Focus On Public Benefits

Group variable annuity contracts are often used to wrap mutual funds to provide greater revenue to plan providers or to provide access to an insurance company’s stable value fund. Every public agency 457(b) plan or 401(a) plan that offers a stable value investment option includes a group variable annuity contract.

Some contracts contain significant “surrender” charges or “back-end loads.” Oftentimes these charges continually renew as new money comes in. Some contracts restrict participant and/or sponsor access to the funds in the event of a contract termination. In many cases, the contract issuer can require a full year’s notice and continuation of the contract before the contract can be surrendered. Because the stable value fund feature of many such contracts guarantees or credits interest at higher than short term interest rates, some contracts contain a “mark-to-market” feature that allows the issuer to pay over the adjusted market value of the fund (a lower amount) rather than the so-called book value – the amount shown on participant statements. All of these fees, restrictions and adjustments can cause significant problems or issues for plan sponsors who wish to leave an insurance company plan provider for another provider. For these reasons, it is important for plan sponsors and plan committees to know whether their plans are subject to such a contract and what the contract says.

Often a prospective record keeper or investment provider will offer to pay and “finance” any surrender charges or back-end loads that may be incurred by reason of a record keeper transition. Special care must be given to these types of arrangements because the Internal Revenue Service has issued guidance indicating that such payments will generally be treated as additional employer contributions. Unless certain precautions are taken, most plan documents would require that any such payments be allocated to participants based on relative compensation – not based on the actual surrender charges assessed to them.

Because group annuity contracts are generally regulated by State insurance law, the issuers may have less flexibility to modify or change the terms of a contract. That is why it is important for plan sponsors and plan fiduciaries to fully understand the terms of their group annuity contracts. Don’t wait to review your contract until after you have sent a notice of termination to your current provider.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the website. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or e-mail us at jcc@seethebenefits.com.

Originally published in “The Public Retirement Journal,” March-April 2016, and reprinted with permission.

So, here’s the bad news. Governor Jerry Brown referred to the State’s grossly underfunded pension and retiree health obligations in his 2016 State of the State address as “liabilities…so massive that it is tempting to ignore them.” The State’s unfunded retiree health obligation (well in excess of $65 billion) has now surpassed its unfunded pension obligations – and, more importantly, there is no statutory or administrative construct in place (like CalPERS) to force State agencies, cities and local governments to properly fund for these growing obligations. Sure, GASB 45 now forces government to “account for” these liabilities to acknowledge that they really exist; however, it does not by itself mandate funding of these obligations or efforts to control future costs.

None of this is really “new” news. Most of us have seen this coming for some time now. So, what’s the “not so bad news”? Depending on whether you are wearing the hat of someone charged with the responsibility of controlling these liabilities and costs, someone who may be adversely affected by a future reduction in retiree health benefits, or both, the not so bad news is that State agencies, cities and local governments have the tools needed to begin to control retiree health care costs and unfunded liabilities. The real question is whether they have the political skill and will to use them.

In the simplest terms, California law regarding “vested rights” of public employees does not protect retiree health benefits to the same extent that it currently protects pension benefits. With respect to public pension benefits, the courts judicially “imply” a contract (or a vested right) that generally arises when an individual is first hired, which prevents the employer/public agency from reducing or adversely modifying pension benefits unless the employer provides a simultaneous enhancement of pension benefits that is of comparable value. Not so with respect to retiree health benefits. Instead, the California courts recognize that public employers may, if they choose, provide their employees with vested rights to retiree health benefits; however, the extent to which they are protected or vested is strictly a matter of contract law. In other words, the courts have not inferred or presumed some immutable right arising upon hire, as they have in the pension arena.

Of course, things are never so simple. Contracts can be “expressed” – where the terms of the agreement are clearly determined from the written words of the contract, or they can be “implied” – where some or all of the terms of the agreement may be based on the conduct of the parties and, in some cases, relevant written communications outside of the contract.

There have been a number of significant court cases dealing with the rights of California public employees to vested retiree health benefits, most notably the series of federal and California rulings involving the dispute between the retired employees of Orange County and the County of Orange[i] that took over six years to resolve (REOC) and the intervening rulings involving the City of Redding[ii] (Redding). Without going into all of the messy details of these cases (something lawyers love to do), here are the major takeaways from REOC and Redding:

• It is possible for public employees in California to obtain “vested” rights in their retiree health benefits.

• Whether and when retiree health benefits become vested and protected against unilateral modification is a matter of “contractual analysis.” That is, what did the parties negotiate and agree upon?

• A right to vested retiree health can arise by either implied or express contract.

• In analyzing whether there is an express or implied contract to provide vested retiree health benefits, the courts will look at the employer’s legislative acts (i.e., resolutions, ordinances, and approved MOUs). If the parties’ intent to confer a contractual right to retiree health benefits is not explicit, the party asserting the right (i.e., the retirees) has a heavy burden to overcome.

• To find a binding obligation to provide permanent retiree health benefits, the courts will look for resolutions, ordinances, or approved MOUs that:

Explicitly provide for health benefits in perpetuity;

Guarantee that the level of benefits will continue; and

Indicate that the benefit is a continuing obligation.

• A long-term practice of providing a retiree health benefit is not, by itself, enough to create a vested retiree health benefit.

• MOU language conferring retiree health benefits upon “each retiree and dependent…currently enrolled and for each retiree in the future” is enough to create vested retiree health benefits – potentially in perpetuity.

Let’s go beyond the legal takeaways and focus on what public employers need to understand about their retiree health benefits and what can be done with them.

• In most cases, California public employers do not have the kind of language in their MOUs that was present in Redding. In other words, very few employers have contractual obligations to provide retiree health benefits beyond the terms of the current MOUs. Start immediately by having legal counsel look at your resolution/ordinance/MOU language.

• Assuming that the employer is not constrained from making changes in existing retiree health benefits (or future retiree health benefits) by the terms of its contracts, there needs to be an honest assessment of:

The current and projected liabilities associated with retiree health, whether these liabilities (and the assumptions underlying them) are realistic, and how important it is for the employer to control overall benefit costs by reducing retiree health benefits.

The changes that might be available to reduce or control retiree health costs and liabilities (e.g., moving away from a defined benefit retiree health system to a defined contribution system that focuses on what employers can afford to contribute).

Whether there are other aspects of employees’ total compensation and benefits that can be negotiated or reduced in lieu of complete or immediate changes to retiree health.

• Once the numbers have been reviewed and the issue of financial “sustainability” has at least been raised, there needs to be political discussion about the willingness of the employer and its governing board/council to take on this issue.

• Again, assuming that there is the need and the will to make changes, there are a number of things that can be done to begin to control these costs and liabilities:

• Even if the employer is a participating employer in CalPERS and subject to the Public Employees Medical and Hospital Care Act (PEMHCA) and its equal contribution rule, there are adjustments that can be made by using rate groups.[iii]

• Apart from the use of rate groups, employers that are subject to PEMHCA may also be able to lower their mandatory equal contribution rate for both active employees and retirees and then make separate subsidies (outside of PEMHCA) through the use of a cafeteria plan for active employees and a health expense reimbursement arrangement for certain retirees.[iv]

• Some employers such as the County of Sacramento have “re-characterized” their retiree health benefit subsidy as an ad hoc benefit that may or may not be conferred on employees. If this is done, there would be no contractual right, but there might be a benefit conferred if there is sufficient room in the budget.

• If things are really bad, there is always bankruptcy. Based on the experiences of Vallejo, Detroit, Stockton and San Bernardino, literally hundreds of millions of dollars in retiree health obligations were eliminated as part of these bankruptcies.

Given the State of California’s law with respect to public employees’ retiree health benefits, there is bound to be continuing discussion and scrutiny as to what if anything can be done, or is being done, to control these multigenerational obligations.

Editor’s Note: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660 or email us at contactus@seethebenefits.com.

[i] See Retired Employees Association Of Orange County, Inc., v. County Of Orange, 742 F. 3d 1137 (9th Cir. 2014) and Retired Emps. Ass’n of Orange County v. County of Orange, 52 Cal. 4th 1171 (Cal. 2011).

[ii] See International Brotherhood Of Electrical Workers, Local 1245, v. City Of Redding, 210 Cal. App. 4th 1114 (Cal. App. 3rd Dist., 2012); petition for review denied, 2013 Cal. LEXIS 462 (Cal. 2013).

[iii] See Chapter 12: When Treating Everyone The Same May Not Work – Working With PEMHCA’s Equal Contribution Rule, http://focusonpublicbenefits.com/?p=322

[iv] Id.

For many American workers, the Old-Age, Survivors, and Disability Insurance (OASDI) program serves as an important component of their retirement savings. This is not necessarily the case for the millions of workers whose State, local government and public agency employers have “opted out” of OASDI’s combined (employer and employee) 12.4% payroll taxes and are instead participating in a Social Security replacement plan (SSRP).  This article provides a brief introduction to such plans.

In a back-handed way, Section 3121(b)(7)(F) of the Internal Revenue Code states that most individuals’ employee services performed for a State, a political subdivision thereof, or of any instrumentality of a State or a wholly owned political subdivision or instrumentality thereof will be subject to OASDI provided that such individuals are not members of a “retirement system” of such State, political subdivision, or instrumentality.  The term “retirement system” is defined in Section 218(b)(4) of the Social Security Act (Act). These are SSRPs.

So, how does a governmental employer determine whether it must participate in OASDI or if it can opt out by providing some or all of its employees with benefits under a SSRP?

Steps for analyzing OASDI coverage:

1. If the employee’s position is covered by an agreement under Section 218 of the Act (Section 218 Agreement) and no exclusion applies, the employee is covered. A Section 218 Agreement is a written agreement in which a State or local government voluntarily agrees to participate in Social Security. Note that once a State or local government agency becomes covered by a Section 218 Agreement, it is not permitted to withdraw or cancel its participation.
2. If the employee’s position is not covered under a Section 218 Agreement and the employee is covered by a SSRP, the employee’s coverage under OASDI is not mandatory – the sponsoring employer can opt out of OASDI.

Based on numerous cases and inquiries involving these issues, we’ve noticed that:

• Many public agencies do not know whether they and their employees are subject to a Section 218 Agreement. To find out, an agency can contact the State Social Security Administrator for its State. A list of State contacts can be found here.
• Many agencies do not understand whether their retirement plans satisfy all of the requirements for being SSRPs. There are different requirements for defined contribution SSRPs and defined benefit SSRPs.
• Many public agencies that use defined contribution SSRPs do not operate or invest them in accordance with applicable IRS guidelines.

In future posts, I’ll address more of the specific problems that can arise with SSRPs.

One of the more compelling recent trends in the world of tax-deferred savings (i.e., 401(k), 403(b) and 457(b) plans) has been the growth in the use of automatic enrollment, or auto-enrollment, features.  In a typical auto-enrollment situation, the employer enrolls the employee without the employee’s consent at a predetermined level of employee contributions and a default investment option. Under applicable rules, employees must be given notice of the arrangement and the ability to “opt-out.” There is a growing body of research pertaining primarily to 401(k)s that strongly suggests that once employees “automatically” set aside part of their wages in their employer-sponsored retirement plan, they will tend to stay the course and continue the savings practice on their own.

So, if auto-enrollment is such a great idea, why isn’t everyone using it? Like so many things, the answer is, “there may be legal problems.”

In the past, the problem with most auto-enrollment features was that many states’ laws restricted or prohibited an employer from deducting amounts from an employee’s paycheck without the employee’s written consent.  For example, California Labor Code section 221 prohibits such unilateral wage reductions and is punishable both as a misdemeanor crime and through civil penalties. This problem of state laws conflicting with what seemed like a good concept was resolved (partially) as part of the Pension Protection Act of 2007 (PPA), which expressly preempted conflicting state laws as they applied to ERISA plans.

So, the state law problem with auto-enrollment was removed for ERISA-covered plans; but not for non-ERISA plans (those maintained by state and local governments, public agencies and most churches).  The non-ERISA plans are still required to comply with state laws that prohibit deducting amounts from an employee’s paycheck without consent. Despite these impediments, we see news reports and studies suggesting a few local governments, at least, have adopted, or are in the process of adopting, auto-enrollment features in their 457(b) plans. The most notable is the City of Los Angeles.

They’re a non-ERISA plan sponsor, so how come they can do it? It appears that L.A. is relying on an exception contained in California Labor Code section 224 that provides that a wage deduction for pension plan contributions should not violate section 221 as long as it is expressly approved in a collective bargaining agreement.  This strategy/technique appears to open the possibility of auto-enrollment to a much larger potential audience including sponsors of non-ERISA plans like state and local governments, public agencies and churches.  Because of the potential criminal and civil penalties, non-ERISA employers in California should get legal advice before adopting such an arrangement.