607 

 FLORIDA TAX REVIEW 
 
VOLUME 4 2000 NUMBER 9  
 
 Rethinking the Risk of Defined Contribution Plans 
 Regina T. Jefferson* 
 
I. INTRODUCTION ............................................................................. 609 

A. Plan Classification ............................................................ 610 
B. The Shift From Defined Benefit Plans to Defined 

Contribution Plans ............................................................ 614 
C. Shortfalls in Defined Contribution Plans.......................... 616 

II. THE PRIVATE PENSION PROGRAM AND THE FIDUCIARY 
LAW ............................................................................................... 620 
A. Fiduciary Standards.......................................................... 620 
B. Fiduciary Breach Under ERISA ....................................... 623 
C. The Fiduciary Rules and Participant Directed 

Plans ................................................................................. 627 
1. Investment Practices and Participant 

Directed Plans ..................................................... 628 
2. The Education and Notification  

Requirement in Participant Directed 
Plans .................................................................... 630 

3. Section 404(c) Plans ............................................ 632 
D. Pension Policy and Participant Directed Plans ............... 634 
E. Residual Liability and a Notification and 

Education Requirement ..................................................... 636 
F. Enforcement of a Notification and Education 

Requirement ...................................................................... 639 
III. INSURANCE PROTECTION AGAINST MARKET 

FLUCTUATIONS ............................................................................. 640 
A. The Gap in Insurance Protection ...................................... 640 
B. Reasons for Shortfalls ....................................................... 641 
C. Insurance Protection Outside of ERISA............................ 645 

1. Guaranteed Investment Contracts ....................... 645 
                                                 

*   Associate Professor of Law, Catholic University of America, 
Columbus School of Law. B.S. Howard University (1981); J.D. George 
Washington University (1987); LL.M.  Georgetown University Law Center 
(1992). I wish to thank my mentor Daniel I. Halperin, Professor of Law at 
Harvard University, for his very helpful comments and suggestions, and 
careful reading of this article. 



608 Florida Tax Review [Vol. 4:9 
 

 

2. Banking Investment Contracts ............................. 647 
3. Retirement Certificates of Deposit (Cds) ............. 648 

D. Defined Contribution Plan Insurance ............................... 649 
E. The Hypothetical Account ProposalCAn Insurance  

Model ................................................................................ 651 
1. Calculation of the Guaranteed Benefit ................ 654 
2. The Hypothetical Account Proposal and 

Insurance Premiums ............................................ 660 
3. Noncompliant Investment Allocations ................. 661 
4. Private Insurers ................................................... 662 

F. Regulating Defined Contribution Plan Insurance ............ 663 
1. The Moral Hazard Problem ................................. 663 
2. The Impact of Defined Contribution Plan 

Insurance on the PBGC ....................................... 665 
3. The Problem of Bailouts ...................................... 667 

G. The Floor-Offset Pension Plan Comparison .................... 669 
IV. FUNDING SHORTAGES IN DEFINED CONTRIBUTION PLANS ....... 671 

A. Funding Under ERISA ...................................................... 671 
B. Minimum Funding Standards and Past Service 

Credits ............................................................................... 674 
C. Past Service Liabilities in Defined Contribution 

Plans ................................................................................. 676 
D. The Funding Rules and Defined Contribution 

Plans ................................................................................. 680 
V. CONCLUSION ................................................................................. 681 
 I.  INTRODUCTION 

In response to pension funding failures and concern that abuses in the 
private pension system were denying benefits to many workers, Congress 
passed the Employee Retirement Income Security Act of 1974 (ERISA).1 
ERISA has several specific objectives: to ensure that workers receive pension 
benefits after they satisfy certain minimum requirements, to ensure that 
sufficient funds are set aside to pay promised pension benefits, to ensure that 

                                                 
1.  The Employee Retirement Income Security Act, better known as ERISA, is a 

massive piece of legislation. ERISA, Pub. L. No. 93-406, 88 Stat. 829 (1974) (codified as 
amended in scattered sections of Titles 26 and 29 U.S.C.).  It originated as early as 1962 when 
President John F. Kennedy commissioned a special cabinet-level task force to evaluate the 
impact of private retirement programs on the nation=s economy and public policy, as well as the 
investment policies of these programs and whether they were sufficient to provide promised 
benefits to the participants. See 120 Cong. Rec. S15,743 (1974) (statement of Sen. Javits). More 
than a decade later, on September 2, 1974, President Ford signed ERISA into law. ERISA 
completely revised the legal framework of the qualified pension plan. Enforcement of 
significant innovations of ERISA were divided among the Internal Revenue Service, 
Department of Labor, and the Pension Benefit Guaranty Corporation. 



2000] Rethinking the Risk of Defined Contribution Plans 609 

 

 

 

workers receive adequate information about their employee benefit plans, and 
to set higher standards of conduct for those managing employee benefits and 
pension funds.2 ERISA has been successful in accomplishing many of its 
goals.3 Today employees vest earlier, more plans are adequately funded, and 
plan participants are more knowledgeable about their retirement benefits.4 
Moreover, since the passage of ERISA, increased participation and 
contribution rates in private pension plans have caused the average income of 
retired individuals to be comparable to that of the rest of the population.5A.  
Plan Classification 

Retirement plans are divided into two distinct categories: defined 
benefit plans and defined contribution plans.6 Both types of plans can have 

                                                 
2.  It is hereby declared to be the policy of this Act [ERISA] to protect . . . the interests 
 of participants in employee benefit plans and their beneficiaries, by 
requiring the disclosure and reporting to participants and beneficiaries of financial 
and other information with respect thereto, by establishing standards of conduct, 
responsibility and obligation for fiduciaries of employee benefit plans, . . . by 
requiring them to vest the accrued benefits of employees with significant periods of 
service, to meet minimum standards of funding, and by requiring plan termination 
insurance. 

ERISA ' 2(b), 29 U.S.C. ' 1001(b)-(c) (1999). 
3.  The growth of the pension system has resulted in an enormous accumulation of 

pension assets. Private and public pension funds currently hold more than $4.5 trillion in assets. 
This staggering sum reveals that a very large percentage of personal savings and of aggregate 
capital formation in the United States occurs through the medium of pension plans. Paul 
Yakoboski et al., PBGC Solvency: Balancing Social and Casualty Insurance Perspectives, 
Employee Benefit Research Institute Issue Brief No. 126, 5-6 (May 1992) [hereinafter PBGC 
Solvency]. 

4.  See generally John R. Keville, Note, Retire at Your Own Risk: ERISA=s Return on 
Investment?, 68 St. John=s L. Rev. 527, 528 (1994). 

5.  Although much attention has been devoted to the widely known decrease in 
participation rates and pension sponsorship in the 1980s, relatively little attention has been 
focused on the reversal of these trends during the last several years. See Paul Yakoboski & Celia 
Silverman, Baby Boomers in Retirement: What are Their Prospects? Employee Benefit 
Research Institute Issue Brief No. 151, 14-15 (July 1994); see also William F. May, Future 
Policies for Employer-Based Pension Plans, in Search for a National Retirement Income Policy 
101, 103 (Jack L. VanDerhei ed., 1987). The bulk of retirement income increasingly comes 
from employer sponsored pension plans. Id. at 14-15. As of 1983, one thousand of the largest 
nonfederal pension plans held assets of approximately $806 billion. Id. at 102-04. A nation wide 
survey in May 1983 by the Employee Benefit Research Institute and the U.S. Department of 
Health and Human Services indicated that approximately 56% of the 88 million nonfarm 
workers in America were covered by a private pension plan. See John H. Langbein & Bruce A. 
Wolk, Pension and Employee Benefit Law 25 (2d ed. 1995) (citation omitted). In 1993, 
participation increased so that private and public pension plans held more than $4.6 trillion in 
assets. See id. at 20, 736 (citation omitted). This figure represents more than a 300% increase 
from 1983. See id. 

6.  See ERISA ' 3(34), 29 U.S.C. ' 1002(34) (1999) (defining Adefined contribution 
plan@ as a Apension plan which provides for an individual account for each participant and for 



610 Florida Tax Review [Vol. 4:9 
 

 

similar income replacement objectives and can be used equally effectively for 
retirement saving purposes.7 Structurally, however, the two types of plans are 
very different; the distinguishing feature is risk allocation.8 A defined benefit 
plan pools the plan=s assets in an aggregate trust fund and promises a fixed 
amount to plan participants at retirement regardless of investment 
performance.9 In a defined benefit plan the sponsoring employer is liable for 
the payment of plan benefits and therefore bears the risk of accumulating 
insufficient assets. 

To protect defined benefit plan participants in the event that an 
employer becomes insolvent, the Pension Benefit Guaranty Corporation 
(PBGC) insures a limited accrued benefit, which is phased in over a five-year 
period.10 The maximum insurable benefit is approximately $35,000 per year 
for an individual who retires at age 65.11 To the extent that a participant=s 

                                                                                                                   
benefits based solely upon the amount contributed to the participant's account, and any 
income . . . which may be allocated to such participant=s account@); id., ERISA ' 3(35), 29 
U.S.C. ' 1002(35) (1999) (defining Adefined benefit plan@ as a Apension plan . . . which is not an 
individual account plan and which provides a benefit derived from employer contributions 
which is based partly on the balance of the separate account of a participant@); see also Keville, 
supra note 4, at 528; Mary E. O=Connell, On the Fringe: Rethinking the Link Between Wages 
and Benefits, 67 Tul. L. Rev. 1421, 1489 (1993). 

7.  In a defined contribution plan the expected benefit may not be received because of 
inadequate investment performance, or because plan participants may decline to make elective 
contributions. Daniel I. Halperin, Retirement Security and Tax Equity: An Evaluation of 
ERISA, 17 B.C. Ind. & Com. L. Rev. 739, 775-76 (1976) (stating Ait is necessary to decide 
whether defined contribution plans in fact do not promise a specific benefit. Money purchase 
plans have a fixed contribution which under ERISA must be made annually. While 
profit-sharing plans do not have a definite contribution, in many circumstances the employer 
fully intends to contribute the maximum permissible amount.@). 

8.  Daniel I. Halperin, Tax Policy and Retirement Income: A Rational Model for the 
21st Century, in Search for a National Retirement Income Policy 159, 184 (Jack L. VanDerhei 
ed., 1987). 

9.  See Jon Fitzpatrick, Determining if a Small Company Needs a Retirement Plan, 
and Choosing the Best Plan, 14 Tax=n for Law. 76, 78 (1985) (discussing the two types of 
plans). 

10.  ERISA, 29 U.S.C. '' 1301-1311 (1999). Section 1302(a) details why Congress 
created the PBGC. One of the purposes behind the creation of the PBGC was Ato provide for the 
timely and uninterrupted payment of pension benefits to participants and beneficiaries under 
plans to which this subchapter applies.@ Id. ' 1302(a)(2). 

11.  When a plan terminates with insufficient assets, the PBGC is required to pay 
accrued, vested benefits to plan participants up to a guaranteed amount. ERISA limits the Abasic 
guaranteed benefit@ payable by the PBGC to the lesser of the average monthly gross income, 
based on the highest compensation in any consecutive five-year period, or $750 per month, 
adjusted by the cost of living. See 29 C.F.R. ' 4022.22 (1999). Basic benefits Ainclude all 
retirement, death, and disability benefits of current retirees and, for vested current participants, 
the regular retirement benefit payable under the normal annuity form.@ Alicia H. Munnell, 
ERISACThe First Decade: Was the Legislation Consistent With Other National Goals?, 19 U. 
Mich. J.L. Ref. 51, 54 (1985). ABasic benefits do not include lump-sum and special 
supplementary benefits payable under some plans to encourage early retirement.@ Id. ERISA 



2000] Rethinking the Risk of Defined Contribution Plans 611 

 

 

 

vested retirement benefit exceeds the maximum insurable limit, the participant 
bears the risk of insolvency. Relatively few plan participants, however, have 
vested accrued benefits in excess of the insurable limit.12 

In contrast to the defined benefit plan=s aggregate trust, a defined 
contribution plan assigns each participant an individual account.13 At 
retirement the participant receives the entire account balance. The relative 
success or failure of the plan depends on how well the assets have been 
invested.14 There is no PBGC protection because the retirement benefit is 
determined by the account balance, and not by a specific benefit.15 Thus, in a 
defined contribution plan, the participant, rather than the employer and the 
PBGC, bears the risk of accumulating insufficient assets for retirement.16 

                                                                                                                   
also imposes a limit on the insured amounts. For example, in 1998, the PBGC insured up to a 
maximum monthly benefit of $2,880.68, $34,568.16 per year, payable in the form of a life 
annuity commencing at age 65 to a participant in a plan that terminated in 1998. See Pension 
Guarantees, <http://www.pbgc.gov/ygptabl.htm>, Mar. 1999; 29 C.F.R. ' 4022.22(b) (1999). 
ERISA initially provided that upon plan termination, employers were liable to the PBGC for 
any plan asset insufficiencies up to a maximum of 30% of the employer=s net worth, and the 
PBGC absorbed the excess liability. The 30% cap gave employers an incentive to terminate 
their plans when their unfunded insured liability exceeded 30% of the employer=s net worth. 
ERISA was amended in 1986 to avoid this result. The Single Employer Pension Plan 
Amendments Act of 1986 (SEPPAA) limited the employer=s ability to terminate plans with 
unfunded vested accrued benefits. Single Employer Pension Plan Amendments Act of 1986, 
Pub. L. No. 99-272, 100 Stat. 237 (codified as amended in scattered sections of 29 U.S.C.). 

12.  Langbein & Wolk, supra note 5, at 831. Thus, the guaranteed benefit can differ 
drastically from the benefit promised by the plan. 

13.  Defined contribution plans provide individual accounts for each participant. 
Benefits are based solely upon the amount contributed to the participant=s account, with 
adjustments for any income, expenses, gains, and losses. Account balances also may be 
adjusted for forfeitures of the accounts of other participants. See 29 U.S.C. ' 1002(34) (1999). 

14.  Douglas A. Love, ERISA: The Law Versus Economics, 25 Ga. L. Rev. 135, 136 
(1990). 

15.  The PBGC is to provide broad insurance coverage for pension plans, but with 
limits: AExcept as provided in subsection (b) of this section, this subchapter applies to any 
plan . . . .@ 29 U.S.C. ' 1321(a) (1999). The most important exception for defined contribution 
plans: AThis section does not apply to any planC(1) which is an individual account plan [a 
defined contribution plan] . . . .@ Id. ' 1321(b). Thus, defined contribution plans are not insured 
by the PBGC. With no particular, identifiable benefit, there is no appropriate amount to insure. 
See S. Conf. Rep. No. 93-383 (1974), reprinted in 1974 U.S.C.C.A.N. 4890, 4911. The PBGC 
requires minimum funding standards to be met as a condition of protection, but the funding 
standards set out by the IRC and ERISA generally do not apply to defined contribution plans 
since by their nature the amount of funding is merely the individual account balance. See Jay 
Conison, Employee Benefit Plans in a Nutshell 413 (1993). 

16.  See Deborah S. Prutzman & Edwin C. Laurenson, Impact of ERISA on Choice of 
Mutual or Collective Investment Funds as Funding Vehicles, 651 PLI/Comm 789, 805 
(Feb.-Mar. 1993); Yakoboski et al., PBGC Solvency, supra note 3, at 4; see also infra Part 
II.C.1. 



612 Florida Tax Review [Vol. 4:9 
 

 

The most important objective of a retirement program is to provide a 
level of replacement income during retirement sufficient to provide a life style 
commensurate with that of an individual during her working life.17 In both 
defined benefit and defined contribution plans, the income replacement goal 
can be seriously threatened by fiduciary breach, poor investment, or 
inadequate funding.18 When one or all of these events occur, however, it is 
more likely that defined contribution plans ultimately will provide retirement 
benefits that fall short of their goals because such plans are neither PBGC 
insured nor adequately protected by the fiduciary and funding rules. 

When ERISA was enacted, defined benefit was the predominant plan 
type.19 Defined contribution plans typically were used as supplemental plans. 
Since the passage of ERISA, the composition of the private pension system 
has changed dramatically.20 In recent years, there has been a discernable 

                                                 
17.  A large gap exists between what most people expect to receive during their 

retirement and what they actually will receive. A[A] secure retirement will depend on having a 
three-legged stool of income from Social Security, an employer-sponsored pension, and 
personal savings.@ Susan Mitchell, How Boomers Save, Am. Demog., Sept. 1994, at 22. Most 
have not saved enough to meet their demands. See Steven Brostoff, Workers Save More for 
Retirement; Still Fall Short, Nat=l Underwriter Life & Health Fin. Svcs. Ed. Dec. 23, 1996, at 6. 
The annual Workplace Pulse survey for 1996, sponsored by Colonial Life and Accident and 
ECFC, stated that the average 30-year-old worker would have to save $662 more each year Ato 
achieve an annual retirement income of $26,256 in 1996 dollars.@ Id. The survey also stated that 
A[a] 60-year-old worker with $140,000 already saved for retirement would need to save an 
additional $2,325 a month to achieve an annual retirement income of $26,256.@ Id. 
AMarried-couple households headed by 35-to-44-year-olds with a total income of $40,000 to 
$60,000 a year need to save $200,000 by age 65 to maintain a similar standard of living after 
retirement, if they have a pension. Those without a pension need to save $270,000.@ Mitchell, 
infra, at 25. 

18.  See discussions infra Part II.B; Part II.C; and Part IV.A. 
19.  Between 1975, the year ERISA became effective, and 1990, the total number of 

private defined benefit plans increased from 103,000 in 1975 to 175,000 in 1983, then fell to 
113,000 in 1990. Celia Silverman et al., Employee Benefit Research Institute, EBRI Databook 
on Employee Benefits 139 (3rd ed. 1995) [hereinafter EBRI Databook]. Meanwhile, the total 
number of private defined contribution plans increased from 208,000 in 1975 to 599,000 in 
1990. Id. 

20.  The composition of the workforce has changed as well. See EBRI Databook, 
supra note 19, at 7-10. The number of workers between the ages of 55 and 64 will increase from 
11.3 million in 1970 to 17.4 million in 2005. See Gerald Cole & Marjorie N. Taylor, Caught 
Between Demographics and the Deficit: How Can Retirement Plans Meet the Challenges 
Ahead?, Comp. & Ben. Review 32, 32 (Jan.-Feb. 1996). This increase in the number of older 
workers is predicted to result in a skills gap between generations. More jobs are predicted to be 
open, however they will be entry level positions. The older generation will create what is termed 
the Agraybeard ceiling@ by staying in upper level positions, preventing advancement and 
training for the next generation. When the baby boomers finally retire, the next generation will 
be too under-skilled to move into their positions. See Ron Stodghill, II, The Coming Job 
Bottleneck, Bus. Wk., Mar. 24, 1997, at 184. Not only is the workforce aging rapidly, but it is 
becoming increasingly transient. AAmerican workers born after World War II will have at least 
10 jobs over the course of their working lives. Workers who do not remain at a single job for a 



2000] Rethinking the Risk of Defined Contribution Plans 613 

 

 

 

movement toward using defined contribution plans as primary retirement 
saving vehicles.21 This trend has serious implications for the private pension 
system because it shifts the risk of accumulating insufficient retirement assets 
from the sponsoring employer to the employee. The use of defined 
contribution plans as primary savings vehicles also eliminates the significance 
of many of the protective measures introduced by ERISA.22 Consequently, 
unless Congress amends the pension law as it applies to defined contribution 
plans, many future retirees may not receive the retirement benefits that they 
expect, or the level of protection envisioned by the drafters of ERISA. The 
prospect of benefit shortfalls in defined contribution plans will become an 
increasingly serious societal problem as more and more participants depend 
on them for their retirement security. 
 
B.  The Shift From Defined Benefit Plans to Defined Contribution Plans 

                                                                                                                   
long period are better served by defined contribution plans@ because they vest immediately and 
are easily rolled into a new employer=s plan or individual retirement account. Keville, supra note 
4, at 542 (footnotes omitted). But see Yakoboski & Silverman, supra note 5, at 21-27. 
Yakoboski and Silverman argue that boomers are, in fact, expected to have longer tenure figures 
(as of retirement) than previous generations, so they could not be more mobile. See id. at 23-24. 
Boomers already had higher tenure levels than their predecessors when they hit age groups 
25-34 and 35-44 in 1991, and tenure levels were higher in the 1980s and 90s for both men and 
women than in the 1950s, 60s, or 70s. See id. Yakoboski and Silverman also posit that the 
increase in the number of defined contribution plan participants is due mostly to small firms 
adding the plans, especially 401(k) plans, where they previously had none. See id at 21-23. 

21.  As a percentage of the total number of private pension plans, the number of 
defined benefit plans fell from 33% in 1975 to 16% in 1990. See Yakoboski & Silverman, supra 
note 5, at 21 (Table 14). Defined contribution plan have increased as a percentage of aggregate 
private pensions from 67% in 1975 to 84% in 1990. See id. As of the end of 1992, private 
defined benefit plans held $1.57 trillion in assets and private defined contribution plans held 
$911 billion. Similar changes took place with regard to the number of participants in defined 
contribution and defined benefit plans between 1975 and 1990; however, the number of 
participants in defined benefit plans continues to exceed the number of participants in defined 
contribution plans. Id.; see also Keville, supra note 4, at 529. However, recent trends show an 
increase in the establishment of defined contribution plans so that in a few years defined 
contribution plans are likely to be the prevalent plan type, assuming no major changes in 
pension law. 

22.  The reallocation of risk has been manifested by not only an increase in the 
number of defined contribution plans but also a decrease in the number of defined benefit plans. 
See generally, Advisory Council: DOL Report Will Highlight Ongoing Shift in Pension Plans, 
20 Pens. & Ben. Rep. (BNA) 2023 (Sept. 27, 1993). The shift towards defined contribution 
plans can also be seen in the changing composition of private primary plans. See EBRI 
Databook, supra note 19, at 139-45. There was a decrease of 56,651 in the number of private 
primary defined benefit plans between 1985 and 1990. See id. at 140. Meanwhile, between 1985 
and 1990, the number of private primary defined contribution plans increased by 149,078. See 
id. However, most of this shift has taken place among small plans with two to nine participants. 
See id. 



614 Florida Tax Review [Vol. 4:9 
 

 

 
Defined contribution plans are more attractive than defined benefit 

plans to employers for several reasons. First, there are fewer costs and 
administrative burdens associated with establishing and maintaining defined 
contribution plans than defined benefit plans. For example, in defined 
contribution plans there are no fees for actuarial services,23 and no PBGC 
premiums for PBGC insurance.24 Thus, defined contribution plans are an 
attractive alternative for the cost-conscious employer. 

Second, more onerous regulations are imposed on employers who 
sponsor defined benefit plans than those who sponsor defined contribution 
plans. Over the last decade, changes to the laws governing private pensions 
have disproportionately affected defined benefit plans.25 As a result, defined 
benefit plan sponsors find it necessary to amend their plans frequently to 
comply with complex new laws and regulations.26 Burdensome regulation is 
often given as the single most important reason underlying the recent shift to 
defined contribution plans.27 
                                                 

23.  See Langbein & Wolk, supra note 5, at 274 (discussing actuarial fees and 
assumptions); see also generally Halperin, supra note 8, at 186-88. 

24.  The PBGC premium must be paid by all employers who maintain defined benefit 
plans. See generally Langbein & Wolk, supra note 5, at 93-94, 830-31, 854-55. For a discussion 
of the impact of the PBGC premium on the pension system=s structure, see infra Part III.F.2. 

25.  See Defined Benefit Plans: Employers Offer No Replacements in More Than 
One-Third of Terminations, Benefits Today, Jul. 1992, at 223. 

26.  See Vineeta Anand, IRS Cuts Some Slack on Retirement Rules, Pens. & Inv., 
Jan. 10, 1994, at 4; Congress May Ruin the Party, Bus. Ins., Sep. 7, 1992, at 8; see also Keville, 
supra note 4, at 540. Another reason not discussed in the text above that employers may prefer 
defined contribution plans is that the annual cost is not fixed in certain defined contribution 
plans, such as discretionary profit sharing plans or profit sharing plans with contribution 
formulas tied to profits. See Langbein & Wolk, supra note 5, at 42-43 (citing Peter T. Scott, A 
National Retirement Income Policy, 44 Tax Notes 913, 919-20 (1989)). Therefore, employers 
may have more flexibility in lowering their level of annual contribution during economic 
down-turns. In contrast, the annual contribution to a defined benefit plan is determined by the 
experience of the plan with respect to employee turnover, death, and investment returns in a 
given year. Id. at 274. Thus, from year to year the employer=s contribution to a defined benefit 
plan (which is generally not tied to profits) will fluctuate but cannot be decreased or increased at 
the employer's discretion. See Regina T. Jefferson, Defined Benefit Plan Funding: How Much is 
Too Much?, 44 Case W. Res. L. Rev. 1, 27 n.153 (1993). Even with funding flexibility, 
however, most plans are subject to the minimum funding rules to protect against underfunding. 
See 29 U.S.C. ''  1081-86 (1999); IRC ' 412; Langbein & Wolk, supra note 5, at 273. There 
are also caps under ERISA on deductible contributions to prevent tax manipulation through 
overfunding. See IRC '' 404(a)(1)(A)(iii), 412. 

27.  The American Academy of Actuaries conducted a survey of employers that 
found that terminations of defined benefit plans are occurring in part, because of excessive 
government regulation. See Jerry Geisel, Weighty Rules Crush Pension Plans, Bus. Ins., Mar. 
22, 1993, at 3. For example, studies suggest that prolonged rulemaking by the IRS on the 
nondiscrimination requirements for defined benefit plans created too much uncertainty, and 
therefore contributed to the termination of around 40,000 small defined benefit plans between 
1986 and 1993. Deirdre Fretz, The IRS Redefines Benefit Plans, Inst. Investor, Apr. 1993, at 



2000] Rethinking the Risk of Defined Contribution Plans 615 

 

 

 

The reasons employees prefer defined contribution plans are different 
from those of the employer, and often relate to custom, flexibility, and 
participant involvement, rather than the inherent characteristics of the plan.28 
For example, defined contribution plans typically have more liberal vesting 
schedules than defined benefit plans.29 Also, some defined contribution plans 
allow pre-separation distributions; others give participants control over the 
investment of their plan assets.30 
 
C.  Shortfalls in Defined Contribution Plans 
 

Notwithstanding ERISA=s general success in improving the funding 
and delivery of retirement benefits, several areas of current pension law are 
particularly inadequate in preventing shortfalls in defined contribution plans. 
First, in defined contribution plans, the fiduciary rules do not provide the same 
level of protection as they do in defined benefit plans. Historically, ERISA=s 
fiduciary rules focused on employer mismanagement and the unauthorized use 
of plan assets.31 In defined contribution plans, however, it is often the 
employee rather than the employer who makes the allocation and investment 
decisions regarding plan assets. In such plans, the employers= liability for poor 
investment performance as a plan fiduciary is reduced; consequently, many of 

                                                                                                                   
149. 

28.  Another significant reason that defined contribution plans are often selected by 
employees as the plan type of choice is because the defined contribution plan structure is more 
advantageous to the more mobile members of the workforce with respect to the way it measures 
vested benefits. For example, if an employee terminates employment at age 35 after 10 years of 
service and the retirement benefit provided by the plan is 1% per year of service times final 
compensation, the participant would have earned 10% at the time of termination. In contrast, in 
a defined benefit plan, the contribution level anticipates a certain level of benefits based on 
estimated final pay; thus, the percentage of contribution and the accumulation at any given point 
will be greater than if no increase in pay were anticipated. See Halperin, supra note 8, at 185-86. 

29.  See IRC ' 411 (providing minimum vesting standards for qualified plans); see 
also generally Langbein & Wolk, supra note 5, at 109-14. Although not required by the 
minimum vesting standards, the vesting standards have historically been more generous in 
defined contribution plans. Id. However, no rules prevent a defined benefit plan from being just 
as liberal in its vesting and distribution rules. 

30.  These plans are referred to as participant directed plans. See infra Part II.C.1; see 
also Michael J. Canan, Qualified Retirement and Other Employee Benefit Plans ' 16.3, at 
787-88 (1996 student ed.); Langbein & Wolk, supra note 5, at 50-51, 347-48; John J. McGrath, 
Integration of Benefits and Allocation Formula, 402 PLI/Tax 385, 414 (1997). 

31.  AMost of [ERISA=s] fiduciary standards represent a codification of the common 
law of trusts.@ Elaine McClatchey Darroch, Mertens v. Hewitt Associates: The Supreme Court=s 
Dismantling of Civil Enforcement Under ERISA, 1994 Det. C.L. Rev. 1089, 1092. The 
fiduciary standards were included in ERISA as a response by Congress to the Akickbacks, 
embezzlement, outrageous administrative costs, and excessive investments in the securities of 
plan sponsors/employers@ discovered through Senate committee investigations in the 1950s. Id. 



616 Florida Tax Review [Vol. 4:9 
 

 

the fiduciary rules are irrelevant for such plans.32 Thus, participant 
involvement creates tension between individual choice and the retirement 
benefit protection provided by the fiduciary laws. On the one hand, participant 
involvement is desirable because it allows employees to be more active in the 
management of their retirement assets; on the other hand, when participants 
who lack financial expertise make investment decisions, their assets are often 
exposed to much greater risks. 

                                                 
32.  In some instances, the fiduciary rules have been used to provide only limited 

relief for fiduciary breaches in defined contribution plans. AIf a participant . . . exercises control 
over the assets in his account, the fiduciaries of the plan will not be liable for any loss or for any 
breach of fiduciary duty which is the result of the participant=s exercise of control.@ Joseph R. 
Simone & Glenn E. Butash, Statutory Framework, ALanguage@ and Fiduciary Responsibility 
Provisions of ERISA, 385 PLI/Tax 7, 28 (1996) (footnotes omitted). 



2000] Rethinking the Risk of Defined Contribution Plans 617 

 

 

 

A second reason defined contribution plan participants are more likely 
to experience shortfalls in their retirement benefits is because the insurance 
program for retirement plans has a gap in its insurance protection. As 
mentioned earlier, defined benefit plans are insured by the PBGC, whereas 
defined contribution plans are not. Defined contribution plans are not insured 
because there is a reluctance on the part of policymakers to insure investment 
performance, as opposed to calculable retirement benefits.33 Interestingly, the 
distinction between insuring investment performance and insuring calculable 
benefits is largely one of perception. Although insuring a minimum return in a 
defined contribution plan may appear problematic and incompatible with the 
existing defined benefit plan insurance model, a guarantee of a minimum 
investment return can be exactly what occurs in a defined benefit plan under 
current law. 

The disparate treatment of investment performance in the two types of 
plans can be illustrated best by contrasting a traditional defined contribution 
plan, such as a profit sharing plan,34 with a non-traditional cash balance plan.35 
The cash balance plan is a hybrid plan that has design features of a defined 
contribution plan, but in actuality is a defined benefit plan.36 The cash balance 
plan promises benefits in the form of a hypothetical account which increases 
with annual pay credits and annual interest credits.37 The pay credits are 

                                                 
33.  See infra Part III.D. 
34.  A profit-sharing plan is a plan which provides for the participation in the 

employer=s profits by the employees. See Canan, supra note 30, at ' 3.11, at 93. The plan must 
have a predetermined formula for distribution of contributions made to the plan among the 
participants at some fixed point in time, e.g., retirement or death. See id. 

35.  The cash balance plan operates very much like the profit sharing plan in terms of 
the contribution formula, but the retirement benefit itself is based on specific provisions of the 
plan document rather than the actual experience of each account. See Plan Administration: IRS 
Updating COBRA Regulations to Provide New Guidance, Consultant Says, 19 Pens. & Ben. 
Rep. (BNA) 592 (Apr. 6, 1992) [hereinafter COBRA]. In 1985, the cash balance plan was 
introduced by the Bank of America. The bank concluded that a defined contribution-like plan 
would be more effective than the social security offset pension plan it maintained at the time in 
giving more mobile workers a reason to A. . . stay one more year.@ However, switching to a 
defined contribution plan would have lowered benefits for senior employees approaching 
retirement age. A defined contribution plan also would have transferred the investment risk to 
all employees. Additionally, changing to a defined contribution plan would have required 
terminating the existing plan, and that could have had adverse tax consequences. Thus, the cash 
balance plan was created to allow Bank of America to achieve its goal without the problems that 
would result from switching to a defined contribution plan. Vincent Amoroso, Cash Balance 
Plans, 15 Pens. & Ben. Rep. (BNA) 339 (Feb. 22, 1988). 

36.  Amoroso, supra note 35, at 339. As a defined benefit plan, the cash balance plan 
is subject to the funding rules of IRC. See IRC ' 412. See infra Part III.E. Contribution levels 
are determined using actuarial assumptions for investment earnings, turnover, and death. See 
John Fitzpatrick, supra note 9, at 78. 

37.  See COBRA, supra note 35, at 592. 



618 Florida Tax Review [Vol. 4:9 
 

 

determined in the same manner as employer contributions are determined in a 
profit sharing plan.38 Unlike the profit sharing plan, however, the cash balance 
plan guarantees an annual interest rate credit which is a proxy for investment 
earnings.39 

In a cash balance plan, as with all other defined benefit plans, the 
employer, rather than the employee, assumes the primary investment risk. 
Thus, for example, if the cash balance plan assumes an interest return of ten 
percent, and the actual investment return is five percent, the employer would 
be responsible for the difference between the assumed rate of return and the 
actual experience of the plan.40 If the employer were unable to make the 
additional contribution, the PBGC would be liable to the extent of the 
participants= vested accrued benefits.41 

Therefore, in reality the PBGC does insure against the failure to earn 
the expected rate of return in defined benefit plans. Under similar 
circumstances, however, there would be no protection in a defined 
contribution plan. As a result, a defined contribution plan participant would 
experience a shortfall in her expected retirement benefit.42 

Because the shift from traditional defined benefit plans to more 
flexible savings arrangements is more commonly accomplished by means of 
conventional defined contribution plans, such as money purchase plans and 
profit sharing plans rather than cash balance plans, protection against 
unfavorable investment returns will be unavailable for increasing numbers of 
participants in defined contribution plans.43 As the use of hybrid plans such as 
cash balance plans expands, the continued reliance on plan classification to 
                                                 

38.  The pay credits are not related to the plan asset levels. Id. 
39.  The interest rate credit is generally related to a nonstatic indicator, such as the 

yield on treasury instruments. Annuity benefits under a cash balance plan are determined by a 
formula that converts the account balance into a monthly benefit. Alternatively, participants 
may elect to receive lump-sum distributions when they terminate employment. Like defined 
contribution plans, cash balance plans provide greater benefits to employees who terminate 
employment before reaching retirement age. Id. Unlike the typical defined contribution plan, 
however, additional benefits in the event of disability, or death and ad hoc retirement increases 
can be made available in the cash balance plan. Id. Although the cash balance plan provides for 
optional form of payment as a lump sum, the PBGC does not guarantee the lump sum value of 
participants benefits; the PBGC guarantees only straight life annuity payments. 

40.  The cash balance plan falls within the broad coverage of ERISA ' 4022 which 
provides that the PBGC shall guarantee the payment of all accrued benefits up to the limit under 
a single employer plan that terminates with insufficient assets. As a result, the cash balance plan 
is protected by the federal insurance program.  

41.  ERISA provides in pertinent part that the PBGC Aguarantee[s] . . . the payment of 
all nonforfeitable benefits . . . under a single-employer plan which terminates at a time when 
[ERISA section 4021] applies to it.@ 29 U.S.C. ' 1322(a) (1999). 

42.  See discussion infra Part III.D. 
43.  See discussion infra Part III.D; see also 29 U.S.C. '1321(b)(1) (1999) (providing 

that protection is unavailable to individual account plans); Keville, supra note 4, at 556 
(discussing the lack of PBGC protection for defined contribution plans). 



2000] Rethinking the Risk of Defined Contribution Plans 619 

 

 

 

determine insurance protection eligibility will become increasingly confusing, 
and create more and more anomalous results. This situation is particularly 
disturbing since the cash balance plan is functionally similar to a defined 
contribution plan.  

Insufficient funding of the expected retirement benefit is the third 
reason defined contribution plan participants may not receive the retirement 
benefits they expect. When a plan is established, a participant's projected 
retirement benefit can be divided into two essential parts: (1) the portion 
attributable to the future; and (2) the portion attributable to the past. When 
newly established plans give credit for past service, the plans incur liabilities 
for prior years of service, although they have not accumulated any assets. 
Plans typically fund their initial past service liabilities over thirty-year 
periods.44 Thus, assuming that there are no benefit increases and the actual 
assumptions are correct, if the plan continues to operate for at least thirty 
years, there is no risk of a funding shortage. If the plan terminates before the 
funding period has run, however, there may be insufficient contributions to 
cover the portion of the benefit attributable to past service.  

Although defined contribution plans generally do not provide 
explicitly for past service, many of them do provide for such benefits 
implicitly.45 However, because the PBGC fails to insure not only benefits 
attributable to future service in defined contribution plans, but also those 
attributable to past service, the past service benefit is not protected. Thus, 
defined contribution plan participants are more likely to experience shortfalls 
in both the past and future portions of their expected retirement benefits. 

In defined contribution plans, just as in defined benefit plans, when 
shortfalls occur with respect to the past service benefit, it is because the 
employer fails to make sufficient contributions, not because unfavorable 
investment performance has occurred. Accordingly, in both types of plans the 
portions of the expected retirement benefit attributable to past service are 
equally insurable and pre-fundable. Therefore, even if one believes that there 
should be no protection in defined contribution plans of the portion of the 
expected retirement benefit attributable to future service because the benefit 
depends on future investment performance, one could view the portion of the 
retirement benefit based on past service credit very differently. 

                                                 
44.  The serious underfunding of several large plans was caused by the 30-year 

funding period for past service credits. Thus, the Pension Protection Act of 1987, Pub. L. No. 
100-203, 101 Stat. 1330-33 (1987) (codified in scattered sections of 29 U.S.C.), required more 
rapid funding of underfunded plans due to concerns about the solvency of the defined benefit 
plan system. For more information on minimum funding standards, see 29 U.S.C. ' 1082 
(1999); IRC ' 412(l). 

45.  See discussion infra Part IV.C. 



620 Florida Tax Review [Vol. 4:9 
 

 

Because current pension law provides defined contribution plans 
inadequate protection, the shift from traditional defined benefit plans to more 
flexible defined contribution plans as primary retirement saving vehicles 
compromises ERISA's goal of guaranteeing the delivery of expected 
retirement benefits. This result is not inevitable, however. In order to provide 
the protection Congress intended to confer upon private pension plan retirees 
when it enacted ERISA, the fiduciary and funding laws should be amended. 
Additionally, insurance protection should be extended to all, or some portion, 
of the defined contribution plan benefit, in order to prevent shortfalls in the 
expected retirement benefits of defined contribution plans. 

This article explores the feasibility of each of these suggestions, and 
separately analyzes the impact of the following in defined contribution plans: 
(1) inadequate fiduciary rules; (2) unfavorable investment performance; (3) 
lack of insurance protection; and (4) inadequate funding practices. This article 
concludes that the impact of these risks is extremely disparate between defined 
benefit plans and defined contribution plans. Part II shows that inadequate 
fiduciary rules threaten the success of ERISA as the use of defined 
contribution plans as primary savings vehicles escalates. Part III demonstrates 
a need for insurance protection against unfavorable investment performance in 
defined contribution plans, and proposes an insurance model to resolve 
existing inequities among participants in the two types of plans. Part IV 
determines that past service credits in defined benefit plans and defined 
contribution plans are indistinguishable; consequently, at a minimum, the 
portion of the expected retirement benefit attributable to past service warrants 
pre-funding, or some level of insurance protection. 
 
 II.  THE PRIVATE PENSION PROGRAM AND THE FIDUCIARY LAW 
 
A. Fiduciary Standards  
 

One of the primary goals of ERISA is to establish higher fiduciary 
standards in order to provide greater protection of retirement benefits.46 
Although ERISA has been relatively successful in achieving this goal, recent 
developments in fiduciary law threaten its success, potentially placing plan 
participants in a more disadvantageous position than they were in prior to the 
passage of ERISA. 

                                                 
46.  See 120 Cong. Rec. S15,738, 15,741 (1974), reprinted in 1974 U.S.C.C.A.N. 

4639, 5186-87 (statement of Sen. Williams). 



2000] Rethinking the Risk of Defined Contribution Plans 621 

 

 

 

Before ERISA, the state common law of trusts and the Internal 
Revenue Code governed a trustee=s conduct in the administration and 
investment of pension assets.47 Common law doctrine required the trustee Ato 
make such investments . . . as a prudent [person] would make of his own 
property.@48 The common law of trusts also imposed a duty of loyalty on the 
trustee and governed the remedies available to plan participants and their 
beneficiaries in the event of fiduciary breach.49 

Currently, ERISA delegates to the federal government the duty of 
establishing all pension policy and law.50 While ERISA preempts state law, 
including the state common law of trusts, ERISA=s fiduciary standards are 

                                                 
47.  Until 1974, the Internal Revenue Code=s exclusive benefit rule, still in effect 

today, prescribed the only federal guidelines applicable to plan fiduciaries. The exclusive 
benefit rule provided that a plan would not qualify for preferential tax treatment if it was not 
maintained for the exclusive benefit of plan participants and their beneficiaries. IRC ' 401(a). 
Historically, courts have not rigidly enforced the exclusive benefit rule, and the IRS has had a 
practice of not penalizing investments whose primary purpose is for the benefit of plan 
participants and their beneficiaries, in spite of their contemporaneous generation of collateral 
benefits for others. See Shelby U.S. Distribs., Inc. v. Commissioner, 71 T.C. 874, 885 (1979); 
Maria O=Brien Hylton, ASocially Responsible@ Investing: Doing Good Versus Doing Well in an 
Inefficient Market, 42 Am. U.L. Rev. 1, 38 (1992); see also IRC ' 404 (a)(l)(A)(i), (c)(l). For 
further discussion of the exclusive benefit rule, see Langbein & Wolk, supra note 5, at 649. An 
employee benefit plan fiduciary=s behavior was also judicially reviewable under the 
Taft-Hartley Act. See Labor-Management Relations Act (Taft-Hartley Act), Pub. L. No. 
80-101, 61 Stat. 136 (1947) (codified as amended at 29 U.S.C. '' 141-87 (1998)). The Act 
provided that multi-employer plans must be in the form of a trust arrangement. 29 U.S.C. 
' 186(c)(5) (1998). The Act provides federal jurisdiction for claims seeking enforcement of a 
collective bargaining agreement requiring maintenance or funding of an employee benefit plan. 
Id. at ' 185(c). The Act was used to challenge fiduciary action under an arbitrary and capricious 
standard. This standard was incorporated into ERISA common law, but was modified by the 
Court. See Terese M. Connerton, Suits by Beneficiaries Against Plans or Employers to Recover 
Benefits, SB68 A.L.I.-A.B.A. 569, 614-15 (1997) (discussing Firestone Tire & Rubber Co. v. 
Bruch, 489 U.S. 101 (1989)). The Act was a Arelatively weak and incomplete effort[] to regulate 
employee benefit plans.@ Catherine L. Fisk, Lochner Redux: The Renaissance of Laissez-Faire 
Contract in the Federal Common Law of Employee Benefits, 56 Ohio St. L.J. 153, 162 (1995). 

48.  Restatement (Third) of Trusts (Prudent Investor Rule) '181 (1992). Harvard 
College v. Amory, 26 Mass. (9 Pick.) 446, first enunciated the traditional standard of the trust 
fiduciary, that the trustee act how Amen of prudence, discretion and intelligence manage their 
own affairs, not in regard to speculation, but in regard to the permanent disposition of their 
funds, considering the probable income, as well as the probable safety of the capital to be 
invested.@ Armory, 26 Mass. (9 Pick.) at 461. 

49.  See Jeffrey A. Brauch, The Danger of Ignoring Plain Meaning: Individual Relief 
for Breach of Fiduciary Duty Under ERISA, 41 Wayne L. Rev.1233, 1248 (1995) (discussing 
Justice Brennan=s concurrence in Mass Mutual Life Ins. Co. v. Russell, 473 U.S. 134, 152-54 
(1985), in which he argued that legislative history showed that Congress intended to incorporate 
into ERISA the fiduciary standards of the common law of trusts); see also Hylton, supra note 47, 
at 39. 

50.  See ERISA ' 514(a), 29 U.S.C. ' 1144(a) (1999). 



622 Florida Tax Review [Vol. 4:9 
 

 

rooted in state common law tradition and pre-ERISA regulations. Like the 
common law, ERISA regulates fiduciary activities and protects pension assets 
from mismanagement, fraud, and bankruptcy. Under ERISA, a fiduciary=s 
conduct is governed by the Aprudent [person] rule,@51 the general fiduciary 
standards of ERISA section 404, and the prohibited transaction rules of 
ERISA section 406.52 

Commentators are in general agreement that Congress intended the 
prudent person rule to be applied more liberally under ERISA than was 
customary at common law.53 Nevertheless, plan fiduciaries must manage all 
activities with respect to the plan solely in a manner consistent with the best 
interests of plan participants and their beneficiaries.54 

Under ERISA, plan fiduciaries are obligated to maximize investment 
returns. In doing so, they are permitted to take into consideration inherent risks 
associated with particular investments.55 Thus, fiduciaries may accept lower 
investment returns in exchange for lower risks, or conversely, expose the 
assets to higher risks in exchange for the possibility of greater returns.56 
However, an overriding rule of fiduciary law is that the investor must always 

                                                 
51.  The prudent man rule is codified at ERISA ' 404(a)(1)(B), 29 U.S.C. ' 

1104(a)(1) (1999). This rule provides that a fiduciary shall act Awith the care, skill, prudence, 
and diligence under the circumstances then prevailing that a prudent man 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.@ 29 U.S.C. '1104(a)(1)(B) (1999). 

52.  ERISA '' 404(a)(1), 406, 29 U.S.C. '' 1104(a)(1), 1106 (1999). 
53.  See e.g., Donovan v. Cunningham, 716 F.2d 1455, 1467 n.26 (5th Cir. 1983) 

(holding that the flexible ERISA prudent man rule takes a facts and circumstances approach and 
does not incorporate the rigorous Aprudent expert@ standard of the common law); Hylton, supra 
note 47, at 39. See also Laurence B. Wohl, Federal Duties Under ERISA: A Tale of Multiple 
Loyalties, 20 U. Dayton L. Rev. 43, 53 nn.34-35 (1994); Jay Conison, The Federal Common 
Law of ERISA Plan Attorneys, 41 Syracuse L. Rev. 1049, 1135-36 (1990). 

54.  See 29 C.F.R. ' 2550.404a-1; see also Dan M. McGill & Donald S. Grubbs, Jr., 
Fundamentals of Private Pensions 115-16, 442-44 (6th ed. 1989); see also Hylton, supra note 47 
and accompanying text. 

55.  The Department of Labor takes the position that Aeconomic considerations are the 
only ones which can be taken into account in determining which investments are consistent with 
ERISA standards.@ Ian D. Lanoff, The Social Investment of Private Pension Plan Assets: May it 
be Done Lawfully Under ERISA?, 31 Lab. L.J. 387, 392. In its evaluation of investment 
choices, the Department of Labor adopts an aggregate analyses which takes the entire 
investment portfolio into consideration rather than individual investments. See Paul J. Wessel, 
Job Creation for Union Members Through Pension Fund Investment, 35 Buff. L. Rev. 323, 340 
(1986). 

56.  See Deborah M. Weiss & Marc A. Sgaraglino, Prudent Risks for Anxious 
Workers, 1996 Wis. L. Rev. 1175, 1198-1200. The Department of Labor has consistently 
rejected the common law approach to evaluating such investment choices with respect to a 
particular investment on the bases of using only the relative risk of the single investment. See 
Joseph R. Simone & Glenn E. Butash, Statutory Framework, ALanguage@ and Fiduciary 
Responsibility Provisions of ERISA, 385 PLI/Tax 7, 27 (1996). 



2000] Rethinking the Risk of Defined Contribution Plans 623 

 

 

 

adequately diversify the investment portfolio in order to reduce the risk of 
investment losses.57 

Historically, the fiduciary rules have been interpreted to provide 
greater protection to participants in defined benefit plans than in defined 
contribution plans.58 One explanation for the different interpretations in the 
two types of plans is the level of employer involvement. In a defined benefit 
plan the employer determines the level of retirement benefit, who participates, 
and the manner in which the plan's assets are invested.59 By contrast, in a 
defined contribution plan, it is often the employee who makes the decisions 
about participation, contribution, and asset management. Furthermore, 
because defined benefit plans have calculable retirement benefits, plan 
participants readily can determine whether a failure to provide promised 
retirement benefits is attributable to fiduciary breach. In defined contribution 
plans, benefits are based upon the participants' individual account balances 
and therefore indeterminate in nature. Thus, absent a showing of imprudent 
investment choices, a plan participant would have difficulty demonstrating 
fiduciary breach when account balances fall short of the expected retirement 
benefits.60 
 
B.  Fiduciary Breach Under ERISA 
 

ERISA defines a Afiduciary@ as one with discretionary authority or 
control over pension plan assets, or one who manages pension assets.61 
Accordingly, employers, plan trustees, fund managers, and all other 

                                                 
57.  See Hylton, supra note 47, at 15, 17-18. Also see ERISA ' 404(a)(1), 29 U.S.C. 

1104(a)(1) (1994) (requiring that Aa fiduciary shall discharge his duties . . . (C) by diversifying 
the investments of the plan so as to minimize the risk of large losses@); see also Hylton, supra 
note 47, at 16 (noting that Arisk and return are positively correlated@). Diversification is a key 
method of reducing risk without reducing aggregate returns from a portfolio of assets. It 
exemplifies the old axiom: ADon=t put all your eggs in one basket.@ Essentially, diversification is 
spreading investment funds into areas which will react differently to the market, thereby 
eliminating risk. See Richard J. Teweles et al., The Stock Market 386-87 (6th ed. 1992). 
ADiversification results from the interplay of three elements: (1) the number of different 
holdings; (2) the proportions in which different securities [or other assets] are held; and (3) the 
extent to which the securities [or other assets] held react in a dissimilar fashion to the same 
future contingencies.@ Janet E. Kerr, Suitability Standards: A New Look at Economic Theory 
and Current SEC Disclosure Policy, 16 Pac. L.J. 805, 817 (1985). A perfectly diversified 
portfolio will eliminate nonmarket risk, leaving the assets to fluctuate according to the market. 
See id. at 818. 

58.  See Keville, supra note 4, at 547-48, 552. 
59.  Subject to the minimum participation standards of IRC ' 411. 
60.  See discussion infra Part II.B. 
61.  IRC ' 4975(e)(3); ERISA ' 3(21)(A), 29 U.S.C. ' 1002(21) (1999). 



624 Florida Tax Review [Vol. 4:9 
 

 

individuals who provide investment advice for profit are ERISA fiduciaries.62 
However, individuals who render professional services to a pension plan in a 
purely ministerial capacity are not considered fiduciaries.63 ERISA does not 
expressly address or regulate the activity of those who are involved indirectly 
with the management of the plan=s assets.64 For example, investment managers 
are clearly ERISA fiduciaries, but it is unclear whether investment consultants 
are considered fiduciaries.65 Thus, it is sometimes difficult to determine 
whether a service provider is acting in a fiduciary or ministerial capacity.66 

Under ERISA, A[f]iduciaries who breach their fiduciary duties are 
personally liable to the plan to make good any resulting losses to the plan.@67 
ERISA provides that equitable or remedial measures shall be awarded as a 
                                                 

62.  See e.g., Blatt v. Marshall & Lassman, 812 F.2d 810, 813 (2d Cir. 1987). 
63.  For example, actuaries, attorneys, accountants, and plan administration 

companies all have been held to be nonfiduciary third parties. See Painters of Philadelphia 
District Council No. 21 Welfare Fund v. Price Waterhouse, 879 F.2d 1146, 1149 (3rd Cir. 1989) 
(holding that performance of a standard audit did not make the accounting firm ERISA 
fiduciaries because the firm had no discretionary authority over management of the plan assets); 
Pension Plan of Public Service Co. of New Hampshire v. KPMG Peat Marwick, 815 F. Supp. 
52, 55 (D.N.H. 1993) (holding that an accounting firm that provides typical auditing services to 
an ERISA plan was not an ERISA fiduciary); see Maria Linda Cattafesta, Note, Mertens v. 
Hewitt Associates: A Narrow Interpretation of ERISA Precluding Nonfiduciary Liability for 
Money Damages Under ERISA, 43 Cath. U.L. Rev.1165, 1170 n. 23 (1994); Anoka 
Orthopaedic Assoc. v. Lechner, 910 F.2d 514, 517 (8th Cir. 1990) (holding that ministerial tasks 
performed for the purpose of collecting information was not a discretionary act and did not 
qualify the attorney as an ERISA fiduciary); New York Teamsters Council Health and Hospital 
Fund v. Estate of De Perno, 816 F. Supp. 138, 148 (N.D.N.Y. 1993); see Cattafesta, supra, at 
1170 n.22; Pappas v. Buck Consultants, Inc., 923 F.2d 531, 538 (7th Cir. 1991) (holding that an 
actuary who performs usual actuarial services is not an ERISA fiduciary); Fechter v. 
Connecticut General Life Ins. Co., 798 F. Supp. 1120, 1125 (E.D. Pa. 1991) (same); see 
Cattafesta, supra, at 1169-70 nn.20-21; Pohl v. National Benefits Consultants, Inc., 956 F.2d 
126, 128-29 (7th Cir. 1992) (holding that the performance of clerical, mechanical, and 
ministerial services did not confer discretionary authority over the plan administrator, and thus, 
the plan administrator was not an ERISA fiduciary); Baxter v. C.A. Muer Corp., 941 F.2d 451, 
454-55 (6th Cir. 1991) (holding that a plan administrator who performed claims processing 
services was not an ERISA fiduciary); see Cattafesta, supra, at 1170 n.23. But see Bouton v. 
Thompson, 764 F. Supp. 20, 23 (D. Conn. 1991) (holding that an attorney who exercises 
discretionary control over the management of plan assets is an ERISA fiduciary). 

64.  See ERISA ' 3(14)(A), 29 U.S.C. '' 1002(14)(A), 1101-1114 (1999). 
65.  See Joel Chernoff, Hewitt Decision Challenged; Metzenbaum, Labor 

Department Fight High Court Ruling, Pens. & Inv., Jun. 14, 1993, at 229. Case law regarding 
other service providers gives the only guidance in this area. See Custer v. Sweeney, 89 F.3d 
1156, 1161-63 (4th Cir. 1996) (holding that plan=s attorney is not ERISA fiduciary); United 
States v. Coyle, 63 F.3d 1239, 1246-47 (3d Cir. 1995) (Aby providing medical services to the 
Fund,@ AMMA is a fiduciary under ERISA); see also Andrew T. Kusner, Mertens v. Hewitt 
Associates, and the ERISA Liability of the Professional Service Provider, 15 Berkeley J. Emp. 
& Lab. L. 273, 304-05 (1994). 

66.  See Mertens v. Hewitt Associates, 508 U.S. 248, 262-63 (1993). 
67.  Michael J. Canan & William D. Mitchell, Employee Fringe and Welfare Benefit 

Plans ' 16.5 (1994 ed.). 



2000] Rethinking the Risk of Defined Contribution Plans 625 

 

 

 

court deems appropriate.68 Historically, the beneficiary of a pension trust 
could maintain an equitable suit for damages against not only a fiduciary for 
breach of trust, but also against a participating non-fiduciary.69 Thus, even 
though fiduciaries and participating non-fiduciaries were subject to different 
standards of care, there were remedies available against both, in the event of a 
breach of trust. 

However, in Mertens v. Hewitt, the Supreme Court interpreted section 
502(a)(3) of ERISA as precluding nonfiduciary liability in the event of 
breach.70 The Court held that ERISA does not provide monetary relief against 
participating nonfiduciary third parties, even when they knowingly participate 
in fiduciary breaches.71 The Mertens Court reasoned that because ERISA 
mandates specific remedies and Aallocates liability for plan-related misdeeds 
in reasonable proportion to [the] respective actors= power to control and 
prevent the misdeeds,@ the provision of monetary relief against service 
providers who performed services in the capacity of nonfiduciaries was 
unavailable.72 The Court explained that professional service providers lacked 
the requisite fiduciary control, and became Aliable for damages [ONLY] when 
they cross the line from advisor to fiduciary.@73 

The Mertens Court was concerned that exposing service providers to 
full liability for fiduciary breach would result in higher insurance costs for 
persons who regularly provide advisory services to ERISA plans.74 To do so, 
they feared, ultimately would increase the costs for ERISA plans. In other 
words, the Court believed that money that otherwise would be used for 
retirement benefits would be used to pay for indemnification against potential 
litigation. Thus, the Mertens Court preferred to limit the remedies against 
service providers to court injunctions, or restitution of fees, rather than to hold 
them liable for restoring losses resulting from their participation in fiduciary 
breaches.75 

Interestingly, the common law of trusts accords participants and their 
beneficiaries a cause of action for monetary damages against nonfiduciaries 

                                                 
68.  See ERISA ' 502(a)(3), 29 U.S.C. ' 1132(a)(3)(B) (1998); see Roger C. Siske et 

al., What=s New in Employee Benefits: A Summary of Current Case and Other Developments, 
SB66 A.L.I.-A.B.A. 1, 13-36 (1997). 

69.  Cattafesta, supra note 63, at 1191. The Supreme Court in Mertens defined 
Aequitable relief@ as Ainjunction, mandamus, and restitution.@ Mertens, 508 U.S. at 248. 
Equitable relief is, in fact, remedies awarded that are not monetary. See Black=s Law Dictionary 
539 (6th ed. 1990). 

70.  See Mertens, 508 U.S. at 254. 
71.  Id. 
72.  Id. at 262. 
73.  Id. 
74.  Id.; see also Chernoff, supra note 65, at 3 (discussing the Mertens opinion). 
75.  See Mertens, 508 U.S. at 262. 



626 Florida Tax Review [Vol. 4:9 
 

 

who knowingly participated in fiduciary breaches.76 Thus, under pre-ERISA 
trust law, wealthy nonfiduciaries were discouraged from participating in 
fiduciary breaches fearing that they could be alternative financial resources to 
subsidize lost retirement benefits. For this reason, many commentators 
characterize the Court's restrictive interpretation of ERISA=s fiduciary law in 
the Mertens decision as regressive.77 

The Court=s holding that nonfiduciary service providers are immune 
from fiduciary liability is potentially more devastating to defined contribution 
plan participants than to defined benefit plan participants. In defined benefit 
plans, if the remedies against third party non-fiduciaries are inadequate, the 
minimum retirement benefit is, nevertheless, guaranteed by the employer and 
the PBGC.78 Participants, therefore, do not face the risk of insufficient asset 
accumulation as a result of third party involvement in fiduciary breaches. 
Thus, diverting pension assets to provide a broader range of remedies against 
nonfiduciaries in defined benefit plans could be considered unnecessary or 
inefficient. Consequently, the Supreme Court=s reluctance to have pension 
assets diverted for service provider indemnification can be understood in the 
defined benefit plan context. 

In contrast, however, because there is neither employer liability nor 
PBGC protection in defined contribution plans, defined contribution plan 
participants have no protection against shortfalls. Therefore, if a defined 
contribution plan in which the fiduciary is unable to respond, terminates with 

                                                 
76.  See Kusner, supra note 65, at 280-81 (discussing how some circuits relied on 

pre-ERISA trust law to reach an interpretation of ERISA '502(a) different than the Supreme 
Court did in Mertens). 

77.  See, e.g., Kusner, supra note 65; Dana M. Muir, ERISA Remedies: Chimera or 
Congressional Compromise?, 81 Iowa L. Rev. 1 (1995); Gregory A. Hewett, Should 
Non-Fiduciaries Who Knowingly Participate in a Fiduciary Breach Be Liable for Damages 
Under ERISA?, 71 Wash U. L.Q. 773 (1993). The dissent in Mertens argued that both equitable 
and legal remedies were available under the common law of trusts to ensure that beneficiaries 
received complete relief. See Mertens, 508 U.S. at 264-66. Moreover, the dissent concluded that 
the phrase Aappropriate equitable relief@ used in ERISA ' 502(a)(3) implicitly includes all 
remedies available under equity for breaches which include monetary damages against both 
fiduciaries and nonfiduciaries alike. Id. at 266-67. The dissent=s interpretation would give plan 
participants and their beneficiaries the same protection under ERISA that they would have had 
before the enactment of ERISA. See id. Mertens states in dicta that there is no cause of action 
against a nonfiduciary for knowingly participating in a fiduciary=s breach of duty under ERISA. 
See Remedies: Seventh Circuit Finds No Claim Against Nonfiduciary, Cites Mertens, 21 Pens. 
& Ben. Rep. (BNA) 1675, 1675 (Aug. 29, 1994). Chief Judge Posner and the Seventh Circuit 
followed this Aconsidered dictum@ while holding that there is no cause of action against a 
nonfiduciary who knowingly participates in a fiduciary's breach of duty under ERISA. Reich v. 
Continental Casualty Co., 33 F.3d 754, 757-58 (7th Cir. 1994). The First Circuit has also 
followed Mertens=s lead in holding that equitable remedies are not available against 
nonfiduciaries who knowingly participate in a fiduciary=s breach of duty. See Reich v. Rowe, 20 
F.3d 25 (1st Cir. 1994). 

78.  See infra Part III.A. 



2000] Rethinking the Risk of Defined Contribution Plans 627 

 

 

 

insufficient asset accumulation due to third party fiduciary breach, and the 
remedies against the third party are inadequate to fully restore the lost 
benefits, the plan participants will bear the brunt of the loss.79 Defined 
contribution plan participants are, thus, exposed to much greater risks when 
service providers contribute to plan losses than defined benefit plan 
participants. Accordingly, the use of retirement funds to indemnify service 
providers in connection with a broadening of the remedies against third 
parties, could be reasonably considered an efficient use of defined 
contribution plan assets, because plan participants otherwise have inadequate 
protection.80 Thus, the Mertens holding is less understandable in the defined 
contribution plan context, where participants are exposed to greater risks of 
loss when third parties make investment decisions, or are involved in the 
management of plan assets.81 
 
C.  The Fiduciary Rules and Participant Directed Plans 
 

Although employers who sponsor defined contribution plans are not 
required to allow participants to make individual participation and investment 
decisions, many employers recognize that giving flexibility enables 
employees to customize their retirement programs to accommodate specific 
saving objectives and risk tolerances.82 Thus, growth in the defined 
contribution plan area has been driven largely by the establishment of 

                                                 
79.  If a retirement plan is not covered by Title I of ERISA, the participant will have 

remedies available under state law, including money damages and injunctive relief. See Canan, 
supra note 30, at ' 21.2, at 1024-25. 

80.  Immediately after Mertens was decided, the Department of Labor sought to 
persuade Congress to amend ERISA to assign fiduciary responsibility to anyone directly or 
indirectly involved in the management of pension assets. The Senate Labor Committee drafted 
an amendment to ERISA that explicitly made service providers liable for monetary damages if 
they Aknowingly participate[d]@ in fiduciary breaches. Chernoff, supra note 65, at 1. Senator 
Howard Metzenbaum, with input from the Department of Labor, drafted the amendment to 
reverse the Supreme Court=s Mertens decision. See Chernoff, supra note 65, at 2. The 
amendment was later defeated. Id. 

81.  See infra Part II.C. 
82.  Employees often are asked to decide whether they will participate in the plan, 

how much to contribute to the plan from current compensation, how their funds should be 
invested within choices offered by the employer, and finally, whether to roll over lump sum 
distributions received from the plans on termination of employment. See Keville, supra note 4, 
at 549-51. Interestingly, the reason most employers allow participants to make these decisions 
is a general misconception about ERISA. Basically, employers who sponsor qualified plans are 
convinced that ERISA ' 404(c) protects them from any potential liability arising out of the 
investment returns experienced in a participant=s account if they only transferred investment 
responsibility for the account to the participant. See Jeffrey M. Miller, Employer-Directed Plans 
May Be the Answer, Pension Mgmt., Nov. 1994, at 30. 



628 Florida Tax Review [Vol. 4:9 
 

 

participant directed plans.83 Participant directed plans cover approximately 25 
million employees, and represent the fastest growing component of the private 
sector retirement system.84 In participant directed plans, employees decide not 
only whether to participate, and the level of compensation to be contributed to 
the plan by the employer on their behalves, but also the manner in which their 
accounts are to be invested.85 In such plans, the individual decisions made by 
plan participants ultimately determine the adequacy of the retirement benefit. 

 Notwithstanding the significance of the investment decisions, 
however, ERISA currently imposes no additional notification or education 
requirements on employers who sponsor participant directed plans. ERISA=s 
general fiduciary standards govern the plan=s notification and investment 
practices. Thus, participant directed plans raise an additional question about 
the adequacy of ERISA=s fiduciary rules. Is it appropriate to allow employers 
to shift the responsibility of making critical investment decisions to plan 
participants, who typically lack professional financial training?86 Section 
404(c) safe harbor plans (discussed below) raise even more concerns 
regarding the adequacy of ERISA=s fiduciary rules because under such plans, 
the employer and other plan fiduciaries are almost completely insulated from 
fiduciary liability for the poor investment decisions made by plan participants. 
 

1.  Investment Practices and Participant Directed Plans.CIn 
employer directed plans, a plan administrator or an investment professional 
typically controls the plan investments.87 The investment manager is required 
to allocate investments in a manner that offers protection against inflation, 
market fluctuations, and unfavorable market performance.88 In participant 
directed plans, the same investment strategy is desirable, but generally not 

                                                 
83.  Participant directed plans are typically 401(k) plans; however, other defined 

contribution plans also may give participants the responsibility of choosing how the plan assets 
are to be invested. In addition to the self-directed feature, 401(k) plans often require participants 
to make numerous other decisions about their retirement security. 

84.  Marlene Givant Star, Participants in a Quandry About Plan Options, Pens. & 
Inv., Oct. 17, 1994, at 19. The number of participant directed 401(k) plans has grown rapidly. 
Participation in such plans increased by approximately 45% from 1983 to 1993, attributable in 
large part to the creation of new retirement plans by small businesses. See Canan, supra note 30, 
at '16.3, at 788. 

85.  The investment choice is made among the investment options offered by the 
employer. 

86.  See Mary Rowland, Taking the Power of the 401(k), and Handing it to Someone 
Else, N.Y. Times, June 18, 1995, at F5 (stating that some plan participants have recognized their 
own inadequacies regarding investment management and have turned their retirement accounts 
over to outside stockbrokers). 

87.  See Keville, supra note 4, at 543-44. 
88.  Diversification is Key to Success of Section 401(k) Investments, ASPA Told, 17 

Pens. & Ben. Rep. (BNA) 1243 (July 16, 1990) [hereinafter Diversification]. 



2000] Rethinking the Risk of Defined Contribution Plans 629 

 

 

 

utilized because employees often have not had sufficient investment training 
to achieve this result.89 

                                                 
89.  Insufficient financial training has been cited most frequently as the explanation 

for why participants use overly conservative investment strategies. Id. at 1243. 



630 Florida Tax Review [Vol. 4:9 
 

 

The modern portfolio theory of investment explains that an 
adequately diversified portfolio should include an appropriate balance of 
stocks, bonds, and stable valued funds.90 However, inexperienced participants 
generally fail to adequately diversify their retirement accounts, investing 
disproportionately in stable value funds.91 Because a balanced investment 
portfolio provides a better relationship between return and risk, the failure to 
adequately diversify investment portfolios adversely affects retirement 
income security. A high concentration of stable value, low-yield investments 
generally produces insufficient investment income over one=s working life to 
provide financial security for the retirement years.92 Consequently, a 
participant who disproportionately invests in stable valued instruments would 
have to save greater amounts to be in the same position at retirement as a 
participant who sufficiently diversified their investment portfolio.93 

Not only are inexperienced investors likely to inadequately diversify 
their retirement portfolios, but they also are less likely to recognize the 
financial indicators on which investment professionals rely to know when to 
transfer funds from one investment to another.94 Therefore, inexperienced 
investors may fail to make appropriate changes when such transactions are 
warranted. Under other circumstances, inexperienced investors may act too 
hastily.95 For example, during market down-swings, undisciplined investors 
may abandon high-risk, high-return investments too quickly, notwithstanding 
conventional wisdom that these investments perform best over the long-run.96 

If inexperienced participants do not, or cannot, make good investment 
decisions, they will have insufficient accumulation when they retire. Younger 
employees are particularly vulnerable to less than optimal investment 

                                                 
90.  See J. Michael McGowan, Watching Your Basket: Keys to Nurturing a 

Successful Investment Portfolio, 78 A.B.A. J. 97 (Nov. 1992). 
91.  Diversification, supra note 88, at 1243. 
92.  Overly conservative investment strategy is problematic for two other reasons: 

First, inflation, although averaging only 4% over the last decade, is a potential threat to the 
purchasing power of retirement income. Second, as life expectancies continue to increase, 
assets that participants have accumulated in their defined contribution plan accounts will need 
to stretch farther. Alexander Sussman, The Investment Horizon: How Can Employers Assure 
Adequate Retiree Benefits in the Coming Years?, Comp. & Ben. Rev., Jan. 1, 1996, at 73. 

93.  See Regina T. Jefferson, The American Dream Savings Account: Is it a Dream or 
a Nightmare?, Taxing America 261 (Karen B. Brown & Mary Louise Fellows eds., 1996). 

94.  See Keville, supra note 4, at 545-46 (noting that Athe majority of self-directed 
pension plan investors transferred funds to the stock market after it reached its high in 1987, and 
bailed out after the market crashed soon thereafter@). 

95.  Participants in 401(k) plans are active traders, contrary to popular belief. These 
investors may panic during market fluctuations, selling too quickly, which ultimately could 
threaten their financial security. See Vanessa O=Connell, Market Bumps Rattle Nerves at 
401(k)s, Wall St. J., Aug. 23, 1996, at C1. 

96.  See Judy Greenwald, Investment Education Raises Employer Liability 
Questions: When Does Information Become Advice?, Bus. Ins., Oct. 31, 1994, at 2, 98. 



2000] Rethinking the Risk of Defined Contribution Plans 631 

 

 

 

practices because the compounding of their returns will occur over longer 
periods of time. Thus, the success or failure of participant-directed plans 
hinges on the proper education and notification of plan participants in areas of 
asset allocation, diversification, and risk return.97 

2. The Education and Notification Requirement in Participant 
Directed Plans.CERISA=s mandate of Afiduciary responsibility@ for plan 
trustees, investment managers, and other persons who control pension plans, 
makes all plan fiduciaries ultimately responsible for asset performance in 
retirement plans.98 Thus, in participant directed plans, the employer remains 
liable as an ERISA fiduciary, although the participant makes the investment 
choices.99 Consequently, it is possible for the participant who loses money as a 
result of inadequate investment diversification to bring a cause of action 
against the employer, on the grounds that the availability of the transaction 
implied approval of the investment choice. Alternatively, a participant could 
argue that the employer should have recognized a problem with the 
investment decision, and overruled the allocation. Although a participant 
would have tremendous difficulty meeting the burden of proof for such 
allegations, the employer or plan fiduciaries, nevertheless, would be liable for 
the investment losses if the participant were successful.100 

To minimize their potential liability for poor investment decisions 
made by plan participants, many employers have established education 
programs.101 Providing investment education presents a catch twenty-two for 
                                                 

97.  See James E. Graham, Does 404(c) Provide More Questions Than Answers?, 
Pension World (July 1994) at p. 48. 

98.  See Munnell, supra note 11, at 137; see also supra Part II.B. There is an exception 
for ' 404(c) plans in which the plan fiduciaries are not responsible for the investment decisions 
made by plan participants. See infra Part II.C.3. 

99.  This is true even in ' 404(c) plans in which the employer=s liability is 
significantly minimized. See infra Part II.C.3. 

100.  In participant directed defined contribution plans the fiduciary standards would 
most likely be applied less strictly than in other types of defined contribution plans. Fiduciaries 
of such plans are apparently obligated to exercise only procedural prudence regarding 
investment decisions. Therefore, successful participant claims regarding poor investment 
performance are essentially eliminated in participant directed accounts. To establish fiduciary 
breach or mismanagement in a participant directed plan, participants would be limited to 
showing either that they were not advised properly, that there were not broad enough 
investment choices, or that there were inappropriate investment alternatives. Miller, supra note 
82, at 30. For a discussion of participant directed plans, see supra, Part II.C.1. 

101.  See Thomas R. Hoecker & Nancy K. Campbell, Participant Directed 
Investment PlansCProblems and Solutions, Q245 A.L.I.-A.B.A. 211 (1996); see also EBRI 
Releases Report on Participant Education for Improved Retirement Savings, 95 Tax Notes 
Today 86-51 (May 3, 1995) [hereinafter EBRI Releases]. A survey by EBRI and Matthew 
Greenwald and Associates indicated that 73% of 401(k) participants received some type of 
educational material from their employer. Id. Among the 73% that received the material, 33% 
increased the amount of their contribution and 44% changed the allocation of their money. Id. 



632 Florida Tax Review [Vol. 4:9 
 

 

the employer, however. On the one hand, employers can be held liable if they 
do not provide sufficient investment information to enable plan participants to 
make sound investment decisions. On the other, they can be held liable for 
losses as plan fiduciaries if the information is considered investment advice, 
and later proves to be incorrect.102 

The Department of Labor Regulations explain that Ainvestment 
advice@ consists of recommendations pertaining to property value; 
Ainvestment information@ consists of mere communication that is general in 
nature.103 Accordingly, providing a list of investment vehicles and instructions 
about the investment selection process is likely to be considered mere 
communication. Whereas, specific recommendations about particular 
investments are likely to constitute investment advice.104 

Until recently, employers were counseled that providing bad 
investment advice was a greater risk than providing insufficient investment 
information.105 In other words, employers were more exposed to litigation 
when they established education programs than when they allowed 
participants to make their investment decisions without the benefit of financial 

                                                 
102.  See Mary Rowland, Educate-or Litigate: Educating Pension Plan Participants, 

Inst. Inv., March 1, 1995, at 87. If the information is considered investment advice, those 
providing the information, e.g., employers, plan sponsors, service providers, would be deemed 
fiduciaries, subject to liability under ERISA. See Frederick C. Kneip, Section 404(c): Basic 
Principles, 397 PLI/Tax 43 (1997); See also Roger C. Siske et al., What=s New in Employee 
Benefits: A Summary of Current Cases and Other Developments, SB66 A.L.I.-A.B.A. 1, 78-79 
(1997). 

103.  The Department of Labor has determined that A[a]n investment advisor who 
suggests investment alternatives for a pension plan has a definite fiduciary duty to select 
alternatives prudently.@ Keville, supra note 4, at 551-52. Keville also notes that Aan investment 
advisor who is hired by an employer to provide investment instructions to employees is a 
fiduciary under the terms of ERISA if the advisor is compensated for services rendered.@ Id. 

104.  See Keville, supra note 4, at 551-52. However, any individual giving investment 
information to plan participants may be considered a fiduciary if it reasonable for the participant 
to consider the information investment advice and if the participant acts accordingly to her 
detriment. Jack W. Murphy, Associate Director and Chief Counsel of the Division of 
Investment Management at the SEC stated that an employee sponsor providing information 
would not be considered to be giving advice unless it held itself out as providing advice or 
received additional compensation from employees or third parties for the advice. See Division 
of Investment Management the Year in Review: Regulation of Investment Companies, 
Investment Advisors and Public Utility Holding Companies in 1996, 979 PLI/Corp 7, 680 
(Feb.-Mar. 1997). 

105.  See Rowland, supra note 102, at 87. See also Jeffrey M. Miller, The Difference 
Between Education and Advice, Pension Mgmt., Feb. 1995, at 34. If plan sponsors teach 
participants about investment performance in achieving long-term retirement goals, the sponsor 
will not be considered a fiduciary. Id. However, if the sponsor creates programs which provide 
the basis for participants= investment decisions, plan sponsors may be regarded as fiduciaries 
which exposes them to potential liability. Id. In this situation, sponsors will have crossed the 
line between providing investment information and advice. Id. 



2000] Rethinking the Risk of Defined Contribution Plans 633 

 

 

 

training.106 Because employers are typically unwilling to assume a risk of 
greater exposure to potential liability, it is not surprising that many employers 
have not provided adequate investment education to their employees.107 As a 
result, employees participating in participant-directed plans are often left on 
their own to obtain the education and training necessary to successfully 
manage their retirement savings. 

The significance of the distinction between investment advice and 
investment information is another reason the Mertens decisions is more 
troubling for certain defined contribution plan participants than for defined 
benefit plan participants. In participant-directed defined contribution plans, 
unsophisticated investors unable to distinguish between investment advice 
and investment information may suffer unfortunate consequences as a result 
of misunderstandings. If an investment broker aggressively markets 
alternative investments under the rubric of investment information, 
inexperienced plan participants could interpret the broker=s comments as 
specific recommendations, rather than general information. Believing that 
they have received investment advice, participants may rely on the 
communication and make decisions that adversely affect the build-up of their 
accounts. Under Mertens, money damages would be unavailable to the plan 
participants in this situation, even if the broker had adequate assets to restore 
plan losses.108 Thus, the participants ultimately would receive smaller 
retirement benefits than expected.109 

3.  Section 404(c) Plans.CAnother method of minimizing liability for 
poor investment performance is for the employer to adopt a section 404(c) 
plan.110 An employer's exposure to fiduciary liability is substantially reduced 

                                                 
106.  See Rowland, supra note 102, at 87; see also Miller, supra note 105, at 30 (not-

ing that in the 1980=s, employers thought they could avoid liability altogether by transferring the 
investment responsibility to plan participants). 

107.  See Rowland, supra note 102, at 87. Recent numbers suggest that there has been 
an increase in education programs offered by employers. However, many employers make such 
programs available because it is important for them to encourage low and middle income 
employees to participate in elective contribution plan. See EBRI Databook, supra note 19. 
However, with the introduction of the new safe harbor rules for nondiscrimination in 401(k) 
plans many employers may discontinue these programs. 

108.  See supra Part II.B. The only chance for the participant to receive money 
damages is for her to demonstrate that she reasonably interpreted the comments as investment 
advice. An investment advisor who directs participant investment selections for a pension plan 
has a fiduciary duty to select alternatives prudently. See Keville, supra note 4, at 548-52. 

109.  A cause of action may be available under common law, however. See infra Part 
III.A. 

110.  ERISA ' 404(c), 29 U.S.C. ' 1104(c) (1999). This section provides: 
(c)(1) In the case of a pension plan which provides for individual accounts 
and permits a participant or beneficiary to exercise control over assets in his 
account, if a participant or beneficiary exercises control over the assets in 



634 Florida Tax Review [Vol. 4:9 
 

 

if the plan complies with the rules and regulations of section 404(c), Asafe 
harbor@ plans.111 These rules require the employer to give a broad range of 
investment options, and reasonable instructions regarding the significance of 
the options.112 

Unlike traditional participant directed plans in which plan fiduciaries 
retain some obligation to make sure that the plan assets are protected against 
losses, section 404(c)safe harbor plans essentially shield the employer and 
                                                                                                                   

his account (as determined under regulations of the Secretary)- 
(A) such participant or beneficiary shall not be deemed to be a fiduciary by 
reason of such exercise, and 
(B) no person who is otherwise a fiduciary shall be liable under this part for 
any loss, or by reason of any breach, which results from such participant's 
or beneficiary=s exercise of control. 

Id. Section 404(c) of ERISA is elective and applies only to defined contribution plans, such as 
401(k) plans, where participants control the investment of their assets. Id. 

111.  29 C.F.R. ' 2550.404c-1 (2000). The ' 404(c) regulations were issued in 
October of 1992. 57 Fed. Reg. 46932 (1992). The regulations define an ERISA ' 404(c) plan as, 
generally, a defined contribution plan that provides participants with the opportunity to 
Aexercise control over assets@ in their accounts and provides the participant with Aan opportunity 
to choose from a broad range of investment alternatives.@ 29 C.F.R. ' 2550.404c-1(b)(1)(i), (ii) 
(2000). See also Canan, supra note 30, at '16.3, at 788-89. However, ' 404(c) relief is not 
available in transactions where a plan fiduciary has exercised improper influence or 
concealment of material nonpublic facts known by the fiduciary, or takes instructions from a 
participant that is known by the fiduciary to be legally incompetent. 29 C.F.R. 
' 2550.404c-1(c)(2) (2000). 

112.  See Canan supra note 30, at ' 16.3, at 791-93. A broad range of investment 
alternatives means: 

(I) A plan offers a broad range of investment alternatives only if the available 
investment alternatives are sufficient to provide the participant or beneficiary with a 
reasonable opportunity to: 

(A) Materially affect the potential return on amounts in his individual 
account with respect to which he is permitted to exercise control and the 
degree of risk to which such amounts are subject; 
(B) Choose from at least three investment alternatives: 

(1) Each of which is diversified; 
(2) Each of which has materially different risk and 
return characteristics; 
(3) Which in the aggregate enables the participant or 
beneficiary by choosing among them to achieve a 
portfolio with aggregate risk and return characteristics 
at any point within the range normally appropriate for 
the participant or beneficiary; and  
(4) Each of which when combined with investments in 
the other alternatives tends to minimize through 
diversification the overall risk of a participant=s or 
beneficiary's portfolio; 

(C) Diversify the investment of that portion of his individual account with 
respect to which he is permitted to exercise control so as to minimize the 
risk of large losses. . . . 

29 C.F.R. ' 2550.404c-1(b)(3) (2000). 



2000] Rethinking the Risk of Defined Contribution Plans 635 

 

 

 

other plan fiduciaries from any liability.113 Regardless of how plan 
participants allocate their assets in such plans, plan fiduciaries are not liable 
for any losses that result from poor investment returns.114 These plans, 
therefore, place the entire risk of accumulating insufficient assets from poor 
investment decisions on the participants.115 

As is the case in traditional participant directed plans, the employer 
who sponsors a section 404(c) safe harbor plan has no obligation to assist 
participants in making their investment decisions. Furthermore, as discussed 
above, the employer is discouraged from doing so because such assistance 
could trigger fiduciary liability in plans that are otherwise in compliance with 
section 404(c).116 Therefore, participants in safe harbor plans have little or no 
recourse against employers, administrators, or service providers for 
investment losses.117 They are barred from claiming that the employer either 
should have recognized a problem, or provided different investment 
options.118 In traditional participant directed plans, these allegations might be 
successful on the grounds that a failure to diversify the participant's account 
violates ERISA=s prudence and diversification rule.119 
 
D.  Pension Policy and Participant Directed Plans 
 

                                                 
113.  See Investments: Pension Plan Participants Need Education on Investments, 

Group Told, 21 Pens. & Ben. Rep. (BNA) 775 (Apr. 18, 1994). However, ' 404(c)compliance 
does not shield the employer from all fiduciary liability. Plan fiduciaries are still accountable for 
making certain that the investment options offered are sound and the investment managers 
selected are competent. See 29 C.F.R. ' 2550, 404c-1(a)(2) (2000). See also Rowland, supra 
note 102, at 87-88; Keville, supra note 4, at 549. 

114.  See Frederick C. Kneip, Section 404(c): Basic Principles, 397 PLI/Tax 43, 
46-48 (May 1997). 

115.  See Canan, supra note 30, at ' 16.3, at 793; see also Greenwald, supra note 96, 
at WL p. 2-3; 29 C.F.R. ' 2550.404c-1(b)(1), (2) (2000). 

116.  See also supra Part II.C.2; Keville, supra note 4, at 551-52. 
117.  See ERISA ' 404(c)(2), 29 U.S.C. ' 1104(c)(1)(B) (1999) (providing that a 

fiduciary is not liable for a loss resulting from the exercise of control by a participant or 
beneficiary); 29 C.F.R. ' 2550.404c-1(d)(2)(i) (2000) (providing that when independent control 
over the assets is exercised by a participant or beneficiary, the fiduciary is not responsible for 
any loss that is the direct and necessary result). However, there remains some liability for the 
employer. See Kneip, supra note 114, at 69-70. 

118.  See Hoecker & Campbell, supra note 101, at 213; but see 29 C.F.R. 
' 2550.404c-1(d)(2)(ii)(A)-(E) (2000) (providing that ' 404(c)=s limit on fiduciary liability will 
not be available if, for example, the participant's decision would violate provisions in the plan 
documents). 

119.  See Weiss & Sgaraglino, supra note 56, at 1213; Patricia Wick Hatamyar, See 
No Evil? The Role of the Directed Trustee Under ERISA, 64 Tenn L. Rev. 1, 18-19 (1996); see 
also supra Part II.A. 



636 Florida Tax Review [Vol. 4:9 
 

 

Employers prefer participant directed plans because they are more 
convenient and less costly to maintain than other plans, and some employers 
establish these plans in efforts to minimize their liability for investment 
decisions.120 Employees typically prefer participant-directed plans because 
they believe that the plan=s flexibility can provide greater long term rewards, if 
they make wise investment decisions.121 However, it is not uncommon for 
plan participants to have inflated opinions about their investment expertise.122 
Thus, rather than increasing their retirement income security, participant 
directed plans, in reality, may decrease the retirement income security of those 
who are inexperienced in financial investment. 

This is particularly true as the emergence of new products and 
services makes investment decision making more difficult. For example, some 
plans allow participants to execute trades on a daily, rather than monthly 
basis.123 Other plans provide broad ranges of options that include the entire 
universe of publicly traded stock.124 Expansive measures such as these are 
increasingly offered, although the complexity of the limited investment 
options previously available to plan participants was well beyond the 
understanding of the average investor.125 

The popularity of participant directed plans does not necessarily stem 
from the fact that they are the best way to maximize retirement income 
security, however. Rather their popularity stems from the fact that they are 
what both employers and employees seemingly prefer.126 Despite their 
overwhelming popularity, participant directed plans present a very difficult 
trade-off.127 Employees are given greater flexibility and autonomy in making 
investment decisions, but they are also exposed to greater risks of investment 
losses. Moreover, as employers increasingly establish participant directed 

                                                 
120.  See supra Part I.B. 
121.  See Star, supra note 84, at 19. 
122.  Two thirds of participants surveyed in a study conducted by Buck Consultants 

of New York and Phoenix Hecht of the Research Triangle in North Carolina, preferred to 
manage their own assets. See Star, supra note 84, at 19; Jan M. Rosen, Self-Directed Retirement 
Plans, N.Y. Times, Dec. 1, 1990, at A1. 

123.  See Brian E. Schaefer, The Trouble With Daily Switching for 401(k)s, Pens. & 
Inv., March 6, 1995, at 12; see also Star, supra note 84, at 19. When plans allow fund switches 
on a daily basis, it may cause participants to play the market, producing inferior results in the 
long run. 

124.  See Schaefer, supra note 123, at 12. 
125.  See Star, supra note 84, at 19 (explaining that those who are significantly affect-

ed by the complexity are those under age 30, over age 55, and the poor). 
126.  See supra Part I.B. 
127.  The combination of imprudent investment allocation and the elimination of the 

employer responsibility for the participant=s investment decisions is likely to result in benefits 
which fall short of the expected retirement income replacement goal for some participants. See 
Donald Faller, Give 401(k) Participants Customized Assistance, Nat=l.Underwriter Life & 
Health Fin. Serv. Ed. 22 (May 15, 1995). See also supra Part II.C.1. 



2000] Rethinking the Risk of Defined Contribution Plans 637 

 

 

 

plans, undoubtedly more of them will turn to safe harbor plans that provide 
even less protection for plan participants, in order to avoid unwanted exposure 
to fiduciary liability.128 

Notwithstanding the shortcomings of participant directed plans, it 
would nevertheless be difficult, and perhaps counter productive, to eliminate 
them as retirement savings options, because of their tremendous appeal to 
employees and employers alike. In the absence of participant directed plans, 
some employers may choose not to establish plans, and some employees may 
choose not to participate. Even so, the self-help approach adopted by 
participant directed plans is inconsistent with ERISA=s goal of increasing the 
retirement income security of plan participants. To provide the level of 
retirement income security envisioned by ERISA as originally drafted, there 
should be some residual fiduciary responsibility imposed on employers who 
sponsor participant directed plans. An education and notification requirement 
should also be imposed on sponsors of such plans. These changes would 
ensure that plan participants are qualified to make prudent investment 
decisions with regard to their retirement savings, and can appreciate the 
significance of the risk of shortages when they do not.129 
 
E. Residual Liability and a Notification and Education Requirement 
 

The private retirement system is employment based.130 Therefore, it is 
only through employment relationships that such benefits are made available. 
One of the rationales for the employment based characteristic of the private 
pension program is that there are comparative advantages from saving in 
employer sponsored plans as opposed to personal savings arrangements.131 
First, saving for retirement requires financial investment expertise. Because it 
is more likely that the employer is in a better position to retain financial 
experts than the employees, participants typically receive greater returns 
inside a plan than outside.132 Second, an employer who invests large amounts 
can benefit from economies of scale. As a result, investment returns should be 

                                                 
128.  The Greenwich Associates studies indicate that 29% of companies with defined 

contribution plans are planning to comply with the safe harbor rules of ' 404(c) in the near 
future. See supra Part II.C.3. The Department of Labor regulations on participant investments 
under ' 404(c) of ERISA were issued in October 1992 and took effect January 1, 1994. See 
Most Firms Comply with Section 404(c) Rules, 21 Pens. & Ben. Rep. (BNA) 1100 (June 6, 
1994). 

129.  See supra Part II.C.2. 
130.  See Langbein & Wolk, supra note 5, at 32. 
131.  See Munnell, supra note 11 at 54; see also Langbein & Wolk, supra note 5, at 

32. 
132.  See Langbein & Wolk, supra note 5, at 32. 



638 Florida Tax Review [Vol. 4:9 
 

 

higher, and administrative costs should be lower, inside an employer 
sponsored plan.133 

Another characteristic of the private pension system is that it is 
voluntary. Employers are encouraged to establish qualified plans with 
substantial tax benefits.134 The basic tax advantage is tax deferral. Amounts 
contributed to qualified plans by employers are not taxed to the employee 
when they are made. Also the earnings on the contributions accumulate 
tax-free, and the employee is not taxed on the amounts in the plan until they 
are distributed.135 In connection with the favorable tax treatment of pension 
plans, the Treasury forgoes large amounts of tax revenue each year.136 

Because the preferential tax treatment of retirement benefits reduces 
the employee=s current taxable income, it is possible for the employer to 
deliver a dollar of retirement income at a lower cost than it could deliver a 
dollar of current wages to its employees.137 Accordingly, an employer is able 

                                                 
133.  See Langbein & Wolk, supra note 5, at 32-33. Although not discussed in this 

article, wider participation is another reason the private pension system is employer based. In 
other words, another rationale for the tax favorable treatment of qualified plans is that 
retirement benefits for rank and file employees will exist only if Congress provides tax 
incentives that will induce higher paid employees to support the establishment of employer 
sponsored retirement savings plans. Id. at 200-03 (citing Bruce Wolk, Discrimination Rules for 
Qualified Retirement Plans: Good Intentions Confront Economic Reality, 70 Va. L. Rev. 419, 
426-33) (1984). 

134.  AQualified plans provide the most tax effective way of delivering retirement 
income, because (i) the employer receives a current tax deduction for contributions to a trust, 
(ii) the trust pays no tax on its investment income, and (iii) the employee pays no tax until he 
receives a distribution from the trust.@ Max J. Schwartz & Lora S. Collins, Securing the Promise 
to Pay: Funding of Non-Qualified Deferred Compensation, 328 PLI/Tax 275, 279 (July-August, 
1992); see also Frank P. Vanderploeg, Role-Playing Under ERISA: The Company as 
AEmployer@ and AFiduciary,@ 9 DePaul Bus. L.J. 259, 272 n.43 (1997). 

135.  See Langbein & Wolk, supra note 5, at 156. 
136.  The cost to the Treasury is in the form of forgone revenue. The annual cost of 

the private retirement program is an estimated $64 billion. See EBRI Databook, supra note 19, 
at 19-23, tbl. 2-5. The tax expenditure estimates for pensions are calculated on a cash flow basis. 
This method of calculation has the effect of placing no value on the pension promise itself, only 
on the advanced funding of the promise. See EBRI, Pension Tax Expenditures: Art They Worth 
the Cost?, Feb. 1993, #134. 

137.  See IRC ' 402(a)(1). An employee may be willing to accept a lesser-valued 
plan contribution in exchange for current compensation, e.g., a $4,500 plan contribution in 
place of $5,000 in current compensation, because the $4,500 is tax free. See Mary 
Oppenheimer, From Meldrum to Indopco: Should Qualified Plan Professional Fees Be 
Capitalized?, 40 Wayne L. Rev. 109, 131-132 (1993) (citing Bruce Wolk, Discrimination Rules 
for Qualified Retirement Plans: Good Intentions Confront Economic Reality, 70 Va. L. Rev. 
419, 432 (1984)); Langbein & Wolk, supra note 5, at 149 (discussing the tax treatment of 
qualified plans). A related but different issue is the extent to which current wages are reduced in 
connection with expected retirement benefits, i.e., higher pensions lead to lower wages. While 
no one would deny that the retirement income contribution is a part of an employee=s wage 
package, the extent to which workers wages are effected by their expected retirement incomes is 
difficult to determine. See Munnell, supra note 11, at 2. One view says the plan participants give 



2000] Rethinking the Risk of Defined Contribution Plans 639 

 

 

 

to reduce current compensation by more than the actual amount of 
contributions made to the plan. Arguably, the economic benefits enjoyed by 
employers are justifiable only if participants are in fact better off being 
covered by an employer sponsored arrangement than they otherwise would be.  

Although sponsors of participant directed and employer directed 
plans enjoy equal tax benefits, participants of the plans are not accorded the 
same nontax advantages. In participant directed plans, participants, not the 
employer, make the investment decisions. Thus, the participants do not benefit 
from the employer=s investment programs, or financial guidance. Furthermore, 
any advantages derived from economies of scale are diminished, if the 
participants fail to make prudent investment decisions. Therefore, another 
reason to impose residual liability on sponsors of participant directed plans is 
to justify the economic benefits they receive, as well as to justify the overall 
cost of the retirement savings program.138 

The education requirement should also mandate a variety of 
educational mediums. There is substantial evidence showing that printed 
communication generally is ineffective in aiding the investment education of 
plan participants because employees either do not understand written 
materials, or disregard them.139 Thus, the requirement should specifically 
include a complement of written materials, seminars, and financial planning 
software on retirement asset management. Additionally, the education 
provided should be responsive to the investment needs of different groups of 
participants. For example, there should be age specific information.140 

                                                                                                                   
up wages equal to the value of the benefits that they accrue each year. See Edward Thomas Veal 
& Edward R. Mackiewicz, Pension Plan Terminations 204 (1989). Another view is that of the 
Aimplicit contract@ hypothesis. This view says that an employee=s wages are reduced equal to the 
level payment needed to fund the pension that is expected to be received if the plan continues 
indefinitely and the participant has a normal working life time with the employer. For example, 
if an employee expects to be employed for 30 years, and the anticipated normal retirement 
benefit under the plan is $300 per month, and the first year=s amortization of this benefit would 
be approximately $270. Thus, the participant=s current wages would be reduced by that amount 
to fund the expected retirement benefit. Id. at 204. 

138.  See Glenn E. Coven, Corporate Tax Policy for the Twenty-First Century: 
Integration and Redeeming Social Value, 50 Wash. & Lee L. Rev. 495, 512 (1993); see also 
Jefferson, supra note 93, at 253 (stating that all taxpayers pay the subsidy by paying Ahigher tax 
rates on the portions of their [retirement] incomes that do not enjoy special tax treatment@). 

139.  See generally Ed Peratta, 401(k) Communication That Works, Pens. Mgmt., 
Dec. 1995, at 32; EBRI Releases Report on Participant Education for Improved Retirement 
Savings, 95 Tax Notes Today 86-51 (May 3, 1995). 

140.  Investment horizons will vary with age and will therefore affect investing 
strategies. Because of this, employer-provided information will need to address different issues 
with various groups. See Laurence B. Wohl, Fiduciary Duties Under ERISA: A Tale of 
Multiple Loyalties, 20 U. Dayton L. Rev.43, 92 (1994); Keville, supra note 4, at 544. 



640 Florida Tax Review [Vol. 4:9 
 

 

Finally, an education requirement should address the timing and 
frequency of retirement planning information. Presently, some employers 
offer one-time retirement planning sessions to older employees who are 
approaching retirement, but do not provide similar sessions for younger 
workers.141 However, because the assets of younger workers are invested over 
longer periods of time, they are more likely to suffer from imprudent 
investment strategies than older employees.142 Therefore, it would be 
important for the education requirement to require financial training for all 
workers throughout their working lives. 

The education requirement would not only enable participants to 
make better investment decisions, but also would eliminate the catch 
twenty-two that employers currently face regarding investment advice and 
investment information.143 The content, frequency, and medium of all 
communication regarding investment would be regulated. All participants 
would receive the same education. It would therefore no longer be necessary 
to use a cumbersome facts and circumstances analysis to classify 
communications between employers and employees as either advice or 
information. More importantly, however, plan participants would be better 
able to make prudent investment decisions and appreciate the future value of 
their expected retirement income in order to determine whether it is necessary 
for them to supplement their expected retirement benefits with increased 
personal savings.144 
 
F.  Enforcement of a Notification and Education Requirement 
 

Under a properly implemented notification and education 
requirement, when an employer failed to comply, fiduciary liability for the 
resulting losses would be reinstated. Although determining the actual loss in a 
defined contribution plan is not a straightforward calculation, the loss could be 
determined using any one of several approaches. For example, the actual loss 
could be determined by the excess of either the average rate of return for 
Treasury Bills, or the average rate of return for a specified portfolio mix, over 
the actual rate of return earned by the account.145 

After determining the loss, an excise tax should be imposed on the 
employer. The excise tax could be a flat rate excise tax designed to recoup an 

                                                 
141.  See Keville, supra note 4, at 544. 
142.  Id. Poor returns compounded over the working life of a young employee result 

in greater gaps between expected and actual benefits than poor returns compounded only briefly 
as for older employees. Id.; cf. Fitzpatrick, supra note 9, at 79. 

143.  See supra notes 101-102 and accompanying text. 
144.  See Dallas Salisbury, ERISA=s Success and the Vista for the Future, Pens. & 

Inv., Aug. 22, 1994, at 14. 
145.  See discussion infra Part III.E.1. 



2000] Rethinking the Risk of Defined Contribution Plans 641 

 

 

 

account holder=s lost investment build-up. Alternatively, like the section 4971 
tax for underfunding, the flat rate excise tax could be imposed at a rate high 
enough to both recoup asset losses, and discourage noncompliance. Another 
option is for the excise tax to be calculated on a case-by-case basis, using 
particular facts and circumstances to measure the loss, exactly.146 Regardless 
of how the tax is determined or structured, however, under no circumstances 
should employers who completely insulate themselves from liability for 
imprudent investment decisions enjoy the same level of tax benefits as 
sponsors who retain liability when such losses occur. 
 
 III.  INSURANCE PROTECTION AGAINST MARKET FLUCTUATIONS 
 
A.  The Gap In Insurance Protection 
 

The goal of ERISA was not only to protect participants from fiduciary 
misconduct and asset mismanagement, but also to protect plan participants 
from pension default.147 Thus, in addition to establishing higher fiduciary 
standards for managers of employee benefits, as part of ERISA Congress also 
established a federal insurance program administered by the PBGC to protect 
participants from benefit loss due to plan failure.148 

Under the pension insurance program the PBGC provides substantial 
protection of defined benefit plan accruals, but not of defined contribution 
plans.149 Section 3(34) of ERISA specifically provides that PBGC protection 
is not available to individual account plans.150 This section defines individual 
account plans as plans in which the level of benefit for each employee 
fluctuates depending on the experience of the account. Because the retirement 
benefit in defined contribution plans is dependent upon actual contributions 
made to an account and the investment performance of each separate account, 
all defined contribution plans are excluded from ERISA=s insurance 
program.151 

When ERISA was established in 1974, Congress could not have 
anticipated the recent shift from defined benefit plans to defined contribution 
plans.152 Thus, the failure to provide insurance protection for defined 

                                                 
146.  See Jefferson, supra note 26, at 36. 
147.  See Langbein & Wolk, supra note 5, at 92-93. 
148.  See McGill & Grubbs, supra note 54, at 55. 
149.  See Edward R. Mackiewicz, Pension Plan Terminations: Procedures and 

Liabilities, 444 PLI/Comm 51, 58 (1988); see also Keville, supra note 4, at 553. 
150.  See 29 U.S.C. ' 1002(34) (1995) (defining a defined contribution plan as a plan 

providing an individual account for each participant). 
151.  ERISA, 29 U.S.C. ' 1321(b). 
152.  See supra Part I.A. 



642 Florida Tax Review [Vol. 4:9 
 

 

contribution plans may have been appropriate when the number of defined 
contribution plans was not expected to rise. However, because thousands of 
plan participants now rely upon defined contribution plans as their primary 
retirement savings vehicles, the financial security of many future retirees will 
depend on how successful defined contribution plans are in accumulating, and 
delivering their expected retirement benefits. Therefore, notwithstanding the 
historical explanation for the absence of insurance protection for defined 
contribution plans, the gap in insurance protection is no longer appropriate or 
justifiable. Insuring a minimum investment return in retirement savings plans 
is not only a feasible idea, but what actually occurs under the existing defined 
benefit plan insurance program in certain circumstances. 
 
B.  Reasons for Shortfalls 
 

 Two of the most prevalent reasons for shortfalls in defined benefit 
plans are the failure of employers to contribute sufficient amounts for past 
service costs, and unfavorable investment returns.153 The funding of ongoing 
defined benefit plans is determined by the use of actuarial cost methods. 
Actuarial cost methods estimate plan costs and assign the costs to appropriate 
years.154 The present value of pension benefits and liabilities depends on the 
actuarial assumptions selected for interest, early retirement, turnover, and 
salary increases.155 

 The funding rules require a plan sponsor to contribute annually an 
amount equal to the current plan year cost. This amount is referred to as the 
Anormal cost@ of the plan.156 The normal cost allocates future plan costs over 
the life of the plan and can vary significantly depending on the actuarial 
assumptions and the funding method used by the plan. 

In addition to the plan's normal cost, the employer=s annual 
contribution must cover amounts attributable to supplemental costs. Unlike 
                                                 

153.  See Canan, supra note 30, at 605, 609. 
154.  Cost are assigned to appropriate years to prevent the employer=s deduction from 

being too large, as well as to create a systematic funding schedule. See Jefferson, supra note 26, 
at 5; McGill & Grubbs, supra note 54, at 375; see IRC ' 412. Any of several actuarial cost 
methods may be selected if the actuary certifies that the method and assumptions are reasonable 
in the aggregate. McGill & Grubbs, supra note 54, at 393-94. ERISA lists six acceptable 
actuarial cost methods, but it is possible that additional methods may be designated as 
acceptable by the Internal Revenue Service. Id. Any change in the method used may be made 
only with the prior approval of the Internal Revenue Service. Id. 

155.  See Jefferson, supra note 26, at 11 (citing Langbein & Wolk, supra note 5, at 
228). 

156.  The normal cost will vary depending on the funding method selected. See 
Jefferson, supra note 26, at 5. If a plan=s cost is determined on the basis of accrued benefits, the 
normal cost is the actuarial present value of the benefits accrued in a given year. Id. If the cost is 
based on projected benefits, the normal cost is generally the level percentage of pay necessary 
per year to fund the projected benefits for all years of service. Id. 



2000] Rethinking the Risk of Defined Contribution Plans 643 

 

 

 

the normal cost, the supplemental costs may not be funded at once, but rather 
must be amortized over specified periods of time.157 Supplemental costs 
include amounts derived from plan amendments, experience losses,158 
inaccurate actuarial assumptions, and past service credits.159 

Liabilities for past service credits are the most common supplemental 
cost.160 Past service liability occurs when an employer gives credit for service 
prior to the date on which the plan was established.161 Thus, prospectively 
viewed the past service liability, also known as the accrued liability, is the 
amount that, together with future plan costs, is expected to cover all benefit 
costs incurred under the plan.162 

The excess of the accrued liability over a plan=s assets is the 
Aunfunded past service liability.@163 When plans terminate before there is time 
to make sufficient contributions to cover the past service liability, there will be 
insufficient funding, unless errors in the accompanying actuarial assumptions 
are offsetting.164 

Regardless of how carefully the actuarial assumptions are selected, 
advanced funding methods produce only cost estimates, not actual costs.165 
Thus, typically a plan will either have a funding surplus or a funding 
deficiency, since any deviation in the assumptions when compared with actual 
plan experience will produce a shortfall, or a windfall.166 

                                                 
157.  See discussion infra Part IV.C. 
158.  Experience losses occur when actual plan costs exceed the actuarial estimates 

for a given plan year. For example, if the actuary assumes that the plan investments will earn 8% 
and the investment earned only 5%, the plan will have a deficiency, or an actuarial loss. See 
generally Canan, supra note 30, at ' 12.3, at 607-11; Langbein & Wolk, supra note 5, at 285. 

159.  Supplemental costs also include waived funding deficiencies, which occur 
when the Secretary of the Treasury, acting through the Internal Revenue Service, waives part or 
all of a plan=s annual contribution upon a showing of substantial financial hardship such that 
making the plan contribution would adversely affect plan participants. See IRC ' 412(d); see 
also Langbein & Wolk, supra note 5, at 290-91. 

160.  Past service liability can arise in two ways: (1) it may accrue for service 
rendered before the plan was adopted, or (2) it may apply to service rendered by an employee 
after adoption of the plan but prior to a plan amendment which provides increased coverage for 
such service. See Canan, supra note 30, at 593. 

161.  AThe past service liability is also referred to as the >accrued liability.= Despite its 
name, the accrued liability of a plan is not an accounting or legal liability.@ Jefferson, supra note 
26, at 5 n.21. 

162.  Id., at 5. 
163.  IRC ' 412(b)(2)(B). 
164.  If, for example, there were substantially higher turnovers among nonvested 

participants, there may be sufficient forfeitures to offset an incorrect interest rate assumption. 
See Halperin, supra note 7, at 772-73. 

165.  See Jefferson, supra note 26, at 11. 
166.  Id., at 12. 



644 Florida Tax Review [Vol. 4:9 
 

 

 When a defined benefit plan terminates with insufficient assets, the 
PBGC pays the plan=s vested accrued benefits at the time of termination.167 
Accordingly, the PBGC insures plan participants against shortfalls that arise 
from the differences in the estimated funding cost and the actual cost of a 
defined benefit plan.168 Regardless of which actuarial assumption is 
inaccurate, all deficiencies are treated the same. If a plan experienced losses 
due to an erroneous turnover assumption and ultimately terminated, the PBGC 
would be liable for the unfunded vested accrued benefits. Similarly, if the 
deficiency were attributable to an erroneous interest rate assumption, the 
PBGC would also be liable.169 

In reality, the latter situation is more likely to occur.170 Because the 
interest rate assumption typically reflects the long-term nature of the pension 
obligations, a change in the interest rate assumption affects the valuation 
results more than a change in any other actuarial assumption.171 Although the 
impact of an inaccurate interest rate assumption depends upon the number of 
years involved, the age distribution of plan participants, and the weighting of 
plan liabilities,172 the rule of thumb to which actuaries generally adhere is that 
a 2% change in the interest rate results in a change in liabilities of 

                                                 
167.  After five years of participation, the PBGC guarantees the participant=s vested 

accrued benefits. In order to fund the cost of the benefits, the PBGC uses the assets held by the 
underfunded plan and then makes up the shortfall with its own funds. Daniel Keating, Pension 
Insurance, Bankruptcy and Moral Hazard, 1991 Wis. L. Rev. 65, 70 (1991). 

168.  The use of different funding methods could impact whether a plan has an actual 
funding deficiency or not. See Jefferson, supra note 26, at 31-32; see generally Norman P. Stein, 
Reversions from Pension Plans: History, Policies, and Prospects, 44 Tax L. Rev. 259, 265-67 
(1989). 

169.  Provided the assumptions are reasonable. 
170.  See Jefferson, supra note 26, at 54. 
171.  Id., at 54. A long term interest rate assumption is very difficult to project with 

certainty. The impact of the valuation interest rate on pension costs estimates depends upon the 
number of years involved in the interest discount, therefore, different parts of the evaluation are 
affected differently by a change in the valuation interest rate assumption. However, there is a 
rule of thumb to estimate the effect on liabilities of a change in the interests assumption. See id., 
at 34 n.181 (citing  Stuart G. Schoenly, Pension Topics 10-11 (1991) (Society of Actuaries No. 
460-24-91)). 

172.  The following comparisons illustrate the relationship between age and liability: 
 
Age    7% factor as      8% factor as 

a % of 6% factor  a % of 7% factor  
25  Deferred Life Annuity 
commencing at age 65         64.2%           64.7% 

45  Deferred Life Annuity  
commencing at age 65         77.5%           77.9% 

65  Life Annuity          93.5%           93.8% 
Schoenly, supra note 171, at 19. 



2000] Rethinking the Risk of Defined Contribution Plans 645 

 

 

 

approximately 6% in a valuation period.173 Thus, accuracy of the interest rate 
assumption is especially critical in preventing shortfalls. 

Assuming all other assumptions are correct, when a plan experiences 
losses due to erroneous interest rate assumptions, a funding deficiency would 
result.174 In such cases, if the plan terminated, and the employer were unable to 
make an additional contribution, the PBGC would pay the unfunded vested 
accrued benefits.175 When the PBGC pays any portion of the retirement 
benefits in plans in which all actuarial assumptions other than the interest rate 
assumption are correct, the PBGC effectively insures a minimum investment 
return. Therefore, participants in defined benefit plans are insured against poor 
investment performance. 

The PBGC=s guarantee of a minimum investment return in defined 
benefit plans can be demonstrated best by a numerical illustration. Consider a 
defined benefit plan that assumes an 8% investment yield, uses an accurate 
mortality assumption and salary scale projection,176 has made no past service 
award, and uses an accrual formula of 2% times average compensation times 
years of service. Assume Employee X is age 50, 100% vested, was hired at age 
45, and received $50,000 of compensation for each of the last five years. 
Employee X, therefore, currently has an accrued benefit of $5,000 per year.177 

Further assume that over the last five years, the plan has experienced 
losses attributable to an actual 7% investment return, as compared to the 8% 
return assumed by the plan. All other assumptions are accurate. Using the 2% 
to 6% rule of thumb, there would be a shortfall of approximately 12%. If the 
employer terminated the pension plan at this point, the shortfall in Employee 
X=s retirement benefit would be provided by the PBGC.178 In other words, the 
PBGC would guarantee a retirement benefit based upon an expected 
investment return of 8%. Interestingly, in a defined contribution plan there 
would be no insurance protection if the account balances of plan participants 
were less than expected as a result of unfavorable market conditions. 

Opponents of federal insurance for defined contribution plans argue 
that losses in defined contribution plans resulting from market fluctuations are 
too difficult to measure.179 Others argue that even if such losses are 
measurable, it is inappropriate for the federal government to insure them 
because Title IV of ERISA was established only to guarantee pension benefit 

                                                 
173.  Id. at 18. 
174.  This is true, unless there are offsetting errors in connection with the other 

accompanying assumptions. 
175.  See supra note 41 and accompanying text. 
176.  See Jefferson, supra note 26, at 11. 
177.  2% x $50,000 x 5 years = $5,000 
178.  See supra Part I.A. 
179.  See Keville, supra note 4, at 554. 



646 Florida Tax Review [Vol. 4:9 
 

 

promises, not minimum investment returns.180 As illustrated above, however, 
although it appears that the existing insurance program for underfunded 
terminated defined benefit plans insures something other than a minimum 
investment returns on the plan assets, this is exactly what occurs in certain 
instances. In fact, one of the most significant risks against which a terminated 
defined benefit plan is protected is market fluctuation.181 Therefore, objections 
to insuring investment returns in defined contribution plans on the grounds 
that it is inconsistent with the underlying policy of ERISA=s Title IV insurance 
are invalid. Furthermore, resistance to defined contribution insurance because 
the insurable risks in defined benefit and defined contribution plans are 
different is also unfounded. 

 
C.  Insurance Protection Outside of ERISA 

Although there is no PBGC protection for defined contribution plans 
under ERISA, participants investing in certain relatively safe low-risk, 
low-yield instruments are nevertheless eligible for other insurance protection 
against market down-turn.182 Stable-value investment contracts marketed by 
the banking industry are insured by the Federal Deposit Insurance Corporation 
(FDIC). Similar instruments marketed by insurance companies are covered by 
state-regulated insurance.183 Thus, defined contribution plan participants 
investing in relatively safe, low-yield investments are covered by some type of 
governmental insurance.184 

 
1. Guaranteed Investment Contracts.CHistorically, insurance 

companies and banking institutions only provided investment management 
services. In more recent years, however, both industries have expanded their 
roles to include offering stable-value investment contracts, in addition to 
providing managerial expertise.185 The Guaranteed Investment Contract 

                                                 
180.  See Keville, supra note 4, at 554 (stating that defined contribution plan insur-

ance might encourage Aspeculative investing by employees who are not risk averse, and could 
result in multiple payouts if employees repeatedly lost principle@). 

181.  See Sean S. Hogle, The Employee as Investor: The Case for Universal 
Application of the Federal Securities Laws to Employee Stock Ownership Plans, 34 Wm. & 
Mary L. Rev. 189, 240 n.96 (1992). 

182.  See discussion supra Part III.A, infra Part III.F, G. 
183.  See FDIC, Facts About Bank Investments (last modified Jul. 27, 1999) 

<http://www.fdic.gov/deposit/investments/facts/index.html>. 
184.  As a result, some defined benefit plan participants have two levels of insurance 

protection. 
185.  Pension assets are generally managed by a plan trustee. A trustee can be either 

an employee of the plan sponsor, a bank, a trust company, or an insurance company. When the 
assets are trusteed by an employee, bank, or trust company, the employer makes annual 
contributions directly to the plan. When the funds are trusteed by an insurance company, the 
employer pays the insurance company annual premiums in exchange for the insurance 



2000] Rethinking the Risk of Defined Contribution Plans 647 

 

 

 

(GIC) is the stable value instrument offered by insurance companies.186 They 
have flourished since their inception in the early 1970=s.187 The success of 
GICs is attributed to the perception that they are extremely safe 
investments.188 While the term Aguarantee@ may imply that the insurer 
provides Afail safe@ protection for the return of the principal, the guarantee 
actually only applies to the interest rate and expense schedule.189 Thus, the 
safety of the entire instrument depends on the solvency and credit worthiness 
of the issuing insurance company.190 

Although interest rates paid to GICs have declined from their peak in 
the late 1980=s, GICs nevertheless have remained very popular.191 GICs are 
regulated under state insurance laws which vary from jurisdiction to 
jurisdiction. Therefore, the level of protection and payment criteria vary.192 

                                                                                                                   
company=s promise to pay future plan benefits as they become due. See Employee Benefit 
Research Institute Issue Briefs 15 (June 1994). See also Part II.C. 

186.  The term GIC is most often defined as a Guaranteed Investment Contract; 
however, GIC sometimes is referred to as a Guaranteed Income Contract, Guaranteed Interest 
Contract, or Guaranteed Insurance Contract. All of these terms convey the same meaning which 
is a Afail safe guarantee of principal and a predetermined rate of interest to be credited over the 
investment=s life.@ Kenneth L. Walker, What is a GIC?, in Guaranteed Investment Contracts: 
Risk Analysis and Portfolio Strategies 21 (Kenneth L. Walker ed., 1992). 

187.  William H. Smith, A Plan Sponsor=s Perspective, in Guaranteed Investment 
Contracts: Risk Analysis and Portfolio Strategies 1 (Kenneth L. Walker ed., 1992). Today=s 
GICs have an outstanding balance of approximately $200 billion and are issued at the rate of 
approximately $40 billion annually. Id. 

188.  Keville, supra note 4, at 543-44. Additionally, the nonvolativity of GICs enable 
the employer to avoid having to report negative returns in the annual financial statements given 
to plan participants. Defined benefit plans generally have not purchased investment contracts 
because of their low yield. 

189.  Walker, supra note 186, at 22. 
190.  GIC owners are considered the policyholder of the insurer. In most 

jurisdictions, the policyholder enjoys a senior lien over the general creditors of the insurer. 
Thus, in the event of bankruptcy, the policy holder would generally rank ahead of the general 
creditors of the insurance company. Walker, supra note 186, at 22. See also Smith, supra note 
187, at 1. 

191.  See Frederick C. Kneip, Synthetic BICs and GICs, 381 PLI/Tax 273, 275 
(1996). Approximately 70% of all 401(k) assets are committed to GICs or other similar stable 
valued options. See generally Walker, supra note 186, at 32. 

192.  Many amounts deposited by plans with an insurer are allocated to a separate 
account. These separate accounts are generally deemed by state insurance laws to be the 
property of the insurer. Robert E. Rice, Synthetic BICs & GICs, 339 PLI/PAT 321, 330-31 
(1993). Consequently, if the insurer initiates insolvency or rehabilitation proceedings, the plan=s 
account may be frozen indefinitely, which could affect benefit liquidity or the interest rate 
earned on the GIC. Id. It has been suggested that to avoid this, physical custody of the assets 
could be placed in a third party. This would allow the plan uninterrupted access, and would also 
make the insurer a fiduciary of the plan. Id. In addition, annuitants may have a claim in the state 
liquidation proceedings. James Epstein, Protecting Pension Annuities When Insurance 
Companies Fail: The ERISA Fiduciary Standards, 44 Fla. L. Rev.107, 110 (1992); see also 



648 Florida Tax Review [Vol. 4:9 
 

 

For example, under certain state insurance laws, GICs are protected against 
insolvency by life insurance guaranty funds which typically limit the amount 
payable per claim.193 

 
2.  Banking Investment Contracts.CThe Bank Investment Contract 

(BIC) is another type of stable-value instrument.194 BICs are offered by banks 
rather than by insurance companies.195 BICs are insured by the FDIC, up to 
$100,000, per deposit, per account.196 

                                                                                                                   
Peter A. Fine, What to do if Your Insurer is Insolvent, 439 PLI/COMM 139 (1987). Also, 
insurance industry practice has been to protect annuitants hurt by the collapse of an annuities 
company through the state insurance regulations. Retirees at Risk: The Executive Life 
Bankruptcy: Hearing Before the Subcomm. on Labor of the Sen. Comm. on Labor and Human 
Resources, 102 Cong. 23 (1991) (statement of David George Ball, Asst. Secretary, Pension and 
Welfare Benefits Administration, U.S. Dept. of Labor). 

193.  However, any attempt to access a guaranty fund to satisfy GIC claims against a 
large insolvent insurer would raise the following issue: 

most such funds are not Apre-funded@; instead, an assessment is made by the 
fund against the remaining solvent insurance companies doing business in 
the state only after the need to honor claims has arisen. If the claims 
presented to the guaranty fund were very large, it might not be possible to 
make sufficient assessments without jeopardizing the financial health of the 
remaining insurance companies. 

Rice, supra note 192, at 331. It is uncertain whether a GIC purchased by a retirement plan would 
constitute a single claim, or whether the per-claim provisions would Apass through,@ and apply 
to each beneficiary of the plan. Whether the claim is viewed as a single claim or not determines 
the applicable level of insurance protection under state law. Id. 

194.  The legal form of the BICs differs from bank to bank. Banks generally issue 
BICs either in the form of time deposits or money market deposit accounts. The Board of 
Governors of the Federal Reserve, which regulates the banking industry, provides definitions 
for each form of deposit accounts in its regulations. David J. Salvin, Bank Investment Contracts, 
in Guaranteed Investment Contracts: Risk Analysis and Portfolio Strategies 37 (Kenneth L. 
Walker ed., 1992). 

195.  Although BICs are similar to GICs in many respects, the industry distinctions 
between banking and insurance account for differences such as credit-worthiness, plan 
language, government reporting, pricing, and most importantly, the availability of FDIC 
insurance. Walker, supra note 186, at 38. The relative success of BICs stems from the desire for 
industry diversification. Prior to the introduction of BICs, a plan wishing to offer a stable value 
option was limited to GICs and money market funds. Sponsors were dependent upon the 
solvency of the insurance industry. Id. at 38-39. BICs allowed employers to spread their 
investments over two industries. However, simultaneously with the rise in BIC popularity, 
many large banks saw their credit ratings drop, and experienced downgrades and negative press. 
The insurance industry, being the familiar option, did not experience similar consequences. Id. 
at 39. 

196.  Both the principal and the interest of a BIC account are federally insured in 
domestic member banks. A domestic member bank is Aa depository institution that is a member 
of the Federal Reserve.@ Michael Gordon Hales, The Language of Banking 114 (1994). 
National banks are required to be members; state-chartered commercial banks and mutual 
savings banks may become members at their election. Id. Member banks are owners of stock in 
Federal Reserve Banks and choose some of the Reserve Bank directors. Id. 



2000] Rethinking the Risk of Defined Contribution Plans 649 

 

 

 

Until recently, when an employer sponsored a retirement plan 
invested in BICs, a $100,000 cap applied to the plan as a whole. The cap did 
not pass through to individual participants. However, in 1991 Congress passed 
the Federal Deposit Insurance Corporation Improvement Act of 1991 
(FDICIA), which established pass-through insurance for certain banks that 
brokered deposits to retirement plans.197 As a result, FDIC insurance currently 
applies to individual plan participants as if they were individual depositors.198 

 

3.  Retirement Certificates of Deposit (CDs).CRetirement 
Certificates of Deposit (CDs) are a personal savings alternative available to 
taxpayers outside of the employer-sponsored regime.199 A retirement CD is an 

                                                 
197.  Under provisions set forth by the Comprehensive Deposit Insurance Reform 

and Taxpayer Protection Act of 1991, deposits of trusts may not be insured on a pass-through 
basis A(A) if the trustee or an organizer of the trust solicits persons to transfer funds into the 
trust; (B) if interests in the trust are sold to beneficiaries; (C) if there are more than 10 settlors or 
grantors of the trust; or (D) in such other circumstances as the Board of Directors may 
prescribe.@ 137 Cong. Rec. S17910, S17923 (daily ed. Nov. 23, 1991). Additionally, banks must 
meet the requirements of IRC '' 401(a) and 403(b)(9). Pass-through FDIC insurance protection 
generated considerable controversy. The American Council of Life Insurance (ACLI) sought 
the repeal of pass-through insurance legislation. The ACLI was established in 1976 after a 
merger of several existing organizations. It currently represents 532 U.S. legal reserve life 
insurance companies, providing industry reports, consumer brochures on insurance, and unified 
lobbying efforts for life insurers at state and federal levels. See Nina Easton, Financial Industry 
Lobbyists Come from Different Perspectives, American Banker, Oct. 19, 1985, at 11; see also 
American Council of Life Insurance, http://www.acli.com (as of March 1998). See Investments: 
Federal Deposit Insurance Unnecessary Due to Existing Protections, Official Says, 18 Pens. 
Rep. (BNA) 781 (May 6, 1991) (maintaining that this result is dangerous as it tempts poorly 
capitalized banks to offer very high yields in order to attract deposits, thereby increasing the 
likelihood of bank failure). 

198.  In 1994, the Federal Deposit Insurance Corporation finalized regulations to 
incorporate the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) 
relating to deposits for employee benefit plans accepted on a Apass-through@ basis. Alson R. 
Martin, Recent Developments Affecting PCs and Other Closely Held Businesses, C884 
A.L.I.-A.B.A. 1, 34 (Feb. 10, 1994). The regulations explicitly provide that the $100,000 
limitation applies to the aggregate interests of an employee=s deposits with the insured 
institution under all plans established by the same employer, or by the same employee 
organization. See id. at 35. For purposes of the $100,000 limitation, IRA=s and participant 
directed individual account plans established by the individual investor are aggregated with 
employer sponsored amounts. See id. at 35. 

199.  A Retirement CD is a special type of BIC. It is therefore accurate to refer to 
Retirement CDs as BICs. Most BICs are issued as fixed-rate instruments, typically issued as 
nonnegotiable, benefit responsive arrangements. They sometimes contain a window provision, 
and often have early-withdrawal provisions that allow withdrawals to be made before maturity 
for reasons other than benefit payments after the imposition of a market adjustment. When the 
benefit-responsiveness and window features are removed, what remains is a fixed-rate, 
nonnegotiable instrument that contains an early-withdrawal penalty. This instrument is known 
as a time deposit or nonnegotiable certificate of deposit, or a Retirement CD. See McGill & 



650 Florida Tax Review [Vol. 4:9 
 

 

insurance contract that is invested in CDs. This arrangement offers tax deferral 
until retirement on the investment returns, and provides guaranteed interest 
rates for periods up to five years, on amounts payable as annuities.200 The 
Retirement CD is a savings option which is particularly attractive to 
individuals close to retirement who are looking for safe places to store their 
personal savings.201 

Currently, rates for Retirement CDs are better than national CD 
averages; however, because funds cannot be transferred to other banks without 
paying taxes and penalties, it is expected that banks will establish rates below 
market levels during subsequent 5 year periods.202 Presumably, heightened 
consumer interest in Retirement CDs is largely attributable to the fact that 
these savings arrangement are insured by the FDIC up to $100,000, per 
account, per individual. 

 
D.  Defined Contribution Plan Insurance 

FDIC insurance encourages investment in BICs and retirement CDs 
over other noninsured forms of investment. However, an investment strategy 
that disproportionately selects low-risk, low-yield instruments such as BICs, 
and retirement CDs, contravenes the modern portfolio theory of investment 
which emphasizes diversification as a means of maximizing investment 
returns.203 Therefore, the use of conservative investment strategy is not 
appropriate for long term investment goals, such as retirement savings. 

The fact that participants tend to under-diversify their investment 
portfolios by disproportionately investing in stable-value instruments suggests 
there is a need for Congress to enact laws which encourage participants to 
invest their retirement savings more aggressively, rather than more 
conservatively.204 A properly designed federal insurance program for defined 
contribution plans could achieve this goal. A defined contribution insurance 
program which guaranteed an average rate of return over a participant=s 
working life would encourage participants to invest more aggressively 
because a portion of the risk of loss would shift from the participant to the 

                                                                                                                   
Grubbs, supra note 54, at 475-78. 

200.  These arrangements also rely on the favorable treatment of annuity contracts 
under IRC ' 1275(a)(1)(B)(i). See Stephen D. Palmer, Comment, What do you Get When you 
Cross a Certificate of Deposit with an Annuity?: The Retirement Certificate of Deposit 
Struggles for Survival, 45 Emory L.J. 1429, 1432 (1996). 

201.  The high demand for Retirement CDs suggests that many savers are willing to 
forgo higher returns and immediate penalty-free access to their funds in exchange for federal 
insurance. See id. at 1459. 

202.  See Duff McDonald, Retirement CDs Offer More Than 7% - Plus Headaches, 
Money, May 1, 1995, at 57. 

203.  See supra Part II.C.1. 
204.  See supra Part II.C.2. 



2000] Rethinking the Risk of Defined Contribution Plans 651 

 

 

 

insurer.205 This approach is consistent with ERISA=s goal of increased 
retirement security, because a balanced investment portfolio increases 
retirement security by maximizing long-term returns.206 

Federal insurance for defined contribution plans also would eliminate 
the uncertainties and inconsistencies that result from the gap in insurance 
protection for defined contribution plans. Under existing law, plan participants 
receive vastly different levels of insurance protection of their retirement 
benefits depending on the classification of their retirement plan, the type of 
investments selected, and the states in which they reside.207 Federal insurance 
for defined contribution plans would eliminate these inequities by conferring 
upon all qualified plan participants some level of insurance protection. 

Defined contribution plan insurance is a highly controversial concept. 
Resistance to the idea includes both theoretical and practical concerns. There 
are, for example, concerns about identifying the goals and objectives of the 
program. There is also concern about defining an insurable accrued benefit in 
the context of individual account plans. Furthermore, issues regarding the 
appropriate insurance levels and applicable limitations would have to be 
resolved before a defined contribution plan insurance scheme could be 
adopted. 

While all of these concerns are valid and should be addressed prior to 
the establishment of a defined contribution plan insurance program, they are 

                                                 
205.  See discussion infra Part III.E.1. 
206.  The most conservative investments are not necessarily the most prudent ones 

since A>an investment can ordinarily be made which will yield a higher income and as to which 
there is no reason to anticipate a loss of principal.=@ Weiss & Sgaraglino, supra note 56, at 1185 
n.23 (quoting Restatement (Second) of Trusts ' 227(a)). 

207.  The Executive Life crisis of 1988 best illustrates the magnitude of the threat 
imposed by the gap in insurance. The Executive Life Insurance Company invested heavily in 
junk bonds. When the market crashed in the late 1980=s, Executive Life was unable to pay its 
contracts and ultimately filed bankruptcy. While all plan participants whose assets were 
invested in Executive Life were affected by the company=s collapse, the damages were more 
devastating for some participants than for others. Employee-participants in defined benefit 
plans were accorded PBGC protection while those in defined contribution plans were not. 
Because payments of defined contribution retirement benefits varied under state laws, some 
retirees received as much as 70% of their retirement benefits, while others received none. Had 
investors selected BICs instead of GICs, the participants would have been insured up to 
$100,000 per account. From a pension policy perspective, it is difficult to justify this result. 
Until the conservatorship of Executive Life, there had never been an instance when an insurance 
carrier had not been able to honor its investment contracts. Therefore, the Executive Life crisis 
can be viewed as a milestone in pension history. Policymakers should be aware of the level of 
devastation that defined contribution plans can experience when retirement funds disappear. 
Moreover, the Executive Life crisis should serve as a reminder that as long as the gap in federal 
insurance protection exists for defined contribution plans, the promise of ERISA will not be 
fulfilled for some plan participants. See Gary M. Ford, Defined Contribution Plan GIC 
Litigation, Annuities Legislation, and PBGC Legislation, C996 A.L.I.-A.B.A. 183, 187 (1995). 



652 Florida Tax Review [Vol. 4:9 
 

 

not unique to such a program. When the existing defined benefit plan 
insurance program was established, policymakers found it necessary to 
address many of the same issues, including the appropriate levels of benefits 
to insure, and the necessary limitations to impose.208 The pre-ERISA 
Committee placed limits on the maximum insurable amount in defined benefit 
plans because it believed it inappropriate to guarantee amounts in excess of a 
basic retirement benefit.209 The structure of these limits remains in effect 
today. Thus, there are many lessons that can be learned from the existing 
defined benefit plan insurance program in connection with the implementation 
of a new insurance program for defined contribution plans. 
 
E.  The Hypothetical Account ProposalCAn Insurance Model 
 

The defined contribution insurance model proposed in this section is a 
risk-based, voluntary program that uses a diversified hypothetical account to 
determine the level of insured benefit. This proposal provides insurance 
protection for defined contribution plans comparable in amount and objective 
to the insurance protection currently available for defined benefit plans. Using 
this approach, participants of defined contribution plans would be insured 
against the risk of earning less than average investment returns, over their 
working lives. 

Under the Hypothetical Account Defined Contribution Plan Insurance 
Program, to the extent that a participant=s account complied with a prescribed 
diversification standard, she would receive a minimum benefit at retirement. 
The minimum retirement benefits would based on hypothetical annual rates of 
investment returns, and would be payable when the insured participant 
reached her social security retirement age.210 Insured amounts would be 
payable in the form of a life annuity, rather than a lump sum, in order to spread 
the risk of payment over longer periods of time.211 

                                                 
208.  See Ford, supra note 207, at 186-87. 
209.  This figure has been amended since the establishment of ERISA in 1974. 

Initially, defined benefit plans were insured up to the vested accrued benefit, not to exceed $750 
per month and not more than 50% of wages. The current insurable benefit in a defined benefit 
plan is the lesser of $30,000 per year, or 100% of compensation. 29 C.F.R. ' 4022.22; see supra 
note 12 and accompanying text. 

210.  AThe Social Security retirement age is currently 65, but it will eventually in-
crease to 66 for those born after 1938 and 67 for those born after 1954.@ Langbein & Wolk, 
supra note 5, at 268. Distributions prior to a participant=s social security retirement age would be 
permitted in the event of death or disability. 

211.  In order to avoid a possibility of initial payments being made based on a number 
of years less than 5, under a defined contribution plan insurance program, only participants age 
60 and below should be eligible to initially participate. This was a problem under the current 
pension insurance program. As a result, when it was first established the PBGC had to pay large 
sums that were attributed to years prior to the establishment of the insurance program. 



2000] Rethinking the Risk of Defined Contribution Plans 653 

 

 

 

Annual guaranteed rates of investment return would be determined by 
the performance of a hypothetical account assumed to be invested according to 
a prescribed diversification formula. For a given year, the guaranteed annual 
rate of return would be the average of the annual hypothetical investment 
returns for the five prior years. A five-year average is used instead of the 
performance of a single year to diffuse the impact of sudden market 
fluctuations, and further spread the risk of payment. The use of a five-year 
average to determine the annual guaranteed minimum rate of return would 
also protect participants against sudden downturns in the investment 
market.212 

Insurance protection would be determined by the extent to which an 
account complied with a prescribed allocation formula. In connection with the 
prescribed allocation formula, it would be necessary to develop an indexing 
system to evaluate all investment funds, so that the level of risk of a 
participant's investment allocation could be compared to the risk of the 
prescribed allocation.213 A ratings system similar to that supplied by the 
various rating services, such as Standard and Poors, could be utilized to 
facilitate the indexing process.214 Alternatively, a totally independent rating 
system could be developed based on the historical investment performances, 
and long-term accumulation projections for retirement plan assets215. 

The Hypothetical Account proposal allows sponsoring employers and 
plan participants to insure some, or all, of an account balance, in exchange for 
the payment of an annual insurance premium. Although the annual premium 
would be paid separately from the individual accounts, the payment of an 
annual premium would obviously impact a participant=s investment position, 
by decreasing the assets that remained available for her to contribute to the 
plan. Even after taking the premium payment into account, however, in most 
circumstances insurance protection under this proposal should provide a 
return on aggregate employer contributions of an amount at least as great as 
the return on an account exclusively invested in low-risk, low-yield 

                                                 
212.  However, if unfavorable market conditions existed over a sustained period of 

time, the guaranteed rate of return would eventually reflect such losses. 
213.  For this purpose the Standard and Poors rating system could be used, or 

alternatively, a new rating system could be developed. 
214.  AA Standard & Poor=s insurance claims-paying ability rating is an opinion of an 

operating insurance company=s financial capacity to meet the obligations of its insurance 
policies in accordance with their terms.@ Claims paying ability ratings are divided into two 
broad classifications. Rating categories from AAA to BBB are classified as Asecure@ 
claims-paying ability ratings and are used to indicate insurers whose financial capacity to meet 
policyholder obligations is viewed on balance as sound. Rating categories. Allan G. Richmond, 
Quality-Analyzing the Life Insurance Industry, in Guaranteed Investment Contracts: Risk 
Analysis & Portfolio Strategies 100 (Kenneth L. Walker ed., 1992). 

215.  The investment practices for pensions typically reflect longer term investments. 



654 Florida Tax Review [Vol. 4:9 
 

 

instruments, such as BICs.216 Thus, insurance protection under the 
Hypothetical Account insurance model should encourage risk averse 
individuals who are more likely to disproportionately invest in stable-value 
instruments, to invest more aggressively.  

Unlike the existing mandatory insurance program for defined benefit 
plans, the Hypothetical Account insurance program would be voluntary. The 
voluntary characteristic of the proposal strikes a balance between individual 
choice and retirement income security. However, because of the voluntary 
characteristic of the program, it is unlikely that all defined contribution 
accounts would be covered. 

The Hypothetical Account insurance model hinges on a 
diversification formula, which defines an acceptable range of complementary 
allocations with respect to both investment categories, and risk classifications. 
The diversification formula would be designed to approximate an average rate 
of return for accounts invested in average risk investment instruments over a 
participant's working life.217 For example, the safe harbor diversification 
allocation could be selected consistently with the recommendations of 
financial planning experts218 who advise individuals to place 60% of their 
investment assets in the stock of companies with moderate volatility,219 25% 
in Ainvestment-grade@ bonds,220 and 15% in stable-value instruments, for a 
moderate return. 

                                                 
216.  If the insured rate is only slightly greater than the BIC return insuring, the 

account balance generally would still be advantageous. However, it is plausible that the insured 
rate would be substantially higher than that of the BIC because the safe harbor standard would 
require some portion of the account to be put in stocks and some portion to be put in bonds, 
which have rates that are generally higher than BIC returns. These instruments are currently 
FDIC insured. See discussion supra Part III.C. 

217.  The diversification formula would have to take into account the different 
recommendations for different age groups. Therefore the prescribed diversification formula 
would account for the more aggressive investment strategies that are recommended at the front 
end of one=s working life as well as the more conservative strategy that is recommended at the 
back end of one=s working life. See Weiss & Sgaraglino, supra note 56, at 1206-08. 

218.  See Strong Funds, Retirement Planning: Five Model Investment Strategies 
(visited Feb. 6, 2000) 
<http://www.strong-funds.com/strong/Retirmenent98/ind/products/5pies.htm>. 

219.  Beta is a measure of a stock=s risk in relation to the market. For example, if the 
market is up 10% over the last year, and a particular company=s stock price is also up 10% then 
the stock would have a beta of 1.0. The same principle applies when the market is down as when 
the market is up.  <www.duke.edu/%7echarvey/Classes/wpg/bfglosb.htm>. See Campbell R. 
Harvey, Hypertextual Finance Glossary (visited Feb. 6, 2000). 

220.  Most corporate or municipal bonds are graded by Standard & Poor=s Corpo-
ration, by Moody=s Investors Service, Inc., or both. The issuers must pay these agencies a fee to 
review and to rate their bonds. Bonds are rated from the highest quality to the lowest on either 
the Standard & Poors scale AAA/AA/A/BBB/BB/B/CCC/CC/C/D, or the Moody=s scale 
Aaaa/Aa/A/Baa/Ba/B/Caa/Ca/C/. Any bond rated in the top four categories is considered an 
Ainvestment grade@ bond. See 



2000] Rethinking the Risk of Defined Contribution Plans 655 

 

 

 

The level of insurance protection and the cost of the insurance 
premium would depend on the degree to which the participant=s allocation 
complied with the diversification formula. Using the established indexing 
system, a risk factor would be assigned to all allocations in order to compare 
their risk exposure to that of the prescribed diversification standard. In order 
for an account to be fully insurable at the regular premium rate, the 
participant=s account could not be exposed to an investment risk greater than 
that of the prescribed diversification formula. Accounts having a risk factor 
greater than that of the prescribed diversification formula would not be in 
compliance with the diversification standard, and accordingly, not insurable at 
the regular premium rate. 

A very simple model of a diversification standard exists under current 
law for mutual funds. To qualify as adequately diversified, no more than five 
percent of a mutual fund=s assets may be invested in the securities of any one 
issuer.221 The Hypothetical Insurance Model proposed in this section adopts a 
similar approach. In order for an account to be insurable at the regular 
premium rate, the Hypothetical Account proposal requires that the investment 
exposure of a participant=s portfolio be limited to the investment risk of the 
prescribed diversification standard. 
 

1.  Calculation of the Guaranteed Benefit.CUnder the Hypothetical 
Account proposal, an individual=s insurable principal would equal their annual 
employer contributions times the annual guaranteed rates of return, for each 
year of employment.222 Each year=s guaranteed rate of investment return 
would be based on the annual performance of a hypothetical portfolio, 
assumed to be in compliance with the prescribed diversification formula. The 
annual performance of the hypothetical account would be determined by the 
weighted average of the annual investment returns for a hypothetical portfolio 
using the prescribed diversification formula. The annual guaranteed rate of 
return for a given year would equal the average of the annual rates of 
investment return for the hypothetical account, over the five prior years. 

An insured participant=s minimum retirement benefit would be 
determined by comparing her actual account balance at retirement age to the 
Hypothetical Account balance determined by the annual guaranteed rates of 
return for each year of employment, prior to retirement.223 If the participant's 
                                                                                                                   
<http://www.strong-funds.com/strong/LearningCenter98/concepts/glossary.htm#B>. 

221.  See Weiss & Sgaraglino, supra note 56, at 1208; citing former 15 U.S.C. 
' 80a-5(b)(1) (1994). 

222.  The covered amount includes the elective contributions made by plan 
participants. 

223.  However, the minimum guaranteed amount applies only to the extent that the 
account had been invested according to the prescribed diversification standard. 



656 Florida Tax Review [Vol. 4:9 
 

 

actual account balance fell short of the hypothetical account balance 
determined by the annual guaranteed rates of return, the difference would be 
paid by the insurer. 

The Hypothetical Account insurance model is designed to protect the 
participant against the negative effects of severe market contractions over the 
participant's working life. Thus, if the market took a sudden downturn 
immediately preceding a participant's retirement, the participant would be 
guaranteed at least an average return on her aggregate contributions over her 
working life, notwithstanding her actual account balance at retirement. 

Under the Hypothetical Account model, to avoid sudden fluctuations 
in payment claims, insurance protection would not be available for early 
distributions. Any distribution made from an account before a participant died, 
became disabled, or attained social security retirement age would constitute an 
early distribution.224 Even if the plan provided for such distributions prior to 
normal retirement, such as for hardship, insurance protection would be 
unavailable. At an insured participant=s death, the insured benefit would be 
calculated using the nonparticipant spouses=s retirement age.225 Under current 
law, similar treatment is given in connection with Qualified Preretirement 
Survivor Annuities (QPSAs) which provide survivor benefits to 
non-participant spouses in the event that a participant dies before reaching 
retirement age.226 Insurance protection also would be unavailable for 
contributions made after retirement age. If an individual worked beyond 
retirement age, the insured retirement benefit would be unaffected by post 
retirement contributions or post retirement market conditions.227 

The following example numerically illustrates the proposed 
Hypothetical Account insurance model. Assume that Employee X participates 
in a profit sharing plan which annually contributes 10% of compensation. 
Also, assume that Employee X had compensation of $100,000 throughout her 
employment, began participating in the plan in 1986, and reached social 
security retirement age in 1995. Additionally, assume that the prescribed 
diversification formula was to allocate 60% to stocks, 25% to bonds, and 15% 

                                                 
224.  This approach is generally consistent with current pension law. AUnder ' 72(t), 

a 10-percent additional tax is generally imposed on the taxable portion of any distribution made 
before the employee attains age 591/2, other than distributions made after the employee's death 
or by reason of disability. See Langbein & Wolk, supra note 5, at 349. 

225.  If the spouse were substantially older, there would be a sudden fluctuation. 
226.  The Retirement Equity Act (REAct) of 1984 mandates that plans recognize the 

surviving non-employee spouse as a plan beneficiary. This benefit is referred to as a Qualified 
Preretirement Survivor Annuity (QPSA). See Langbein and Wolk, supra note 5, at 555-56. 

227.  Because the insured benefit would be payable as an annuity, there could be 
some adjustment to the benefit for the delay in the annuity starting date. 



2000] Rethinking the Risk of Defined Contribution Plans 657 

 

 

 

to stable-value instruments.228 Further assume that Employee X=s entire 
account was insured at all times.229 

The annual rates of returns for 1981-1995 are illustrated in column 5 
of Table I.230 As described earlier, these numbers are assumed to be the 
composite annual investment returns of a hypothetical portfolio, assumed to 
be in compliance with the diversification standard.231 Column 6 of Table I 
illustrates the annual guaranteed rate of return, based upon an average of the 
hypothetical annual investment returns for the five prior years. 

The actual composite rates of return for 1986-1995 are listed in 
column 2 of Table II. These numbers have been selected randomly to 
represent the average actual rate of return for funds in a particular account, 
invested according to the prescribed diversification formula.232 

The annual contributions made to the employee's account for years 
1986 through 1995 are listed in column 2 of Table III. The actual account 
balances for the corresponding years are listed in columns (3)-(12) of Table 
III. 

The annual Hypothetical Account balances as determined by the 
annual guaranteed hypothetical return for years 1986-1995. These numbers 
are listed in columns (3)-(12) of Table IV.233 

Table V shows the benefit Employee X was entitled to receive at 
retirement in 1996. The guaranteed minimum retirement benefit is the greater 
of columns 1 and 2 in Table V, in the participants retirement year. If Employee 
X had died or become disabled prior to her retirement date, the guaranteed 
benefit would have been the greater of column 1 and 2 in the year in which the 
participant=s death or disability occurred. 

When the participant reached age 65 in 1995, the actual account 
balance was $190,325, and the hypothetical account balance was $203,824. 
Because the insured account balance exceeds the actual account balance, the 
participant would be entitled to receive the difference from the insurer. 
Employee X, therefore, would receive $203,824 at retirement, rather than 
$190,325, payable in the form of an annuity. While $190,325 would be paid 
                                                 

228.  See supra notes 218-20 and accompanying text. 
229.  In other words, the account was in compliance each year with the prescribed 

diversification standard. 
230.  The selected rates are assumed to reflect a composite of 60% moderately 

volatile stock, 35% investment grade bonds, and 15% stable-value instruments. For purposes of 
this illustration, the numbers in columns 2, 3, and 4, of Table I have been randomly selected. 

231.  The separate rates of return for stock, bonds, and stable-valued funds for 
1981-1995 are illustrated in columns 2, 3, and 4 of Table I, respectively. 

232.  The annual average hypothetical rate of return is a weighted average of 60% 
stock, 35% bond, and 15% stable-value funds. 

233.  These numbers are derived by multiplying the insured interest rate (Table II, 
column 2) by the actual contribution (Table III, column 2). 



658 Florida Tax Review [Vol. 4:9 
 

 

from the participant=s individual account, the additional $13,499 would be 
paid by insurance. The insured=s benefit in this example represents an increase 
of more than 7% in the participant=s retirement benefit. 
 Table I 
   (1)         (2)  (3)      (4)   (5)        (6) 

Annual             Annual      Annual  Annual 
Hypothetical          Average           Annual 

Hypothetical         
Hypothetical    Rate of Return     Hypothetical   Guaranteed 
Rate of Return    Rate of Return      for Stable              Rate of           

Rate of 
Year          for Stocks              for Bonds       Value Funds           Return*          
Return**  
1981          14%        10%      6%                 11.8%
         ------- 
1982          15         11      7                 12.9
         ------- 
1983          16         12      8                 13.8 
         ------- 
1984          17         13      9                 14.9
         ------- 
1985          16         12      8                 13.8
         ------- 
1986          15         11      7                 12.9
          13.4% 
1987          12         10      6                 10.6
          13.7 
1988          13         11      7                 11.7
          13.2 
1989          14         12      8                 12.6
          12.8 
1990          15         11      7                 12.9
          12.3 
1991          16         10      6                 13.0
          12.1 
1992          17           9      5                 
13.3          12.2 
1993          16           8      4                 
12.2          12.7 
1994          15           7      5                 
11.6          12.8 
1995          14           8      

6                 11.3          12.6 
*Weighted average of 60% stock, 35% bonds, and 15% stable value funds. 
** Average of five prior years. 
 
 
 Table II 

  (1)      
(2) 

Year   Actual Rates of 
Return*  



2000] Rethinking the Risk of Defined Contribution Plans 659 

 

 

 

1986      
15% 

1987      14 
1988      14 
1989      13 
1990      13 
1991      12 
1992      12

       
1993      10

       
1994      10 
1995      9 

* These numbers are selected randomly to represent the weighted average of actual returns for 
an account invested according to the prescribed diversification formula. 
 



660 Florida Tax Review [Vol. 4:9 
 

 

 Table III 
 Actual Annual Account Balances* 
Composite rate of return from Table II. 
 
 Table IV 
 Hypothetical Annual Account Balances* 
 
 Table V 
(1)              

(2) 
 
 (3)
 
 
 (4) 

   Actual Annual  Hypothetical Annual 
Date Account Balances*

  Account 
Balances**
 Insurance 
Payment  

1/1/87       $  11,500          $ 11,340           $         0 
1/1/88           24,510             24,264                      0 
1/1/89           39,341             38,786                      0 
1/1/90           55,756             55,031                      0 
1/1/91           74,304             73,029                      0 
1/1/92           94,420             93,076                      0 
1/1/93         116,950           115,652                      0 
1/1/94         139,646           141,610               1,964 
1/1/95         164,611           171,015               6,404 
1/1/96         190,325           203,824             13,499 
*Figures from Table III. 
** Figures from Table IV. 
 

2. The Hypothetical Account Proposal and Insurance 
Premiums.CAlthough insurance protection would provide greater protection 
against shortfalls in the expected retirement benefit, the payment of annual 
premiums would necessarily lower the net investment return for insured plan 
participants. Thus, in some instances the participants= actual investment return 
could be lower than the average return for uninsured accounts.234 For example, 
assume that the average composite rate of return for a diversified portfolio is 
10% in a particular year, and the annual guaranteed hypothetical rate of return 
is 92%.235 Further assume that the regular annual insurance premium is 
approximately 1% of the investment return. Therefore, in that year, 
participants electing defined contribution plan insurance would receive a less 

                                                 
234.  The after-premium rate of return. 
235.  The annual hypothetical rate of return is based on the average rate of return of 

the hypothetical account for the five prior years. 



2000] Rethinking the Risk of Defined Contribution Plans 661 

 

 

 

than average net return on their investments.236 Specifically, insured 
participants would receive a net annual rate of return of 9%, (a 10% actual 
return less 1% paid for the premium) instead of the 10% annual return that an 
uninsured participant would receive.237 Similarly, if the market suddenly 
performed better than average, at 12% for example, an insured participant 
would receive a lower net rate of return.  

If the market suddenly performed substantially worse than average, 
however, the insured participant would receive a greater than average 
investment return. For example, assume that the annual composite investment 
return fell to 7% in the next year, and the annual hypothetical guaranteed rate 
of return was 92%. The insured participants in that year would receive a net 
investment return of 82%, which is 12% above the uninsured participant=s 
investment return. 

 
3.  Noncompliant Investment Allocations.CFor the regular premium 

amount, insurance protection would be available to individuals who seek 
average returns by means of the diversification formula. An average rate of 
return would be guaranteed to individuals who take substantially lower than 
average risks, but only if they were charged an additional risk related 
premium. The additional premium would be economically derived to reflect 
the increased likelihood that such an account would earn significantly less 
than the minimum guaranteed rate of return. Therefore, paying higher 
premiums for below-average risk allocations, could be viewed as functionally 
equivalent to a participant investing their funds more aggressively.238 As a 
result, in this situation, defined contribution plan insurance would not only 
guarantee some level of protection for accrued retirement benefits in defined 
contribution plans, but also would help to solve the problem of overly 
conservative investment practices.239 

To illustrate, assume the same facts in the example above in which the 
annual guaranteed rate of return is 92%, and the average composite rate of 
return for a diversified portfolio is 10%. Further assume that a conservative 
investment strategy yields 2% below the average market return, or 8% in this 

                                                 
236.  This assumes that the annual guaranteed hypothetical rate of return is less than 

10%. 
237.  The annual guaranteed hypothetical rate of return would be 10% minus 1% for 

the premium payment, or 9%. 
238.  For simplicity, it is assumed that the participant is 100% invested in 

stable-valued instruments; however, if a participant invested 100% in stable-value instruments, 
it would appear to be unnecessary to provide insurance protection as the assets would not be 
exposed to very much risk. Thus, it would be more likely that the participant invested 
somewhere between 100% and the prescribed percentage for stable-valued instruments. 

239.  See supra Part II.C.1. 



662 Florida Tax Review [Vol. 4:9 
 

 

particular year. Also assume that the additional insurance premium charged 
for conservatively invested portfolios is 2% of the average investment return. 
Accordingly, under normal market conditions, a conservatively invested, 
insured participants would receive a net investment return of 72%, which is 
22% less than an uninsured average return, and 2% less than she would have 
received had she not been insured and had invested conservatively.240 

However, assuming the same 2% differential between average risk 
and below average risk portfolios used above, if the market performed 
substantially worse than average, at 7% for example, the under diversified 
uninsured portfolio would yield only a 5% rate of return. If it is assumed that 
the guaranteed annual rate of return is 92%, the insured participant would 
receive a net investment return of 72%, which is 22% more than the 
uninsured conservative investor, and 2% more than the uninsured average 
risk investor.241 Thus, under the proposed defined contribution plan insurance 
model, there are incentives for both the average risk taker as well as the less 
than average risk taker to insure against the risk of market fluctuations. 

Insurance protection for the regular premium amount would not be 
available to those who take greater than average risk with respect to either 
investment category or risk classification, unless they demonstrated that 
special circumstances warranted a deviation from the prescribed 
diversification standard. For example, again assuming that the safe harbor 
formula were 60% stocks, 35% bonds, and 15% stable-value instruments, a 
participant very close to retirement who invested 85% in stable-value 
instruments and 15% in bonds, could still be eligible for insurance protection 
at the regular rate, if it could be shown that the allocation was not overly 
conservative in light of the participant=s time horizon.242 Under such a 
scenario, however, the participant would only be entitled to receive a level of 
insurance protection based upon a lower rate of return consistent with the asset 
mix for the regular premium amount. If, the noncompliant asset allocation 
neither comported with the prescribed diversification standards, nor satisfied a 
facts and circumstances test for the diversification requirement, insurance 
protection would be unavailable, unless an economically derived additional 
premium were charged. 
 

                                                 
240.  That is, a guaranteed annual rate of return of 92%, minus a 2% premium for the 

use of conservative investment strategy. 
241.  The 82% return is based on the five prior year average of 92% minus 1% for 

the premium payment.  
242.  Time horizon refers to the number of years left to save for retirement. This 

strategy would be used in order to provide protection against a down turn in the market with 
insufficient remaining time to offset such losses. A lower rate of return would be guaranteed 
consistent with the asset mix, however. 



2000] Rethinking the Risk of Defined Contribution Plans 663 

 

 

 

4.  Private Insurers.CThe hypothetical insurance account model for 
defined contribution plan insurance could just as easily be offered by a private 
insurance company as by a federal agency.243 Private insurers could compete 
for a share of the defined contribution plan insurance market by offering 
comparable insurance protection at a lower premium. If the private sector 
became involved, there would have to be some means by which the financial 
viability of the insuring companies could be evaluated and monitored by the 
federal government. Realistically, it is unlikely that the private sector could 
effectively compete because the premium charged by the federal government 
would more than likely always be less, since it could approach the insurance 
program as a revenue neutral activity. Thus, the private insurer, who would 
have to charge a premium sufficiently high to provide a profit margin, would 
be at a competitive disadvantage.  

Interestingly, the private industry has not sought in any meaningful 
way to offer insurance to defined benefit plans under the current insurance 
system.244 Perhaps one explanation is that under ERISA, PBGC insurance is 
mandatory for all employers who sponsor defined benefit plans.245 Therefore, 
it is impractical for a private insurer to compete because an employer choosing 
private insurance would incur duplicate insurance costs.246 If employers were 
permitted to substitute private insurance for PBGC protection, the private 
industry would be more likely to compete in the retirement plan insurance 
market. 

Nevertheless, the existing defined benefit plan structure would seem 
to provide greater incentives for private competition than a defined 
contribution plan insurance program, because there can be funding surpluses 
in defined benefit plans.247 The possibility of the insurer capturing a portion, 
or all, of a funding excess would appear to be sufficient to generate greater 
interest in insuring defined benefit plans. For example, an insurer of defined 
benefit plans could provide premium discounts in exchange for a 
pre-determined percentage of a plan surplus in the event of plan 
termination.248 There are no such possibilities in a defined contribution 
                                                 

243.  Subject to regulation by the government. 
244.  A participant can obtain insurance on their own to the extent that insurance 

companies will provide insurance protection on an individual basis, but there is no established 
program which would spread the risks among numerous plan participants. 

245.  See Daniel Keating, Chapter 11=s New Ten-Ton Monster: The PBGC and 
Bankruptcy, 77 Minn. L. Rev. 803, 806-07 (1993); see also supra Part I.A. 

246.  Unless the PBGC elected to give way to private insurance. 
247.  An excess occurs in a defined benefit plan when the assumptions used by the 

plan are more conservative than the experience of the plan. A plan=s Aexperience@ describes the 
actual cost of the plan. Actuarial gain or loss is measured by the difference between the actual 
cost of the plan and the actuarial estimates for a plan year. 

248.  When a plan terminates with excess assets, the employer is permitted to capture 



664 Florida Tax Review [Vol. 4:9 
 

 

insurance arrangement because there are no funding excesses in individual 
account plans. Therefore, the profits of an insurer of defined contribution 
plans would be limited to the difference in the insurance premiums charged 
and the payment of the minimum guaranteed rates of return. 
 
F.  Regulating Defined Contribution Plan Insurance 
 

1.  The Moral Hazard Problem.CJust as a disparity in risk allocation 
distinguishes defined benefit and defined contribution plans structurally, a 
disparity in risk allocation also distinguishes the insurability of these plans. 
When a defined benefit plan terminates with insufficient funds, the sponsoring 
employer is primarily liable for the asset deficiencies. The PBGC is only 
secondarily liable.249 Therefore, an employer who sponsors a defined benefit 
plan and does not anticipate insolvency is more likely to exercise caution to 
avoid exposing the plan assets to unreasonable investment risks.250 

By contrast, when a defined contribution plan terminates with 
insufficient assets, there is no employer liability. Thus, a provider of defined 
contribution plan insurance would be primarily liable for any deficiencies that 
a participant experienced. Accordingly, the employer, or participant, making 
the investment decisions would have no incentive to avoid exposing the 
account to unreasonable investment risks.251 

This concern expresses the moral hazard problem of insurance 
protection: those who are insured against certain risks have no incentive to use 
optimal care to avoid the insured risk.252 For example, an employer sponsoring 
an insured money purchase plan, who recognized that it had no liability for 
plan losses, may invest disproportionately in high-risk, high-yield instruments 
in order to reduce the amount of future employer contributions necessary to 

                                                                                                                   
the excess. This is referred to as a reversion. The employer, however, must pay an excise tax on 
the reverted amount. Interestingly, in some instances, plans considered underfunded under 
IRC  ' 412 standards can have excess assets at plan termination because the actuarial 
assumptions for ongoing plans differ from those used in connection with terminating plans. 

249.  Employers will pay either by providing the benefits or by reimbursing the 
PBGC. See supra note 12 and accompanying text. 

250.  If the employer anticipates insolvency, however, the employer may 
nevertheless take unreasonable risks knowing that the promised benefits would be paid by the 
PBGC. 

251.  Daniel Keating, Pension Insurance, Bankruptcy and Moral Hazard, 1991 Wis. 
L. Rev. 65, 66-67. 

252.  For purposes of defining moral hazard problems it is important to distinguish 
between two types of risks: reactive and fixed. A reactive risk is one over which the insured has 
some control. An example of this type of risk would be an automobile wreck due to controllable 
causes, such as speeding. A fixed risk is one for which the insured has no control, such as 
damage from floods and other acts of God. AFor a moral hazard problem to exist, there must be 
some element of reactive risk involved.@ In other words, the insured must have some 
opportunity to exercise due care. Id. at 68. 



2000] Rethinking the Risk of Defined Contribution Plans 665 

 

 

 

reach a certain level of retirement benefit.253 Alternatively, the employer may 
use the same strategy to increase plan benefits. However, a similarly 
motivated employer sponsoring a defined benefit plan would not choose to 
expose its plan assets to unreasonable risks because the employer would be 
liable for any asset deficiencies.254 

Prior to the passage of ERISA, there was concern that the adoption of 
defined benefit plan insurance would also encourage abusive practices 
regarding risk exposure. Legislative history reveals that some policymakers 
specifically feared that defined benefit plan insurance would enable employers 
to promise excessively generous pension benefits in efforts to satisfy 
increasing labor demands.255 There was also concern that an employer might 
establish or amend a plan to provide substantial past service benefits, realizing 
that if funding were inadequate to pay the benefits, the PBGC would subsidize 
the remaining deficiency.256 As a result, the pre-ERISA Committee 
determined that it was necessary to adopt safeguards against this type of 
abusive behavior. The Committee initially imposed restrictions on an 
employer's ability to recover from the PBGC. It required employers to 
reimburse the PBGC for asset deficiencies of up to 30% of the employer=s net 
worth.257 Subsequently, ERISA was amended to require that employers 
reimburse the PBGC for the full amount of the plan=s funding deficiency.258 

In connection with defined contribution plan insurance, it would be 
necessary to adopt similar protective measures to address the moral hazard 
problem. The prescribed diversification standard used in connection with the 
Hypothetical Account model discussed above accomplishes this goal by 
placing limitations on the level of risk to which an insured account may be 
exposed.259 
 

2. The Impact of Defined Contribution Plan Insurance on the 
PBGC.CSkeptics of defined contribution plan insurance protection maintain 
that extending PBGC insurance protection to defined contribution plans would 
intensify the financial troubles of the PBGC.260 This particular concern is 
valid, however, only if the defined contribution plan insurance program 
                                                 

253.  A money purchase plan is a defined contribution plan that has a definite 
contribution formula. In contrast, a profit sharing plan is a defined contribution plan that can 
have an indefinite contribution formula. 

254.  The employer would be liable to the PBGC. 
255.  See generally Langbein & Wolk, supra note 5, at 78-79. 
256.  See discussion infra Part IV.B, C. 
257.  See supra note 11 and accompanying text. 
258.  The Omnibus Budget Reconciliation Act of 1987 eliminated the 30% cap on the 

plan sponsors= liability. 
259.  See discussion infra Part IV.B, C. 
260.  See Langbein & Wolk, supra note 5, at 848-49. 



666 Florida Tax Review [Vol. 4:9 
 

 

replicated or expanded the existing insurance program for defined benefit 
plans. A newly established defined contribution plan insurance program 
should do neither. A defined contribution insurance program should be 
uniquely designed to reflect not only differences in plan type and plan 
structure, but also recent awareness of design deficiencies in the defined 
benefit plan insurance program.261 

Congress has conducted numerous studies to assess the strengths and 
weaknesses of the PBGC insurance program. These studies identify inherent 
problems with the PBGC insurance program, paying special attention to the 
mid 1980=s, when the PBGC=s liabilities began to increase.262 Some studies 
have concluded that the PBGC=s financial problems primarily stem from the 
potential liability of underfunded ongoing pension plans terminating. Other 
studies have concluded that the real crux of the PBGC=s funding crisis stems 
from the fact that the PBGC is not structured as a bona fide insurance 
company.263 

Two characteristics distinguish the PBGC insurance program from 
the bona fide insurance model used in the private sector. First, the PBGC 
premium is not fully risk based.264 As a result, healthy plans in thriving 
industries pay the same premiums as barely funded plans in troubled 
industries. Second, the PBGC premium is only partially economically 
derived.265 Consequently, extremely well funded plans pay the same premium 
as plans that are only adequately funded. Although there are new increased 
variable rate premiums which require underfunded plans to pay higher 
premiums, there is still no corresponding adjustment to decrease the premiums 
of well funded plans.266 

                                                 
261.  See generally Keville, supra note 4, at 553-54. 
262.  Richard A. Ippolito, A Study of the Regulatory Effect of the Employee Retire-

ment Income Security Act, 31 J.L. & Econ. 85 (1988) [hereinafter Ippolito, Regulatory Effect]. 
263.  See Richard A. Ippolito, Pension Security: Has ERISA Had Any Effect?, in 

Langbein & Wolk, supra note 4, at 91, 93 [hereinafter Ippolito, Pension Security]; Ippolito, 
Regulatory Effect, supra note 262, at 109-10. 

264.  See Ippolito, Pension Security, supra note 263, at 93; Ippolito, Regulatory 
Effect, supra note 262, at 85. 

265.  See Ippolito, Pension Security, supra note 263, at 93; Ippolito, Regulatory 
Effect, supra note 262, at 109-110. Studies show that the PBGC needs to impose a flat rate 
premium of at least $50 per participant to pay for its expected future liabilities. See Ippolito, 
Pension Security, supra note 263, at 93. Even though the removal of the cap on variable 
premiums in 1994 was estimated to raise approximately $650 million per year, the PBGC 
expected that their losses in future years will range between $12 and $20 billion. See Leigh 
Allyson Wolfe, Is Your Pension Safe? A Call for Reform of the Pension Benefit Guaranty 
Corporation and Protection of Pension Benefits, 24 Sw.U.L. Rev.145, 154-55 (1994). Thus, 
even with its increased rates, the PBGC premiums still are not economically adequate. 

266.  AThe flat-rate premium is $19 per participant, and the variable premium is $9 
per $1,000 of unfunded vested benefits with a maximum variable rate charge of $53 per 
participant for a total maximum rate of $72 per participant.@ Wolfe, supra note 265, at 154. 



2000] Rethinking the Risk of Defined Contribution Plans 667 

 

 

 

The failure to calibrate PBGC insurance premiums to fully reflect risk 
and cost results in a cross-subsidization from the beneficiaries of well funded 
plans to less well funded plans.267 If a fully risk based insurance model were 
utilized for defined contribution plan insurance, employers or participants 
who invest in high-risk instruments would be required to pay more than those 
who invest at average risks.268 Under such a model, the institution insuring the 
plan could be no better or worse off economically for having established the 
program.269 As a practical matter, any proposal to federally insure defined 
contribution plans should not duplicate the shortcomings of the existing 
insurance program. The defined contribution plan insurance program should 
be a new program with a risk-based premium. The Hypothetical Account 
model described in Part III.E is an example of such a program. 
 

3.  The Problem of Bailouts.CSome commentators have expressed 
concern that a defined contribution plan insurance program would increase 
federal exposure, possibly leading to a bailout similar to that of the 1980=s 
saving and loan crisis. This is unlikely, however, because the need for the 
1980 bailout developed out of circumstances unique to the savings and loan 
industry. 

The savings and loan crisis occurred when savings and loan 
institutions promised high investment returns in order to attract greater 
numbers of investors and remain competitive in the financial lending 
market.270 In efforts to generate sufficient income to pay the promised returns, 
the savings and loan institutions invested in short-term high-risk bonds. When 

                                                 
267.  William H. Simon, The Prospects of Pension Fund Socialism, 14 Berkeley J. 

Emp. & Lab. L. 251, 256 (1993). A cross-subsidization of the beneficiaries as a class by the rest 
of the population can also occur if the insurance funds become insolvent and the federal 
government bails the companies out with general revenues. Id. 

268.  See Jefferson, supra note 26, at 40-41. 
269.  Plans covering employees of troubled industries would be charged more 

because there exists a greater risk of plan failure. See generally Ippolito, Pension Security, supra 
note 263, at 93-95 (contrasting the PBGC program with private insurance). 

270.  The savings and loan problem began in 1980 when interest rate legislation was 
passed which deregulated the liabilities (i.e., deposits), but not the assets of the savings and 
loans. Soon after, federal tax incentives were introduced in 1981 and 1982 which encouraged 
real estate projects to be undertaken that were not economically viable. During the same time, 
the federal government tightened the money supply, which caused government bond interest 
rates to rise. This situation forced the savings and loans to seek higher short term rates through 
junk bonds. Making matters worse, in 1986 oil plunged to $10 a barrel, and the income tax 
incentives were taken away with no grandfather provisions. Also, one year later the stock 
market plummeted, and finally in 1989 the Financial Institution=s Reform, Recovery and 
Enforcement Act (FIRREA) imposed higher capital standards on the thrift industry, creating a 
situation in which more savings and loan institutions had to be seized by the government than 
had been anticipated. Yakoboski, supra note 3, at 18. 



668 Florida Tax Review [Vol. 4:9 
 

 

the underlying businesses for the high-risk investments became insolvent, the 
savings and loans lost substantial sums of money. As a result, they were 
unable to meet their financial obligations as they became due. Therefore, it 
became necessary for the federal government to bail out the industry. 

Like the savings and loans, defined contribution plan sponsors and 
participants would have incentives to maximize returns by investing in 
high-risk, high-return instruments.271 However, the comparison between 
defined contribution plan insurance and the savings and loan crisis is 
nevertheless invalid. There were many factors in the savings and loan crisis 
which are inapplicable to the retirement system. First, there is an important 
distinction between the savings and loan industry and retirement plans with 
respect to cash flow. Funds placed in savings and loan institutions are 
available to depositors upon request. Therefore, when news that the savings 
and loans were experiencing financial difficulties reached the public, many 
depositors withdrew their funds from these institutions. This response made a 
bad situation worse. 

In contrast, in retirement savings arrangements early distributions are 
generally disallowed unless specific events occur, such as early retirement, 
disability, or death.272 Even when other early distributions are permitted by the 
plan, a 10% excise tax ordinarily applies to discourage participants from 
withdrawing their funds prior to retirement age.273 Furthermore, an insurance 
program for defined contribution plans could impose additional restrictions on 
payment. Under the Hypothetical Account Model for defined contribution 
plans proposed in Part III.E, insurance protection would be unavailable until a 
participant attained normal retirement age, became disabled, or died, 
notwithstanding the distributable events allowed by the plans.274 Thus, the 
distribution rules of ERISA, as well as additional restrictions imposed by the 
insurance program, would prevent a single event from increasing the volume 
of insured claims as it did in the savings and loan crisis.275 

The second difference between the FSLIC's guarantee of savings and 
loan funds and a guaranteed benefit in a defined contribution plan program is 
industry diversification and its impact on the incident of failure. The funds 
guaranteed in the savings and loan crisis were exposed almost exclusively to 
the risk of a single industry, real estate. Thus, the savings and loan funds were 
                                                 

271.  Sponsors and participants would do so to achieve returns in excess of 
guaranteed rates. 

272.  See Regs. ' 1.401-1(b)(1)(i). 
273.  Distributions before a participant reaches age 592 are normally considered 

early. Exceptions to the 10% excise tax on early distributions are found in IRC ' 72(t). 
274.  See discussion supra Part III.E.1. 
275.  Limitations on the insured amounts, such as those discussed in connection with 

the Hypothetical Account insurance model, would also prevent a brief period of fluctuations in 
the financial market from triggering the level of insurance claims filed during the savings and 
loan crisis. See Yakoboski, supra note 3, at 20. 



2000] Rethinking the Risk of Defined Contribution Plans 669 

 

 

 

extremely vulnerable to fluctuations in a particular market. By contrast, 
retirement plan assets are ordinarily more diversified. Specifically, defined 
contribution plan accounts in compliance with the diversification formula of 
the Hypothetical Account model described above, are required to be invested 
in multiple markets according to the prescribed portfolio mix.276 Therefore, it 
is unlikely that defined contribution plans would fail as a result of the collapse 
of a single market. Moreover, because the guaranteed minimum benefit under 
the Hypothetical Account model would be based on a five-year average rate of 
return instead of the performance of a single year, there would be an additional 
measure of protection for the insurer.277 As a result, any fluctuations in the 
market would be spread over a period of years. 

The third difference between the savings and loan crisis and the 
retirement system is the presence of fraud and mismanagement. The savings 
and loan crisis did not result merely from aggressive investment activity. 
Fraud and mismanagement were present in approximately 60% of the savings 
and loan failures, and directly linked to the insolvency of at least 25% of the 
failed institutions, while evidence of fraud and mismanagement in pension 
plans is relatively low.278 This fact alone suggests that a defined contribution 
plan insurance program would not be exposed to the same risk of failure that 
the savings and loan industry was exposed to in the 1980=s.279  
 
G.  The Floor-Offset Pension Plan Comparison 
 

While the Hypothetical Insurance model discussed above proposes a 
new method of guaranteeing a minimum benefit in defined contribution plans, 
a minimum benefit in connection with defined contribution plans is not a 
totally new concept. A type of minimum benefit protection similar to that 
provided by the Hypothetical Defined Contribution Model currently can be 
achieved if an employer adopts a floor-offset pension plan.280 Thus, insuring 

                                                 
276.  See supra Part III.E.1. 
277.  See supra Part III.E describing the Hypothetical Account proposal. 
278.  See Yakoboski, supra note 3, at 20. 
279.  Another difference not discussed in the text of this article is the significance of 

loan participation in the savings and loan crisis. As the savings and loans found themselves 
constrained by limits on the amount they could lend to a single borrower, they began to sell 
portions of loans to other institutions. Many of the secondary lenders relied on the underwriting 
capacities of the originating savings and loans. Thus, the savings and loans were extremely 
vulnerable. Although a large proportion of defined benefit plan assets are placed in bank pooled 
funds and similar investments where investment results are shared, the investment strategy is 
fundamentally different. Id. at 20. 

280.  The majority of firms with floor-offset plans have between 5,000 and 20,000 
employees, according to a study conducted by Robinson and Small in 1993. Typically, floor 
offset plans provide a floor benefit for a career employee of between 40 and 60% of 



670 Florida Tax Review [Vol. 4:9 
 

 

defined contribution plan retirement benefits is neither theoretically nor 
practically as different as one may initially believe. 

A floor-offset plan, also known as a feeder plan, is a hybrid 
arrangement. While most hybrid arrangements are single plans which 
combine characteristics of both defined benefit and defined contribution 
plans, the floor-offset plan consists of two separate plans: a defined benefit 
and a defined contribution plan. The defined benefit plan is the Afloor@ plan. 
The floor plan uses a standard formula to establish a minimum benefit level 
that represent the employer=s income replacement goals. The formula may 
take into account age, service, and compensation. 

The defined contribution plan is the Abase@ plan. The employer makes 
the annual contributions to the base plan.281 If the base plan provides a benefit 
at least equal to the minimum established under the floor plan, the participant 
receives the balance of the defined contribution account as her retirement 
benefit.282 In such cases, no benefit is paid from the floor plan. If, however, the 
defined contribution plan provides less than the minimum benefit established 
under the floor plan, as a result of investment performance or inflation, for 
example, payments will be made from the floor plan to offset the shortfall in 
the base plan benefit. 

The floor-offset plan is generally offered by employers who wish to 
maximize both the flexibility of defined contribution plans, and the retirement 
income security of defined benefit plans.283 In a floor-offset plan, the 
employer typically is responsible for the investment of assets in both the 
defined benefit and defined contribution plans. If the participants rather than 
employers controlled the investments of the funds in the defined contribution 
base plan, in cases where the floor-offset plan was set at a sufficient level the 
participants would have incentives to invest in high-risk, high-yield 
instruments, knowing that the minimum benefit under the defined benefit floor 
plan would be adequate for retirement.284 However, because the employer is 
the party making the investment decisions, and the one who bears the risk of a 

                                                                                                                   
pre-retirement compensation. EBRI, Special Report, Hybrid Retirement Plans: The Retirement 
Income System Continues to Evolve 18 (1996) [hereinafter EBRI]. 

281.  Any defined contribution plan can be used as the base plan in a floor-offset plan; 
however, the standard profit sharing plan is most frequently used in such arrangements. 

282.  See EBRI, supra note 280, at 17. 
283.  Another situation for which a floor offset plan would be offered is a situation 

where the key employees are older and do not have sufficient time to accrue adequate retirement 
benefits under a traditional defined contribution plan. Thus, by offering a floor offset plan, these 
employees could be assured of receiving the desired level of income replacement at retirement 
from the defined benefit floor plan. See EBRI, supra note 280, at 18. As is the case with most 
hybrid retirement plans, there are many different plan designs. Because of the presence of both 
a defined benefit and a defined contribution plan, the floor offset plan may incorporate design 
features that are typically limited to one plan type or the other. Id. 

284.  See supra notes 251-61 and accompanying text. 



2000] Rethinking the Risk of Defined Contribution Plans 671 

 

 

 

shortfall in the expected retirement benefit, the moral hazard problem is 
avoided.285 

Interestingly, when the minimum benefit level in a floor-offset plan 
roughly approximates an average investment return on employer contributions 
over a participant=s working life, the floor-offset arrangement provides a 
minimum retirement benefit guarantee very similar to the minimum benefit 
guarantee described under the Hypothetical Account proposal described in 
Part II.E. In both cases, participants are guaranteed receipt of a minimum 
benefit at retirement. The minimum benefit is calculated with reference to an 
expected return over the participant=s working life. The major difference 
between the two guarantees is the source of the guarantee. In a floor- offset 
arrangement, the expected retirement benefit in the defined contribution plan 
is guaranteed through the defined benefit floor plan. In the Hypothetical 
Account proposal, a governmental agency similar to the PBGC guarantees the 
benefit through a bona fide insurance program.286 In both cases the potential 
for the moral hazard problem of insurance protection is essentially eliminated. 
In the floor-offset plan, there is no moral hazard problem because the 
employer makes the investment decisions. In the Hypothetical Account 
Insurance Model, there is no moral hazard problem because the diversification 
standard restricts the use of overly aggressive investment strategies. 

The use of floor-offset plans is not prevalent.287 Because the 
floor-offset plan involves both a defined benefit and a defined contribution 
plan, the administration of such plans is more complicated than that of either 
type plan. Additionally, because the cost of the plan depends on the 
contributions made to the defined contribution offset plan and their investment 
build-up, a highly volatile portfolio in connection with the offset plan could 
result in losses and increase the funding of the defined benefit floor plan. 
Consequently, the cost of the floor plan could be more expensive than 
maintaining either a traditional defined benefit plan or a traditional defined 
contribution plan.288 Therefore, most employers would not choose to provide 
floor-offset plans because of the additional costs and administrative burdens 
associated with maintaining floor offset plans. 

                                                 
285.  Because the minimum benefit in a floor offset arrangement is provided by the 

defined benefit floor plan, the investment risk in a floor plan is substantially borne by the 
employer. See supra notes 252-54. 

286.  See supra Part III.E. 
287.  See Cash Balance Pension Plans and Other Hybrid Retirement Plans, 

<http://www.ebri.org/fundamentals/chpt10.html>; see also EBRI, supra note 280. 
288.  Although some employers who establish floor-offset plans view the defined 

contribution plan as the primary retirement saving vehicle, many others view the defined benefit 
plan as the primary vehicle. Consequently, they recognize the defined benefit plan cost at all 
times. See EBRI, supra note 280, at 18. 



672 Florida Tax Review [Vol. 4:9 
 

 

Although the existence of the floor-offset plan demonstrates that the 
concept of defined contribution plan insurance is neither theoretically nor 
practically impossible, the limited use of such plans suggests that they have 
little impact on the retirement income security of the majority of defined 
contribution plan participants. Therefore, to ensure that more than a nominal 
percentage of defined contribution plan participants receive adequate 
protection against retirement benefit shortfalls, a guarantee of a minimum 
benefit should be available to all defined contribution plan participants 
through a defined contribution insurance program. 
 
 IV.  FUNDING SHORTAGES IN DEFINED CONTRIBUTION PLANS 
 
A.  Funding Under ERISA 
 

Pre-ERISA funding rules were not only inadequate in providing 
financial security for plan participants, but also created many problems related 
to underfunding.289 Participants often did not receive the benefits they 
expected from plans that were in compliance with the existing funding 
rules.290 Shortfalls in the expected retirement benefits are serious problems. 
Shortfalls threaten the financial security of plan participants not only because 
the retirement benefit received from the plan is more likely to be insufficient 
for the participant=s retirement needs, but also because in reliance on their 
expected retirement benefits, participants are likely to have decreased 
personal savings. Furthermore, when the participant becomes aware of the 
shortfall, there likely will be too few years of employment remaining to 
appreciably increase personal savings to offset the loss of benefit.291 As a 
result, when retirement plans are inadequately funded, participants may be 
worse off than they would have been in the total absence of a plan. 

                                                 
289.  One such case was the Studebaker case. This case made policymakers aware of 

the inadequacy of the existing funding requirements and consequently caused them to focus on 
plan funding and related matters. Thus, Athe closing of the Studebaker automobile plant in South 
Bend, Indiana, in December of 1963 is regarded as a pivotal event@ leading to the enactment of 
ERISA. See Langbein & Wolk, supra note 5, at 62. As a result of the plant closing, 5,000 
workers were dismissed and 1,800 more eventually lost their jobs. Id. When the plant closed, 
the company entered into an agreement with the United Automobile Workers (UAW) for the 
termination of its pension plan. Id. at 63. AThe termination agreement implemented the default 
priorities contained in the plan.@ Id. It divided the plan participants into three groups and paid 
their benefits accordingly: (1) 3,600 retirees and active workers who had reached the plan's 
normal retirement age of 60 received their full benefits in the form of life annuities, (2) 4,000 
employees age 40 to 59 who had at least 10 years of service with the employer received lump 
sum payments representing approximately 15% of the actuarial value of their accrued benefits, 
and (3) 2,900 workers had no vested rights and received nothing. Id. 

290.  See also Jefferson, supra note 26, at 8-9. 
291.  See id. at 18-29. 



2000] Rethinking the Risk of Defined Contribution Plans 673 

 

 

 

Therefore, in addition to strengthening the fiduciary rules and creating 
a federal insurance program, ERISA established minimum funding standards 
to help prevent funding shortages in qualified retirement plans.292 The purpose 
of the funding standards is twofold. The funding standards not only provide 
greater retirement security to plan participants but also provide greater 
protection for the PBGC against underfunding in defined benefit plans.293 

The minimum funding standards apply to all defined benefit plans, 
and some defined contribution plans.294 Because they are required to have 
definite contribution formulas, money purchase plans and target benefit plans 
are two types of defined contribution plans which are subject to the minimum 
funding rules. Profit sharing plans are not subject to the minimum funding 
rules because they are not required to have a definite contribution formula.295 

In a defined contribution plan, if the required contributions are not 
made and the plan terminates, there is no PBGC protection, although there 
would most likely be shortfalls in the expected retirement benefits. In a 
defined benefit plan if the required contributions are not made and the plan 
terminates, the employer and the PBGC would be liable for the payment of the 
expected retirement benefits. Thus, adequate funding is even more critical to 
                                                 

292.  See IRC ' 412 (1998). The funding rules of this section are enforced with severe 
penalties. Any plan that fails to comply with the appropriate minimum funding standard must 
pay an excise tax equal to 10% of the underfunded amount, in addition to an interest charge. If, 
the plan fails to correct the deficiency after receiving notification from the IRS that a deficiency 
exists, an excise tax of 100% of the deficiency is imposed. See Canan supra note 30, at 652. Plan 
costs are determined through actuarial valuations which estimate the cost of the plan and assign 
charges to the appropriate plan years as annual payments. In order to produce such estimates, 
the actuary must make assumptions about the future experience of the plan including the rate of 
investment return on plan assets, turnovers resulting in forfeitures of nonvested benefits, salary 
increases, the retirement age of plan participants, and the number of participants electing 
optional benefits offered by the plan. Thus, the amount that an employer is required to 
contribute in a particular year to properly fund a plan can vary tremendously depending on the 
actuarial assumptions used for each of these incidents. 

293.  Canan, supra note 30, at ' 12.1, at 605. The funding rules require that employers 
contribute annually at least the normal cost of the plan and the amount necessary to amortize 
any unfunded liabilities over a period ranging from 15 to 40 years. See Jefferson, supra note 26, 
at 6; see also McGill & Grubbs, supra note 54, at 381-82. 

294.  Canan, supra note 30, at ' 12.2, at 606. Money purchase plans and target benefit 
plans are subject to the minimum funding standards. The minimum funding standard for money 
purchase pension plans require the plan to contribute an amount which does not depend upon 
the uncertainties of actuarial assumptions. The rules are similar for target benefit plans. 
However, the funding rules provide that all pension plansCwhether defined contribution or 
defined benefitCare subject to the IRC ' 4971 excise tax, if the required contributions are not 
made to the plan. Id. The excise tax is 10% of the underfunded amount, and 100% of the 
underfunded amount if the underfunding is not timely corrected after notification by the IRS. Id. 
at 605. 

295.  Profit sharing plans are permitted to make discretionary contributions. Stock 
bonus plans, like profit sharing plans, are also excluded from the minimum funding standards. 



674 Florida Tax Review [Vol. 4:9 
 

 

the retirement income security of plan participants in defined contribution 
plans than in defined benefit plans, since neither the employer nor the PBGC is 
liable for the shortfalls. 

Even though the funding rules do not require it, employers who 
sponsor defined contribution plans frequently fund toward ERISA=s maximum 
permissible amount because of other considerations.296 When defined 
contribution plans are funded toward specific income replacement goals, 
funding shortages can occur if insufficient contributions are made. Although 
the funding rules help to prevent deficiencies attributable to inadequate 
funding in defined benefit plans, they do little to prevent deficiencies 
attributable to inadequate funding in defined contribution plans.297 For defined 
contribution plans, the funding rules require only that plans annually 
contribute amounts specified by the plan=s contribution formula.298 Thus, in 
addition to inadequate fiduciary rules and the absence of insurance protection, 
inadequate funding rules are another reason defined contribution plan 
participants may not receive their expected retirement benefits. 
 
B.  Minimum Funding Standards and Past Service Credits 
 

As described in Part III, when a plan is established, a participant's 
expected retirement benefit consists of two parts: the portion attributable to 
future earnings and the portion attributable to past earnings.299 While it is the 
entire retirement benefit that the participant ultimately relies upon, the two 
portions of the retirement benefit describe conceptually distinct benefits. 
Consequently, they are treated very differently for funding purposes. 

Retirement benefits are deferred compensation. The benefits are 
earned during employment, but paid during retirement.300 When a plan is 
newly established, the portion of the expected retirement benefit attributable 
to future years presumably will be funded by a reduction in current wages. For 
example, if a retirement plan provides an annual contribution of 10% of 
compensation and a participant earns $50,000, the participant will receive a 

                                                 
296.  IRC '' 404. 
297.  However, most defined contribution plans are profit-sharing which are not 

subject to the minimum funding standards at all. See supra note 34, infra note 310 and 
accompanying text. 

298.  The funding rules have limited application to money purchase plans and target 
benefit plans. The rules have no applicability to profit sharing plans. See Canan, supra note 30, 
at 606. 

299.  Past service liability occurs when a retirement plan provides a benefit for 
service before the establishment of the plan or provides for retroactive benefit increases. See 
supra Part III.B. 

300.  This Acommonly accepted modern account of pension obligations@ is referred to 
as the deferred wage theory. See Langbein & Wolk, supra note 5, at 16. 



2000] Rethinking the Risk of Defined Contribution Plans 675 

 

 

 

plan contribution of $5,000.301 In that same year the employee=s wages would 
be reduced by a corresponding amount.302 If the plan were to terminate the 
next year, theoretically, the employee=s wages should increase.303 From the 
additional compensation, the employee would be able to increase personal 
savings to offset any reduction in the expected retirement benefit that resulted 
from the plan=s premature termination. 

Therefore, because there is a corresponding increase in current wages 
which allows increased personal savings, participants could have no 
reasonable reliance on their expected benefits to the extent that they are 
attributable to future earnings. By contrast, however, if one believes that past 
service benefits are entirely related to past periods of service, theoretically, 
compensation from previous periods would have already been cut, in order to 
fund the benefit attributable to past service. Consequently, if the plan 
terminates, to the extent that past service benefits have not been funded, a 
participant=s current wages would not increase.304 The participant, therefore, 
may be unable to increase personal savings to offset the reduction in the 
expected retirement benefit. This result suggests that it is reasonable for the 
participant to rely on the portion of the expected retirement benefit attributable 
to past service since there is neither a corresponding wage increase, nor 
sufficient time to offset a reduction in the expected retirement benefit.305 

When a newly established plan gives credit for past service, the plan 
has an unfunded initial past service liability because the plan has liabilities for 
prior years of service, but no assets.306 These liabilities are generally funded 
over a period of thirty years.307 It is unlikely that such a plan will ever be fully 
funded, however, because ongoing plans typically fund not only the initial 

                                                 
301.  Interest is not accounted for. 
302.  There are numerous theories as to the benefits= impact on compensation. See 

Veal & Mackiewicz, supra note 137, at ' 12.1.1, at 205. 
303.  There is no adjustment for interest and the tax-free build-up. 
304.  For example, consider a 64 year old participant. It would obviously have to be 

some other participant's wages that were reduced to fund the past service portion of the 64 year 
old=s benefit. 

305.  See Jefferson, supra note 26, at 48. 
306.  For a more detailed discussion see Halperin, supra note 7, at 771. 
307.  Allowing past service credits to be funded over 30 years has been responsible 

for underfunding in a large number of plans. Because of concerns about funding inadequacies 
the Pension Protection Act of 1987 mandated more rapid funding of underfunded plans with 
more than 100 participants. ERISA ' 302(d); IRC ' 412(l). AFor such plans, the minimum 
required contribution is the greater of (1) the amount determined under the normal funding rule, 
or (2) the sum of (a) normal cost, (b) the normal charges and credits reflecting changes in 
actuarial assumptions and net experience gains or losses, (c) the >deficit reduction contribution,= 
plus (d) the >unpredictable contingent event amount.= @ See Langbein & Wolk, supra note 5, at 
287. For plans in existence on January 1, 1974, the amortization period is forty years. See IRC 
' 412(b)(2)(B)(i). 



676 Florida Tax Review [Vol. 4:9 
 

 

unfunded liability over thirty years, but also subsequent past service liabilities 
over additional thirty year periods. If a plan with past service credits continues 
in operation, liabilities for past service generally will not cause a funding 
shortage.308 If the plan terminates before all of the funding periods have 
expired, however, the plan will have insufficient assets to cover the plan's 
accrued liabilities.309 Thus, notwithstanding compliance with ERISA=s 
minimum funding standards, a plan can be inadequately funded on plan 
termination. As a result there would be insufficient assets to pay the portion of 
the benefit attributable to the past service credits.310 

In defined benefit plans, the entire vested accrued benefit is insured 
after five years by the PBGC, including the portion of the benefit attributable 
to the past service credit. In defined contribution plans, no portion of the 
retirement benefit is insured, including the portion of the retirement benefit 
attributable to past service. Thus, if a defined contribution plan terminates 
prematurely, plan participants could experience shortfalls in both the past and 
future portions of their expected retirement benefits. This result is 
inappropriate if one accepts the theory that the portion of the expected 
retirement benefit attributable to past earnings in both types of plans is 
inherently different than the portion of the benefit attributable to future 
earnings. Conceivably, the past service benefits in all plans could be insured 
by the time a participant reaches normal retirement age, even if the future 
service benefits are not. 
 
C.  Past Service Liabilities in Defined Contribution Plans  
 

The rationale for requiring participants in defined contribution plans 
to assume the risk of adverse market conditions with respect to the 
accumulation of the future benefit does not adequately explain why they 
should be required to assume the risk with respect to the portion of their 
benefit attributable to previously earned amounts. Most defined contribution 
                                                 

308.  The initial unfunded accrued liability can be funded over periods as short as 10 
years or over periods as long as 30 to 40 years, depending on the effective date of the plan. See 
McGill & Grubbs, supra note 54, at 399. If, however, no additional amendments were made to 
the plan, the plan would be fully funded in exactly 30 years from its establishment date. See 
Halperin, supra note 7, at 771. 

309.  Payments for certain plan liabilities are projected over periods ranging up to 30 
years; thus, when a plan terminates prematurely and all of its accrued liabilities become due and 
payable, the plan would most likely be unable to pay the retirement benefits of plan participants. 
However, inadequate funding can occur for numerous other reasons. The use of erroneous 
actuarial assumptions in the projection of future plan costs can either overstate plan assets or 
understate plan liabilities, resulting in plan losses. The adoption of plan amendments, which 
provide more generous plan benefits, can also create funding deficiencies. 

310.  The past service liability would not present a problem as long as the plan 
continues to operate because contributions would generally exceed the benefits paid out. See 
Halperin, supra note 7, at 771. 



2000] Rethinking the Risk of Defined Contribution Plans 677 

 

 

 

plans do not expressly distinguish between the portions of the benefit 
attributable to future costs and those attributable to past costs. In defined 
contribution plans, annual contributions are usually based upon a certain 
percentage of compensation.311 For example, a plan may require the employer 
to annually contribute 10% of each participant=s compensation, and there 
generally would be no explicit recognition of a liability for past service. It 
would therefore appear that defined contribution plan sponsors ignore service 
prior to the establishment date of the plan for purposes of allocating annual 
contributions.312 However, this assumption is not necessarily correct. 

Certain hybrid defined contribution plans explicitly award past 
service credits. The target benefit plan is an example of such a plan.313 The 
target benefit plan computes the retirement benefit in the same manner as a 
defined benefit plan.314 When a target benefit plan is established, a projected 
retirement benefit, or Atarget@ benefit, is calculated for each participant.315 The 
                                                 

311.  See Canan, supra note 30, ' 3.52, at 174. 
312.  See Wayne J. Howe, Education and Demographics: How do They Affect 

Unemployment Rates?, 111 Lab. Rev. 3 (1998). The method of contributing under profit 
sharing and stock bonus plans provides the employer greater flexibility. In such plans 
employers are permitted to make annual discretionary contributions subject to certain 
limitations. See Canan, supra note 30, at 94. Plans having cash or deferred provisions generally 
do not take into account past service. However, there are certain ways in which they might. For 
example, a plan could permit a higher deferral percentage for employees with a certain length of 
service. Extreme care would have to be taken so as not to violate the antidiscrimination norms. 
Id. at 174. 

313.  After the annual contributions are determined and allocated, the target benefit 
plan operates like any other defined contribution plan. At retirement, the individual=s account 
may be paid in a lump sum or used to purchase an annuity. However, the actual benefit could be 
more or less than the target benefit, depending on whether the actual investment earnings of the 
fund and the annuity purchase rates were more or less favorable than the actuarial assumptions 
used to calculate the contribution levels, or whether the plan did not terminate prematurely. See 
McGill & Grubbs, supra note 54, at 115. The target benefit plan is easier to administer than a 
traditional defined benefit plan. No actuarial valuations or reports are required. Thus, although 
the target benefit resembles a defined benefit plan in many respects, its allocation of investment 
risk is very different. As a defined contribution plan, the participant, bears the risk of 
unfavorable investment returns rather than the employer. Therefore, if the plan terminates early 
or if there is a substantial deviation in the experience of the plan as compared to the actuarial 
assumptions used by the plan, a participant=s retirement benefit could differ drastically from the 
targeted amounts. Because the target benefit plan is an individual account plan, and the 
retirement benefit is based on the value of the participant=s individual accounts, the target 
benefit plan is excluded from PBGC coverage. Therefore, there is no federal insurance 
protection for target benefit plan participants if the plan terminates with insufficient assets. See 
id.  

314.  See Halperin, supra note 8, at 176. See Employee=s Right to Convert Policy Not 
Incident to Ownership, IRS Says, Vol. 11, No. 36, Pens. & Ben. Rep. (BNA) 1135 (Sept. 3, 
1984). 

315.  The targeted benefit assumes that each participant will work until normal 
retirement age. 



678 Florida Tax Review [Vol. 4:9 
 

 

employer's annual contribution level is the sum of the amounts that are needed 
to annually fund each participant's targeted benefit.316 The annual contribution 
is then allocated to the individual accounts according to the amount necessary 
to fund each participant=s targeted benefit.317 Because the target benefit plan 
uses a benefit accrual formula to determine the retirement benefits,318 it is 
possible for the employer to account for service prior to the establishment of 
the plan, by expressly awarding past service credits. 

The use of past service credits in a target benefit plan is illustrated by 
the following example. Assume an employee age 45 has 10 years of service at 
the time a target benefit plan is established, and the plan recognizes past 
service. If the plan provides 1% per year of service, the employee can expect a 
30% benefit at age 65, assuming the plan=s investment performance is 
predicted accurately. The employee, accordingly, could assume a 10% benefit 
has already been earned when the plan is established. 

If level contributions are made over the next 20 years, there will be 
sufficient assets when the employee attains age 65 to pay the entire expected 
retirement benefit. If the plan were to terminate at any point before the 
participant reaches age 65, however, there would be insufficient funds to pay 
the past service benefit, and the participant would receive less at retirement 
than she expected.319 Thus, the participant would have been misled by the past 
service credit award.320 The worst case scenario would occur at the end of year 
one. At this point the employee's account balance would fall significantly 
short of that required to provide an 11% benefit. 

While the target benefit plan is the only defined contribution plan 
which allows the employer to expressly award credit for prior service, past 
service credit can be given implicitly in other types of defined contribution 
plans. For example, in a money purchase plan an allocation of employer 
contributions can be based on years of service, or on compensation.321 In other 
types of defined contribution plans employers can take past service into 
                                                 

316.  As is the case of all defined benefit plans, the target benefit plan provides higher 
contributions for older, more highly compensated employees. 

317.  See McGill & Grubbs, supra note 54, at 115. The contributions are determined 
by multiplying the target benefit by a factor in the plan that varies by age. Id. 

318.  To the extent that the experience approximates the assumptions used to 
determine the projected benefit, the benefits will approximate those provided under a defined 
benefit plan with a benefit formula. The target benefit plan is even subject to the maximum 
limits on contributions which can limit the contributions that could otherwise be made to older 
participants. Id. 

319.  See Halperin, supra note 7, at 776-77. 
320.  But see id. at 772-78 (positing that we should treat past service in defined 

benefit plans like we treat it in defined contribution plans, which is to allow the same funding). 
321.  When this approach is used, care must be taken that such formulas are not 

discriminatory in favor of the highly compensated employees. See Quality Brands, Inc. v. 
Commissioner, 67 T.C. 167 (1976); See also Canan, supra note 30, at 98; see also Halperin, 
supra note 7, at 776; see also Regs. ' 1.401-4(a)(2)(iii). 



2000] Rethinking the Risk of Defined Contribution Plans 679 

 

 

 

account by permitting higher deferral percentages for employees with greater 
lengths of service.322 

When an employer awards past service implicitly, it is more difficult 
to exactly determine the portion of the employer=s annual contribution 
attributable to past service. Difficulty notwithstanding, it is nevertheless 
reasonable to assume that some portion of the annual contribution in defined 
contribution plans is made implicitly for prior service. Employers who 
sponsor defined contribution plans presumably would want to reward prior 
service for the same reasons that employers who sponsor defined benefit plans 
would. Therefore, even absent an explicit past service credit, a participant 
could reasonably consider her defined contribution plan as providing for past 
service when the plan is established.323 

When credit for prior service is implicitly awarded, the portion of the 
annual contribution attributable to past service can be estimated, if the 
contribution level is known and certain assumptions are made. The annual 
accrual rate can be determined by dividing the expected retirement benefit by 
the participant=s projected years of service. The future accrual rate can be 
determined by dividing the expected retirement benefit by the total years of 
projected future service. Taking the difference in these two results makes it 
possible to separate the portion of the projected benefit attributable to future 
earnings from the portion attributable to past earnings. 

To illustrate, assume an employee with 15 years of service is age 50 
when a defined contribution plan is established. Furthermore, the plan has a 
normal retirement age of 65, and the plan=s annual contribution formula, 
which was derived with a specific income replacement goal, is 20% of 
compensation. Thus, the expected retirement benefit will accrue at a rate of 
20% of the employee's annual compensation per year over the next 15 
years.324 

If the employee=s future compensation and investment earnings rate 
on future accruals are assumed, the expected retirement benefit can be 
calculated when the plan is adopted.325 For example, if annual compensation is 
expected to remain at $50,000 over the next 15 years, and an investment return 
on the future contributions of 10% is assumed, the expected retirement benefit 
would be $25,937.326 If the expected retirement benefit is divided by thirty, the 
total years of service, the portion of the retirement benefit attributed to each 
                                                 

322.  For example 401(k) plans. See supra Part I.A. 
323.  See Canan, supra note 30, at 174. 
324.  Plus an adjustment for interest. 
325.  If the contribution is known, the expected pension can be approximated by 

making assumptions about the period of service, the employee=s salary, and the earnings on the 
fund. For simplicity, there is no salary scale increase used in this problem. 

326.  $10,000 x 1.1010 = $25,937. 



680 Florida Tax Review [Vol. 4:9 
 

 

year of service can be determined. In this example each year=s accrual would 
be $865 per year.327 Thus, when the plan is established, the participant has 
already earned 15 years of accruals, or a benefit of $12,975.328 As a result, the 
participant should reasonably expect to receive at retirement a $12,975 benefit 
for her prior years of service. This result occurs, however, only if some portion 
of each year=s annual contribution is attributable to the funding of the past 
service liability. 

If the plan continues to operate over the next 15 years, the participant 
would most likely be indifferent about whether any portion of the benefit was 
attributable to a past service credit, or not. This is because after 15 years the 
funding goal would be achieved, assuming the interest assumption were 
correct. However, if the plan were to terminate earlier, there would be 
insufficient contributions to cover the initial past service liability of $12,975. 
As a result, the uninsured defined contribution plan participant would not 
receive the full past service benefit that she expected, and perhaps had already 
earned. 
 
D.  The Funding Rules and Defined Contribution Plans 
 

In defined benefit plans, the distinction between past service and 
future service credits has substantial significance.329 In defined benefit plans, 
whether liabilities are attributable to the future or to the past determines their 
tax treatment,330 funding periods,331 and the level of insurance protection they 
received.332 Although the distinction between past service and future service 
theoretically exist in defined contribution plans, under current law the 
distinction has no practical significance in such plans. This is even true for 
target benefit plans which expressly award past service credits. 

The inadequacies of the funding and insurance laws with respect to 
defined contribution plans is particularly evident in money purchase plans. 
Money purchase plans are subject to the minimum funding standards.333 
Employers are subject to substantial penalties if the plans they sponsor fail to 
comply with these rules.334 Although the applicability of the funding rules to 
money purchase plans and target benefit plans may appear to provide 
                                                 

327.  $25,937/30 = $865. 
328.  $865 x 15 = $12,975. 
329.  For example, as discussed earlier, past service must be amortized over 10 to 30 

years, while current liabilities are expensed. 
330.  Generally, the maximum amount that an employer may deduct in a plan year is 

the sum of the normal cost and an amount sufficient to amortize the unfunded past service 
liability over ten years. 

331.  Future plan costs may not be funded in advance. 
332.  Future costs are not insured. 
333.  See IRC ' 412. 
334.  See IRC ' 4971. 



2000] Rethinking the Risk of Defined Contribution Plans 681 

 

 

 

additional protection to plan participants against shortfalls, there is no such 
protection. If a money purchase plan terminates prematurely and there have 
been insufficient contributions made to fund the past service portion of the 
expected retirement benefit, the participants will receive less than they expect 
at retirement. This would be the same result in other defined contribution 
plans which are not subject to the funding rules. Thus, the requirement that 
certain defined contribution plans comply with the funding rules is 
misleading. Participants are given the false impression that their expected 
benefits are adequately funded since the plans are subject to ERISA=s 
minimum funding standards. 

The opportunity for misimpression is particularly well illustrated by 
the target benefit plan. Although the funding standards apply to target benefit 
plans, and the employer is allowed to expressly recognize prior service, there 
are nevertheless no additional funding requirements. Thus, a participant=s 
retirement benefit could differ drastically from the targeted amount expressly 
stated in the plan. To avoid this result, Congress should amend the funding 
rules to have greater impact in their applicability to defined contribution plans. 
Similar to the treatment of defined benefit plans, employers sponsoring 
defined contribution plans subject to the funding rules should be required to 
annually contribute amounts necessary to fund the past service portion of the 
expected retirement benefit.335 

Admittedly, such a change is likely to have relatively little effect. As 
discussed above, very few defined contribution plans explicitly award past 
service credits.336 Consequently, only the few employers who sponsor target 
benefit plans that award past service credits would be affected by the more 
stringent funding requirements. Also, because the profit sharing plan, which is 
the most popular type of defined contribution plan, is not subject to the 
funding rules at all, such a remedy is not likely to have a meaningful impact on 
the majority of plan participants now covered by defined contribution plans.337 

Therefore, the inadequacies of the funding rules as they apply to 
defined contribution plans make the argument for defined contribution plan 
insurance more compelling. Insurance protection is critically important for the 
retirement security of defined contribution plan participants because the 
funding rules do very little to protect them. At the very least, in defined 
contribution plans, the portion of the expected retirement benefit attributed to 
past service should be guaranteed. With slight modification, the Hypothetical 

                                                 
335.  For example, an employer sponsoring a target benefit plan that awarded a past 

service credit, would be required to make annual contributions in pre-determined amounts to 
cover the portion of the expected retirement benefit attributable to past service. 

336.  See supra Part IV.B. 
337.  See supra Part IV.C. 



682 Florida Tax Review [Vol. 4:9 
 

 

Account Insurance Model discussed in part two of this article could very 
effectively be used for this purpose.338 
 
 V.  CONCLUSION 
 

Participants who depend on defined contribution plans as their 
primary retirement savings vehicles are exposed to substantially greater risks 
of shortfalls in their expected retirement benefits than participants in defined 
benefit plans. Those individuals who rely on participant directed plans are 
even more at risk. Because the existing fiduciary and funding rules are 
inadequate as they apply to defined contribution plans, there is a critical need 
for Congress to consider amending the pension laws to be more responsive to 
the risks of shortfalls in defined contribution plans. Moreover, because the gap 
in insurance protection further exposes defined contribution plan participants 
to plan losses, a defined contribution plan insurance program should be 
established. 

Insuring defined contribution plans does in fact present difficult 
trade-offs. However, many of the concerns regarding such a program are 
reactionary rather than substantive. As for the relatively few substantive 
concerns, the overwhelming need to amend ERISA to be responsive to the 
current pension climate would appear to offset any difficulties that these 
concerns present. Therefore, notwithstanding the complexity of implementing 
a defined contribution plan insurance program, policymakers should seriously 
consider establishing an insurance program for defined contribution plans to 
meet the needs of future retirees. 

Frequent and significant post-ERISA amendments that 
disproportionately affect defined benefit plans have led many to conclude that 
increased government regulation has been the impetus for the migration away 
from defined benefit plans to defined contribution plans.339 Moreover, the 
regulations affecting defined benefit plans generally have been more 
burdensome than those affecting defined contribution plans.340 Consequently, 
some skeptics of defined contribution plan reform may fear that increased 
regulation of defined contribution plans in connection with the fiduciary rules, 
insurance requirements, or the funding rules would adversely impact the 
establishment rate of defined contribution plans. Although frequent 
amendments have undoubtedly contributed in some measure to the shift from 
defined benefit plans to defined contribution plans, the magnitude of the effect 
of governmental regulation is probably grossly overstated.341 
                                                 

338.  See Part III.E. 
339.  See Keville, supra note 4, at 534. This trend appears to apply to all work 

industries and all plan sizes. Id. at 536. 
340.  Id. at 535-37. 
341.  In some instances, new legislation affecting defined contribution plans has not 



2000] Rethinking the Risk of Defined Contribution Plans 683 

 

 

 

An analysis of current establishment trends reveals that numerous 
other factors are responsible for the shift from defined benefit plans to defined 
contribution plans.342 Business considerations unrelated to pension plans are 
also responsible for an increase in the number of defined contribution plans. 
The introduction of 401(k) plans, and greater portability of defined 
contribution plans have also adversely affected the establishment of defined 
benefit pension plans.343 

Even if government regulation affecting defined benefit plans has 
been more frequent than that affecting defined contribution plans, the number 
of changes does not necessarily indicate the significance of those changes. For 
example, while adjustments to the PBGC premium have been numerous, the 
premium, per employee, has remained relatively level over the past twenty 
years.344 A nominal premium increase per participant is probably too small to 
make a significant difference in the employer=s selection of a plan.345 
Similarly, it is unlikely that the introduction of a relatively low premium for 
defined contribution plans, or more stringent fiduciary rules in participant 
directed plans, would affect the establishment of these plans. This is true 
especially since other government regulations continue to place relatively 
smaller burdens on defined contribution plans than on defined benefit plans.346 

A 1990 PBGC study supports the conclusion that the movement 
toward defined contribution plans is not solely in response to increased 
government regulation of defined benefit plans or additional plan costs.347 
Rather, the results of the study indicate that the primary cause of the recent 
decline in participation in defined benefit plans was a structural shift in the 
economy rather than conscious decisions made by plan sponsors and 

                                                                                                                   
only been less burdensome but has even relaxed existing restrictions. Id. For example, shortly 
after Congress increased the PBGC premiums paid by defined benefit plan sponsors in 1977, 
the attractiveness of defined contribution plans increased by introducing 401(k) arrangements 
making employee contributions tax deductible for the first time. The premiums were raised 
again in 1986 and then again in 1990. Id. 

342.  Id. 
343.  Because the net increase in defined contribution plans is far greater than the net 

decrease in defined benefit plans, it is reasonable to conclude that many workers, particularly 
those in small firms, who currently have defined contribution plans, previously would have had 
no plans at all rather than traditional defined benefit plans. Paul Yakoboski & Celia Silverman, 
Baby Boomers in Retirement: What are Their Prospects?, in Retirement in the 21st Century: 
Ready or Not 13.33 (Dallas L. Salisbury & Nora Super Jones eds., 1994). 

344.  The premium increase is relatively small if the amounts are adjusted for 
inflation. 

345.  See Halperin, supra note 8, at 160-61. 
346.  See generally, PBGC Study, Consultants Concur, Plans Will Not Vanish in 

Future, Vol. 17, No. 52 Pens. & Ben. Rep. (BNA) 2103 (Dec. 24, 1990). 
347.  PBGC studies show that the shift of smaller plans toward defined contribution 

plans is offset by the slight shift of larger plans toward defined benefit plans. Id. 



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employees.348 Small businesses typically prefer defined contribution plans; 
while large, unionized, manufacturing companies traditionally favor defined 
benefit plans.349 Since most of the recent growth in American industries has 
occurred in the service and high technology area, more defined contribution 
plans have been established.350 

                                                 
348.  See id.; see also Mark Daniels, Pensions in Peril: Single Employer Pension Plan 

Terminations in the Context of Corporate Bankruptcies, 9 Hofstra Lab. L.J. 25, 27-29 (1991). 
349.  See Canan, supra note 30, at 211-13. 
350.  See Keville, supra note 4, at 541-42.