses and may offer other optional forms of benefit, such as an annuity that provides a payment with a guarantee period or in a single lump sum payment. Conversions from the normal form to the optional form use the plan’s actuarial equivalence definition. A plan may have several different actuarial equivalence definitions for different purposes. The Internal Revenue Code requires plans to use at least a minimum basis for calculating lump sums and certain other accelerated forms of payment. When choosing between optional forms of benefit, participants must also receive a disclosure of the relative value of each optional form to the normal form. These requirements have evolved over the past 50 years to address emerging concerns about employee protections.
Disclosure Requirements
ERISA requires plans to provide participants with notices containing important information about the plan and about the participant’s benefits. Annual notices, such as the original Summary Annual Report (generally replaced with the Annual Funding Notice) and the Summary Plan Description, notify participants about the financial status of the plan, major events that have happened during the year, and current benefit provisions, including major changes in those provisions. Participants must also receive statements of their benefits in the plan. The rules require that these disclosures be provided in non-technical language so participants can understand what is being communicated. The rules also prescribe deadlines for each disclosure.
Retirement Income
The trend toward account-based plans, including DC plans as well as cash balance and other hybrid DB plans, has accustomed participants to thinking of and taking distribution of their retirement benefits as a lump sum instead of a lifetime annuity. When a retiree chooses to forgo an annuity for a lump sum, they take on the investment risk and longevity risk associated with converting that lump sum into retirement income. Unfortunately, many retirees do not have the necessary financial expertise to effectively manage these risks. Without the longevity risk pooling that an annuity provides, a prudent retiree needs to plan for a longer-than-average lifetime. This will produce lower monthly retirement income. Further, participants taking lump sums from DB plans before normal retirement age may often forfeit the values of early-retirement subsidies available in the annuity form, because plans are not required to include those subsidies in the lump sum.
Although DB plans must offer participants annuity options, except for very small benefits, DC plans have no such requirements. A 2022 survey by the Bureau of Labor Statistics showed that only 14% of private sector employees have access to DC plan lifetime annuity options.29 Both the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE) and SECURE 2.0 included provisions intended to encourage lifetime income options in DC plans, the effectiveness of those provisions remains to be seen. Related to this point, the Academy published a position statement regarding the importance of Retirement Income Options in Employer-Sponsored Defined Contribution Plans in 2017.
29 “How do retirement plans for private industry and state and local government workers compare?” U.S. Bureau of Labor Statistics; January 2023.
Conclusion
Since its enactment in 1974, ERISA has clearly improved the security of America’s private-employer retirement system for those workers who participate in DB plans.
This issue paper highlights the various protections that ERISA provides through:
• The creation of PBGC-insured benefits that are available should a plan sponsor be unable to maintain its plan;
• Pre-funding rules that have reduced the number of employers requiring such protection; and
• Establishing specific protections for benefits, such as more stringent vesting rules and spousal benefits.
However, ERISA has not been successful in ensuring that most workers have access to retirement plans or secure lifetime income, as 31% of private sector employees lack plan coverage altogether and only 7% accrue benefits under a DB plan.30 In DC plans, only 14% of private sector employees have access to annuity options.31
Moreover, ERISA has also created some significant challenges for DB plan sponsors, such as high PBGC premiums, complex funding rules, and myriad administrative requirements. These challenges have contributed to the decline of DB plans over the years. Many employers now rely substantially or exclusively on 401(k) plans, which shift risk to employees and do not generally allow for efficient pooling of those risks. While ERISA has strengthened protections for individual participants in single-employer DB plans, far fewer workers benefit from those protections today than did at ERISA’s adoption 50 years ago.
31 “How do retirement plans for private industry and state and local government workers compare?”; Op. cit.
ERISA at 50 years
and the democratization of advice through defined contribution plans
ERISAʼs impact
Provided a way for people to obtain retirement security and helps millions of Americans prepare for retirement
Served as a catalyst for the creation of financial education, investment solutions, and advice services
Opened a new advice channel for workplace savers beyond traditional advice and wealth management options
Set the foundation for future innovations driven by technology, advice, and investments
1974 was a memorable year
The Rubik’s cube was invented, and Skittles were introduced, but 1974 was also memorable for more consequential events.
Through the Equal Credit Opportunity Act (ECOA), women gained greater control over their finances with new access to lines of credit, and the Employee Retirement Income Security Act (ERISA) was passed. ECOA was an important step to providing women equal access to the financial system. And in the same spirit of ECOA, ERISA was passed with the goal of improving and safeguarding the retirement security and healthcare plans of Americans.
96% of employers offer a matching contribution of eligible employees made contributions
%
The original intent of ERISA remains true to this day: protect workers in employer-sponsored retirement and health plans
ERISA has had an outsized influence on the retirement security of millions of Americans. The legislation also gave rise to the 401(k) and modern-day defined contribution (DC) market. According to the latest 401(k) survey from the Plan Sponsor Council of America (PSCA), 96% of employers offer a matching contribution and 86% of eligible employees made contributions.1
Over time, 401(k) plans have proven to be an invaluable financial resource for millions of Americans regardless of age, income, gender, or ethnicity.
ERISA remains the foundation on which today’s retirement plans are governed. Over the course of 50 years, new legislation, regulatory guidance, and judicial opinions have strengthened and expanded ERISA’s foundation. Expanding retirement plan access and coverage to many Americans — especially those who may need it the most — remains a priority.
Today, 401(k) plans have created more than $7 trillion in wealth for more than 70 million active plan participants and millions more former and retired employees2
The growth and evolution of DC plans also created the demand for education, guidance, enhanced investment options, and advice services to help workplace savers manage their DC assets. Employers and retirement providers over time responded by making educational and advisory services available to most 401(k) plan participants.
ERISA and the evolution of 401(k) plans democratized advice and made it available to most covered Americans regardless of income, gender, wealth, or age
Plan Sponsor Council of America (PSCA), “66th Annual Survey of 401(k) Plans,” 2023.
The early days
In the 1980s, a changing economic environment, employment trends, and shifting corporate approaches to employee benefits led to the rapid growth of DC plans, specifically 401(k) plans
It marked a shift from employers assuming the risk and responsibility of managing traditional pension plans — defined benefit plans — for their employees, to workers bearing that risk and responsibility through DC plans.
As a result, DC plans opened the doors to investing for millions of Americans and we believe created a greater need for financial advice to manage this new pool of assets.
Corporate DC participants (thousands)
Corporate DC assets (billions)
Employee Benefits Security Administration, United States Department of Labor, Private Pension Plan Bulletin Historical Tables and Graphs 1975-2021, September 2023.
DC participants and assets grew dramatically in the 1980s and 1990s, but participants had limited access to advice through their employer plans
Participants were primarily self-directed investors who received education and communications about the importance of diversification, saving early, the power of compounding, and other financial basics. Access to personalized investment advice that’s based on an individual’s unique situation, risk tolerance, and personal goals would come later, driven by technological improvements and legislative changes.
Investment options and advice evolve under the Pension Protection Act of 2006
The DC investment landscape under the ERISA umbrella evolved over the years to better meet individual needs and provide necessary safeguards
Early on, the overall distribution of 401(k) assets between 1996 and 2000 highlighted the need for greater diversification.3 Almost 20% of assets was invested in company stock and a similar percentage of assets was in a combination of guaranteed investment contracts and money market funds.
Professionally managed fund options were few and far between and limited at the time to balanced funds. Although company stock usage was skewed toward larger plans, the lack of professionally managed fund options applied to all 401(k) plans.
allocation percentage by investment category3
Expanding access to embedded professional management through target date funds
The need to reduce risk, plan for retirement across individuals’ lifecycles, and incorporate professional investment management became focal points for 401(k) product development and service offerings
Target date funds (TDFs) were developed in the mid-1990s, but adoption remained low. This dynamic began to change with the passage of the Pension Protection Act of 2006 (PPA). In 2006, less than one in five 401(k) participants held a target date fund, accounting for only 5% of 401(k) plan assets.4 Fast forward to 2022 and 68% of participants used target date funds, accounting for 38% of assets.5
With fiduciary protections from PPA, auto enrollment and target date funds began to take off. TDFs addressed concerns about poor participant account diversification trends and offered embedded professionally managed strategies for participants. Auto enrollment and TDFs can help drive better participation and asset allocation behavior, but due to its structure, their impact on engagement or retirement planning on the part of participants can be more limited.
A new century opens advice doors
Guidance, not financial advice, was the norm for retirement plans until the turn of the century
Fiduciary liability under ERISA was one of the top reasons the majority of employers shied away from adding advice services and plan providers were hesitant to offer them.
In late 2001, the Department of Labor issued Advisory Opinion 2001-09A — more commonly known as the SunAmerica opinion. The opinion opened the door for advisory services/ professionally managed accounts as long as certain conditions were met. Other providers modeled their professionally managed account offerings based on the SunAmerica opinion, and managed accounts began to gain traction. DOL provided further validation by allowing professionally managed accounts to be the QDIA for a retirement plan.
Managed account asset growth in DC plans (billions)
The collapse of Enron in 2001, WorldCom in 2002, and the dotcom bubble crash were also big drivers in highlighting the need for advice. Enron was the largest corporate bankruptcy filing at the time and Enron employees suffered retirement plan account losses due to high company stock allocations that approached 60% of plan assets.6
Enron employees weren’t the only ones with significant company stock allocations. According to EBRI/ICI 2000 data, almost half (48%) of 401(k) participants under the age of 40 in plans with company stock had more than 20% of their account balances invested in that asset class.7 The dotcom bubble and tech crash that took place in 2000 hit many investors and savers hard and underscored the importance of diversification and investment advice.
Cerulli Associates as of December 31, 2023. (Empower Webinar, Advice for all: Strategies to elevate your practice, June 18, 2024.)
Why advice is increasingly important today
Americans surveyed by Empower are looking for help from financial services firms about many topics, including: Taxes
One-on-one financial coaching Reducing debt
People face more complex and interconnected financial needs than in past decades
They also face a constant stream of financial, economic, and other news that can be hard to decipher, may create financial anxiety, and leaves people uncertain about how to take action if needed.
Simply put, people may need help moving forward
Empower research shows that people are looking for extensive help from financial services companies to help lower their financial stress. It’s not just about preparing for retirement; it’s also about managing a wide variety of short-term and longer-term financial needs so that people are in a position to plan for retirement.
Tools financial service companies should provide to help lower financial stress
Timely strategic advice based on current market conditions or events
One-on-one financial coaching
Help reducing debt
Financial trackers (e.g., a dashboard toward a certain savings goal, etc.)
Help with my taxes
Estate planning help
Empower, “Financial Happiness,” 2023.
Only 50% of Americans with a household income of less than $50K are financially literate 8
Sample account types that help save for different goals
Financial literacy is an opportunity
Let’s explore the need for advice by looking at the baseline financial literacy of Americans. An Ipsos poll found that the average American rates themself as being moderately financially literate (6.2 out of a 10 point scale). However, results from a financially literacy quiz show that close to a quarter of respondents who rate themselves as being financially literate don't qualify as such.8
This suggests there’s a need for greater financial education about basic financial issues
Long retirements are difficult to plan for
This is not a new development, but one that hasn’t gone away. Americans are living longer in retirement, and they may need help figuring out how much income they’ll need. They may also need help generating income in retirement that can last for 10, 20, or possibly more than 30 years.
Patchwork of financial account types help, but add complexity
Americans have access to a wide variety of financial products and account types that can help them save. The creation of targeted products for different savings goals has been a positive development, but it has left some workers scratching their heads on how to leverage these to allocate and increase their savings.
There are a number of enhanced savings vehicles available
And with so many account types to choose from and each account having different account features, it’s no wonder people need help figuring out how to move forward.
College savings
529 accounts
Healthcare Health reimbursement arrangements (HRAs)
Flexible spending accounts (FSAs)
Health savings accounts (HSAs)
Long-term care savings
Educational saving accounts (ESAs)
Retirement
401(k)s: traditional, Roth, after tax
IRAs: rollover, spousal, Roth
Social (in)Security
People need help figuring out when to claim Social Security. Claiming strategies are complex, and, complicating matters more, a quarter of workplace savers don’t expect Social Security to be available when they retire.9
Generational wealth
According to industry research, approximately $84 trillion will be passed on over the next 20 years in what is being dubbed as the greatest generational wealth transfer in history. Owners of that wealth need help figuring out how to manage and transfer those assets in a tax-efficient manner.10 And for those expecting a wealth transfer, they need help preparing for it.
Healthcare and long-term care in retirement
Retiree healthcare in retirement, even with Medicare, is a significant expense. In fact, EBRI estimates that some couples could need more than $400,000 to cover their healthcare expenses in retirement.11 Then there’s the possibility of needing long-term care, which is typically not covered by Medicare.
The bottom line is that people want and need help managing their financial lives, and the workplace is a natural source to access that help
The workplace: A trusted and accessible source
Employers and organizations are already offering their employees a wide range of benefits to make sure they are taken care of, but also to remain competitive with talent recruitment and retention.
As for employees, they are accustomed to turning to their employers and benefits providers for help with retirement planning, healthcare needs, disability benefits, and more.
Financial advice is an extension of already offered benefits, and it’s becoming more than a “nice to have” benefit
Most workplace savers prefer receiving financial advice through their retirement plan
21% are indifferent
27% prefer to find a financial advisor on their own
67%
of Americans believe that employers have a responsibility to help with financial planning12
53% prefer financial advice/ portfolio management services through their 401(k) plan (managed account)
Cerulli Associates, “401(k) Managed Accounts: A Misunderstood Value Proposition,” May 2024.
Financial advisors and retirement providers most trusted Americans with access to a defined contribution plan look to different sources to access financial advice. However, there is a divergence between where people go to for advice and the sources they trust the most.
Financial advice sources used and valued/trusted the most
A financial advisor or retirement provider were among the top consulted and most trusted sources of advice
Women are 50 % more likely than men to believe they don't have enough savings to work with an advisor
Workplace savers can be apprehensive about asking for advice
However, less than half of Americans are using a financial advisor, according to Empower research of Americans with and without DC plans.12 The most common reasons for not using an advisor are the perception that it will be too expensive and not having enough assets to merit meeting with a financial advisor.13
It’s important to note some key gender differences when it comes to usage of financial advisors13
Fewer women with access to defined contribution plans use professional advisors compared to men (35% vs. 45%).
About half of women and men (51% vs. 47%) not using an advisor believe it will be too expensive.
Women are 50% more likely than men to believe they don’t have enough savings to meet with an advisor.
Only 11% of women (compared to 23% of men) say they don’t use an advisor because they are confident with their investment knowledge and decision making.
Bridging the advice gap is critical given that men’s average 401(k) account balances are 50% higher than women’s9
35% of women with access to defined contribution plans use professional advisors
Reasons why workplace savers don’t use an advisor
Think it will be expensive
Think they don’t have enough savings to warrant professional services
Not sure of the value they provide
Seems complicated to find or select one
Do not trust them to put savers' interests first
Confident with investment knowledge/ability to make decisions on their own
Afraid they won’t be taken seriously
Hard to find an advisor who looks like them or understands their culture
If not using a financial advisor, many individuals need financial advice from other sources
We already noted that a financial advisor was a top trusted and consulted source for advice.
But for individuals not using an advisor, more than half (51%) consider their employer or retirement provider as their primary source for retirement planning and financial advice.
>50% of respondents not working with an advisor look to their employer and plan provider for advice
Employer/previous employer
Automated online investment service (e.g., Betterment, Wealthfront) Other Traditional media (e.g., TV shows, newspaper) Retirement savings provider (e.g., Empower, Schwab)
member or friend/former co-worker
Cerulli Associates 2024. (Empower Webinar, "Advice for all: Strategies to elevate your practice," June 18, 2024.)
Analyst note: This question was only asked to respondents who do not work with a financial advisor. Respondents were asked, "What is your primary source for retirement planning and financial advice?" "Other" includes "my personal mathematical calculations," "personal college degree in finance and economics," and "my own research."
Advice for all
Individuals at all income and asset levels can benefit from advice DC plans, and the providers servicing those plans, have helped equalize the advice playing field by providing access to many participants. An Empower analysis of corporate DC participants who had an advice interaction with an Empower registered representative via a phone consultation in 2023 shows that workplace savers of all income levels and ages are represented.14 However, a clear opportunity exists to broaden the usage of advice by younger participants and those with lower income levels.
Distribution of corporate DC workplace savers by advice interaction and income
Distribution of corporate DC workplace savers by interaction and generation
Baby boomers
Xers
Key findings
Advice is improving retirement plan savers’ retirement readiness
Advice is making a difference
Empower’s analysis also shows that corporate workplace savers who have taken advantage of an advice consultation available through their DC plans are significantly better prepared for retirement than those who haven’t.
Key workplace saver retirement metrics by advice criteria
Empower analysis of 7.8 million corporate DC participants as of December 31, 2023.
People using an advisor feel better off
People who use an advisor compared to those who don’t are more likely to:
Feel more financially healthy and confident about their retirement readiness
Consider themselves to be knowledgeable about investing
Be more comfortable making investment decisions
Plan to retire early or as planned
How participants working with or without an advisor feel
In-plan advisory services
Meeting the needs of a diverse population base requires a broad set of products and advisory services. Advisory services provided through managed accounts are another avenue for participants to benefit from advice. Managed accounts allow participants to personalize their accounts based on their personal situation, benefit from professional management, access one-on-one advice services when needed, plan retirement distribution strategies, and optimize Social Security strategies among other needs.
Technology has been instrumental in bringing this degree of investment and retirement personalization to workers at a reasonable cost
From an employer or organization’s perspective, there is a growing recognition of the complex financial needs of their employees. There is also an increased interest in how technological advances can support participant needs. These are some of the factors why plan sponsors are adding in-plan advice.
Reasons for offering managed accounts15
More customizable to participant demographics than TDFs
Recommended by plan advisor More advisor involvement in design
With managed accounts, participants can actively personalize their portfolio beyond age, savings rate, marital status, and other information that’s already available through the recordkeeper. About two-thirds of participants actively personalize their strategies by providing common items such as retirement age, retirement need, outside accounts, and spousal information 17 At retirement, people are generally more focused on replacing their monthly income for the rest of their lives
Target date funds and managed accounts can help participants save and build a nest egg from which to generate retirement income. Empower research finds that individuals closest to retirement are 18% more likely to meet their retirement income goal.18
Managed accounts have been shown to help drive better retirement outcomes
Managed account users are
The income replacement statistic is based on Lifetime Income Scores (LIS) data as of September 30, 2023, for participants who are 60+ in age across corporate, not-for-profit, and government plans that own target date funds (those who have 95% or more assets in up to two TDFs). Data includes participants with available
data and LIS scores. more engaged16 and save more than engaged TDF users9
What’s next?
Legislative changes to ERISA have revolutionized the defined contribution and financial advice market over the years
We believe ERISA has been a key catalyst in making financial advice available to millions of Americans, and that it will provide access to millions more pursuing their financial freedom.
We also believe some key areas of innovation to look out for include:
Artificial intelligence (AI)
AI has the power to transform the DC market from many perspectives, including streamlining operations, enhancing product development, and taking personalized advice to a new level.
Retirement income
Demand for and availability of retirement income solutions is on the rise, but legislative changes may be needed to help secure Americans’ retirement. Automatic or opt-out income solutions could revolutionize how Americans generate lifetime income just like autoenrollment drove plan participation and usage of TDFs.
Personalization
Tailored product solutions will be the norm in DC plans as participants demand greater personalization. One-size-fits-all solutions will take a back seat.
Institutional-styled portfolios go down market
Asset classes and investment strategies once limited to endowments, family offices, pensions, and sovereign wealth funds will make their way to defined contribution plans. Advisory services like managed accounts will be the chassis through which these new strategies help to optimize the retirement portfolios of Americans.
1 Plan Sponsor Council of America (PSCA), “66th Annual Survey of 401(k) Plans,” 2023.
2 ICI 401(k) Res ource Center, ici.org/401k.
3 Employee Ben efits Institute (EBRI) Issue Brief Number 239, “401(k) Plan Asset Allocation Account Balances, and Loan Activity in 2000,” November 2001.
4 Holden, Sarah, Jack VanDerhei, and Steven Bass, “401(k) Plan Participants’ Use of Target Date Funds,” EBRI Issue Brief, no. 537, and ICI Research Perspective, vol. 27, no. 7, September 2021.
5 Holden, Sarah, Steven Bass, and Craig Copeland, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2022,” EBRI Issue Brief, no. 606, and ICI Research Perspective, vol. 30, no. 3 April 2024.
6 CBS News: The Early Show by Sarah Katt, 401(k) Advice, May 8, 2002.
7 VanDerhei, Jack, “Retirement Security and Defined Contribution Pension Plans: The Role of Company Stock in 401(k) Plans,” February 27, 2002. Available at SSRN: ssrn.com/abstract=1259375 or dx.doi.org/10.2139/ssrn.1259375.
8 Ipsos Public Poll Findings, Over one in three Americans are not considered financially literate, April, 27, 2022.
9 Empower, “Empowering America’s Financial Journey,” December 2023. Empower conducted a nationally representative online survey of full-time employees at for-profit companies with access to a defined contribution (DC) plan offered by their employer. Survey was conducted in August 2023 with a sample size of 2,511 working Americans between the ages of 18 and 70.
10 The New York Tim es, “The Greatest Wealth Transfer in History Is Here, With Familiar (Rich) Winners,” May 14, 2023.
11 Spiegel, Jake, and Paul Fronstin, “Projected Savings Medicare Beneficiaries Need for Health Expenses Increased Again in 2023: Some Couples Could Need as Much as $413,000 in Savings,” EBRI Issue Brief, no. 599 (Employee Benefit Research Institute), January 18, 2024.
13 Empower conducted a nationally representative online survey of full-time employees at for-profit companies with access to a defined contribution (DC) plan offered by their employer. Survey was conducted in August 2023 with a sample size of 2,511 working Americans between the ages of 18 and 70.
14 Analysis of 7. 8 million corporate DC participants (active and not active) who are recordkept by Empower as of December 31, 2023.
15 Plan Sponsor Council of America 64th Annual Survey, 2022.
16 Empower defin es engagement as at least one interaction with Empower’s workplace savings site, and/or mobile apps, the Customer Care Center, or our advisory services over a 12-month period.
17 Empower Advisory Group, LLC recordkeeping data as of December 31, 2023. Personalization is defined as confirming, adjusting, or providing more information through the Empower Personal Dashboard™ or an advisor representative.
18 The income rep lacement statistic is based on Empower Lifetime Income Score℠ (LIS) data as of September 30, 2023, for participants who are 60+ in age across corporate, not-for-profit, and government plans that own target date funds (those who have 95% or more assets in up to two TDFs). Data includes participants with available salary data and LIS scores.
Empower refers to the products and services offered by Empower Annuity Insurance Company of America and its subsidiaries. This material is for informational purposes only and is not intended to provide investment, legal, or tax recommendations or advice.
The research, views, and opinions contained in these materials are intended to be educational; may not be suitable for all investors; and are not tax, legal, accounting, or investment advice.
“EMPOWER” and all associated logos and product names are trademarks of Empower Annuity Insurance Company of America.
SECURE
2.0 AND THE PAST AND FUTURE OF THE U.S.
RETIREMENT SYSTEM
J.Mark Iwry, David C. John, and William G. Gale
ABSTRACT
The SECURE 2.0 legislation, passed in December 2022, is the most extensive set of changes to retirement law in the last 15 years. In this paper, we place SECURE 2.0 in the context of the ongoing evolution of the retirement system, summarize its key provisions, and discuss the need for additional reforms. Because 2024 marks the 50th anniversary of the passage of ERISA, assessing the broad arc of retirement policy and behavior is particularly timely. Previous reform efforts, including automatic 401(k)s, Automatic IRAs, and the saver’s credit, aimed to make retirement saving easier and more rewarding for rank-and-file workers. More recently, SECURE and SECURE 2.0 improved and expanded the saver’s credit (renamed the saver’s match), expanded automatic enrollment, and extended plan participation to more part-time employees. They also facilitated multiple-employer plans and took steps to improve account portability and disclosure, reduce pre-retirement leakage, facilitate emergency saving, and promote better options to convert savings into retirement income. However, there are still important avenues for policy to make the retirement system more equitable and effective. Particularly important are eliminating the coverage gap and closing the racial, ethnic, and gender gaps in retirement wealth. Other key goals include helping workers convert savings into reliable lifetime income; encouraging people to work longer; reducing pre-retirement leakage, including by ensuring that retirement savings can follow workers from job to job; and exempting smaller savers from the required minimum distribution rules.
ACKNOWLEDGEMENTS
Iwry is a Nonresident Senior Fellow at the Brookings Institution and a Visiting Scholar at the Wharton School at the University of Pennsylvania. John is Senior Policy Advisor at the AARP Public Policy Institute and a Nonresident Senior Fellow at Brookings. Gale holds the Miller Chair in the Economic Studies Program at Brookings. The authors thank Josh Gotbaum, Oliver Hall, and Ben Harris for helpful comments and Sam Thorpe for outstanding research assistance and comments.
DISCLOSURES
Iwry periodically provides, in some cases through J. Mark Iwry, PLLC, policy and legal advice to plan sponsors and providers, government officials, academic institutions, other nonprofit organizations, trade associations, fintechs, and other investment firms and financial institutions, regarding retirement and savings policy, pension and retirement plans, and related issues. Iwry is a member of the American Benefits Institute Board of Advisors, the Board of Advisors of the Pension Research Council at the Wharton School, the Council of Scholar Advisors of the Georgetown University Center for Retirement Initiatives, the Panel of Outside Scholars of the Boston College Center for Retirement Research, the CUNA Mutual Safety Net Independent Advisory Board, the Executive Committee of the Improving Taxation Project, and the Aspen Leadership Forum on Retirement Savings Advisory Board. He also periodically serves as an expert witness in federal court litigation relating to retirement plans. The authors did not receive any financial support from any organization or person for any views or positions expressed or advocated in this document. They are currently not an officer, director, or board member of any organization that has compensated or otherwise influenced them to write this paper or to express or advocate any views in this paper. Accordingly, the views expressed here are solely those of the authors and should not be attributed to any other person or organization.
During his service in the U.S. Treasury Department as Benefits Tax Counsel, Deputy Assistant Secretary (Tax Policy), and Senior Advisor to the Secretary with responsibility for national retirement and health care policy (1995-2001, 2009-2017), Iwry was involved in initiating, directing, or overseeing the development, proposal, advocacy for, and/or implementation of many of the legislative, regulatory, and administrative policies provisions, proposals, and guidance discussed in this paper, including payroll deduction IRAs; automatic enrollment and automatic asset-allocated investing; the saver’s credit and saver’s match; payroll deduction IRAs; the SIMPLE-IRA; automatic rollover of small benefits from plans to IRAs; provisions and guidance expanding portability and rollovers; inclusion and formulation of the Automatic IRA proposal in Obama Administration budgets and in proposed legislation; the QLAC; annuities embedded in QDIA target date funds; rollover of DC plan lump sums to DB plans to purchase lifetime DB pensions; guidance prohibiting corporate plan sponsor buybacks of DB pensions in pay status; emergency savings draft guidance; regulatory safe harbor protection for and permission to use myRAs in state-based auto IRA programs; legislative exemption of all but large plan and IRA balances from required minimum distributions; variable DB and defined ambition plans; multiple employer and pooled employer plans (MEPs/PEPs); long-term part-time employee participation, and other provisions ultimately enacted in the SECURE and SECURE 2.0 legislation.
The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports, published online. The findings, interpretations, and conclusions in this report are solely those of its authors and are not influenced by any donation.
Once dominated by employer-sponsored pensions,
the U.S. retirement system has evolved steadily to one where most private sector workers have access to retirement savings accounts. These accounts increasingly embody features rooted in behavioral economics—including automatic enrollment and default investment options. This gradual evolution has been driven by a mix of changing demographics, employers’ desire to reduce their risks and pension costs, and incremental policy reforms at the federal and state levels intended to improve retirement security for more people.
The SECURE 2.0 Act of 2022 (“SECURE 2.0”), passed in December 2022, is the most extensive set of changes to retirement law in the last 15 years. In this paper, we place SECURE 2.0 in the context of the ongoing retirement evolution, summarize certain key provisions, and discuss the need for additional reforms. Because 2024 marks the 50th anniversary of the passage of ERISA, assessing the broad arc of retirement policy and behavior is particularly timely.
The paper is organized in several sections. The first section below briefly describes the evolution of the retirement system in the last quarter of the 20th century, from a system where pensions—specifically employer-sponsored defined benefit plans—were predominant to one where 401(k)-type plans and individual retirement arrangements (IRAs) became increasingly important. The ascension of 401(k) plans and IRAs as the main retirement vehicles for rank-and-file workers shifted most of the financial risks onto individuals and created a host of related problems. Addressing these issues has been the principal focus of retirement policy over the past 25 years.
The second section discusses a series of previous reform efforts that aimed to make retirement saving easier and more rewarding for the majority of workers. These policies include the development and promotion of automatic 401(k)’s, Automatic IRAs, and the saver’s credit. These changes are gradually moving the retirement system in the right direction, but many more reforms are required.
The third section discusses the more recent evolution of retirement policy, embodied in the SECURE (2019) and SECURE 2.0 (2022) legislation. These changes include improving and expanding the saver’s credit (renamed the saver’s match), helping savers manage their accounts during their working years by improving portability and disclosure, reducing pre-retirement leakage, and facilitating emergency saving. Importantly, these two bills aim not only to help workers accumulate more resources for retirement, but also to help savers better convert their savings into retirement income.
A concluding section discusses additional steps to create a more equitable and effective defined contribution system that utilizes proven behavioral strategies to achieve better retirement outcomes. Some of these include eliminating the coverage gap so that everyone can supplement their Social Security with retirement savings, increasing focus on closing racial, ethnic and gender gaps in retirement wealth, creating better options to convert savings into lifetime retirement income, introducing policies that encourage people to work longer, taking steps to ensure that retirement savings would follow workers from job to job, and providing reforms to the required minimum distribution rules.
I.The Retirement System in the Late 20th Century
A.DEFINED BENEFIT PLANS
ERISA—the Employee Retirement Income Security Act of 1974—reshaped the laws governing private pensions in the U.S. But even as ERISA began to take effect, the basic nature of the system it was intended to reform—one dominated by defined benefit (DB) pension plans—was changing. The past half century has seen a secular, systemic shift away from a system in which private-sector workers who had retirement coverage often had access to DB plans, which provided meaningful, regular retirement income to millions of middle-income households. However, even in this era, coverage was far from universal.
Traditionally, DB plans were established, funded, and managed by employers for their employees or by unions for their members. Designed mainly to augment Social Security benefits, the funds provided by employers, often pursuant to collective bargaining agreements, were invested collectively and professionally. With benefit formulas based largely on the level of an employee’s wages and length of service, the plans aimed mainly to pay a lifetime, guaranteed stream of monthly income (although, typically, the payments were not fully adjusted for inflation). The plans insulated workers against many sources of uncertainty, including risky asset returns, counterparty risk, longevity risk, and the risks associated with poor choices regarding how much to contribute, how to invest the funds, and how much or how quickly to withdraw funds in retirement.
DB plans minimize the need for workers to take initiative or make decisions. Under the DB framework, the employer or union sponsoring the plan makes contribution and investment decisions, and also bears the risk in terms of investment returns and employee longevity. Workers, in effect, swap administrative responsibilities, investment risk, and longevity uncertainty for the risks of pension underfunding (which ERISA mitigated to some extent by creating a federal
insurance program), lack of benefit portability, and the significantly larger chance of losing their benefits due to job change, unemployment, or if their employer terminates the plan before a worker can accumulate a significant benefit. At the time, many DB plans required employees to serve for many years before a worker qualified for their benefits. As a result, not only did many workers receive nothing at all, but many others also received only a small benefit.
ERISA did not require employers or unions to offer retirement plans, but if pension promises were made, ERISA generally sought to ensure that they were kept and that plans were structured in a way that generally protected covered workers’ reasonable expectations. The law obligates plan sponsors to manage and operate pension plans in the interest of participating employees and retirees and in accordance with the plan’s terms and ERISA’s fiduciary standards.
Many employers—not only in the U.S. but also in the UK and other developed economies—have chosen not to sponsor DB pension plans. Increasingly, employers are deterred by what, to them, are the DB’s drawbacks: cost, administrative burden, risk of litigation, potential liability, and potential volatility of funding obligations. In particular, fluctuating market values and interest rates can lead to unexpected increases in pension funding obligations that can wreak havoc with corporate financial statements. And in declining industries with shrinking work forces facing stiff global competition (including, at various times, U.S. autos, steel, tire, trucking, airlines, and U.S. manufacturing generally), there is a steadily increasing ratio of (a) pensioners depending on financial support from company-sponsored pension plans to (b) active workers producing revenues that help the company fund those pensions.
Moreover, even in thriving sectors of the economy, as life expectancies have increased markedly over the past century, the ratio of retirement person-years to working person-years has continued to increase. As
a result, pension liabilities have loomed larger than expected on the balance sheets of many corporate DB plan sponsors.
For workers, while DB plans have major advantages, they also have some drawbacks. Although they protect workers from many financial risks and provide regular monthly income guaranteed for life (and often for the lives of both an employee and their spouse), DB benefits for many workers are not payable until the relatively distant future. This makes them harder for many employees to relate to than more tangible, liquid retirement savings account balances that accumulate more visibly in the short term. While many individuals prefer the certainty of pension benefits, many others want more choice, more control, greater liquidity, the possibility of access to more versatile savings before retirement, and flexibility to take more or less than the regular monthly DB payment.
Traditional pension plans also tend to disproportionately reward longer-service, older, and well-paid employees, with vesting schedules and benefit accumulation formulas often reserving the richest benefits for a relatively small fraction of workers who retire from the sponsoring employer. In addition, DB benefits may not be as well suited as retirement savings plans for a mobile workforce or for those moving in and out of the workforce due to family responsibilities or other reasons. Changing jobs can slow the rate of DB benefit accumulation, and the fact that most employers do not sponsor DB plans and the friction involved in moving DB benefits from one employer to another further impede the portability of DB pensions.
Accordingly, with the increase in global competition and changes in the U.S. work force—including the markedly declining market share of organized labor, which traditionally has bargained for DB pensions—the number of DB plans and the number of workers they cover have declined steadily.1
B.THE RISE OF 401(K) PLANS
The universe of defined contribution (DC) retirement savings plans—already less protective of individuals than DBs—also shifted. “Classic” DC plans that already
existed, such as “profit-sharing: or “money purchase pension” plans2 typically were funded, invested, and managed mainly by employers. They “defined” the employer’s contributions (which could be substantial) rather than the employee’s ultimate benefits. Over time, however, the dominant vehicles outside of the DB space became a different type of DC plan—mainly new types of worker-funded retirement saving accounts. These are exemplified by the 401(k), which is mostly funded by employee elections to redirect a portion of their take-home salary or wages to a tax-favored retirement saving account, and the IRA, which is entirely funded by the individual who owns it. Thus, the shift away from pensions was not “just” a shift in the form from DB to DC. Rather, within the DC category, it included a substantial shift from employer-funded and employer-managed pension plans to retirement saving accounts funded and run mainly or largely by workers or individual savers. In doing so, it also placed almost all of the responsibility and risks on the employees.
Starting in the early and mid-1980s and spurred on by the growing availability of mutual funds as a widely accessible means of efficiently diversifying investment risk, 401(k) plans came onto the scene.3 These retirement saving plans did not define the ultimate benefit, nor—being mostly self-funded by employees—did they define the employer’s or employee’s contributions. Employees decided how much to contribute on a tax-favored basis, investment earnings accumulated on a tax-deferred basis, and payouts, typically in retirement, would be included in taxable income. Nondiscrimination standards were designed to give employers incentives to encourage broad participation by moderate- and lower-income employees and to limit the disparities in saving and benefits between them and executives or business owners. Partly for this reason, employers often voluntarily matched employee contributions.
While 401(k)s at first were typically offered mainly as supplements to a mainstay DB pension, they expanded rapidly and gradually became the primary private-sector retirement plan for tens of millions of workers. Between 1980 and 2019, the percentage of private-sector U.S. workers participating in 401(k) and other DC plans increased from 17% to 52%, while the
percentage covered by DB plans dropped from 39% to 8%. Figure 1 shows the change in participation in DC and DB plans from 1975 to 2019.4 This same period also saw a dramatic expansion of IRAs, which ERISA authorized mainly to offer tax-favored retirement benefits that would help fill the gap for individuals who had no access to an employer plan, and also to give plan participants a tax-favored destination for rollovers of benefits when leaving a job.
In the 1980s and 1990s, the typical 401(k) plan was a “do-it-yourself” vehicle. While this was a popular design, it raised many issues as 401(k)s became the main retirement vehicle for rank-and-file workers. The 401(k) and IRA rules that existed at the time did not require employers to offer a 401(k) or an IRA; and
provided little guidance about (a) whether an employee should participate; (b) how much to contribute initially and how much to raise contributions over time; (c) how to invest account balances, and (d) when and in what form to withdraw plan savings. In addition, the 401(k) and the IRA do not naturally protect individuals against their lack of professional investment experience and judgment. Savers also can be exposed to market volatility and sequence-of-returns risk, uncertainty about how much to contribute and at what pace to spend down their account balance, or the risk of outliving their retirement resources. Improving the 401(k) and IRA system to address these issues has been a main focus of retirement plan reform over the past 25 years, as discussed below.
FIGURE 1
II.Making Retirement Saving Easier and More Rewarding
Helping retirement savers to have better outcomes and reduced risk began with regulatory changes by the Treasury Department starting in 1998 that first defined, approved, and began to promote automatic enrollment (paired with automatic diversified investing) in 401(k)s and similar plans. As evidence mounted that automatic features worked and private-sector interest and take-up in the market increased, the regulatory reforms expanded and were eventually complemented by federal legislation. The legislation, especially 2006’s Pension Protection Act (PPA06), enabled the private sector to implement the auto features more expansively. In short, despite delays and obstacles, the automatic 401(k) illustrates how innovative policymaking can work—beginning with more limited changes to test the premise, then evaluation in academic and think tank settings, and finally gradual implementation and expansion through governmental and private-sector action.
In 2006, inspired by the success of automatic features in 401(k) plans, the Retirement Security Project proposed a nationwide Automatic IRA program. As described below, while Congress has continued to consider the Auto IRA legislation without acting on it, 15 States (to date) have adopted the concept by enacting Auto IRA programs for their citizens.
A.THE AUTOMATIC 401(K)
As DB plans continued to erode, policymakers in the Office of the Benefits Tax Counsel at the U.S. Treasury Department in the late 1990s formulated a regulatory strategy to reshape the rapidly spreading “do-it-yourself” 401(k) to incorporate certain valuable attributes of DBs and other traditional pensions (Clinton Administration History Project 2001). DBs and traditional pre-401(k) DC plans generally cover employees automatically, without requiring them to take the initiative to enroll. Accordingly, rulings issued by Treasury and IRS in 1998 and 2000 outlined a new 401(k) paradigm. Instead of having to sign up for a 401(k) plan (and too
often failing to do so out of inertia, procrastination, or indecision about how much to contribute or how to invest), employees could be automatically enrolled in the plan. The new guidance announced that “auto enrollment” was lawful for 401(k) and similar plans, and that, accordingly, plan sponsors may, but are not required to, automatically enroll employees into the plan if it provides explicit advance written notice. Unless an employee affirmatively opted out of participation, the employer could deduct a portion of the employee’s pay and contribute it to the plan on a pre-tax basis.
The implications and power of this strategy have been transformative for the 401(k) system. The default affects not only enrollment; plans automatically enrolling employees must specify the level of contribution and how the funds will be invested among the available options. Employees are free to reject those defaults and make their own affirmative choices, but if they don’t, they are enrolled in the plan’s choices. The government’s rulings made clear that it was not requiring plans to use any particular contribution level (like 3% of pay) or any particular investment as the plan’s defaults. But because the rulings used particular facts to illustrate how automatic enrollment and the defaults could work, plans and their legal counsel paid close attention to those examples. Three of those illustrative facts are particularly worth noting: the default contribution level was not the same in all the rulings (3% of pay in several rulings and 4% of pay in another); the plan’s use and continuation of employer matching contributions in all the rulings, and a default investment consisting of a balanced fund of diversified stocks and bonds—and explicitly not stock of the employer sponsoring the plan—in all the rulings. (Rev. Rul. 98-30; Rev. Ruls. 2000-8, 2000-33; Rev. Proc. 2000-35; Rev. Rul. 2009-30; IRS Notice 2009-66).
Moreover, Treasury’s decision to use the term “automatic enrollment” in 1998 was intended to cue the market to recognize that enrollment was only one phase of the saving cycle that could usefully be made
automatic (Iwry 2020). In addition to automatic investing, beneficial defaults could apply also to distributions, including rollovers. Later, Treasury/IRS made clear—prompted by Thaler and Benartzi’s “Save More Tomorrow” proposal—that plan sponsors could also default participants into increasing their contribution rate over time5 (IRS 2004). Automatic escalation of contributions improves the adequacy of saving. It also helps address the concern that some new employees could passively accept the plan’s initial default rate and never increase it even though it would not produce sufficient levels of savings. If forced to make an explicit election, they would otherwise decide to contribute at a higher rate.
The market took up automatic enrollment gradually at first, but before the 2006 Pension Protection Act (PPA 06)took effect in 2007, an estimated 41% of large employer 401(k)s (and a lower but substantial percentage of all 401(k)s) had already adopted it. (Gale, Iwry, and Orszag 2005b; Plan Sponsor Council of America 2008). After the 2006 legislation took effect, removing some of the potential obstacles to auto enrollment, this expansion—already accelerating—continued. Today, it is estimated that roughly 3 out of 4 larger 401(k) plans use auto-enrollment, although take-up in the smaller plan market remains distinctly lower (Dietrich 2022).
Early on, the evidence in the market, including research by Madrian and Shea (2001), Thaler and Benartzi (2004), and others, suggested that auto-enrollment was significantly increasing plan participation, which provided an additional boost to policy efforts. Plans in which two-thirds or three-quarters of eligible employees traditionally participated would see their participation rates rise to 9 out of 10 or even higher when they switched to auto-enrollment. One powerful example: in the mid-2000s, the largest DC plan in the world—the Thrift Savings Plan (TSP), which resembles a 401(k) and covers over 6 million U.S. federal government employees—adopted auto-enrollment despite an already high participation rate. TSP’s Executive Director estimated that this step raised the participation rate from about 85% to more than 90% and increased the number of employees participating in the plan by approximately 300,000.6 Importantly, auto-enrollment
tends to raise participation especially by those who otherwise confront the greatest challenges to saving and who are disadvantaged by racial, ethnic, and gender savings, income, and wealth disparities (Madrian and Shea 2001, Francis and Weller 2021).
Because defining auto-enrollment and declaring it lawful was an administrative rather than a legislative initiative, it was able to progress from concept to settled law within a few months without congressional involvement. However, after Treasury and IRS issued their landmark guidance in 1998 and President Clinton then showcased the concept in a speech covered by major media, various Members of Congress began to express both support and interest in promoting the practice. Nonetheless, even without help from Congress, auto-enrollment caught on in the market, first slowly and then rapidly in the years leading up to 2007. That said, the regulators began to hear auto-enrollment issues from plan sponsors that only Congress could address. Therefore, legislation was drafted in 2005 and added to PPA 06 (a bill which was intended mainly to deal with DB pension issues) to help lay to rest three particular concerns with auto-enrollment.
The first concern was that newly auto-enrolled employees who failed to read or understand the advance written notice of auto-enrollment and their opt-out rights might be unpleasantly surprised to find their takehome pay reduced by contributions they had never explicitly authorized. The then-existing 401(k) restrictions preventing active employees from withdrawing from their accounts might also keep them from obtaining a refund of their unintentional contributions. In addition, employees who could get their money back might incur a 10-percent early withdrawal tax. Congress solved this by providing a 90-day grace period in which plans could retroactively “unwind” automatic contributions by refunding them to requesting employees, free of the 10-percent tax.
Second, employers were concerned that their limited relief from fiduciary liability when employees “self-direct” investments by selecting from among plan options did not apply to investments made by auto-enrollment (i.e., without an explicit employee investment election). The Labor Department therefore issued
regulations assuring the market that certain default investments entitle plan fiduciaries to the same relief they enjoy when employees choose their own investments. The regulations extended the limited fiduciary relief for “self-directed” investments to three “qualified default investment alternatives” (“QDIAs"): balanced funds, target-date funds, and professionally managed accounts.
Third, some plan sponsors expressed a concern that state anti-garnishment, worker protection laws might prevent 401(k) auto-enrollment by prohibiting paycheck withholding without an employee’s explicit written authorization. PPA 06 solved this by preempting state laws to the extent necessary to permit auto-enrollment.
In addition, industry lobbyists proposed—and Congress agreed to—a new statutory nondiscrimination safe harbor to encourage plans to adopt auto-enrollment. Plans obtained a free pass from nondiscrimination standards if they auto-enrolled employees at 3% of pay, automatically escalating 1% each year up to at least 6%, and offered specified employer matching (or made nonmatching) contributions with two-year vesting. As policy, this raised some concerns, but it did serve to illustrate to the market the auto-escalation feature (Retirement Security Project, 2006).
B.THE AUTOMATIC IRA
The automatic 401(k) helped millions who were eligible to participate in retirement savings plans, but failed to help the large share of the workforce whose employers did not offer such a benefit. To address the needs of this group, Iwry (2006) and Iwry and John (2006, 2021) proposed to extend the power of auto-enrollment to the tens of millions of workers without access to employer plans.
The proposal would apply automatic enrollment to payroll deduction IRAs. This enables an employer to facilitate tax-favored saving by its employees easily without the employer decisions, tasks, and responsibilities involved in sponsoring an ERISA-covered plan and overseeing investments in the plan’s trust (Gale et al. 2009). Starting in 1997, the Treasury Department
had encouraged small employers that did not wish to sponsor a retirement plan to simply let their employees use the employer’s existing payroll system to save a portion of their wages in an IRA. Treasury deliberately made this entirely voluntary for employers in the hope of expanding coverage without subjecting firms to even the most minimal requirements. Moreover, in the conference report to the Taxpayer Relief Act of 1997 (Pub. L. 105-34, which also included other important retirement provisions), Congress made a point of weighing in to support Treasury’s efforts, stating that “employers that choose not to sponsor a retirement plan should be encouraged to set up a payroll deduction [IRA] system to help employees save for retirement by making payroll-deduction contributions to their IRAs,” and accordingly encouraged the Treasury Secretary to “continue his efforts to publicize the availability of these payroll deduction IRAs” (H. Rept. 220, 105 Cong. 1 sess. (1997)). But despite those efforts, over the ensuing quarter century the take-up of voluntary payroll deduction IRAs has consistently been close to zero. Therefore, responding to both the failure of the voluntary payroll deduction IRA and the success of automatic enrollment in 401(k) plans, the Automatic IRA proposal would require employers that chose not to sponsor a retirement plan to simply serve as a conduit, automatically enrolling employees into contributing a portion of their own wages to payroll deduction IRAs provided and managed by the private sector.
This combined three key building blocks of the current retirement system. First, payroll deduction saving at the workplace, which continues automatically on a “set it and forget it” basis; second, federally tax-favored individual retirement accounts—the most portable and simplest vehicle in the private pension system (and which do not require employers to select or oversee investments or plan administration); and third, automatic enrollment, borrowed from the 401(k) market, to maximize participation while preserving individuals’ freedom of choice regarding participation and investment.
Taken as a whole, these features make it easy for workers to save in a rudimentary structure without threatening to compete with or crowd out actual employer-sponsored retirement plans. In fact, Auto-
matic IRAs can act much like a benign “gateway drug” making it easier to persuade employers to sponsor plans because they have had some experience with a simplified version of a payroll deduction retirement benefit.
The Auto IRA proposal (like the state Auto IRAs discussed below) was designed to make the default type of IRA a Roth—which is often better suited for lower-income taxpayers, who face low (or zero) current income tax rates, and which permits tax-free withdrawals to meet emergencies or other immediate needs. The default investment generally is a low-cost target date fund offered by private-sector firms. Employees can opt out at any time or override the defaults regarding the type of IRA, rate of contributions, or type of investment. To mesh with and support the private pension system, savings accumulated in Auto IRAs can—and in many cases eventually will—be rolled over to most regular private-sector IRAs or plans.7
The smallest and newest employers are exempted from the requirement, and covered employers are not required—or even permitted—to contribute. The absence of employer contributions to Auto IRAs and the major difference between their $7,000/$8,000 IRA 2024 contribution limits and the $23,000/$30,500 401(k) 2024 employee contribution limits (and $69,000/$76,500 total DC plan 2024 contribution limits) help ensure that Auto IRAs are not as attractive as, and likely will not crowd out or compete with employer-sponsored retirement plans. In fact, an important secondary purpose of the Auto IRA is to facilitate marketing of 401(k) plans (as well as other tax-qualified and SIMPLE-IRA plans) by amplifying the messaging about the importance of saving and demonstrating to employers the popularity and value of tax-favored saving in the workplace. In addition, many Auto IRA contributors would also qualify to receive the saver’s credit (discussed below), and small employers facilitating these Automatic IRAs would receive a small federal tax credit to help defray any administrative costs.
The Auto IRA proposal promptly received a favorable reception from across the political and policy spectrum, including endorsement by Martin Feldstein, the Chair of the Council of Economic Advisors in the
Reagan Administration, Laura Tyson, his counterpart in the Clinton Administration, and ultimately by both 2008 Presidential candidates, then-Senators Obama and McCain (Retirement Security Project 2008). Congressional offices on both sides of the aisle requested briefings and, later, potential legislative drafts. According to an editorial in The New York Times, “The best idea yet developed for making savings universal is an IRA that is funded with automatic direct deposits from a paycheck. The brainchild of researchers from the Heritage Foundation and the Brookings Institution, the automatic IRA would use a no-frills design and economies of scale to overcome the problem of high fees on small accounts. Congress should pass legislation to establish auto-IRAs, and the President should sign it” (New York Times, 2006).
The federal Auto IRA proposal was introduced as legislation by Republican and Democratic co-sponsors in both the House and Senate tax-writing committees. But despite its auspicious beginnings, the prospects of passage suffered from the widening partisanship exacerbated by the 2010 party-line passage of the Affordable Care Act. Republican leadership identified the bill as another Obama administration proposal that, if enacted, would give the President a victory. Meanwhile the bill’s Republican lead cosponsors failed to win reelection. President Obama included the proposal in each of his eight annual budgets, while Democrats—including Rep. Neal (D-MA) and others in the House and Senators Bingaman (D-NM), Kerry (D-MA), and Whitehouse (D-RI)—continued to introduce the bill in each Congress, hoping for renewed bipartisan support (S. 1141; H.R. 5376).
In 2002, one of the co-authors began exploring whether state governments might be able to play a supporting role assisting the private sector and the federal government in expanding retirement coverage—not for state and local government employees, most of whom are already covered by retirement plans, but for private citizens. With outreach to state treasurers and legislators, including conferences bringing interested parties together from around the country, this state-based initiative began to take shape and pick up momentum in a half dozen states by 2005 (Iwry 2003b; Iwry 2006).
By 2008, it was becoming clear that the preferred approach for the states would be a state-based version of the federal Auto IRA model; and by the end of 2023, 15 states—California, Colorado, Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Minnesota, Nevada, New Jersey, New York, Oregon, Vermont, and Virginia—had adopted Auto IRA legislation, and other states have bills pending. With only a few variations, the state Auto IRA programs are very similar.8
Implementation thus far in roughly half of these states provides proof of concept and has enabled almost a million lower- and moderate-income individuals to begin saving conveniently at work on a tax-favored basis. Importantly, federal courts have rejected a challenge arguing that the state Auto IRAs should be preempted by ERISA (Iwry 2020). Moreover, evidence suggests that the state Auto IRAs are also beginning to promote wider adoption of 401(k) and similar plans in the private sector (Chalmers et al. 2021, 2022; Guzoto et al. 2023; Tergesen 2023b; Samuels 2023).
Most state Auto IRAs are run by a state board that has fiduciary responsibility for overseeing the program and contracts with private sector recordkeepers and asset managers to administer it. The boards, often chaired by the State Treasurer, generally consist of both state government officials and private sector representatives. Employers that do not sponsor a 401(k) or other retirement plan are required only to facilitate auto-enrollment of their employees into the state program’s private-sector-managed IRAs. State Auto IRA programs generally use a target date fund as the default investment and offer a handful of other investment alternatives. Providers are chosen by competitive bidding. Employers’ responsibilities are quite limited: first, registering on a state web site and uploading their employee roster and related contact information to the private sector Auto IRA program manager/recordkeeper firm which will contact employees and administer contribution elections. The program manager then notifies employers of each employee’s election so employers can withhold the appropriate amounts from pay and remit them to the program manager for investment in the IRAs. Survey data from the Pew Charitable Trusts suggest that only a small fraction of employers
incur any out-of-pocket administrative costs or are not satisfied with the programs (Guzoto et al. 2023).
Proponents of state Auto IRAs have proposed that state programs join in partnerships to realize economics of scale and to help states with smaller populations start their own programs faster and at a lower cost (Correia 2023). Colorado has entered into a partnership with Maine and Delaware and is working on similar arrangements with other states.
C.SAVER’S CREDIT
Tax benefits for retirement saving tend to be weighted heavily toward high-income households even after taking into account the indirect “trickle down” benefits for rank-and-file participants in qualified plans (Congressional Budget Office 2021). The Saver’s Credit, enacted by Congress in 2001, provides a very partial amelioration of that pattern. The U.S. Treasury Department had developed and proposed it as a 50-percent refundable tax credit for lower- and moderate-income savers, to be deposited in their retirement accounts. The proposal was designed to reduce the disparity in tax incentives for those in lower tax brackets, and to encourage them to contribute to an employer plan or IRA. At the time, the retirement industry was developing the extensive Portman-Cardin legislative package, which was largely focused on increasing saving incentives for more affluent individuals and encouraging employers to sponsor plans by raising the maximum limits on tax-favored contributions and benefits in employer plans and IRAs. Accordingly, Treasury proposed that the saver’s credit be added to Portman-Cardin in order to include at least one significant provision targeted explicitly to benefit the majority of U.S. workers instead of benefiting mainly affluent savers (Gale, Iwry, and Orszag 2004a, 2004b).
A version of the saver’s credit was included in the Portman-Cardin bill before it was enacted as part of the larger 2001 EGTRRA tax legislation. However, to divert revenues to fund other provisions, the managers of the bill cut back drastically on the structure and magnitude of the proposed credit. As enacted, it became a temporary and nonrefundable credit, therefore of use only to savers who have federal income tax liability (cutting
out a large majority of the savers who would otherwise be eligible). The simple 50-percent credit rate was converted to three tiers: a 10% credit for most eligible savers, 20% for some others, and 50% for only a very small number of the lowest-income savers. In addition, the credit would not be deposited to a retirement account and therefore has typically been consumed or applied to reduce debt. These changes made the credit difficult to understand and to use; in fact, some simpler experimental efforts obtained higher take-up rates despite being less financially rewarding (Duflo et al. 2006, 2007).
III.SECURE and SECURE 2.0
While the basic changes to automatic saving structures and enactment of the Saver’s Credit more than two decades ago have shown promise, the intended breakthroughs in expanding coverage, closing the racial, ethnic, and gender gaps in retirement saving and security, providing reliable and adequate retirement income, and achieving sufficient portability of benefits have yet to be achieved. In recent years, Congress has taken a few limited additional steps by enacting the SECURE Act and the SECURE 2.0 Act, signed into law in 2019 and 2022, respectively.
These Acts include further efforts to expand retirement plan coverage and automatic saving; expand and reform the Saver’s Credit; improve options to provide lifetime retirement income (and thus eliminate longevity risk); and require plans to offer participation to a wider group of part-time employees. They also enhance portability; expand tax credits for small employers to adopt new plans, contribute, and auto-enroll employees; improve disclosures; reduce pre-retirement leakage; allow plans to offer small immediate taxable payments to induce participation by nonparticipating employees (Tergesen 2023a); facilitate multiple employer plans; and make emergency saving easier and more accessible. At the same time, SECURE and SECURE 2.0 include various other provisions, not discussed here, that misallocate resources, exacerbate inequalities, and miss opportunities to improve the system.9 For a list of specific provisions and their revenue estimates, see JCT (2019) and JCT (2022).
A.AUTO FEATURES IN SECURE/SECURE
2.0
Building on the spread of auto-enrollment and related auto features in the 401(k) market and of state-facilitated Auto IRAs, efforts were made in Congress in 2021 to enact the nationwide Automatic IRA, including recognition and support for state-based Auto IRAs, while also providing further incentives for adoption of 401(k)s and other employer-sponsored plans (Ebeling 2021). When this legislative proposal failed to garner sufficient bipartisan support, the proponents resigned themselves to a far less ambitious and thoroughly bi-
partisan legislative package that at least would include a requirement that 401(k) plans incorporate auto-enrollment and other automatic features and would expand the saver’s credit. A version of this, combined with numerous other retirement provisions, became SECURE 2.0. The legislative compromise reflected in SECURE 2.0 requires new 401(k)s and similar plans to adopt auto-enrollment and auto-escalation of employee contributions (but beginning at 3% of pay, which is now considered a relatively modest initial default rate). The requirement is also rather weak because nearly all plans in existence before 2023 are exempted.
An unsuccessful attempt was made to require employers to periodically re-auto-enroll existing employees who are not participating, so that practice remains voluntary for plans. (Treasury has been asked to provide guidance on whether the auto-enrollment and auto-escalation required of new plans extends beyond new hires to other employees.) SECURE 2.0 also codifies and makes permanent an existing IRS administrative safe harbor that encourages 401(k) auto-enrollment and auto-escalation in plans that are not subject to the new SECURE 2.0 auto features requirement by facilitating and reducing the cost of correcting plan errors in administering auto-enrollment and auto-escalation.
B.SAVER’S CREDIT/SAVER’S MATCH
Shortly after the Saver’s Credit was enacted in 2001, an effort began to persuade Congress to restore the credit to its originally proposed form: a permanent, refundable, 50-percent credit deposited in the saver’s retirement account like a matching contribution. (Gale, Iwry, and Orszag 2004a, 2004b, 2005). Just as auto 401(k) features help make retirement saving easier for moderate- and lower-income workers, the reformed saver’s credit would help make saving more remunerative for them. Redesigning the credit as a government matching contribution was intended to further stimulate saving.
In SECURE 2.0, Congress made major structural improvements along these lines. The redesigned saver’s match under SECURE 2.0 provides for a single 50%
match rate and is effectively “refundable”—available to all savers with modified AGI below $71,000 if married ($35,500 if unmarried) regardless of whether the saver has a federal tax liability. This “refundability” will expand the number of workers who will be eligible if they save by tens of millions .
The form of the credit will be changed to a government matching contribution (and hence the credit is renamed the “saver’s match”) of up to $1,000 (50% of up to $2,000 of the saver’s retirement contributions) into a retirement plan account or IRA designated by the saver. Because the match will be automatically deposited into a retirement savings account rather than paid directly to the saver, it is more likely to be saved than spent. The 50% match is fully available to married savers with modified AGI not exceeding $41,000 ($20,500 for those who are unmarried), with the percentage phasing down gradually to zero if their modified AGI is between $41,000 and $71,000 (half these amounts for unmarried).
Converting the saver’s credit to the saver’s match entailed substantial revenue cost and was controversial in Congress. SECURE 2.0 therefore restricted it in six significant ways. First, although the match rate was increased to 50%, the income eligibility limits were set lower than current-law limits; accordingly, while refundability dramatically increases the total number of eligible savers, not everyone eligible for the current credit will be eligible for the expanded match.
Second, to reduce the 10-year revenue cost under current budget scoring rules and to provide plans, their recordkeepers, and the IRS more time to prepare for the new matching deposits, the saver’s match will not take effect until 2027, and the existing, smaller credit will remain in effect until then. Third, also to limit revenue cost, the match, while excludable from the saver’s income when earned and deposited to the plan or IRA, will be taxable when ultimately distributed, much like employer contributions to DC plans (instead of more generous Roth treatment upon distribution, which would cost more revenue).
Fourth, owing to apparent concerns about the difficulty of enforcing this distinct, non-Roth tax treatment if the
match was deposited in a Roth IRA or Roth 401(k) account, SECURE 2.0 prohibits deposit of the match into those Roth vehicles. Fifth, to accommodate the possible preferences or concerns of some plan sponsors, recordkeepers, and IRA trustees about taking in the new matching deposits, no plan or IRA will be required to accept them, even if it is the saver’s only retirement account and hence the one to which the saver contributed to earn the match. Sixth, if a saver makes taxable early withdrawals from a retirement savings account during a specified lookback period, they will reduce the match amount.
C.RETIREMENT INCOME
As noted, the shift away from pensions, DB and other, has largely transformed our private pension system to an account-based retirement saving system. DB pensions are traditionally designed to supplement Social Security and protect retirees from the risk of outliving their savings by providing regular (typically monthly) income for life, replacing the paychecks they once received. In contrast, 401(k)s and IRAs provide account balances instead of income, and usually do not assist households to determine how and how much to spend month by month in retirement.
Accordingly, recent years have seen efforts to restore the “pension” to our private retirement system. For example, from 2010 through 2016, an Executive Branch initiative promoted a national dialogue on lifetime retirement income and public-private efforts to foster it in DC plans. This initiative included Treasury/IRS guidance creating a new income vehicle—the Qualified Longevity Annuity Contract (QLAC)—that protects against the risk of outliving 401(k) or IRA savings. A QLAC simplifies the challenge of managing those assets over an uncertain period by establishing a fixed time horizon and is exempt from the required minimum distribution requirements discussed below (U.S. Treasury 2014a). Treasury/IRS guidance also permitted fixed income annuities to be embedded in target date fund qualified default investment alternatives (QDIAs) in DC plans (as proposed in Gale et al. 2008 and Iwry and Turner 2009), accumulating gradually as deferred annuity units that can reduce interest rate risk and help accustom participants to receiving
monthly annuity payments when they retire (U.S. Treasury 2014b). Other Treasury/IRS initiatives encouraged DB and DC plan sponsors to allow employees to roll DC plan lump sums into the employer’s DB plan to purchase a DB pension; clarified the rules governing annuities in 401(k) plans; and prohibited plan sponsors conducting pension risk transfers from cutting off ongoing DB pensions by offering to buy them back from retirees for cash (IRS Notice 2015-49).
SECURE and SECURE 2.0 built on these prior initiatives in several ways. The SECURE Act introduced a long-awaited fiduciary safe harbor designed to help protect plan sponsors from ERISA fiduciary liability if a private-sector insurance company prudently selected by the plan sponsor to provide annuities for plan participants ultimately fails to meet its decades-long obligations. However, the safe harbor was designed by the insurance industry in a way that includes at any given moment nearly every annuity provider in the market— an overbreadth that defeated the purpose of giving plan sponsors confidence that they need not incur the cost of engaging expert consultants as independent fiduciaries to select truly dependable annuity providers. Other SECURE and SECURE 2.0 provisions promoted lifetime income by requiring DC plan benefit statements to provide regular projections of the retirement income equivalent of the saver’s account balance (as proposed in Gale, Iwry, John, and Walker 2008). Other provisions facilitated, in certain circumstances, the portability of annuity contracts in DC plans and IRAs; raised the maximum QLAC dollar amount that can be purchased, eliminated the restriction on purchasing QLACs with more than 25% of the purchaser’s plan or IRA balance; and relaxed some of the other restrictions on the offering of annuity contracts in DC plans.
D.MANAGING RETIREMENT ACCOUNTS
The U.S. private pension system has yet to achieve adequate “portability” of benefits—either in the sense of tracking and moving benefits or of continuing to save an adequate amount—as workers change jobs or exit and reenter the workforce. DB plans are less portable than DC, as noted earlier, but DC plans are not portable enough, even with the ability to move retirement savings into IRAs.
The Portman-Cardin legislation included in EGTRRA (2001) expanded the ability to transfer assets tax-free (“roll over”) between the various types of tax-qualified plans and accounts. It also dramatically improved portability and put an end to many years of unnecessary leakage by enabling plan sponsors to automatically roll over terminating employees’ small balances (up to $5,000) into IRAs established for them. These default rollovers preserved the savings of millions of people, who otherwise would have had their small accounts cashed out when they left a job unless they affirmatively asked to have the money sent to their new employer’s plan or to an IRA.
But despite these auto rollovers of terminating employees’ small balances, and the 20-percent mandatory withholding imposed on departing participants’ benefits if the savings are not directly rolled over to another plan or IRA, considerable leakage continues to impair retirement security. Small plan and IRA accounts are more likely than larger accounts to be abandoned, lost, or cashed out. This especially hurts the retirement security of Black and Hispanic savers (John et al. 2021a).
One reason for continued leakage is that Labor Department ERISA fiduciary “safe harbor” guidance caused the auto rollover IRAs to be invested in principal preservation assets like money market or stable value funds, which tend to have very low interest rates. This led these “safe harbor” IRA balances to dwindle as investment earnings during the era of low interest rates failed to keep up with the cost of maintaining IRAs. And more generally, savers requesting one plan to roll over their benefits to another commonly encounter foot-dragging, delays, and unnecessary red tape, leading too many of them to eventually give up on rolling over and instead simply take a cash lump sum and spend it.
SECURE 2.0 contains four important and potentially far-reaching provisions that could help alleviate these problems: arrangements for auto-portability; establishment of a lost and found facility; steps toward standardization of data and procedures to facilitate rollovers; and special authorization for emergency savings (John et al. 2021a).
1.Auto-Portability for Small
Balances
Expanding on previous Labor Department guidance, SECURE 2.0 codifies and elaborates on an “auto-portability” agreement among major recordkeeper firms called the Portability Services Network. The agreement requires firms to automatically roll over savers’ small account balances (initially up to $5,000, increasing to $7,000 starting in 2024) from their former employer’s retirement plan to a new employer’s plan, unless the participant objects. This should improve portability and reduce leakage in cases where a terminating employee has a new employer with a plan willing to accept the rollover. At the same time, though, SECURE 2.0 also threatens to ultimately lead to greater leakage insofar as it allows employers that don’t agree to use auto-portability to eject more small accounts (up to $7,000 instead of the previous $5,000 limit) from their plans.
2.Lost & Found
In a separate provision which should also reduce leakage and enhance participant control over their financial future, SECURE 2.0 requires the Labor Department to set up a new online data base to help individuals locate and keep track of their various retirement benefits. Although authority to provide more enhanced features might have made the facility function as a still more useful “dashboard” of retirement benefits (John et al. 2021a), collecting the necessary participant data from plan sponsors and recordkeepers for even a basic registry of benefits will likely be challenging.
3.Standardization to Facilitate Rollovers
Those provisions require Treasury and IRS to consult with private-sector stakeholders and, with their input, develop proposed standard data sets, forms, and procedures to serve as models for use by plans and recordkeeper firms in administering rollovers (as proposed in John et al. 2021b, Appendix C). The hope is that a consultative process and the eventual availability of standard forms, data sets, and procedures—reflecting extensive input and possibly broad consensus from the recordkeeping industry and plan
sponsors—would lead to their uniform and universal (or near universal) adoption.
4.Emergency Saving
A continuing problem for retirement savers—especially lower- but also many middle-income households—is the effect of inevitable unexpected expenses on household finances. All too often, households lack emergency savings and deal with financial emergencies by withdrawing money from their retirement accounts, selling other assets, or taking on high-cost debt such as payday loans or credit card debt. Inflation has made this problem even worse, and in response, a growing number of employers are offering some form of emergency savings benefit.
There are various types of emergency savings benefits. Some are funded by employee payroll deductions and are set up as separate emergency accounts that could be connected to a 401(k) or similar tax-favored retirement plan. Alternatively, these accounts could be freestanding and entirely separate from any plan. Whether part of a plan or not, these accounts can also be funded by some form of employer contributions. Freestanding emergency savings accounts are not tax-favored. A third form of this benefit is a single company fund that could include contributions from either employers or employees or both and is available to advance money to a worker who faces a serious financial problem.
Emergency savings accounts should be separate from general savings, so they are less likely to be used for other purposes. They can be designed to have smaller balances for unexpected short-term needs or larger balances that might, for example, replace a household’s wages during periods of unemployment. The accounts are intended to be used when an unexpected expense strikes, and then be replenished. A continuing problem is that while employees say they want such a benefit, the process of opening an account can be complex and discourage participation. The obvious solution would be automatic enrollment, but this presents legal questions for out-of-plan accounts in the U.S.10
SECURE 2.0 dealt with the need for emergency savings in two ways. First, it allowed 401(k)s and similar plans to automatically enroll non-highly compensated employees into tax-favored, “pension-linked emergency savings accounts” with balances up to $2,500 as part of the plan. They are subject to ERISA, but separate from other accounts, and withdrawals are tax-free and penalty-free. Plans that otherwise offer employer matching contributions must match employees’ emergency saving contributions (but the employer match must not exceed $2,500). Auto enrolled accounts may have a contribution rate of up to 3% of pay. Savers must be permitted to make withdrawals at least monthly and may make up to four withdrawals a year without having to pay fees.
The second provision in SECURE 2.0 does not use a separate emergency savings account; instead, it allows retirement savers to withdraw up to $1,000 penalty free once a year from their retirement savings account in a plan or IRA to meet an emergency. The withdrawal is taxable, but that can be reversed if it is repaid within three years, at which point further annual $1,000 withdrawals may resume.
E.MEPS AND PEPS
The 2019 SECURE Act promoted the spread of multiple employer plans (MEPs). To make it easier and less costly for small businesses to sponsor plans, Congress was lobbied heavily to relax ERISA restrictions that allowed only related employers to co-sponsor a single retirement plan. SECURE therefore amended the law to allow multiple employer plans to be sponsored by unrelated employers. These can be either “open” MEPs or “pooled employer plans” (PEPs), which must satisfy special statutory conditions.11 The stated goal was to achieve economies of scale that reduce the traditionally higher per capita costs of plan sponsorship by small employers, in order to extend coverage to many small business employees who previously lacked access to a plan at work. For further discussion of SECURE’s MEP provisions, see Baily, Harris, and Iwry (2019).
In the wake of SECURE, numerous recordkeepers, asset managers, plan advisors, third-party administrators, and consultancies are now offering PEPs and other open MEPs. Their marketing is targeted not only to small employers without plans but also (more than Congress might have expected) to encouraging existing single-plan sponsors, including larger employers, to participate in a MEP or PEP instead. The ultimate impact of this activity remains to be seen, in part because the pandemic has slowed implementation.
In addition, the industry narrative has evolved from using economies of scale to cover millions of previously uncovered small business employees in lower-cost MEPs to making plan sponsorship more efficient and somewhat cheaper for both small and larger employers. This is possible because MEPs might include larger employers and would provide professional expertise (and hence less fiduciary exposure) in selecting and monitoring investment options and in plan management.
However, SECURE also affirmed that employers participating in open MEPs/PEPs retain their ERISA fiduciary responsibilities, including the decision whether to join a particular MEP or PEP and the selection and monitoring of investment managers and plan administrators. This reflected concerns about protecting workers when their small employers are encouraged by MEP/ PEP promoters and providers to delegate to them plan management decisions and responsibilities. And the open MEP developments (including SECURE’s failure to provide for any certification of MEP promoters or organizers by regulators) also speak to a broader need to fundamentally revise ERISA’s employer-centric structure to facilitate appropriate non-employer-based plan sponsorship and coverage while extending to non-employer providers worker protection responsibilities that are neither excessive nor inadequate.12
IV.Where Do We Go from Here?
A.FOUR OVERARCHING CHALLENGES TO THE U.S. RETIREMENT SYSTEM
The future of retirement in the U.S. will be affected by at least four overarching demographic and program changes. First, the gradual aging of the American population will have significant effects on both retirement security and macroeconomic growth more broadly. Addressing this trend will almost certainly require a combination of policies ranging from possible automatic enrollment in or other means of promoting 401(k) annuities or similar retirement income products (Horneff et al. 2019) to increasing labor force participation among Americans over 65 (Harris 2020).
Second, long-term fiscal imbalances in the U.S. will eventually affect retirement policy. Given the outsized role of major entitlement programs for retirement in the federal budget—Social Security and Medicare alone comprise roughly one-third of total spending— programmatic changes to Social Security and Medicare may well be unavoidable.
Third, the shift toward defined contribution plans has closely linked issues in preparing for retirement and personal finance. Trends in financial metrics like household debt, wealth accumulation, credit delinquency rates, foreclosures, and access to retirement savings accounts have important implications for retirement as well as overall financial wellbeing.
Fourth, retirement savings issues will feature prominently in efforts to reduce or close the racial wealth gap. In 2016, the typical Black household had just 46% of the retirement wealth of the typical white household, while typical Hispanic households had just 49% (Hou and Sanzenbacher 2020). But because most Black and Hispanic retirement wealth comes from Social Security, gaps in personal retirement savings are even bigger: Black households had just 14% of the non-Social Security retirement wealth of white households, and Hispanic households had just 20% (Hou and Sanzenbacher 2020). Dynan and Elmendorf (2023) find similarly stark racial gaps in wealth and retirement
savings; in particular, they estimate that the median white-headed family had eight times as much wealth as the median Black-headed family. These racial gaps have barely budged in the past 50 years (McKay 2022). Current U.S. retirement tax subsidies and the uneven effects of employer matching contributions to DC plans that go disproportionately to better compensated whites—allocate literally hundreds of billions of dollars per year in ways that exacerbate the racial wealth gap (Choukhmane, et al. 2022).
Overall, differences in retirement wealth are larger than can be explained just by racial differences in age profiles, lifetime income, or retirement plan participation. Systematic differences in the receipt of gifts and inheritances (McKernan et al. 2014) and lower rates of return for Black investors, primarily because of differences in asset classes held (Aliprantis and Carrol 2019, Hanna et al. 2010, Sabelhaus and Thompson 2022) also play at least some role. It is also likely that racial and ethnic savers use retirement assets and account features differently.
While retirement policy alone cannot eliminate the persistent racial income and wealth gaps, some of the policy changes suggested here may help. Only 47% of Black employees and 36% of Latino employees work for an employer that sponsors a retirement plan, compared to 58% of white employees (Sabelhaus 2022). Adopting Auto IRAs on a nationwide basis through federal legislation or the expansion of state-level Auto IRAs, expanding automatic enrollment and escalation in employer plans, and implementing the saver’s match for lower- and moderate-income workers may play a role in addressing the significant racial, ethnic, and gender disparities in non-Social Security retirement saving and wealth. In addition, further broadening coverage for and participation by part-time and other workers is likely to have a similar effect as would having more small employers sponsor plans.
With these issues looming, SECURE and SECURE 2.0 are the latest legislative efforts to improve the U.S. retirement system. They include provisions that will take steps to raise coverage and participation, make
saving more rewarding for low- and moderate-income households, and begin to help savers manage their investments and assets during both the working years and retirement. However, both Acts were a mixed bag, as enactment required achieving bipartisan congressional agreement and the support of a range of stakeholders with largely competing commercial and policy interests. Accordingly, even though the legislation includes a number of reforms, it does not reflect a broad or comprehensive vision of needed changes to the private retirement system. As a result, there is still much more work to do.
B.FOUR SPECIFIC AREAS FOR REFORM IN THE DC PLAN SYSTEM
1.Coverage
First, far too many Americans still lack the ability to build financial security by saving through payroll deduction. While reforms in both SECURE laws will help to some extent, this problem will not be solved without requiring those employers that choose not to offer their employees some form of pension or retirement savings plan to at least support efforts to help workers save a portion of their own wages at work. As state-facilitated Auto IRA programs have proven, moderateand lower-income employees want to save and can do so when given a behaviorally realistic opportunity.
2.Retirement Income
Second is the ability of retirees to convert their savings into income. Today, far too many people receive their savings as a lump sum when they retire and are told that only they can decide how to use them. This leaves many at the mercy of well meaning, but mistaken advice from family and friends as well as internet scams that sound promising. More widespread use of annuities can help address this issue, although too many existing annuities are unpopular, nontransparent, confusing, and expensive.
As an alternative to annuity contracts, John, Gale, Iwry and Krupkin (2021) proposed a three-stage lifetime income approach for DC plans. Most of a retiree’s retirement savings would go into a pooled, profession-
ally managed payout investment fund that targets a specified payout but does not guarantee an exact dollar amount. Monthly checks would be adjusted annually based on the pool’s performance. Without contractual guarantees, these managed payout or systematic withdrawal funds avoid the regulatory and insurance costs of commercial annuities. The second component would include an emergency savings account to deal with the inevitable unexpected expenses.13 Finally, a QLAC would provide longevity insurance covering the “tail risk” of outliving one’s savings. The cost of the QLAC would be paid on retirement and consume only a relatively limited portion of an individual’s savings.
As a fundamental preliminary step, the proposal also recommends that plans alert participants approaching age 60 to Social Security Administration disclosures about the increased monthly amount of guaranteed, lifetime, inflation-adjusted Social Security income payable to those who start their retirement benefits at a later age. Plan disclosures could note that it offers benefits that participants delaying the start of Social Security could rely on temporarily for income instead of using other resources.14
A different promising variation on this Social Security bridge concept is a proposal for workers, employers, and government to fund mandatory add-on “supplemental transition accounts for retirement” that would be integrated into the Social Security program and would make payments to individuals aged 62 to 69 for a fixed period of time (Fichtner, Gale, and Koenig 2021). This bridge also allows people to receive larger monthly Social Security benefits.
Other retirement income alternatives include trial annuities, which enroll retiring participants into two years of regular monthly payments so they can sample the annuity experience before making final decisions on how to use their retirement savings, as in Gale et al. (2008), automatic investment of employer contributions to fund accumulation income annuities (Iwry and Turner 2009), and tontine-like longevity risk pooling (Iwry et al. 2020).
Most of these retirement income alternatives could be incorporated in 401(k) or other DC plans, including col-
lective DC plans that provide professional, pooled investment management, yet these particular approaches have seen only limited or no meaningful take-up in the U.S. market to date. That said, the market is increasingly focused on the challenge of converting 401(k) account balances into regular retirement income, and a few initiatives have shown some signs of catching on. One is to embed gradually growing annuities into a plan’s default QDIA target-date fund. This takes advantage of the wide acceptance of target date funds and the need for those funds to include some fixed income exposure, while accumulating deferred annuity units that enable dollar-cost-averaging of interest-rate annuity purchase timing risk (Iwry and Turner 2009; IRS Notice 2014-66).
Another promising approach is the QLAC (recently expanded in SECURE 2.0, as noted, and mainly offered to date through IRAs). In addition, as an alternative to basic income annuities, the insurance industry has been selling plans somewhat more complex guaranteed “living benefits” (lifetime or minimum withdrawal benefits as contingent annuities), fixed indexed annuities, and other products that represent variations on straightforward income annuities. Plans are also beginning to give more serious consideration to platforms offering retiring plan participants a choice of annuity options. However, it is essential that potential users of these more complex annuities understand in advance how they operate, their drawbacks as well as their advantages, and how their features and costs compare to simpler options.
3.Portability
A third problem for retirement savers is the continuing difficulty of moving their accounts when they change employers. All rollovers, regardless of size, should be made easier, faster, and more user-friendly by requiring standardization of the process and data for sending plans, receiving plans (in both cases including IRAs), and participants. In addition, the process should be made far more efficient and transparent by including the standard set of data points on documents that are regularly required to be provided to terminating participants (John et al. 2021a). Plans would be given added protections from losing their qualification for accept-
ing rollovers that proved to be invalid, and acceptance of rollovers would then become mandatory. Congress was unwilling to impose requirements of this sort and instead adopted a weaker version in SECURE 2.0.
One other proposal would be to move from employer-sponsored retirement plans to employer-facilitated accounts that could move with the worker from job to job and could receive contributions regardless of the type of employment. In this arrangement (which might or might not be different from IRAs), an individual would receive a retirement account when they start work and unless they decided to change providers or investments, it would remain with them until retirement. When they joined a new employer, they would provide their Social Security number, bank account information for direct deposit, and retirement account number. The account could receive employee payroll deduction contributions regardless of whether the worker was considered a full time, part time, or contingent worker. If the account owner has two or more jobs at the same time, he or she would be able to contribute payments from them to the same account. In addition, employers would be allowed to make matching or other deposits if they chose to do so (Gale et al. 2020).
4.Required Minimum Distributions Reform
On a final issue, required minimum distributions, Congress, in both SECURE and SECURE 2.0, passed on the opportunity to make major reforms (Iwry et al. 2021). The RMD rules require the taxation of previously tax-deferred retirement savings gradually during retirement. They do so mainly to prevent affluent savers from repurposing those savings for estate planning by leaving them in plans and IRAs to defer tax for generations. For many seniors, these requirements—enforced by stiff penalties—are not easy to comply with, and deferring tax to or beyond future generations is not their objective. The RMD rules therefore should exempt ordinary retirees with small or moderate retirement balances, because they generally need to spend those savings during retirement in any event and will then be taxed on them.
So far, Congress has reduced the penalties for failure to comply with the RMD rules, but it has not targeted them to affect only the most affluent. Instead, SECURE and SECURE 2.0 delayed the age at which RMDs apply from 70 ½ to 72, then to 73, and ultimately to 75 while also exempting Roth 401(k) accounts from RMDs before death. Although these RMD cutbacks lose substantial future revenues without helping most ordinary retirees, they maximize profitable assets under management for the investment industry.
Far more remains to be done to improve the ability of Americans to build financial security in retirement that supplements their Social Security benefits. But federal retirement and savings legislation and regulatory initiatives over the past quarter century, combined with recent progress at the state level, suggest that, even in an era when partisanship and other obstacles impede cooperation on so many issues, further progress is still achievable.
1 Federal legislative and regulatory initiatives in the 1980s and 1990s seemed unable to reverse the decline of DB plans. In part this was because some policy measures were intended to limit companies’ use of DB plans as tax-sheltered corporate savings accounts accumulating surplus dollars that companies could take back (in what were called “reversions”) and use for general corporate purposes. Some of the DB decline reflected elimination of abusive plans that served the interests of relatively affluent business owners and executives to the exclusion of the rank-and-file employees who are the main intended beneficiaries of the large annual retirement tax subsidies (Iwry 2003). In the 1990s and early 2000s, many traditional DB plans were converted to "cash balance” plans, a hybrid plan design with DC-type individual accounts. Cash balance plans are more portable but typically pay fewer pensions and more lump sums. The conversions aroused intense opposition and litigation—mainly for derailing the benefit expectations of older, long-service employees caught in the transition—until legislation in 2006 required transition relief and other protections. Cash balance plans have remained a fixture in the U.S. pension market, and their proponents contend that millions of workers have retained DB coverage because their employer converted to a more appealing form of DB (cash balance) instead of dropping the DB altogether in favor of a 401(k).
2 The money purchase pension plan, a traditional and once-common form of collective DC plan in the U.S., features professional investment, restrictions on leakage, and lifetime income. Unfortunately, money purchase pensions were largely wiped out when the Portman-Cardin legislation (incorporated into the 2001 EGTRRA) expanded tax advantages for 401(k) and profit-sharing plans, a change from the longstanding policy to provide greater tax incentives for employers adopting plans with these pension-like features. See Iwry et al. (2021).
3 Improvements in financial technology also facilitated the change to DC plans operated by increasingly large financial services and recordkeeper firms.
4 One issue with the form 5500 data on which the figure is based is that a single person can "actively participate" in more than one plan (in this case, in both a DB and a DC plan) at the same time.
5 For example, by starting with a 3-percent-of-pay automatic contribution and increasing automatically by 1 percentage point per year unless the employee opted otherwise at any time. See Thaler and Benartzi (2004).
6 These estimates come from an email exchange between one of the authors and Greg Long, former Executive Director of the Thrift Savings Plan, in June 2017. The relevant portion of Long’s email reads: “The TSP had plateaued at a participation rate of around 85% for about a decade. The TSP Enhancement Act of 2009, which included auto-enrollment, changed the status quo. We slowly but steadily ticked-up participation every year since and just crossed 90% in May of this year. The 300,000 figure is the approximate number of people that would not be participating if the TSP were still at an 85% rate.” Full text of the exchange is available on request.
7 However, current law does not allow a Roth IRA to be rolled into a Roth 401(k).
8 In addition, Massachusetts and Missouri have adopted multiple-employer plans, New Mexico has passed a bill providing for a voluntary payroll deduction IRA, and Washington has a “marketplace” intended to help small businesses find a retirement plan.
9 While arguments can be made in defense of such provisions (e.g., increased catch-up contributions, the complicating catch-up Rothification for participants earning over $145,000, the deferrals of required minimum distributions (RMDs) while failing to exempt small savers from RMDs, the increase from $5,000 to $7,000 in the plan auto rollover threshold, some of the changes to the IRS Employee Plans Compliance Resolution System, or the significant increases to the SIMPLE-IRA contribution limits), the policy concerns they raise generally outweigh, in our view, their potential justifications. SECURE 2.0 also includes different kinds of changes that we do not have space to address or mention elsewhere in the paper, but are novel or otherwise noteworthy
and could well have meaningful positive effects even though some also raise potentially significant concerns, such as employer matching contributions for student loan repayment, the starter 401(k) safe harbor which has no employer contributions or nondiscrimination standards, $1,000 penalty-free emergency personal expense distributions, and some of the other changes to the IRS Employee Plans Compliance Resolution System .
10 Experiments in the UK showed that automatic enrollment into emergency saving increased participation by up to 50 percent of the eligible workforce and sharply increased the amount of emergency savings in the accounts. They also showed no change in retirement account savings (Phillips and Stockdale 2023). Along similar lines, actual experience with emergency saving using after-tax employee contributions in a US 401(k) plan initially shows an increase in participation from about 5 percent to about 35 percent of the eligible workforce before versus after automatic enrollment, also without any material reduction in retirement saving. (Plan Sponsor 2023).
11 In practice, a PEP operates much like a MEP, with a plan organizer and multiple participating employers. However, PEPs allow any unrelated employer to join and must be sponsored by a “pooled plan provider” that has registered with the DOL and the IRS. This plan provider will be responsible for ensuring the PEP meets all disclosure requirements and complies with both ERISA and the tax code, along with other requirements. See the discussion in https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-center/ fact-sheets/secure-act-and-related-revisions-to-employee-benefit-plan-annual-reporting-on-the-form-5500.pdf for more details.
12 Australia’s superannuation funds and the UK’s group trusts are among the examples of somewhat analogous non-employer structures in other countries’ private pension systems (Australian Taxation Office 2023; Smith 2023).
13 The Maryland state Auto IRA program defaults savers into an emergency savings fund within the IRA account and is providing or will be providing many of the benefits listed above.
14 Working longer and continuing to save for retirement is generally preferable, but the bridge is important if an employee must stop work due to health or family situations or is laid off and unable to find another job.
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ERISA at 50: No Midlife Crisis for ERISA Preemption
While the Employee Retirement Income Security Act of 1974 (ERISA) is best known for regulating employer-sponsored retirement benefits, it also applies to employer-sponsored benefit plans more broadly, including employer-sponsored health plans Significantly, ERISA effectively preempts state and local regulation of self-funded, employer-provided health benefits. The scope of this has generated some degree of debate. Proponents of ERISA preemption point to the creation of a uniform and predictable regulatory environment for employers with respect to their ERISA-governed benefit offerings, while its detractors believe that state and local governments ought to have a greater role in pursuing health care reform beyond their current ability to regulate health insurance. To better understand the value of ERISA preemption to large employers, the Employee Benefit Research Institute and American Benefits Council conducted roundtable discussions with over a dozen benefits executives at large companies.
Key Insights
• ERISA was enacted, in part, in response to high-profile cases in which workers received substantially smaller retirement benefits than were promised as a result of poorly funded pension plans. However, ERISA does not apply solely to retirement benefits, but also to many employer-sponsored benefits in general, including most employer-sponsored health benefits.
• An important provision in ERISA a legal framework commonly referred to as ERISA preemption effectively renders the federal government the sole regulator of self-funded employer-sponsored health benefits. State and local governments, responding in part to incentives to improve health care outcomes for their constituents and in part to various stakeholders, occasionally pass legislation that may encroach upon ERISA preemption. While these challenges have not completely eroded ERISA preemption, recent court cases have created some uncertainty around the scope of ERISA preemption and the prevailing view that federal law generally should be the sole source of regulation of self-funded group health plans
• To gauge the value that ERISA preemption provides for employers, the Employee Benefit Research Institute and American Benefits Council interviewed benefits executives at large employers in a roundtable format.
• Three main themes emerged in the roundtable discussions. First, under ERISA preemption, there is a uniform landscape of regulations rather than a patchwork of 50 different state-level regulations, which makes it possible for an employer operating in more than one state to administer and offer benefits equitably to their employees, regardless of the state or locality where those employees are located. Second, ERISA preemption reduces administrative costs and burdens, thus enabling employers to deliver richer benefits and lower-cost coverage to their workers. Third, ERISA preemption fosters innovation that would otherwise be stifled by different states requiring different coverages or administrative rules (such as claims procedures or the like).
• Employers remain committed to providing health benefits to employees and their families. If ERISA preemption were eroded, however, benefits executives would worry about higher costs for providing health benefits and would likely closely watch their competitors to determine next steps.
Jake Spiegel is a Research Associate at the Employee Benefit Research Institute (EBRI). Paul Fronstin is the Director of Health Benefits Research at EBRI. This IssueBriefwas written with assistance from the Institute’s research and editorial staffs. Any views expressed in this report are those of the author and should not be ascribed to the officers, trustees, or other sponsors of EBRI, Employee Benefit Research Institute-Education and Research Fund (EBRI-ERF), or their staffs. Neither EBRI nor EBRI-ERF lobbies or takes positions on specific policy proposals. EBRI invites comment on this research.
SuggestedCitation:Spiegel, Jake, and Paul Fronstin, “ERISA at 50: No Midlife Crisis for ERISA Preemption,” EBRIIssueBrief, no. 619 (Employee Benefit Research Institute, September 12, 2024).
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ERISA at 50: No Midlife Crisis for ERISA Preemption
The Employee Retirement Income Security Act (ERISA), as its name suggests, was initially best known for establishing standards for employer-sponsored retirement plans. Passed in 1974, the appetite for pension reform was brought about by several high-profile incidents involving poorly funded and mismanaged pension plans that resulted in beneficiaries receiving much smaller payouts than they had been promised, as was the case with the pension plan of Studebaker, an automobile manufacturer.1 ERISA established basic fiduciary standards for retirement plan trustees, including requirements for reporting to the federal government, a responsibility to disclose information to workers, and minimum funding levels. However, the law applies not only to defined benefit pension plans, but also to employer-sponsored health plans.
A crucial component of ERISA is the legal framework that effectively overrides state and local regulation of employee benefit plans. This legal framework, known as ERISA preemption, supersedes state or local laws to the extent they “relate to any employee benefit plan.” In crafting a law that supersedes state and local benefits legislation, Congress intended for ERISA to establish a nationally uniform standard for employee benefit plans and aimed to avoid the evolution of a patchwork of different state-level regulations and requirements that could stand as a deterrent to employers voluntarily offering benefits to their employees 2
Employers who self-insure (or self-fund) their health plans are exempted from state and local regulations; employers who purchase fully insured plans from insurance carriers, however, are effectively subject to state and local laws, because ERISA preemption permits states to continue to regulate insurance companies and insurance products Since self-funded, employer-provided health plans would only be subject to federal law, this enables employers who sponsor such plans to offer consistent benefits to workers across state lines Proponents of ERISA preemption point to this uniformity as easing administrative burdens and costs for multi-state employers while also allowing them to tailor their benefits to the needs of their work force and provide benefits equitably, regardless of where those workers live
The current ERISA preemption framework is not without its detractors, however. In general, state and local legislators have a vested interest in and strong incentives for passing laws that could reduce the costs patients pay out of pocket for certain types of health care or mandate coverage of certain health services for their constituents Moreover, various stakeholders in the health care ecosystem bring issues to state and local legislators to consider, including efforts to protect certain types of businesses and regulate others Therefore, according to those who take a dim view of ERISA preemption, it is justified for state and local legislators to pass laws that affect self-funded, employer-sponsored health benefits, including efforts to lower costs paid by patients, prohibit certain plan designs, mandate coverage of certain services or drugs beyond those required under federal law, and dictate which providers must be allowed in network. Such an objective has underpinned some of the recent legislative efforts that have encroached upon the ERISA preemption framework.
ERISA preemption has thus far mostly survived legal challenges and been solidified by court rulings and case law Per the legislative language of ERISA, it preempts state and local laws that explicitly regulate health plans. In Shawv Delta AirLines, for instance, the U.S. Supreme Court ruled in 1983 that a New York state law requiring pregnancy-related disability benefits in employer-sponsored health insurance plans was preempted by ERISA This case established a sweeping standard for which state laws run afoul of ERISA preemption. Namely, state laws “having a connection with or referring to” an employee benefit plan would be preempted by ERISA.
Like most matters that end up before the U.S. Supreme Court, there is ambiguity as to whether a particular law has an impermissible interaction with ERISA. As such, ERISA preemption has evolved through case law For instance, in 2020, an Arkansas law setting minimum reimbursement amounts for pharmacy benefit managers (PBMs) was challenged as running afoul of ERISA preemption on the basis that the law could potentially impact the price of administering a
prescription drug plan as part of an employer-sponsored health benefits plan However, the Supreme Court ruled in Rutledgev PharmaceuticalCareManagementAssociationthat “the mechanisms [of the Arkansas law] do not require plan administrators to structure their benefits in any particular manner,” and thus, the Arkansas law is not preempted by ERISA Further challenges may be forthcoming. For instance, in 2023 Florida legislators passed a law regulating PBMs located in the state, and the law appears to apply to both commercial health plans as well as self-insured health plans.
The erosion of ERISA preemption could have profound impacts on employers and workers Legislators intended for ERISA to preempt state and local laws to prevent employers from having to navigate a patchwork of different regulatory regimes depending on the state(s) in which they operate.3 Should state and local legislators continue to pass legislation that chips away at ERISA preemption, employers may have to adhere to different sets of regulations depending on where their workers are located or reside Dealing with these regulations could affect both the cost of providing health benefits and employers’ appetite to continue providing health benefits.
To mark the 50th anniversary of the passage of ERISA, as well as to develop a better understanding of the value of ERISA preemption to employers, the Employee Benefit Research Institute (EBRI) and American Benefits Council (ABC) conducted a series of focus groups with benefits decision makers at large employers. These companies employed over 600,000 workers in aggregate, covered over one million lives in their health care programs, and accounted for over $7 billion in health care spending Not only are large employers more likely to be at the forefront of innovative benefits programs, but they are also more likely to have operations and employ workers in multiple states and, thereby, to rely upon ERISA preemption. The focus groups with benefits decision makers about ERISA preemption touched on several different employee benefit plans but focused on health benefits, as this area is currently a flashpoint
The roundtable discussions with the focus groups lasted for two hours, and each focus group consisted of roughly half a dozen participants. These participants held job titles such as vice president of benefits, head of global benefits, and ERISA and benefits counsel and were closely involved with their respective firms’ benefits designs and offerings The focus groups were structured in such a way that the same questions were asked of each group, but they were loosely structured to give respondents room to expound on a particular question if it proved to generate a fruitful discussion
What Does ERISA Preemption Mean to You?
We began our roundtable discussions by asking benefits executives about how they viewed ERISA preemption. Praise for ERISA preemption was unanimous; essentially, without ERISA preemption, “it would be prohibitively burdensome [to provide health benefits],” offered one executive at a high-tech manufacturer. This sentiment was echoed by others in the group: “Without preemption, it can make the administration of a self-funded health plan really difficult,” added an executive at a media conglomerate.
As this discussion progressed, several themes emerged. Benefits decision makers indicated that ERISA preemption provides immense value to employers and that value manifests in three primary ways. First, benefits executives valued the regulatory certainty that ERISA preemption offers. For companies that have operations in multiple states, sponsoring a single plan with uniform standards is less administratively burdensome than sponsoring a health plan subject to a patchwork of different state- and local-level regulations. Second, they recognized that ERISA preemption enables their firms to innovate and provide customized benefits targeted toward addressing the specific needs of their work force. Third, they appreciated that ERISA preemption effectively reduces the cost of providing benefits for their work force, due to the reduced administrative burden
Uniform Standards, Uniform Benefits
One of the biggest benefits that ERISA preemption offers employers is a uniform standard for employee benefit plans Additionally, the carveout for self-funded plans such that they are regulated solely at the federal level provides
employers additional regulatory certainty Benefits executives in the roundtable discussion expressed a strong appreciation for their ability to offer a consistent menu of benefits across the various states in which they operate
Rather than benefits differing based on employee location, employers place value on ERISA preemption enabling them to offer a consistent, location-agnostic set of benefits. “We have a strong desire for everyone to have equal benefits regardless of where they sit,” said a benefits executive at a tech company, adding, “If we had to have different benefit offerings in each state, I don’t know what we’d do.” Roundtable participants also highlighted fairness and equity concerns as a motivation to offer a consistent set of benefits across all workplaces. “The equity piece is a large conversation now that more people are virtual. If one worker lives in Colorado and one lives in New Jersey, and they get different benefits, that’s not equitable,” explained a benefits executive at an insurance company. “We see this now on certain aspects of paid leave; you may get 13 weeks in one state and eight in another state. How do you make it equitable?”
The ability to offer a consistent set of benefits has second-order advantages as well. “For us, it’s the consistency in terms of administration and being able to offer similar plans across the various states,” explained one benefits executive at a manufacturing firm. “Having a uniform set of rules to follow keeps costs lower,” added a benefits executive at a utility company, citing lower compliance costs as an additional benefit of ERISA preemption Moreover, employees also benefit from “a consistent employee experience … across states,” noted a benefits executive at a consumer goods conglomerate
Additionally, employers view the consistent benefits made possible by ERISA preemption as a tool for increasing work force mobility. If a worker for a firm with operations in multiple states moves from a satellite office in one state to the company headquarters in another, they know they will have access to a similar menu of benefits. “[With ERISA preemption,] we’ve removed a barrier to the mobility of talent, because they know their benefits are staying consistent,” remarked one senior benefits executive at a telecommunications firm. And not only will employees have access to a similar menu of benefits, they can also be confident that a health plan in one state will cover the same health conditions as a similar plan in another state.
Innovation
Proponents of ERISA preemption have cited innovation as an important benefit of preemption. Employers that selfinsure their benefits are better able to address issues specific to their work force rather than being subject to mandates by various state and local initiatives that can apply via regulation of the carrier or a specific insurance product “I can’t imagine a state-by-state regime telling us what to manage,” said one benefits executive at an airline “ERISA is the path to innovation,” agreed a benefits executive at an insurance company, adding, “If we had to be subject to varying state mandates, it’d be a nonstarter.”
Each employer has a unique work force with attendant unique needs and concerns, particularly in terms of health care utilization. A manufacturing firm with a large blue-collar work force will have different health care requirements than a tech company with a predominantly white-collar work force, for instance ERISA preemption “has given us the freedom and flexibility to be innovative, and we have done that. Going to a 50-state [patchwork] solution is the opposite of innovative,” explained a benefits executive at a telecommunications firm A one-size-fits-all, top-down approach from state and local legislators not only worried the benefits decision makers with whom we spoke, but could also undercut their ability to tailor benefits that best serve their work force in the most efficient manner possible
Rather, the benefits executives we spoke to preferred a more targeted approach to designing their benefits. “A lot of innovation comes from point solutions helping employees live healthier, better lives,” observed a benefits executive at an insurance company. “People in Congress don’t think companies do any innovation; [they think] that we just pay for stuff,” lamented a benefits executive at a utility company, while pointing out areas in which self-funded employers enabled by ERISA preemption have produced innovation, such as directing patients to Centers of Excellence and providing assistance and information to patients using specialty drugs to improve adherence and save money A regime
in which different states can mandate different coverages is not conducive to enabling employers to best tailor their health benefit programs to both address the needs of their employees and also contain costs
High Quality, Low Costs
While employers and employees alike face rising health care costs, benefits executives praised ERISA preemption for enabling their companies to deliver high-quality health benefits while mitigating the cost burden on both the plan sponsor and workers “ERISA is the framework that allows all of this to happen in a cost-efficient manner that benefits all,” observed a benefits executive at a telecommunications firm Roundtable participants highlighted two channels by which ERISA preemption enables employers to improve the quality of health benefits and realize cost savings.
First, ERISA preemption reduces costs for employers by reducing administrative burdens and leveraging economies of scale In a hypothetical world in which ERISA preemption disappeared, “I’d have to double my staff, or hire more consultants to manage the complexities … it’s like turning a single benefit plan into 50 benefit plans,” said one executive at a telecommunications firm. “If we had to communicate different plans with different designs to different audiences, we’d have to get additional staff for that as well,” added an executive at an insurance firm. A third executive agreed, adding, “If it wasn’t doubling the staff, you’d be doubling the costs, because you need consultants to help you out It’s more effort to do something that is running efficiently right now.” Not all benefits decision makers have completed cost projections for a world in which ERISA preemption does not exist, but there was unanimous agreement that administrative costs would increase.
Furthermore, ERISA preemption enables employers to use their size to lower costs. Specifically, benefits decision makers cited the ability to negotiate with outside vendors and third-party administrators to leverage economies of scale, a practice that could be threatened by the erosion of ERISA preemption. “If you can’t use the same provider [in each state] on the PBM side, the costs go up. That’s the whole point of just being able to go to [a single vendor]: We can control our costs better,” explained one benefits executive at a media conglomerate, adding, “When you lose that control by having to go with a number of different providers, it’s going to end up costing more ” That sentiment was echoed by others. “ERISA allows us to negotiate with vendors on a larger scale so we can pool our risk and get more competitive pricing,” added a benefits executive at an insurance firm. Another benefits executive observed that the “[economy of scale] accrues to the benefit of your employees … employees save money by virtue of their employers using their scale to negotiate.” Importantly, workers may ultimately bear the costs incurred by the erosion of ERISA preemption.
Second, benefits executives reported that ERISA preemption helps their companies save money by improving health care outcomes through the use of innovative plan designs and strategies that might otherwise bump up against individual state laws in the absence of preemption “We were able to put in an ACO [accountable care organization], which has driven better control over quality and outcomes if certain metrics are met,” explained an executive at a manufacturing company. Better care also manifests in a stronger work force: “People can’t come to work if they’re sick,” as an executive at an insurance company bluntly put it. Driving better outcomes for patients can ameliorate that. “We’re getting productivity in two ways: [Workers] are healthier and they’re staying on top of their costs,” explained a benefits executive at a manufacturing firm.
Several benefits executives worried that, in a world without ERISA preemption, self-funded health plans would not be tenable. “You won’t be able to have self-insured plans anymore, which will jack up the price. You’ll have to give it over to an insurer the reason we all self-insure is because [fully insuring] is too expensive. That’s going to have to be something else the company has to consider,” said an executive at an entertainment conglomerate. While not completely ruling out dropping health benefits, one executive at a manufacturing firm predicted that “our [health] program would not be as rich if ERISA preemption were lifted.”
Commitments to Health Benefits
To the extent ERISA preemption is eroded by the courts, Congress, states, or localities, employers may reconsider their approach to offering health benefits altogether. While several participants voiced doubt that they could continue offering health benefits in the more difficult and uncertain regulatory environment created if ERISA preemption were to disappear, most indicated that there would still exist an appetite to provide employer-sponsored health benefits.
Some executives indicated that their decision might be driven by competitive pressures. “We’d look at what our competitors are doing and do that,” said an executive at a transportation company. “You’d have the issue of competitors; if someone can go work somewhere else to get better benefits, they will,” added an executive at a media conglomerate, indicating that providing health benefits functions as a recruitment and retention tool and would likely continue to do so in the future. “Everyone is going to have the same problem [competing for talent],” they added
In addition to competitive pressures, executives indicated that they preferred to retain control of health benefits, all else being equal. In general, roundtable participants found the option of shunting workers toward state-run health insurance exchanges in lieu of providing health benefits themselves to be unpalatable. “Exchanges haven’t always been the most stable, and state to state, options are very different,” observed an executive at a consumer goods conglomerate. “There’s an element of paternalism. As soon as you take that away, everyone is on their own, and there’s nobody saying ‘hey, we’re here to help you,’” added an executive at a transportation company, referring to the support employers provide their workers to navigate their health benefits and issues in the claims process
Benefits decision makers did note that their companies already face headwinds in providing health benefits to their work force. In particular, “It’s hard to justify the prices of drugs in the U.S. vs. abroad,” noted one executive at a trade association that represents several large companies. “We all have ROE [return on equity] targets … and if there’s a way to say, look, you’re hurting shareholder value, it becomes a question [to drop health benefits],” added an executive at an insurance company. “If and when costs become much more unsustainable I think we’re closer than just 5–10 years out all of us will be looking at what tradeoffs we have to make,” a benefits executive at a manufacturing firm observed soberly While there was no consensus on exactly how far into the future the cost of providing health benefits might become unsustainable, that potential tipping point looms large in executives’ minds
Still, while roundtable participants expressed a sense that there were challenges in providing health benefits, they indicated their companies would continue to do so for the foreseeable future. One benefits executive at an insurance company responded that their firm would stop offering health benefits “when we stop adding value,” an individualized calculation that each employer must conduct on its own. “The trend line is ugly,” quipped one executive at an airline, referring to the pace at which spending on health care was increasing, “but not any uglier than before.”
Conclusion
Currently, employer-sponsored health benefits exist in a superimposed regulatory environment. Employers who purchase insurance through a carrier otherwise known as fully insured health plans find themselves effectively subject to federal regulations as well as state and local ones. Self-funded arrangements, however, are regulated solely at the federal level, thanks to ERISA preemption
However, the ERISA preemption framework is not guaranteed to be retained in its current form indefinitely. Potential conflicts and challenges to ERISA preemption can arise whenever state or local governments pass laws that could be interpreted as relating to and potentially having an impermissible connection with employee benefit plans. Recent examples include a 2020 Vermont law requiring contraceptives to be covered at no cost, or a recent “pay or play” health insurance ordinance in Seattle that set a minimum expenditure employers must pay toward employee health care benefits, along with other reporting requirements. While ERISA preemption has persisted despite these legal challenges thus far, that may not always be the case as courts take evolving views of the scope of ERISA preemption. Furthermore, while this research focused exclusively on health benefits, it should be noted that retirement plans also operate under ERISA’s framework. Consequently, one should expect that many of the benefits of preemption that apply to health plans highlighted by the roundtable participants (e.g., administrative consistency for employers and equitable benefits for employees of a company working in different states) apply to retirement plans as well.
The roundtable participants made clear the immense value that ERISA preemption offers their organizations The legal framework allows companies to offer a consistent menu of high-quality benefits to workers across state lines and fosters employer innovations that address those workers’ specific needs Were ERISA preemption to disappear, benefits executives were not exactly sure how their companies would adapt to the uncertain world and potential morass of state-level regulations, but they recognized that health benefits are still an important tool to recruit and retain a highquality work force.
Endnotes
1 Wooten, James A “The Most Glorious Story of Failure in the Business: The Studebaker-Packard Corporation and the Origins of ERISA,” BuffaloLawReview, 2001.
2 Copeland, Craig and Bill Pierron. “Implications of ERISA for Health Benefits and the Number of Self-Funded ERISA Plans,” EBRIIssueBriefno. 193, January 1998.
3 Pierron, Bill, and Paul Fronstin. “ERISA Pre-Emption: Implications of Health Reform and Coverage,” EBRIIssueBriefno. 314, February 2008.
