Chapter 29: The “Misunderstood” Group Variable Annuity Contract

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.

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Chapter 28: Why Cashing Out PTO Next Year Doesn’t Work

Our efforts to educate employers about the dangers and surprises associated with PTO cash‑outs (see, Chapter 13 and “When Having Your Cake and Eating It May Be a Bad Thing: Cautions About Cash-Outs of Unused Leave Or PTO”) are having an effect. Unfortunately, some of the changes and adaptations to MOUs regarding PTO cash-outs simply do not go far enough.

One of the newer “variations” that we have come across gives employees that have already accrued a certain amount of PTO the right to make an irrevocable election in calendar year 1 to receive a cash-out of a portion of their already accrued PTO as of the beginning of calendar year 2. For example, an employee who has already accrued 120 hours of PTO has the right prior to the end of this year to elect to receive a cash-out of up to 60 of those hours, which will not be paid until the beginning of next year.

Presumably the “thinking” behind this variation is that the employee must make an irrevocable election to receive additional compensation (or not to receive it) in the year prior to the year of actual receipt – and that this timing rule somehow avoids application of the “constructive receipt” doctrine. In our view, it doesn’t.

The reason it doesn’t work to prevent the employees who have the election from being taxable in   year 2 is because the employees have already accrued or earned the PTO that is being cashed out. The consequence is that the employees are being given the absolute right to decide this year whether they will receive additional cash early next year. Yes, the fact that they cannot receive the cash-out this year will prevent the money from being taxed this year, but it will not keep the amount subject to the election from being taxable in year 2. Therefore, all employees who are given the election will have additional taxable income in year 2 even though they do not elect to cash out anything.

So, what’s still missing? In order for the above scenario to turn out correctly, the irrevocable election in calendar year 1 to cash out PTO must be made with respect to PTO that has not yet been earned and which will be earned in calendar year 2 or years into the future. Because the employee does not know whether he or she will earn a specific amount of PTO as of the beginning of year 2, the policy will have to be adapted to account for rates of accrual and the chance that the employee may leave early or not earn the PTO he or she elected to cash out.

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Chapter 27: Do You Have a Proper Cafeteria Plan?

The recent Ninth Circuit decision in Flores v. City of San Gabriel focused on the circumstances under which the value of certain non-cash-wage benefits (such as those provided under “cash-in-lieu” programs or cafeteria plans) must be included in the determination of FLSA overtime wages. We thought that many public agencies would be asking us about whether their cafeteria plans met the “bona fide plan” exception mentioned in the case. However, we were surprised to learn that quite a large number of public agencies still do not have a proper cafeteria plan document even though they maintain “cash-in-lieu” arrangements or benefit programs that operate as nontaxable cafeteria plans. In order to avoid the risk that the IRS might take the position that your cafeteria plan does not have the required “written plan” and that, as a result, your employees are taxable on the amounts that they could have received as wages (even if they selected nontaxable benefits), you should have a cafeteria plan document that satisfies the following requirements:

  1. A specific description of each of the benefits available through the plan;
  2. Rules on participation and requiring that all participants be employees;
  3. Procedures governing employees’ elections under the plan, including the period when elections may be made, the periods with respect to which elections are effective, and providing that elections are irrevocable, except to the extent that the optional change in status rules are included in the cafeteria plan;
  4. How employer contributions may be made under the plan;
  5. The maximum amount of employer contributions available to any employee through the plan, by stating the maximum amount of elective contributions available to any employee through the plan, expressed as a maximum dollar amount or a maximum percentage of compensation or the method for determining the maximum dollar amount;
  6. The plan year;
  7. If the plan offers paid time off, the required ordering rule for the use of nonelective and elective paid time off;
  8. If the plan includes flexible spending arrangements (FSAs), the plan’s provisions complying with any additional requirements for those FSAs;
  9. If the plan includes a grace period, the plan’s provisions complying with the grace period requirements; and
  10. If the plan includes distributions from a health FSA to employees’ HSAs, the plan’s provisions complying with the applicable requirements.
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Chapter 26: Controlling Retiree Health Costs: I’ve Got Some Bad News And Some Not So Bad News…

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.

[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,

[iv] Id.

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Chapter 25: The Salary Continuation Trap

We often are asked to review the tax and employee benefits provisions of employment agreements between public agencies and their key executives. Because we recently have come across the same problem in several of these contracts, I decided to share with you what I will refer to as the “salary continuation trap.”

Experienced and capable chief executives can be hard to find, particularly when it comes to leadership positions of a limited duration – such as oversight of a large public works project or filling a key management position on an interim basis. Usually, these contracts provide for a specified term of employment, which invariably gets modified and extended. They also often contain provisions that allow the executive or the agency to cut short or terminate the agreement in certain cases. Under the circumstances, it is understandable that the executive would want the agreement to contain protections against the premature or unanticipated termination of the contract by the hiring agency.

Sometimes these protective provisions take the form of “severance pay benefits” that provide for the payment of additional monies to the executive following a unilateral termination of the executive’s employment by the agency without cause. Sometimes they just call for the payment of additional monies. As is explained below, it is important for these payments to be characterized as “severance pay” and not as “deferred compensation.”

If future payments of compensation, provided by a State, local government or tax-exempt entity, fall into the category of deferred compensation, they will be subject to taxation under Internal Revenue Code (IRC) section 457(f). This means that any amounts of compensation that are “deferred” under the agreement – that is, payable in the future – will be taxable as and when they are no longer subject to a substantial risk of forfeiture. In other words, if an executive’s contract provides for the payment of deferred compensation (not severance pay) at a specified time in the future and the executive’s rights to such payments are fully vested, the executive will be taxable at the time his vested rights to such compensation were created (i.e., when the contract was formed) even though he or she may not be entitled to actual payment of the monies until sometime in the future. How’s that for a trap?

In case the nature of the trap was not made clear, I’m talking about the fairly common practice of providing for between six and 24 months of so-called “salary continuation” following the expiration or termination of the executive’s contract. The contracts that we have seen simply provide that upon the expiration or termination of the contract by either party (and for whatever reason), the executive will continue to receive “salary continuation” for the specified period. Unless these payments are properly structured as a “bona fide severance pay plan” under IRC section 457(e)(11) – that is, payable only upon the unanticipated termination of employment – the executive and the agency likely have an income tax (or income tax reporting) problem.

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