U.S. Senate
Committee on Governmental Affairs
Enron Hearings
24 January 2000
The Enron Pension Investment Catastrophe:
Why It Happened and How Congress Should Fix It

Statement of Professor John H. Langbein
Yale Law School

                I appreciate the invitation to speak with you about the pension investment aspects of the Enron Corporation bankruptcy. 

                I have been teaching and writing about pension law and pension policy for two decades.  I coauthor the principal book on pension law that is used in American law schools.¹  I serve as a Uniform Law Commissioner from Connecticut, and I was the reporter (drafter) for the Uniform Prudent Investor Act (1994), which now governs fiduciary investing at the state level in most American states. 

                1.  The Enron plan.  Enron Corp. sponsored a 401(k) pension plan for its employees.²  The plan permitted the employee to contribute up to 15 percent of his or her salary, subject to a ceiling.³   Enron made a matching contribution of half of what the employee contributed.⁴  The sums contributed by both employee and employer were tax deferred under Sections 401(a) and 401(k) of the Internal Revenue Code.  The plan provided that Enron's contribution would be entirely in Enron stock.⁵  The employee participant could choose to invest his or her contribution among a menu of options, including leading well-diversified mutual funds⁶ or more Enron Stock. 

                The plan required the employee-participant to hold the employer-contributed Enron shares until age fifty.⁷  Only at that age could he or she direct that the Enron shares be sold and the proceeds redirected into other investments.  With respect to these match shares, the plan made the employee-participants into involuntary Enron shareholders until age 50.

                As Enron's financial difficulties began to be revealed in the fall of 2001, the value of Enron shares, including those held in the pension plan accounts, declined precipitously.  Shares that had traded above $80 per share at the apogee are now effectively worthless.  As a result, many Enron employees have lost huge portions of their expected retirement funds--both the employer match shares and those Enron shares that many employees elected to purchase with their own contributed funds.

                Although some of the alleged financial skullduggery of Enron's managers, directors, and accountants may have violated ERISA fiduciary law, it is vital for Congress to understand that the key feature of the Enron plan that made it possible for these losses to occur--the large concentration of employer stock in the plan's investments--was permitted under ERISA, the federal pension regulatory law. 

                ERISA invited this mess, and unless you change ERISA, I can predict to you with utter certainty that such cases will happen again, as they have repeatedly in the past.  What's new about the Enron calamity is simply the enormity of the losses.

                2.  DC plans.  401(k) plans such as Enron's are known as defined contribution (DC) plans, or in the language of ERISA, as "individual account plans."  DC plans "provide[] for an individual account for each participant;" the participant's "benefits are based solely upon the amount contributed to the participant's account," plus the investment experience (dividends, gains or losses) of the account.  ERISA § 3(34).

                The distinctive feature of any DC plan is that

investment risk rests entirely upon the account of each participating employee.  The employee captures market gains, the employee suffers market declines.

                By contrast, in a traditional defined benefit (DB) plan of the sort that prevails among large employers in manufacturing and transportation industries and utilities, the employer (or other sponsor) bears the investment risk.  In a DB plan the employer promises the employee a certain benefit on retirement, and if the investments in the pension fund don't produce enough to pay the benefit, the employer must make up the shortfall from company assets.

                3.  The DC or 401(k) structure is not the problem.  As ERISA now stands, the high concentration of employer stock that allowed  the catastrophic losses to the Enron employees could only have occurred in a DC plan, because ERISA's diversification requirements (discussed below) would have prevented these concentrations in a DB plan.  It would be a fallacy, however, to conclude that the problem lies in the nature of DC plans.  The truth is that it is as easy to avoid over-concentration in a single stock in a DC plan as in a DB plan.  For example, most of us who are employed in academia participate in DC plans operated by TIAA-CREF.  TIAA-CREF diversifies its stock and bond investments across literally thousands of issues. 

                The ERISA failure that allowed the Enron employees' loss to occur is that ERISA contains an exception to its diversification requirement.  ERISA allows certain types of DC plans, including 401(k) plans, to permit and/or require employees to hold these large concentrations of employer stock in their plan accounts.

                Over the past two decades that 401(k) plans have been allowed⁸ there has been a huge increase in the use of DC plans, especially 401(k) plans.  The Employee Benefits Research Institute (EBRI) reports that as of the year 2000, there were more than 327 thousand 401(k) plans in effect, covering more than 43 million active participants, holding assets of $1.8 trillion.  There are many reasons for this complex development. 

                DC plans do have disadvantages,⁹ but they have two great advantages for employees that help explain their popularity. 

                First, DC plans offset the lack of portability in the private pension system.  DC plans produce better results for the employee who works for several employers across his or her career than does a DB plan, because DB plans use career-average service formulas that favor long-service employees.  DC plans are a response to the increasing mobility of the workforce.

                Second, DC plans encourage employees to engage in more pension saving than usually occurs under DB plans,¹⁰  both because the transparency of the individual account mechanism is easier for the employee to understand and to value than a distant benefit formula; and because there are ways to arrange that any money in a DC account that the employee and his or her spouse do not turn out to need for their retirement will pass to their heirs.  The ability to transfer the account balance on death encourages employees to make more ample provision for their retirement, secure in the knowledge that they will not forfeit the cushion.

                Accordingly, the lesson to learn from the Enron debacle is not that DC plans should be restricted, but that the diversification standards that Congress wisely imposed on DB plans need to be extended to DC plans.

                4. Diversification.  The duty to diversify investments is a standard principle of good fiduciary investing practice, which was long ago¹¹ absorbed into the trust investment law.¹²   ERISA has from its enactment in 1974 imposed this duty to diversify pension fund investments.  ERISA § 404(a)(1)(C).

                ERISA's duty to diversify does not, however, apply to all pension plans.  Rather, Congress allowed an exception for certain types of DC plans.  ERISA §§ 404(a)(2), 407(d)(3).  That exception is a major mistake of pension policy, and until Congress fixes it, I can predict to you with utter certainty that cases like Enron will continue to occur. 

                Let me say a quick word about the underlying economics of the duty to diversify.  The importance of diversification is by far the most important finding in the entire field of financial economics.  Over the past 40 years, we have had a stream of empirical and theoretical studies, which have led so far to six Nobel prizes in economics, conclusively showing that there are large and essentially costless gains to diversifying an investment portfolio thoroughly. 

                Investment risk has three distinct components: market risk, industry risk, and firm risk.  Market risk is common to all securities; it reflects general economic and political conditions, interest rates, and so forth, hence cannot be eliminated.  Industry risk, by contrast, is specific to all the firms in each industry or industry grouping.  Firm risk refers to factors that affect the fortunes only of the particular firm.  My favorite illustration is the example of the international oil companies.  All of them suffered from the 1973 Arab embargo (industry risk).  By contrast, only Exxon incurred the liabilities arising from the great Alaskan oil spill of March 1989 (firm risk).  Holding shares in other industries helped prudent investors to offset the decline of the oils in 1973; holding shares of other oils helped offset the decline in Exxon.

                Only about 30 percent of the risk of security ownership is market risk, that is, risk that cannot be eliminated by diversification.  By contrast, industry risk amounts to about 50 percent of investment risk, and firm risk comprises the remaining 20 percent.¹³  Thus, effective diversification can eliminate roughly 70 percent of investment risk. 

                And that is why, from the standpoint of good investment practice, a portfolio such as the Enron pension fund, so heavily concentrated in a single stock, any stock, is pure folly.  But there are many plans sitting out there with even more employer stock than Enron.  For example, as of January 2000, Proctor and Gamble had a DC plan with 96 percent in employer stock, Pfizer has one with 88 percent, Abbot Laboratories with 87 percent.¹⁴ 

                According to the most recent data reported by EBRI, employer stock comprises 19 percent of all 401(k) plan assets,¹⁵ but that number, which averages plans with and without employer stock,  understates the magnitude of the problem for the plans with the employer stock.¹⁶

                5. What's wrong with employer stock.  A pension fund portfolio holding a massive part of its assets in any one stock is bad; but holding such a concentration in the stock of the employer is worse.  For the employees of any firm, diversification away from the stock of that employer is even more important.  The simple reason is that the employee is already horrifically underdiversified by having his or her human capital tied up with the employer.  The employee is necessarily exposed to the risks of the employer by virtue of the employment relationship.  The last thing in the world that the employee needs is to magnify the intrinsic underdiversification of the employment relationship, by taking his or her diversifiable investment capital and tying that as well to the fate of the employer. 

                The Enron debacle illustrates this point poignantly.  Just when many of the employees have lost their jobs, they have also lost their pension savings, which in a 401(k) plan they could have borrowed against (or with a penalty, withdrawn) in order to tie them over.

                6. The incentives argument.  What's the case for having employer stock in pension funds?  The argument is that employers want to incentivize employees to identify with the stockholders of the firm.  Making employees into stockholders will motivate them to care about the firm's profitability.

                There's a simple answer to that argument:  Don't do it in the pension fund.  If you want to sell stock to your employees for such sound business reasons, go right ahead and do so (subject to adequate disclosure of the risks--a subject to which I shall return).  But you should not be able to treat such a program as a pension fund, for two very good reasons: It abuses the pension tax subsidy and it misleads employee-participants.

                Congress provides two huge tax subsidies for qualified pension plans:  Employee and employer contributions to such plans are tax deferred, and so is any investment buildup.  Congress grants this subsidy in order to promote pension saving, hence to promote retirement income security.  That policy is concerned to protect the employee and his spouse in their post-employment years.  The policy  has nothing to do with promoting employer interests.  To the contrary, the most fundamental principle of ERISA fiduciary law is the so-called exclusive benefit rule, requiring that pension plan investing and administration must be done "solely in the interest of the participants and beneficiaries and ... for the exclusive purpose of providing benefits" to them.  ERISA § 404(a)(1)(A).  Ordinarily, therefore, subordinating the interests of the employees to those of the employer is a breach of the fiduciary duty to avoid such conflicts of interest under ERISA.  Apart from the statutory exception that allows employer stock in pension plans, the message of ERISA is: pension plans are for employees, not for employers.  Congress provides the pension tax subsidy for employee interests.

                Another way to make that point is to remind ourselves that the employee has earned the pension.  Employers do not offer pension plans in order to be nice guys--indeed, employers have a fiduciary duty to their shareholders not to waste the company's assets by giving those assets away to people, even employees.  These plans are not gratuities.  Employers offer pension plans as part of the compensation package, as what we call deferred compensation.¹⁷  Pensions are the employee's earnings, channelled into retirement saving at the source.  We should not let supposed employer preferences interfere with the best interests of the employee.

                As the Enron calamity shows, employees do not understand the risks involved in holding employer stock in their pension accounts.  They rely on these accounts for their retirement.  Many of the employees do not have enough years left in the workforce to be able to replace the losses in subsequent employment.

                7.  The plan formation argument.  The other claim on behalf of the status quo is that in our voluntary private pension system, if you don't let employers stuff employer stock in these plans, they won't offer the plans at all.  This is highly unlikely. 

                In competitive markets, if one employer won't offer a pension plan while others do, that employer will be at a disadvantage in competing for workers.  The employers who offer pensions today do so in order to be competitive for workers who are pension-sensitive, and such employers will continue to want to be competitive for such workers by offering pensions even if the employers are forbidden to stuff the plans with company stock. 

                We heard the same argument when Congress imposed vesting rules in ERISA in 1974, and when congress mandated spousal shares in 1984.  The truth is that sensible pension regulation does not discourage plan formation.  To the contrary, by making pension promises more reliable, it increases the attractiveness of pension plans to employees, and causes firms to offer more of them.

                As regards 401(k) plans, the argument is sometimes made that if employer stock investments were curtailed, employers might  continue to offer 401(k) plans, but employers would not continue to offer matching contributions unless in employer stock.  While I doubt that, there is an easy compromise: let the employer who wishes continue to contribute employer stock (and to get the tax deduction for doing so), but require that the plan fiduciary dispose of it on the open market within a short period and reinvest the proceeds in a diversified portfolio.

                8. The solution is already in ERISA.  If there is one bright spot for the future in the Enron pension catastrophe, it is that we know exactly how to prevent such cases from occurring again.  We not only know the cause, we also know the cure.

                The losses have been caused by allowing DC plans to be underdiversified.  The cure is to require diversification.  Congress has successfully insisted on diversifying plan investments in DB plans for a quarter century.  What is needed is to extend that regime across the DC universe, to cover all tax-qualified plans.

                Congress should not prohibit employer stock from pension plans altogether, because there are situations in which a prudent fiduciary investor may choose to hold some.  For example, it is common for pension investment managers to buy index funds in fiduciary accounts.  Index funds hold shares in all the companies in the index, and the employer may be one of those companies. 

                In ERISA § 407(a)(2), Congress set a ceiling on employer stock, saying that a plan may never hold more than ten percent,¹⁸ but Congress then left it to the prudence and diversification rules of ERISA § 404(a) to govern the question of how much less than 10 percent is appropriate.  The normal answer will be little or none.  The one time a DB plan tried to approach the 10 percent limit, in the most famous of all ERISA investment cases, Donovan v. Bierwirth, the Second Circuit held that the investment in employer stock was imprudent.  Bierwirth stands for the proposition that the prudence and diversification norms of ERISA § 404(a) govern the exercise of the up-to-ten-percent authority in ERISA § 407(a)(2).

                The paradox of ERISA is that it contains both the problem and the solution to the Enron mess.  ERISA contains a diversification regime that would prevent such cases form ever happening again if extended from DB to all DC plans.  (Obviously, were Congress to take that step, it would be important to provide a transition period to assure orderly compliance.)

                9. ESOPs.  I must emphasize that everything I have said about the evils of employer stock in 401(k) plans applies equally to employee stock ownership plans (ESOPs).  It has been known from the beginning in the specialist literature that ESOPs represent bad retirement policy.¹⁹   They are tools of corporate finance masquerading as pension plans. 

                10.  Disclosure.  My main recommendation to you is to extend ERISA's diversification regime to all tax-qualified plans.  If a plan gets the tax benefits of a pension plan, it should not hold material concentrations of employer stock.

                If Congress lacks the political will to take that step, or to take it across the entirety of the DC plan universe, I would offer a weaker alternative: Congress should at least insist upon alerting employees about the risks of holding employer stock.  My source of inspiration is the Surgeon General's warnings on cigarette packages.  The thinking behind those warnings is that people need to be aware of the risks, so that they can alter their behavior.  Transferred to the pension arena, the point is that if employees were warned about the risks of employer stock, they would be in a better position (1) to avoid electing to buy more of it in plans that offer it as an employee option, and (2) to pressure employers to move aaway from ESOPS and to discontinue using employer stock in the match feature of 401(k) plans.

                ERISA § 102 presently requires employers or other plan sponsors to send to employees annually a summary plan description (SPD), describing key features of each plan.  I would recommend that Congress require that the SPD for any plan that contains an employer stock option or employer stock match contain a Surgeon General's warning, something like this:

WARNING

Under commonly accepted principles of good investment practice, a retirement account should be invested in a broadly diversified portfolio of stocks and bonds.  It is particularly unwise for employees, who are already subject to the risks incident to employment, to hold significant concentrations of employer stock in an account that is meant for retirement saving.

                A disclosure solution of this sort is, I repeat, a second best solution. 

                The best solution is for Congress to mandate diversification across the entire universe of pension plans, as a condition of the tax subsidy that Congress grants these plans.   By taking that step, Congress could tell the American worker with confidence that Congress has done what is necessary to assure that there will never again be another Enron-type pension calamity.