Statement of the
Investment Company Institute

On Retirement Security and
Defined Contribution Plans

Submitted to the Committee on Ways and Means
U.S. House of Representatives

February 26, 2002

Table of Contents

The Investment Company Institute (the "Institute")¹ is pleased to submit this statement to the House Committee on Ways and Means with regard to retirement security issues and the rules that govern defined contribution plans. The U.S. mutual fund industry serves the retirement savings and other long-term financial needs of millions of individuals. By permitting individuals to pool their savings in a diversified fund that is professionally managed, mutual funds play an important financial management role for American households.

Mutual funds also function as an important investment medium for employer-sponsored retirement programs, including section 401(k) plans, 403(b) arrangements and the Savings Incentive Match Plan for Employees ("SIMPLE") used by small employers, as well as for individual savings vehicles such as the traditional and Roth IRAs. As of December 31, 2000, about $2.4 trillion in retirement assets, including $1.2 trillion in IRAs and $766 billion in 401(k) plans, were invested in mutual funds. This represented about 46 percent of all IRA assets and 43 percent of all 401(k) plan assets.² In addition, the mutual fund industry provides a full range of administrative services to employer-sponsored plans, including trust, recordkeeping, and participant education services.

Retirement security is of vital importance to our nation's future. The Institute has long supported efforts to enhance retirement security for Americans, including efforts to encourage retirement savings through employer-sponsored plans and IRAs, simplify the rules applicable to retirement savings vehicles, and enable individuals to better understand and manage their retirement assets. Accordingly, in light of the Committee's inquiry and hearing on these important matters, we offer three recommendations.

First, we urge Congress to make permanent the crucial improvements made to our pension laws in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). As the Committee is aware, unless there is congressional action, the provisions of EGTRRA will expire on December 31, 2010.

Second, the Institute recommends that Congress simplify the rules governing retirement savings vehicles. In particular, we urge the repeal of the complex income eligibility rules applicable to IRAs-rules that effectively have deterred many eligible individuals from using these vehicles to save for retirement. The rules on required minimum distributions from retirement plans and the various rules that govern different types of defined contribution plans also should be simplified.

Finally, Congress should enhance participant access to professional investment advice with regard to their pension plan investments. The House has already acted decisively in passing H.R. 2269, the Retirement Security Advice Act, to expand the availability of advisory services to participants and beneficiaries. We urge swift enactment of this important legislation, which will provide individuals with the tools they need to appropriately invest their retirement assets.

I. A Shift in the Pension Landscape
The past few decades have witnessed a remarkable shift in the way Americans save for retirement. When the Employee Retirement Income Security Act (ERISA) was enacted in 1974, defined benefit plans were the primary private sector retirement vehicle for employees. Since the passage of that landmark legislation, defined contribution plans have grown to become an equally important medium through which workers save for retirement. From 1975 to 1998,³ the number of participants in defined contribution plans nearly quintupled from 12 million to almost 58 million. The number of defined contribution plans tripled. In 1975, $74 billion was held in defined contribution plans; today, assets in defined contributions plans stand at about $2.3 trillion, of which $1.8 trillion is held in 401(k) plans.⁴ At the individual participant level, 401(k) plan participants had an average account balance at their current employer of nearly $50,000 as of year-end 2000. Individuals in their 60s with at least 30 years tenure at their current employer had average account balances in excess of $177,000.⁵

Participant-directed defined contribution plans offer many features that are attractive to employees. First, the portability offered under defined contribution plans is well-suited to today's mobile workforce.⁶ Participants in defined contribution plans are generally able to take their retirement assets with them and maintain their value as they move from job to job. The major tax legislation enacted last year-EGTRRA-has enhanced the portability of retirement assets, allowing rollovers between different types of retirement plans, such as 401(k) plans, 403(b) arrangements, government-sponsored 457 plans, and IRAs. The ability to do so enables individuals to consolidate, efficiently manage, and better preserve and enhance the value of their retirement savings.

Second, participants in self-directed defined contribution plans have greater control of their retirement investments. For instance, 401(k) participants have the ability to select from among an average of 12 investment alternatives⁷; the choice permitted in such plans stands in contrast to the traditional defined benefit plan model, under which plan sponsors or appointed investment managers exclusively manage pension assets.⁸ Furthermore, for participants that wish to minimize risk in their 401(k) accounts, most plans offer conservative investment options, such as guaranteed investment products, money market funds and fixed-income investment vehicles.

Third, individual account-based plans provide a visible, understandable account value. Concepts applicable to defined contribution plans such as salary deferral and employer matching contributions are straightforward and easy to understand. In particular, where mutual funds are offered as investment options in a 401(k) plan, investors are able to identify the accurate and current value of their accounts, as mutual fund shares are valued on a daily basis.

Despite the successes of participant-directed retirement plans, however, policymakers must remain vigilant to assure that our pension laws provide individuals with sufficient opportunities and incentives to save, clear and understandable rules that govern long-term savings vehicles, and the education and tools that enable them to make prudent decisions with regard to their retirement savings. Consistent with these objectives, the Institute offers the following recommendations.

II. Make Permanent the Retirement and Education Savings Provisions of EGTRRA
Last year, Congress made sweeping, long-awaited enhancements to our nation's pension laws by enacting EGTRRA. Among the numerous improvements made to the private retirement system, the legislation:

The legislation also created additional long-term savings incentives for education savings vehicles such as Code section 529 qualified tuition programs and Coverdell education savings accounts (formerly education IRAs).⁹

A "sunset" provision, however, was included in EGTRRA for procedural reasons. Thus, all of these (and other important) changes made by EGTRRA will cease to apply after December 31, 2010. Clearly, the consequences of inaction on this issue would be detrimental to our retirement system. For individuals to plan appropriately for their retirement, they must be able to rely on predictable rules-rules that apply now and throughout one's career and retirement. The future termination of these provisions could affect the long-term savings strategies of working individuals, undermining the purpose of these pension reforms.

Accordingly, we urge Congress to eliminate the uncertainty by making permanent the retirement and education savings provisions of EGTRRA.

III. The Need for Simplification
For savings incentives to be effective, the rules need to be simple. Too often, however, frequent legislative changes and regulatory interpretations have led to complicated tax rules that are extremely difficult for taxpayers to understand. Furthermore, these complexities make retirement plan administration more difficult and create disincentives for plan formation. These considerations are also important to financial institutions when they assess whether to make long-term business commitments in the retirement savings market.

Such complexities are clearly evident in our nation's pension laws. Since the passage of the ERISA, there have been over a dozen major amendments to pension laws and the related tax code sections.¹⁰ Many of these legislative changes-most recently, the retirement savings provisions in EGTRRA which were strongly supported by the Institute-have provided new savings opportunities by increasing contribution limits to employer-sponsored retirement plans and IRAs and creating new savings vehicles, including the Roth IRA, SIMPLE plans and 529 qualified tuition programs. Many amendments to our pension laws, however, also have added unnecessary complexity and administrative burdens that serve as disincentives to employers to sponsor retirement plans and to individuals to save for retirement. Easing these burdens will promote greater plan formation, coverage and overall retirement savings.

Last year, the Joint Committee on Taxation made a number of significant recommendations on the overall state of the federal tax system.¹¹ That study included a number of proposals to simplify the rules governing various retirement and education savings vehicles. The Institute reiterates the recommendations made with regard to the Joint Committee's report.¹² Here, we specifically focus our recommendations on the IRA eligibility rules, the required minimum distribution rules that apply to employer-sponsored plans and IRAs, and the divergent rules that govern different types of defined contribution plans.

A. IRA Eligibility Rules
As the Joint Committee recommended in its report last year, the Institute requests that Congress simplify the rules governing IRAs by eliminating the phase-out income eligibility restrictions for IRA contributions and eliminating the income limits on the eligibility to make deductible IRA contributions. Such simplification would address an important need: the current IRA eligibility rules are so complicated that even individuals eligible to make deductible IRA contributions are often deterred from doing so.

When Congress imposed the current income-based eligibility criteria in 1986, IRA participation declined dramatically-even among those who remained eligible for the program. At the peak of IRA contributions in 1986, contributions totaled approximately $38 billion and about 29 percent of all families with a household under age 65 had IRA accounts. Moreover, 75 percent of all IRA contributions were from families with annual incomes of less than $50,000.¹³ However, when Congress restricted the deductibility of IRA contributions in the Tax Reform Act of 1986, the level of IRA contributions fell sharply and never recovered-down to $14 billion in 1987 and $8.2 billion in 1998.¹⁴ Even among families retaining eligibility to fully deduct IRA contributions, IRA participation declined on average by 40 percent between 1986 and 1987, despite the fact that the change in law did not affect them.¹⁵ The number of IRA contributors with income of less than $25,000 dropped by 30 percent in that one year.¹⁶

Surveys by mutual fund companies also show that about fifteen years later, many individuals continue to be confused by the IRA eligibility rules. For example, in 1999, American Century Investments surveyed 753 self-described retirement savers about the rules governing IRAs. The survey found that changes in eligibility, contribution levels, and tax deductibility have left a majority of retirement investors confused.¹⁷ This confusion is an important reason behind the decline in contributions to IRAs from its peak in 1986. For these reasons, the Institute strongly supports a repeal of the IRA's complex eligibility rules, which serve to deter lower and moderate-income individuals from participating in the program.¹⁸

B. Required Minimum Distribution Rules
The Institute also supports efforts to simplify the required minimum distribution (RMD) rules applicable to retirement plans and IRAs. Under these complex rules, plan participants and IRA owners are generally required to take RMDs from their plans and IRAs after reaching age 70½. While the Institute generally supports the substantial steps toward simplification taken in the proposed regulations issued by the IRS last year,¹⁹ we believe that additional reforms could be made to further mitigate the complexity of the rules.

The Joint Committee on Taxation suggested various changes intended to simplify the RMD rules. Specifically, the Joint Committee recommended that: (1) no distribution should be required during the life of a participant; (2) if distributions commence during the participant's lifetime under an annuity form of distribution, the terms of the annuity should govern distributions after the participant's death; and (3) if distributions either do not commence during the participant's lifetime or commence during the participant's lifetime under a nonannuity form of distribution, the undistributed accrued benefit must be distributed to the participant's beneficiary or beneficiaries within five years of the participant's death.

While we have concerns about the unintended consequences of some of these recommendations,²⁰ the Institute supports the Joint Committee's efforts to build upon the simplification achieved by the new IRS proposed regulations. We would be pleased to work with members of the Committee on Ways and Means and the Joint Committee to develop legislative proposals that will make the RMD rules more understandable and less burdensome to taxpayers.

C. Simplifying the Rules for Defined Contribution Plans
Employer-sponsored pension plans are a fundamental component of America's retirement system. As is the case with IRAs, however, the complexity of the rules applicable to employer-sponsored plans frequently deters employers from establishing pension plans and workers from taking advantage of them. By simplifying these rules, Congress would undoubtedly encourage retirement savings.

A wide variety of retirement plans exists. Under the category of defined contribution plans, there are a number of plan types, including 401(k) plans, 403(b) plans and 457 plans, each with its own set of rules. As the divergent rules and plan types often confuse working Americans and employers, the Institute urges Congress to reduce the complexity associated with these retirement plans. The ability of employees to understand the differences among plan types has become even more important as a result of the enactment of the portability provisions of EGTRRA.²¹ As noted above, these provisions enhance the ability of American workers to take their retirement plan assets to their new employer when they change jobs by facilitating the portability of benefits among different types of arrangements, such as 401(k)s, 403(b)s, 457s and IRAs. The Institute strongly supports efforts by Congress to simplify and conform rules that apply to different plan types in order to increase employee understanding and encourage plan formation and coverage.

IV. Enhance the Availability of Professional Investment Advice
Because participants in self-directed retirement plans like the 401(k) are responsible for directing their own investments, it is critical that they have access to information, education and advice that will enable them to prudently invest and diversify their retirement savings. We, therefore, are pleased that the House has passed H.R. 2269, the Retirement Security Advice Act, and hope that the legislation will be enacted into law this year. This legislation, which has also been incorporated into the President's pension reform package, will help equip participants to appropriately invest their retirement assets, while imposing stringent participant protections that would require investment advisers to act solely in the interests of participants and beneficiaries.²²

A. Current Law Restricts the Delivery of Advisory Services
Many retirement plan participants who direct their own account investments seek investment advice when selecting investments in their plans. Today's pension laws, however, significantly and unnecessarily limit the availability of investment advice. Indeed, ERISA severely limits participants' access to advice from the very institutions with the most relevant expertise and with whom participants are most familiar. As a result, only about 16 percent of 401(k) participants have an investment advisory service available to them through their retirement plan.²³ By contrast, more than half of "retail" mutual fund shareholders outside of the retirement plan context have used a professional adviser when making investment decisions.²⁴ Clearly, existing rules have stifled access to professional investment advice to the detriment of plan participants.

The reason that many retirement plan participants do not have access to investment advice is that ERISA's prohibited transaction rules prohibit participants from receiving advice from the financial institution managing their plan's investment options. This is often the same institution that is already providing educational services to participants.²⁵

Under ERISA, persons who provide investment advice cannot do so with respect to investment options for which they or an affiliate provide investment management services or from which they otherwise receive compensation.²⁶ The restriction applies even if the adviser assumes the strict fiduciary obligations under ERISA-which, among other things, require them to act "solely in the interest of participants and beneficiaries"-and even if an employer selects the investment adviser and monitors the advisory services in accordance with its own fiduciary obligations. Indeed, the per se prohibition applies no matter how prudent and appropriate the advice, how objective the investment methodology used, or how much disclosure is provided to participants.²⁷

Because of current legal constraints, the investment advisory services available to plan participants have largely been limited to "third-party" advice providers. Notwithstanding the presence of these third-party advice providers, however, relatively few 401(k) plan participants have investment advisory services available to them through their retirement plans. The Department's recent advisory opinion issued to SunAmerica²⁸ on the provision of advice did little to rectify this problem. The ruling essentially reiterates preexisting restrictions on the provision of investment advice to plan participants-restrictions that limit participants to third-party advice providers. Indeed, in a statement issued contemporaneously with the advisory opinion, Assistant Secretary of Labor Ann Combs expressed strong support for H.R. 2269. Clearly, the availability of advice from third-party providers has not sufficiently addressed participants' needs.

B. The Retirement Security Advice Act
Recognizing this important public policy concern, the House of Representatives passed H.R. 2269, the Retirement Security Advice Act, last November by a vote of 280 to 144. The Administration has also incorporated H.R. 2269 in its broad pension reform proposal.²⁹

H.R. 2269 would expand and enhance the investment advisory services available to participants. In particular, the legislation would allow advice to be obtained from the institutions most likely to be looked to for such services by participants and employers-the financial institutions already providing investment options to their plans. Participants, therefore, would be able to select their plans' providers for advisory services, in addition to third-party advice providers. Similarly, employers would be permitted to arrange for investment advice through a provider with which they are familiar, thereby eliminating the costs and burdens associated with selecting a separate vendor.

H.R. 2269 would enable pension plan participants to access sound investment advice from qualified financial institutions already known to them, while maintaining strict requirements to assure that they are protected from imprudent and self-interested actors. These requirements include subjecting advice providers to strict fiduciary standards under ERISA and extensive disclosures of any potential conflicts of interest to participants.

First, only specifically identified, qualified entities already largely regulated under federal or state laws would qualify as "fiduciary advisers" permitted to deliver advice to participants under the bill.

Second, such advisers would have to assume fiduciary status under the stringent standards for fiduciary conduct set forth in ERISA. This, among other things, would require them to act solely in the interests of plan participants and beneficiaries. These protections would shield participants from imprudent or self-interested advice.

Third, employers, in their capacities as plan fiduciaries, would be responsible for prudently selecting and periodically reviewing any advice provider they choose to make available to their plan participants. Thus, participants would be afforded an additional layer of protection by virtue of the employer's responsibilities as a plan fiduciary.

Fourth, the legislation would establish an extensive disclosure regime. Specifically, the "fiduciary adviser" would have to provide timely, clear and conspicuous disclosures to participants that identify any potential conflicts of interest, including any compensation the fiduciary adviser or any of its affiliates would receive in connection with the provision of advice. Additionally, any disclosures required under securities laws, which apply to similar advice provided outside of the retirement plan context, also must be provided to participants. It is important to note that these disclosure requirements would be in addition to the safeguards discussed above. The bill does not rely on disclosure alone to protect participants; rather, it includes disclosure as part of a broad panoply of protections.

Fifth, any advice provided could be implemented only at the direction of the advice recipient. Participants, therefore, would be free to reject any advice for any reason.

Finally, plan participants would have legal recourse available if a fiduciary adviser violates the standards set forth in the bill or ERISA. For instance, under section 502 of ERISA, a plan or participant could seek relief in federal district court to redress the adviser's violation of its fiduciary duties. Similarly, the Department of Labor has authority under ERISA section 502 to file suit against a fiduciary adviser in violation of ERISA and take regulatory enforcement action, including the assessment of civil penalties for any breach of fiduciary duty.

The participant-protective safeguards and the overall approach of H.R. 2269 stand in stark contrast to an alternative proposal introduced by Senator Bingaman-S. 1677, the Independent Investment Advice Act of 2001. That bill would not expand the types of advisers that may provide investment advice to participants; rather, it would only provide fiduciary relief to employers when selecting and monitoring an investment adviser to provide advice to participants. Under S. 1677, participants largely would be limited to the advisory services of third party advice providers already allowed under current law-which, as noted above, effectively has restricted the availability of investment advice to a small percentage of participants.

In short, there is little question that many plan participants seek and are in need of professional advice. H.R. 2269 would greatly expand the availability of these advisory services, while maintaining rigorous protections against parties that fail to serve participants' interests. We urge Congress to enact this important legislation.

V. Conclusion
Improving and maintaining savings incentives, simplifying the rules governing retirement savings vehicles, and empowering individuals with the education and professional advice they seek will promote greater retirement savings and security for all Americans. The Institute, therefore, urges Congress to advance these objectives by enacting the foregoing recommendations.

¹ The Investment Company Institute is the national association of the American investment company industry. Its membership includes9,040 open-end investment companies ("mutual funds"), 487 closed-end investment companies and 6 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.952 trillion, accounting for approximately 95% of total industry assets, and over 88.6 million individual shareholders.

² Mutual Funds and the Retirement Market in 2000, Fundamentals, Vol. 10, No. 2, Investment Company Institute (June 2001).

³ The most recent data available from the Department of Labor is for 1998. Private Pension Plan Bulletin, Abstract of 1998 Form 5500 Annual Reports, U.S. Department of Labor, Pension and Welfare Benefits Administration (Winter 2001-2002).

⁴ Private Pension Plan Bulletin, Abstract of 1998 Form 5500 Annual Reports, U.S. Department of Labor, Pension and Welfare Benefits Administration (Winter 2001-2002); Mutual Funds and the Retirement Market in 2000, Fundamentals, Vol. 10, No. 2, Investment Company Institute (June 2001).

⁵ 401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2000, Holden and VanDerhei, Perspective, Vol. 7, No. 5, Investment Company Institute (November 2001).

⁶ See Debunking the Retirement Myth: Lifetime Jobs Never Existed for Most Workers, Issue Brief No. 197, Employee Benefit Research Institute (May 1998).

⁷ 44^thAnnual Survey of Profit Sharing and 401(k) Plans, Profit Sharing/401(k) Council of America (2001).

⁸ The growth of the 401(k) and other self-directed retirement plans has also enabled a greater number of Americans to own equity investments. See Equity Ownership in America, Investment Company Institute and the Securities Industry Association (Fall 1999). For example, approximately 29 million households-representing 27.9 percent of U.S. households-and 39.9 million individuals owned stock mutual funds inside employer-sponsored retirement plans in 1999.

⁹ EGTRRA provisions relating to 529 plans, among other things, (1) exclude distributions used for qualified higher education expenses from gross income, (2) replace the current state-imposed "more than de minimis penalty" on nonqualified distributions with a federal 10 percent tax, (3) permit rollovers of amounts between 529 programs for the same beneficiary, and (4) permit a change in designated beneficiary to "first cousins." With regard to Coverdell accounts, changes made by EGTRRA included an increase in the annual contribution limit from $500 per designated beneficiary to $2,000. These provisions generally became effective on January 1, 2002.

¹⁰ Since 1994 alone, Congress has passed five substantial pieces of pension-related tax legislation: the Uruguay Round Agreements Act of 1994, the Uniform Services Employment and Reemployment Rights Act of 1994, the Small Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997, and EGTRRA in 2001.

¹¹ See Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, JCS-3-01, Joint Committee on Taxation (April 2001).

¹² See Statement of the Investment Company Institute for the Hearing on Tax Code Simplification submitted to the House Committee on Ways and Means, Subcommittee on Oversight and Subcommittee on Select Revenue Measures (July 31, 2001); Statement of the Investment Company Institute submitted to the Senate Finance Committee on the Study of the Overall State of the Federal Tax System and Recommendation for Simplification Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (May 7, 2001).

¹³ Promoting Savings for Retirement Security, Stephen F. Venti, Testimony prepared for the Senate Finance Subcommittee on Deficits, Debt Management and Long-Term Growth (December 7, 1994).

¹⁴ Internal Revenue Service, Statistics of Income.

¹⁵ Promoting Savings for Retirement Security, Stephen F. Venti, Testimony prepared for the Senate Finance Subcommittee on Deficits, Debt Management and Long-Term Growth (December 7, 1994).

¹⁶ Internal Revenue Service, Statistics of Income.

¹⁷ American Century Investments, as part of its "1999 IRA Test," asked 753 self-described retirement "savers" ten general questions regarding IRAs. Only 30 percent of the respondents correctly answered six or more of the test's ten questions. Not a single test participant was able to answer all ten questions correctly.

¹⁸ We note that the return of the universal IRA, coupled with the availability of the Roth IRA, would eliminate the need for the nondeductible IRA-thus, further simplifying the IRA rules. However, should Congress retain the income eligibility limits for either the traditional IRA or Roth IRA, the nondeductible IRA would continue to serve a critical objective-enabling those individuals not eligible for a deductible or Roth IRA to save for retirement. Thus, the nondeductible IRA should be eliminated only if Congress repeals the income limits for traditional and Roth IRAs.

¹⁹ See 2001-11 I.R.B. 865 (March 12, 2001).

²⁰ For example, a rule requiring distribution of an entire account balance subject to the RMD rules within five years of the participant's death could result in harsh tax consequences for the participant's beneficiaries.

²¹ See, e.g., sections 641 and 642 of EGTRRA.

²² See section 404 of ERISA, which sets forth the stringent duties of ERISA fiduciaries.

²³ 401(k) Participant Attitudes and Behavior-2000, Spectrem Group (2001). With respect to internet-based advisory services-the method by which most third-party advisers provide investment advice-a Deloitte & Touche survey found that only 18 percent of mid-size to large employers with 401(k) plans offered web-based advice to their employees. 2000 Annual 401(k) Benchmarking Survey, Deloitte & Touche (2000).

²⁴ Understanding Shareholders' Use of Information and Advisers, Investment Company Institute (Spring 1997).

²⁵ Current Department of Labor guidance permits plan service providers to provide "educational" services, but not give actual "investment advice" without violating the per se prohibited transaction rules of ERISA. See Interpretative Bulletin 96-1, in which the Department of Labor specified activities that constitute the provision of investment "education" rather than "advice."

²⁶ See generally section 406 of ERISA for the prohibited transaction rules.

²⁷ Although the Department of Labor is authorized to provide exemptive relief from these rules, the limited exemptions issued by the Department to certain financial institutions have proven to be wholly inadequate, as they have included conditions that act as de facto prohibitions on the ability of these firms to provide advisory services to plan participants. For example, under one approach adopted by the Department, advice may be provided if the institution agrees to a "leveling of fees" it or an affiliate receives from each investment option in the 401(k) plan. This makes little economic sense, however, because advisory fees for various investment options may differ widely from one fund to another, given that the underlying costs differ for each, depending on the type of investments the fund is making.

²⁸ Department of Labor Advisory Opinion 2001-09A.

²⁹ See H.R. 3762, introduced by Representatives Boehner, Johnson and Fletcher (February 14, 2002); S. 1921, introduced by Senators Hutchison, Lott and Craig (February 7, 2002); S. 1969, introduced by Senators Hutchinson, Gregg and Lott (February 28, 2002).