The Great Pension Robbery
Forfeiture rules adopted by private pension plans can deprive employees of benefits crucial to their long-term security.
Question 7. Ask the Candidate:
Shouldn't an employee's pension be protected from forfeiture after he or she has been employed for three years or more?
As discussed in Question 6, Congress encourages the creation of pension plans by granting employers, employees, and the plans highly favorable tax treatment. Congress's intent in granting these favorable tax consequences is to increase the retirement savings of ordinary workers as well as those more highly paid.
Because annual contributions to their accounts are likely to be modest, ordinary workers must accrue benefits early and often if they are to achieve a decent retirement income. Fortunately, workers never may be deprived of pension accounts funded out of their own wages, such as in 401(k) plans. That's not true of contributions by employers to 401(k) plans or to other, traditional pension plans: These contributions can be, and almost always are, subject to severe forfeiture rules.
Say you're in your 20s and have been hired by a large corporation. You expect to work there for two years, maybe a little longer; and then you might move back to your home state. You're told that after one year, the corporation will contribute to its pension plan an amount equal to 7% of your salary. That evening, you thumb through a thick, glossy plan brochure and discover that the contributions, which you pictured as a form of compensation, will not do you a bit of good. If you stick to your schedule, you'll forfeit your entire pension account.
Employers like forfeiture provisions because they encourage valued participants to stay and penalize participants who quit or are fired. Congress always has indulged employers' desires here. Until 1974, an employee who spent her working life with a company could forfeit her entire pension if her employment terminated for any reason prior to her normal retirement age, which usually was set at 65. The Pension Reform Act of 1974 set "limits" on forfeitures but still allowed all of an employee's pension to be forfeited if her employment lasted less than 10 years, or portions to be forfeited if her employment lasted less than 15 years.
Forfeiture provisions today are less harsh, but still highly problematic. Let me tell you about the two most common ones chosen by private employers.
One, known as "5-year cliff vesting," claims the employee's entire pension account--it "falls off a cliff"--if her employment terminates before she has been employed for five years, even if she falls short by only one day and is fired without cause.
The other is a graduated schedule, also specifically approved by Congress:
| Years of Service | Forfeiture |
| Less than 3: | 100% |
| 3 up to 4 | 80% |
| 4 up to 5 | 60% |
| 5 up to 6 | 40% |
| 6 up to 7 | 20% |
| over 7 | 0% |
Under this schedule, if you've worked for 2 years and 11 months when you quit, you forfeit everything. Even if you're fired without cause during your sixth year, you will forfeit 40%.
Irreparable Damage
If you're young and lose your pension after a number of years with a company, sure, you'll feel bad. Chances are, however, you're thinking that you can make up the loss by saving extra amounts in later years. But the early losses are difficult to overcome--particularly for ordinary workers. Because employer contributions typically are defined as a percentage of wages, these workers never have large sums contributed annually to their accounts. Still, saving for retirement as early as possible and without forfeitures makes it possible for saving to grow in value (to "compound the interest") year after year. Given enough time, the effect of compound interest can be dazzling.
Consider Ms. Early. She's 22 years old and works for Goodguy, Inc., which promises to contribute $1,000 to her defined contribution pension account each year of her employment. If she works for 43 years until she is 65, Goodguy will have contributed $43,000. If each year's contribution earns 8%, what will be the size of her account when she is 65? How about $356,000!
Now consider Ms. Late. She's 22 and works for Badguy, Inc. Badguy also promises to contribute $1,000 to her defined contribution pension account each year of her employment. But a few months before she had worked there for five years, she was fired without cause and lost her entire pension under the pension plan's 5-year cliff vesting schedule. She then bounced around among various jobs, each time forfeiting her pension contributions until, at the age of 32, she, too, was hired by Goodguy.
For 33 years, until she was 65, Goodguy contributed $1,000 each year to its pension plan for her, which also earned 8% per year. What do you think those $33,000 of contributions were worth when she reached 65? Only $158,000.
In other words, Goodguy's contributions for Ms. Early were only $10,000 more than they were for Ms. Late, but Ms. Early's pension account was nearly $200,000 more. That's because her contributions had an additional ten years to compound the rate of return. Yes, Ms. Late's forfeiture in Badguy's plan really hurt.
On the other hand, Ms. Late is more fortunate than many others. As mentioned in Question 6, about one-third of all people who are 65 and older receive at least 90% of their income from Social Security because their pension, IRA, and investment income is so small.
What Congress Should Do
Congress should reform the pension tax laws to prohibit the forfeiture of more than 50% of pension accounts after an employee's second year of employment, and prohibit all forfeitures after the third year.
While companies like to use forfeiture provisions to advance their own interests, Congress has an obligation to promote the public interest by strictly limiting forfeitures. We are ill-served when forfeiture provisions discourage employees from leaving one company for a more promising, higher paid job. And it never can be in the public interest for workers to forfeit their pensions when they are fired without cause.
Economists make another crucial point: Employees pay indirectly for most of the pension contributions made by their employers because employers usually reduce their compensation or fringe benefits in light of the pension contributions. Seen this way, the money lost by an employee when she forfeits her pension account is largely her own money.
More limited forfeiture provisions would offer some protection to employers from potentially costly short-term employment arrangements. On the other hand, more restrictive limitations on forfeitures would make the rest of us less vulnerable to the risk that we may be called upon to pay extra taxes to come to the assistance of these workers when they retire.
There's one sure way to know where a candidate stands on this question. He may tell you straight out that he favors these reforms. Keep in mind, however, the "rule of the second clause" in politics, which a cousin explained to me when I moved to Washington, D.C. years ago. The second clause tells us everything. For example, if the candidate says, "No one cares more deeply about the long-term security of the American worker than I do, but (and now really pay attention) we need to take into account the interests of employers as well." Sure we do. And we've just learned precisely how he'll vote.