Public Sector Pension Plans

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A copy of the presentation given at the 2013 ASPPA College of Pension Actuaries (ACOPA) Advanced Actuarial Conference.

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  • For more information, please contact the author of this presentation: Bill Karbon at 609.895.5332 │ e: wkarbon@cbiz.com
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Public Sector Pension Plans

  1. 1. Public Sector Pension PlansWilliam G. Karbon, MSPA, CPCSenior Vice President, Director of ComplianceCBIZ Benefits & Insurance Services, Inc.Lawrenceville, NJ1
  2. 2. 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 Plans2
  3. 3. What Is The Big Deal?3
  4. 4. What Is The Big Deal?• 1 out of 5 employees is a governmentalemployee• Governmental plans hold over $3.5 trillion infunded pension plan assets• Over 2,500 state and local governmental planscovering more than 22 million participants4
  5. 5. What Is The Big Deal?• Increased IRS interest in governmental plans:• IRS hosted governmental plans roundtable as partof initiative to better serve governmental planssector• Issued a survey questionnaire to small sample ofgovernmental plans to obtain information aboutcurrent status of governmental plans• Historically low participation in determination letterprogram5
  6. 6. What Is The Big Deal?• Treasury/IRS issued two advanced notices ofproposed rulemaking on November 8, 2011• Describes rules Treasury/IRS may propose relatingto determination whether:• a plan is governmental plan within meaning of Code§414(d)• plan of Indian tribal government is governmental planwithin meaning of Code §414(d)6
  7. 7. What is a GovernmentalEntity/Plan7
  8. 8. What is a Governmental Entity• U.S. Government• State or Political Subdivision of State• Federal or State Agency or Instrumentality8
  9. 9. 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 isselected• Are employees considered to be governmentalemployees?9
  10. 10. What is a Governmental Entity• Advanced Notice of Proposed Regulations• Major factors• Is entity’s governing board controlled by State or politicalsubdivision?• 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 financialresponsibility for the entity?• If not political subdivision, does entity have authority toexercise sovereign powers of State or political subdivision?10
  11. 11. What is a Governmental Entity• Advanced Notice of Proposed Regulations• Nongovernmental indicators• Private ownership interest• No governmental purpose11
  12. 12. What is a Governmental Plan• Defined identically in Code §414(d) andERISA Section 3(32)• Plan established or maintained for itsemployees by the Government of the UnitedStates, by the government of any State orpolitical subdivision thereof, or by any agencyor instrumentality of any of the foregoing.12
  13. 13. What is a Governmental Plan• Also includes:• Plan to which the Railroad Retirement Act of 1935or 1937 applies if financed by contributionsrequired under that Act• Plan of international organization that is exemptfrom taxation by reason of the InternationalOrganizations Immunities Act13
  14. 14. What is a Governmental Plan• For plan years beginning on or after theenactment of PPA, a Native American tribalplan will be treated as a governmental plan ifsubstantially all active plan participants:• perform essential government functionsand• do not perform commercial activities• Effective for plan year beginning after 8/17/0614
  15. 15. What is a Governmental Plan• Advanced Notice of Proposed Regulations• Government activity factors• Does activity provide public benefit to member of theIndian tribal government• Absence of one or more of the relevant factors forcommercial activity• Commercial activity factors• Is activity operated to earn a profit?• Is activity typically performed by private business?• Are customers substantially from outside the Indiantribal community?15
  16. 16. 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 20051402416
  17. 17. Which Rules Apply?17
  18. 18. Which Rules Apply?• Limited ERISA Applicability• Internal Revenue Code• State Law Applicability• Constitutional Law18
  19. 19. 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§20219
  20. 20. ERISA Exemptions• Funding• State law generally imposes funding requirements.• Fiduciary conduct• Fiduciary standards set by the Internal Revenue Code andConstitutional Law• Civil enforcement• Statutes at federal and state levels treat misuse of trustassets as criminal embezzlement or larceny• Exempt from Title IV defined benefit plantermination insurance provided by the PBGC• Not subject to ERISA Preemption20
  21. 21. ERISA Application• Limited applicability of Title II tax provisions21
  22. 22. 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 enhancedbenefits 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 Requirements22
  23. 23. Exemptions From the Code• Exempt from:• §417 Minimum Survivor Annuity Requirements• Approximately ½ of the states require spousal consent oracknowledgement for waiver of survivor benefits• DB Plans offering lump sum option are exempt from IRC§417(e) applicable interest rate and mortality tablerequirements23
  24. 24. 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 plan24
  25. 25. Exemptions From the Code• Exempt from:• §401(a)(13) Anti-assignment rules• Participants protected by state spendthrift trust rules• §416 Top Heavy Requirements25
  26. 26. 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 goodfaith interpretation of Code §401(a)(9)• Actuarial increases after age 70 ½ are not required26
  27. 27. Application of the Code• Subject to:• §415 Maximum Benefit and Contribution Limits• Certain exceptions including the exemption of DB plansfrom 100% of high 3-year average compensation limit• §414(q) Highly Compensated Employee• Limited applicability since governmental plans are exemptfrom nondiscrimination rules27
  28. 28. Application of the Code• Section 401(k) transitional rule• TRA 86 prohibited adoption of CODA bygovernmental entity unless:• Entity adopted CODA prior to 5/6/86• If entity adopted CODA by 5/6/86, any CODA adoptedby entity is treated as adopted by that date28
  29. 29. 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 separatedfrom service during or after the calendar year inwhich employee attains age 5029
  30. 30. Application of the Code• PPA provided for limited exception to Code§72(t) early distribution tax:• “qualified public safety employee” means anemployee of State or of a political subdivision ofState whose principal duties require specializedtraining in the area of police protection, firefightingservices, or emergency medical services for anyarea within the jurisdiction of the State or thepolitical subdivision of the State30
  31. 31. Application of the Code• PPA added an exclusion from income anydistribution 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 dependentOr• $3,00031
  32. 32. Application of the Code• “eligible retirement plan” is a governmental planwhich is a Code §403(2) annuity, 457(b) or 403(b)annuity plan• “eligible retired public safety officer” is an individualwho, by reason of disability or attainment of NRA isseparated from service as a “public safety officer”• “qualified health insurance premium” is a premiumfor an accident or health insurance plan, or qualifiedlong-term care insurance contract32
  33. 33. QDRO• Exempt from ERISA’s preemption of DROs.• In many states, state law provides for recognitionof DRO by governmental plans• State laws vary• Should be addressed in plan document• IRC §414(p)(11) makes QDRO provisionsapplicable to governmental plans which allowsdistributions from DROs to be treated as QDROsfor tax purposes33
  34. 34. Plan Document Issues34
  35. 35. Plan Document Issues• Plans that are tax-qualified under Code§401(a) may apply for a favorabledetermination letter.• No prototypes for a governmental plan• IRS does not have a volume submitter programfor governmental plans• IRS has created a “modified volume submitterprogram” by assigning all plans from one state tosame reviewer• Typically, state legislature defines basics to be included inplans for that state35
  36. 36. Plan Document Issues• Originally all governmental plans were subjectto Cycle C deadline (regardless of EIN)• Prior to Cycle C deadline, IRS issued guidanceallowing all governmental plans to change toCycle E• Cycle E deadline is January 31, 201636
  37. 37. Constitutional Law37
  38. 38. Constitutional Law• State courts have ruled that Contract Clause ofConstitution would grant contractual rightsunder state and local law.• Rulings have stated that a participant’s rightsto a pension attach upon:• Hire• Vesting• Retirement38
  39. 39. Constitutional Law• Birnbaum v NY State Teachers RetirementSystem prevents cutback of existing benefitsand future benefit accruals for existingemployees• May require modification to benefits for new hiresonly39
  40. 40. Constitutional Law• Governmental plans are exempt from anti-cutback rules of IRC §411• Court rulings regarding Constitutional lawprovides same protections as IRC §411 anti-cutback provisions40
  41. 41. State Law Issues41
  42. 42. 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)42
  43. 43. State Law Issues• The Uniform Management of Public EmployeeRetirement 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 participantsand beneficiaries so they can oversee the Trustees• Requires state enactment43
  44. 44. Funding and Trust Issues44
  45. 45. Funding• Governmental plans are EXEMPT from IRC §§ 430 and 436• DB plans must be funded through a trust• Typically, state law determines fundingrequirements• Contribution rate is established• Actuarially determined• State law may impose qualification standardson the plan actuary45
  46. 46. Funding• Setting employer contribution rate• State legislature or legislative authority of localgovernment approves a specific rate• Typically, based on recommendation of actuary• To change rate, legislative body must amendstatute• State constitution or statute may imposelimitations• i.e, cap/limit on amount rate can increase in one year46
  47. 47. Funding• Unlike private sector plans, manygovernmental defined benefit plans arecontributory.• According to Public Fund Survey• Median employee contribution rate is 5.0% foremployees who participate in Social Security, 8.5%for those who are exempt from Social Security47
  48. 48. Funding• Under IRC §414(h)(2), mandatory employeecontributions are treated as employercontributions• Reduces participant’s taxable income byamount of mandatory contribution.• Subject to Social Security and Medicare taxes• Unlike IRC §401(k) plans48
  49. 49. 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)49
  50. 50. Funding• Milliman 2012 Public Pension Funding Study• Measured aggregate funded status of 100 largestU.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%50
  51. 51. Funding• Milliman 2012 Public Pension Funding Study• Aggregated asset allocation• Equities 51%• Fixed income 26%• Real estate 7%• Private equity, hedge, commodities 13%• Cash 4%• Significant variation from plan to plan• Non-fixed income ranged from under 40% to over 80%51
  52. 52. Trust Issues• Governmental plans are subject:• IRC §401(a)(2) which states that funds in trust mustbe 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 withprevailing rate.• Plan maintains sufficient liquidity to permit distributionsaccording to plan terms.• Provide safeguards and diversity of a prudent investor52
  53. 53. Trust Issues• State fiduciary requirements imposed by:• State court interpretations of federal and stateconstitutional requirements• State statutes, regulations, or rules governinggovernmental retirement plans• State conflict of interest statutes• General state fiduciary standards• Common-law fiduciary rules53
  54. 54. Prohibited Transactions• Exempt from ERISA prohibited transactionrules and requirements of IRC §4975• Subject to prohibited transaction rules underIRC §503(b)54
  55. 55. Prohibited Transactions• IRC §503(b) prohibits following transactionswith related persons:• Lend trust assets without adequate security and areasonable rate of interest• Pay compensation exceeding reasonable allowance forsalaries/other compensation for personal servicesactually rendered• Make part of its services available on preferential basis55
  56. 56. Prohibited Transactions• IRC §503(b) prohibits following transactionswith related persons:• Make substantial purchase of securities for more thanadequate consideration.• Sell substantial part of it s securities for less thanadequate consideration.• Engage in any other transaction which results in asubstantial diversion of its corpus.56
  57. 57. Coping With Rising DB PlanCosts57
  58. 58. 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 benefitaccruals for current participants• Look at ancillary benefits58
  59. 59. Rising DB Plan Costs• Benefit Formula• Cash Balance• Benefit Multiplier• Definition of Compensation• Averaging Period• Employee Contributions• Contribution Rate• Interest Crediting59
  60. 60. 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 servicerequirements of ERISA §20260
  61. 61. 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 recentexperience study61
  62. 62. Unique Issues62
  63. 63. Service Credits• State and local plans can provide for purchaseor transfer of service credits to increasebenefits• Non-vested service from one governmental planmay be purchased to provide benefits undercurrent governmental plan63
  64. 64. Service Credits• DB plans can provide additional service creditsby:• Transferring assets representing value of benefitsunder prior governmental plan to currentgovernmental plan• Transferring funds from DC account to DB plan• Pick-up contributions• After-tax contributions64
  65. 65. Service Credits• PPA clarified application of permissive servicecredit rules under Code §415• Administrative complexity and funding issuescan be addressed by plan design65
  66. 66. Service Credits• Paying for service credits• Actuarial equivalence• Actuarial liability• Other• Cost neutrality66
  67. 67. Airtime• Purchase years of service that are not basedon actual service of any kind• Used to meet minimum requirements forretirement benefit or increase the size of theretirement benefit67
  68. 68. Airtime• Example• Katie is a participant in a municipal DB plan.• Plan allows for unreduced early retirementbenefits upon attainment of age 60 andcompletion of 25 years of service• Katie is age 60 with 20 years of service• If plan has airtime provision, Katie can buy 5 yearsof service to qualify for unreduced earlyretirement benefits68
  69. 69. Accumulated Leave Contributions• May be treated as employer contribution toDC plan• May be used to purchase additional servicecredits under a DB plan• Not subject to discrimination testing69
  70. 70. DROP• Deferred Retirement Option Plan• Employee eligible to receive retirementbenefits under DB plan continues to workwithout additional DB accruals• Instead, funds are credited to a separateaccount during the years of continuedemployment70
  71. 71. DROP• Example– Jon is eligible for early retirement on 1/1/2013.– He is entitled to an unreduced early retirementbenefit of $3,000 per month– Under DROP, Jon will not accrue additionalbenefits for future service. However, $3,000 amonth will be credited to Jon in a separateaccount71
  72. 72. DROP• Method of crediting interest determines formof 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 COLA72
  73. 73. DROP• Adverse impact on plan cost• Higher paid, long service employees will remainwith employer for a longer period of time• Assume all participants eligible for DROP will takeadvantage of subsidized early retirement• Absent DROP, participants typically do not takeadvantage of subsidized early retirement benefitunless post-retirement health coverage isprovided73
  74. 74. LOSAP• Length Of Service Award Program• Retirement benefit provided to volunteerfirefighters and other emergency serviceproviders• Benefits based on years of service asvolunteer• Benefits paid after retiring as volunteer74

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