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      Public Pension Plan Choices: Too Big, Too Small & Just Right?

      If you are a California governmental employer, you may have more alternatives than you realize for providing significant and cost-effective retirement benefits to your employees. Many California public agencies incorrectly assume that they must participate in the behemoth California Public Employees' Retirement System (CalPERS) if they wish to provide quality retirement or health benefits to their employees. This article explains some of the options, other than CalPERS, that are available to public agencies and the reasons for considering these options.

      These alternatives generally apply to "smaller" governmental agencies, such as municipalities, utility districts, state commissions and water districts that are not required by federal or state statute to participate in the state retirement system. In California, all public safety personnel and university employees must participate in CalPERS. In some cases, due to collective bargaining agreements or statutory mandates, large groups of employees are required to receive their retirement benefits through a statutorily mandated retirement system such as the California State Teachers' Retirement System (CalSTRS).

      Since there are many state and local governmental employers whose employees are not required to be covered by the state-sponsored retirement system where they are located, these employers have the opportunity to evaluate and determine whether they and their employees would be better off by not joining the state-sponsored retirement system and instead adopting their own plan. In California, a public employer that is not required to participate in CalPERS can elect to become a "contracting agency" and participate in CalPERS by entering into a contract with the CalPERS Board of Administration "to have all or any part of its employees become members of this system."

      As "local miscellaneous members," such employees will become entitled to benefits under the CalPERS retirement system in accordance with the resolutions that the agency's governing board adopts stating which benefit formula and design options (all of which are limited by state law) are being chosen. For example, one of the available formulas is 2.0% of each covered employee's compensation multiplied by the employee's years of service for the state, or one of its agencies or subdivisions, with normal retirement at age 60.

      The Cost Of The "Too Big?"

      CalPERS and most other state retirement systems are designed as defined benefit pension plans, under which the members are paid a specified benefit upon retirement or certain other events, normally based upon their years of covered employment and their annual compensation during their last few years of employment. Under such plans, the employer and/or retirement system assumes the risk that there will be sufficient assets available to pay the promised benefits when the employee retires. Because it is the employer that assumes the "risk of investment" under a defined benefit plan, many city and county governments were asked by CalPERS to significantly increase their rates of contribution to make up for the poor investment results of the post-dot com recession. Furthermore, if the dramatic losses of 2008 – 2009 do not reverse themselves immediately, it is anticipated that CalPERS will significantly increase employer contribution rates beginning in the 2010 – 2011 plan year.

      One significant problem for employers that maintain defined benefit pension plans is that the cost of funding such plans typically increases during times of economic downturn – exactly when the employer can least afford to raise the funding of its plan. As part of its recent attempt to solve California's dramatic budget deficit, the California legislature tried to resort to the issuance of pension bonds (that is, borrowing approximately $2 billion to help pay for a current pension funding shortfall).

      The Risk Of The "Too Small?"

      In an effort to avoid some of the fiscal uncertainties of defined benefit pension plans, many public employers have adopted defined contribution plans, under which the covered employees' benefits are not specified or promised. Instead, these plans allow their employees to take advantage of strong returns in the equity markets. The employees' benefits at retirement or termination of employment consist of whatever contributions the employer has made to the plan plus the net earnings that those contributions have generated. Perhaps the most popular defined contribution plan that public employers use is a money purchase pension plan, under which the employer is required to contribute a certain percentage of each covered employee's annual compensation, say 10%, to the plan, and each member's ultimate plan benefit is determined solely by the amount of these contributions and the net earnings that they generate over the employee's period of service with that employer.

      Although defined contribution plans enjoyed significant investment gains during much of the 1990s, many of them also suffered significant losses during the 2008 – 2009 melt down. In many cases, the employees' investment return during 2008 was between -25% and -30%. And as many of those employees near retirement age with the highest rate of compensation of their careers and many years of service, they and their employers are faced with the very real possibility that their retirement plan will not provide sufficient funds to sustain them during their retirement years. This is particularly true where the employee has not been participating in the defined contribution plan for a significant number of years (e.g., 25 or more). This problem is exacerbated by the fact that, as state or local employees, they may be entitled to little or no federal Social Security benefits. Thus, just as quickly as such employers abandoned state retirement systems during the good years, they are now looking for ways to make up for the losses suffered during the recent bad years. Of course, with talk of the possibility of a large and sustained bull market in the future, when and if we turn the corner, some employers and younger employees relish the idea of a defined contribution plan.

      Is There A "Just Right?"

      From time to time, these public employers consider whether it makes sense to join (or in some cases, rejoin) their state retirement system. By so doing, they hope to transfer the risk of poor investment results from the employee (under the defined contribution/ money purchase pension plan approach) to the employer (under its defined benefit style retirement system). More importantly, they hope to utilize a defined benefit pension formula to significantly boost the retirement benefits of employees with many years of service but relatively small retirement benefits.

      In California, for instance, such transfers are permitted provided that the covered employees voluntarily elect to transfer all plan assets to CalPERS, and the public employer agrees to make the required contributions. In most cases, employee contributions are also required. However, the cost of transition in required contributions can be prohibitively expensive for the employer since generally it will have to provide the funds not only for the employees' future years of service, but also for each employee's past years of service that have been inadequately funded. This may be due to the transferred assets having been significantly reduced during the recent economic downturn. This "past service liability," which can amount to hundreds of thousands or even millions of dollars even for relatively small employers, must be "amortized" by increased future employer contributions. Since state retirement systems such as CalPERS require this past service liability to be amortized over a relatively short period of time after the transition, the employer's contribution obligation can be increased to prohibitive levels.

      Case Study

      Consider, for example, a small utility district with eight employees and under $500,000 in its money purchase pension plan. The district has considered becoming a contracting agency under CalPERS because its plan had not accumulated sufficient assets to provide an adequate retirement income for 3 very long-term employees who were nearing retirement age. However, when the CalPERS actuary calculated the amount of the required contributions, even after all of the existing plan assets were transferred to CalPERS, the 10% annual employer and 0% annual employee contributions that the district and its employees had been making would be insufficient. The CalPERS cost for benefits would balloon to a 41.4% annual employer and a 7% annual nondeductible employee contribution. In addition, the employer would be limited in its choice among only five permitted benefit formulas and almost no flexibility in such areas as determination of compensation, eligibility requirements, vesting of benefits, etc.

      Because of the prohibitive cost and inflexibility of the CalPERS program, a pension actuary designed a defined benefit pension plan for the district that met the district's cost objectives. The district could afford a 20% annual employer contribution and a 0% annual employee contribution. At the same time it could provide the same benefits that the covered employees would have received under CalPERS!

      Coincidentally, the district's plan would be exempt from the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). This would ensure the plan's tax qualification without complying with many of the Internal Revenue Code's requirements that do not apply to governmental plans and which complicate and burden private sector employer plans. Since most of the tax-qualification prohibitions against discrimination in coverage and benefits do not apply to governmental plans, a customized plan is an ideal vehicle for providing special treatment in terms of immediate eligibility, accelerated vesting, increased contribution levels, increased benefit levels, etc., to targeted employees or groups of employees.

      Other "Just Right" Strategies

      Another reason that public agencies should consider adopting a qualified retirement plan, either instead of CalPERS or in addition to CalPERS, is the fact that these plans can be useful in providing supplemental retirement benefits to a group of key employees. In many cases, a supplemental executive retirement program for certain key employees of a public agency can also be a qualified retirement plan. In contrast, private sector employers must set these up as non-qualified deferred compensation plans. When possible, the agency should use a qualified plan for this purpose since it provides more favorable tax treatment than a non-qualified plan.

      What To Do?

      Any California governmental employer that has the right to choose between the state's retirement system and its own properly-designed plan will, in many instances, come out ahead in terms of cost and flexibility by choosing to adopt its own plan. Thus, if you are currently participating in a state-sponsored retirement system, you need to ask yourself whether you are getting just the right size benefits, for the right cost, from your current retirement plan design and administration. If you are unsure about the answer to this question, you may contact us.