Public Sector Pension Plans

William G. Karbon, MSPA, CPCSenior Vice President, Director of Compliance

CBIZ Benefits & Insurance Services, Inc.Lawrenceville, NJ

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What We Will Cover• What Is The Big Deal?• What is a Governmental Entity / Plan?• What Rules Apply?• ERISA Applicability• Applicability of the Internal Revenue Code• Plan Document Issues• State Law Issues• Constitutional Law• Funding and Trust Issues• Rising DB Plan Costs• Issues Unique to Governmental Plans

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What Is The Big Deal?

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What Is The Big Deal?

• 1 out of 5 employees is a governmental employee

• Governmental plans hold over $3.5 trillion in funded pension plan assets

• Over 2,500 state and local governmental plans covering more than 22 million participants

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What Is The Big Deal?• Increased IRS interest in governmental plans:• IRS hosted governmental plans roundtable as part

of initiative to better serve governmental plans sector

• Issued a survey questionnaire to small sample of governmental plans to obtain information about current status of governmental plans

• Historically low participation in determination letter program

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What Is The Big Deal?• Treasury/IRS issued two advanced notices of

proposed rulemaking on November 8, 2011• Describes rules Treasury/IRS may propose relating

to determination whether:• a plan is governmental plan within meaning of Code

§414(d)• plan of Indian tribal government is governmental plan

within meaning of Code §414(d)

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What is a Governmental Entity/Plan

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What is a Governmental Entity

• U.S. Government• State or Political Subdivision of State• Federal or State Agency or Instrumentality

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What is a Governmental Entity

• Currently• Depends on Degree of Entity’s Control• Additional factors:• Is there specific legislation creating entity?• Entity’s source of funds• Manner in which board of directors or trustees is

selected• Are employees considered to be governmental

employees?

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What is a Governmental Entity• Advanced Notice of Proposed Regulations• Major factors• Is entity’s governing board controlled by State or political

subdivision?• Are governing board members publicly nominated/elected?• Are entity’s employees treated same as State employees?

• i.e. given employees are granted civil service protection

• Does State or political subdivision have financial responsibility for the entity?

• If not political subdivision, does entity have authority to exercise sovereign powers of State or political subdivision?

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What is a Governmental Entity• Advanced Notice of Proposed Regulations

• Nongovernmental indicators• Private ownership interest• No governmental purpose

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What is a Governmental Plan

• Defined identically in Code §414(d) and ERISA Section 3(32)

• Plan established or maintained for its employees by the Government of the United States, by the government of any State or political subdivision thereof, or by any agency or instrumentality of any of the foregoing.

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What is a Governmental Plan• Also includes:• Plan to which the Railroad Retirement Act of 1935

or 1937 applies if financed by contributions required under that Act

• Plan of international organization that is exempt from taxation by reason of the International Organizations Immunities Act

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What is a Governmental Plan

• For plan years beginning on or after the enactment of PPA, a Native American tribal plan will be treated as a governmental plan if substantially all active plan participants:• perform essential government functions

and• do not perform commercial activities•Effective for plan year beginning after 8/17/06

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What is a Governmental Plan

• Advanced Notice of Proposed Regulations• Government activity factors• Does activity provide public benefit to member of the

Indian tribal government• Absence of one or more of the relevant factors for

commercial activity• Commercial activity factors• Is activity operated to earn a profit?• Is activity typically performed by private business?• Are customers substantially from outside the Indian

tribal community?

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What is a Governmental Plan

• Special situations:• State bar association – PLR 9749014• Fire department – PLR 200326036• Hospital authority – DOL Advisory Opinion 2003-

18A• Indian tribal police department – PLR 200514024

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Which Rules Apply?

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Which Rules Apply?

• Limited ERISA Applicability• Internal Revenue Code• State Law Applicability• Constitutional Law

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ERISA Exemptions• Exempt from Title I:• Reporting and Disclosure• Form 5500• SAR• SPD

• Vesting• Subject to Pre-ERISA Vesting Rules

• Participation• Exempt from age and service requirements of ERISA

§202

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ERISA Exemptions• Funding• State law generally imposes funding requirements.

• Fiduciary conduct• Fiduciary standards set by the Internal Revenue Code and

Constitutional Law• Civil enforcement• Statutes at federal and state levels treat misuse of trust

assets as criminal embezzlement or larceny

• Exempt from Title IV defined benefit plan termination insurance provided by the PBGC

• Not subject to ERISA Preemption20

ERISA Application

• Limited applicability of Title II tax provisions

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Exemptions From the Code• Exempt from:• §401(a)(4) Discrimination Testing• PPA applied exemption to all governmental plans

• Political forces may limit the ability to provide enhanced benefits to elected officials or management

• §410(a) Minimum Participation Standards• §401(a)(26) Additional Participation Requirements• PPA applied exemption to all governmental plans

• § 410(b) Minimum Coverage Requirements

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Exemptions From the Code

• Exempt from:• §417 Minimum Survivor Annuity Requirements• Approximately ½ of the states require spousal consent or

acknowledgement for waiver of survivor benefits• DB Plans offering lump sum option are exempt from IRC

§417(e) applicable interest rate and mortality table requirements

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Exemptions From the Code

• Exempt from:• §411 Vesting and DB accrual rules• State and local plans subject to pre-ERISA vesting rules• Full vesting on termination or partial termination of plan

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Exemptions From the Code

• Exempt from:• §401(a)(13) Anti-assignment rules• Participants protected by state spendthrift trust rules

• §416 Top Heavy Requirements

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Application of the Code

• Subject to:• §401(a)(17) Compensation Limit• May grandfather 1993 compensation (adjusted to

$380,000 for 2013) limit for plan participants as of July 1, 1993

• §401(a)(9) Minimum Distribution Requirements• PPA requires governmental plans to comply with a good

faith interpretation of Code §401(a)(9)

• Actuarial increases after age 70 ½ are not required

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Application of the Code

• Subject to:• §415 Maximum Benefit and Contribution Limits• Certain exceptions including the exemption of DB plans

from 100% of high 3-year average compensation limit

• §414(q) Highly Compensated Employee• Limited applicability since governmental plans are exempt

from nondiscrimination rules

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Application of the Code

• Section 401(k) transitional rule• TRA 86 prohibited adoption of CODA by

governmental entity unless:• Entity adopted CODA prior to 5/6/86

• If entity adopted CODA by 5/6/86, any CODA adopted by entity is treated as adopted by that date

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Application of the Code

• PPA provided for limited exception to Code §72(t) early distribution tax:• Exception applies to DB plan distributions to

“qualified public safety employee” who separated from service during or after the calendar year in which employee attains age 50

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Application of the Code

• PPA provided for limited exception to Code §72(t) early distribution tax:• “qualified public safety employee” means an

employee of State or of a political subdivision of State whose principal duties require specialized training in the area of police protection, firefighting services, or emergency medical services for any area within the jurisdiction of the State or the political subdivision of the State

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Application of the Code

• PPA added an exclusion from income any distribution from an “eligible retirement plan” for health insurance premiums• Exclusion cannot exceed lesser of:• amount paid by “eligible retired public safety officer” for

“qualified health insurance premiums” of the employee, spouse or dependent

Or

• $3,000

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Application of the Code• “eligible retirement plan” is a governmental plan

which is a Code §403(2) annuity, 457(b) or 403(b) annuity plan

• “eligible retired public safety officer” is an individual who, by reason of disability or attainment of NRA is separated from service as a “public safety officer”

• “qualified health insurance premium” is a premium for an accident or health insurance plan, or qualified long-term care insurance contract

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QDRO• Exempt from ERISA’s preemption of DROs.• In many states, state law provides for recognition

of DRO by governmental plans• State laws vary

• Should be addressed in plan document

• IRC §414(p)(11) makes QDRO provisions applicable to governmental plans which allows distributions from DROs to be treated as QDROs for tax purposes

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Plan Document Issues

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Plan Document Issues• Plans that are tax-qualified under Code §401(a)

may apply for a favorable determination letter.• No prototypes for a governmental plan• IRS does not have a volume submitter program

for governmental plans• IRS has created a “modified volume submitter

program” by assigning all plans from one state to same reviewer• Typically, state legislature defines basics to be included in

plans for that state 35

Plan Document Issues• Originally all governmental plans were subject

to Cycle C deadline (regardless of EIN)• Prior to Cycle C deadline, IRS issued guidance

allowing all governmental plans to change to Cycle E• Cycle E deadline is January 31, 2016

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Constitutional Law

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Constitutional Law

• State courts have ruled that Contract Clause of Constitution would grant contractual rights under state and local law.• Rulings have stated that a participant’s rights

to a pension attach upon:• Hire

• Vesting

• Retirement

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Constitutional Law

• Birnbaum v NY State Teachers Retirement System prevents cutback of existing benefits and future benefit accruals for existing employees• May require modification to benefits for new hires

only

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Constitutional Law

• Governmental plans are exempt from anti-cutback rules of IRC §411

• Court rulings regarding Constitutional law provides same protections as IRC §411 anti-cutback provisions

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State Law Issues

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State Law Issues

• Many states may impose Title I issues:• Funding• States may impose standards similar to ERISA

• May impose asset allocation requirements

• Fiduciary issues• May impose standards in addition to IRC §401(a)(2)

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State Law Issues

• The Uniform Management of Public Employee Retirement Systems Act (UMPERSA) that:• clearly establishes fiduciary duties of Trustees

• gives Trustees the powers to do the job

• holds Trustees responsible for their actions

• requires disclosure of information to participants and beneficiaries so they can oversee the Trustees

• Requires state enactment

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Funding and Trust Issues

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Funding• Governmental plans are EXEMPT from IRC § §

430 and 436• DB plans must be funded through a trust• Typically, state law determines funding

requirements• Contribution rate is established• Actuarially determined

• State law may impose qualification standards on the plan actuary

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Funding• Setting employer contribution rate• State legislature or legislative authority of local

government approves a specific rate• Typically, based on recommendation of actuary

• To change rate, legislative body must amend statute

• State constitution or statute may impose limitations• i.e, cap/limit on amount rate can increase in one year

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Funding

• Unlike private sector plans, many governmental defined benefit plans are contributory.

• According to Public Fund Survey• Median employee contribution rate is 5.0% for

employees who participate in Social Security, 8.5% for those who are exempt from Social Security

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Funding

• Under IRC §414(h)(2), mandatory employee contributions are treated as employer contributions

• Reduces participant’s taxable income by amount of mandatory contribution.• Subject to Social Security and Medicare taxes

• Unlike IRC §401(k) plans

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Funding

• According to Morningstar report:• 2011 Funding Ratios• Illinois 43.4% (Liability of $6,505 per capita)

• Kentucky 50.5% (Liability of $4,488 per capita)

• Connecticut 53.4% (Liability of $5,885 per capita)

• Wisconsin 99.8% (Liability of $23 per capita)

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Funding

• Milliman 2012 Public Pension Funding Study• Measured aggregate funded status of 100 largest

U.S. public pension plans• Reported assets = $2.7 trillion

• Reported liabilities = $3.6 trillion

• Aggregate funding ratio = 75.1%

• Median interest rate assumption = 8.00%

• Liability-weighted average rate = 7.80%

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Funding• Milliman 2012 Public Pension Funding Study• Aggregated asset allocation• Equities

51%

• Fixed income26%

• Real estate7%

• Private equity, hedge, commodities 13%

• Cash4%

• Significant variation from plan to plan• Non-fixed income ranged from under 40% to over 80%

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Trust Issues• Governmental plans are subject:• IRC §401(a)(2) which states that funds in trust must

be used for exclusive benefit of employee/beneficiary• Rev Rul 69-494 which states:• Investment’s cost cannot exceed FMV at time of purchase.• Investment provide fair return commensurate with

prevailing rate.• Plan maintains sufficient liquidity to permit distributions

according to plan terms.• Provide safeguards and diversity of a prudent investor

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Trust Issues

• State fiduciary requirements imposed by:• State court interpretations of federal and state

constitutional requirements• State statutes, regulations, or rules governing

governmental retirement plans• State conflict of interest statutes• General state fiduciary standards• Common-law fiduciary rules

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Prohibited Transactions

• Exempt from ERISA prohibited transaction rules and requirements of IRC §4975

• Subject to prohibited transaction rules under IRC §503(b)

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Prohibited Transactions• IRC §503(b) prohibits following transactions with

related persons:• Lend trust assets without adequate security and a

reasonable rate of interest• Pay compensation exceeding reasonable allowance for

salaries/other compensation for personal services actually rendered

• Make part of its services available on preferential basis

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Prohibited Transactions• IRC §503(b) prohibits following transactions with

related persons:• Make substantial purchase of securities for more than

adequate consideration.• Sell substantial part of it s securities for less than

adequate consideration.• Engage in any other transaction which results in a

substantial diversion of its corpus.

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Coping With Rising DB Plan Costs

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Rising DB Plan Costs• Asset allocation• Risk / volatility• New GASB rules

• Constitutional law issues may limit alternatives• May not be able to reduce or eliminate future benefit

accruals for current participants• Look at ancillary benefits

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Rising DB Plan Costs

• Benefit Formula• Cash Balance• Benefit Multiplier• Definition of Compensation• Averaging Period

• Employee Contributions• Contribution Rate

• Interest Crediting

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Rising DB Plan Costs• Vesting• Remember, state/local plan subject to pre-ERISA rules

• Death Benefits• What is provided by group plan?

• Disability• What is provided by group plan?

• Eligibility• Remember, exempt from age and service

requirements of ERISA §20260

Rising DB Plan Costs• Actuarial issues• Funding method• Use EAN due to new GASB rules?

• Asset averaging• Amortization of unfunded liability• Level dollar v. level % of pay

• Amortization period

• Assumptions• New GASB rules require disclosure of date of most recent

experience study61

Unique Issues

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Service Credits

• State and local plans can provide for purchase or transfer of service credits to increase benefits• Non-vested service from one governmental plan

may be purchased to provide benefits under current governmental plan

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Service Credits

• DB plans can provide additional service credits by:• Transferring assets representing value of benefits

under prior governmental plan to current governmental plan

• Transferring funds from DC account to DB plan• Pick-up contributions• After-tax contributions

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Service Credits

•PPA clarified application of permissive service credit rules under Code §415

• Administrative complexity and funding issues can be addressed by plan design

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Service Credits

• Paying for service credits• Actuarial equivalence

• Actuarial liability

• Other

• Cost neutrality

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Airtime

• Purchase years of service that are not based on actual service of any kind• Used to meet minimum requirements for

retirement benefit or increase the size of the retirement benefit

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Airtime

• Example• Katie is a participant in a municipal DB plan.• Plan allows for unreduced early retirement

benefits upon attainment of age 60 and completion of 25 years of service

• Katie is age 60 with 20 years of service• If plan has airtime provision, Katie can buy 5 years

of service to qualify for unreduced early retirement benefits

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Accumulated Leave Contributions

• May be treated as employer contribution to DC plan

• May be used to purchase additional service credits under a DB plan

• Not subject to discrimination testing

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DROP

• Deferred Retirement Option Plan• Employee eligible to receive retirement

benefits under DB plan continues to work without additional DB accruals

• Instead, funds are credited to a separate account during the years of continued employment

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DROP

• Example– Jon is eligible for early retirement on 1/1/2013.– He is entitled to an unreduced early retirement

benefit of $3,000 per month– Under DROP, Jon will not accrue additional

benefits for future service. However, $3,000 a month will be credited to Jon in a separate account

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DROP• Method of crediting interest determines form

of plan (DB or DC) for IRC §415 purposes • Actual earnings of trust or directed account • DC plan

• Stated rate (i.e. funding rate or T-bill rate) • DB plan

• Variations to separate account approach• payment of an additional check each year• crediting of COLA

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DROP

• Adverse impact on plan cost • Higher paid, long service employees will remain

with employer for a longer period of time

• Assume all participants eligible for DROP will take advantage of subsidized early retirement

• Absent DROP, participants typically do not take advantage of subsidized early retirement benefit unless post-retirement health coverage is provided

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LOSAP

• Length Of Service Award Program• Retirement benefit provided to volunteer

firefighters and other emergency service providers

• Benefits based on years of service as volunteer

• Benefits paid after retiring as volunteer

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