An increasing number of cities, public agencies and special districts are investigating the use of an Internal Revenue Code section 115 trust to help them better manage the short-term costs and long-term liabilities associated with pensions. What is a 115 trust and how does it work?
A 115 trust is a vehicle for segregating agency funds from general assets for the purpose of funding essential governmental functions. For example, a 115 trust can be used to set aside monies to meet future pension contributions or liabilities. Funds placed in a 115 trust are irrevocably committed for the essential government function(s) specified in the applicable trust agreement (e.g., pension obligations). Therefore, the monies held in such trusts can be invested in accordance with the rules governing such special purpose accounts. For example, 115 trust funds dedicated to satisfy pension obligations can be invested in the same manner as funds in a typical pension fund rather than as part of the agency’s general fund. Thus, by setting aside funds in a 115 trust, agencies can potentially earn a higher rate of return on monies set aside for future pension obligations.
A 115 trust can also be used as a rate stabilization fund. Recent changes in rate smoothing strategies by CalPERS have increased volatility in employer contribution rates. Monies set aside in a 115 trust can be used to ease budgetary pressures resulting from unanticipated spikes in employer contribution rates. For example, a CalPERS employer that has extra money after making its current CalPERS contribution might set aside some or all of the surplus to use in future years when the required contribution is less affordable. Why not simply pay the extra money to CalPERS? This is, of course, an option, and the monies will be applied to that agency’s overall liabilities. But many CalPERS employers are not entirely comfortable surrendering their surplus funds to the vagaries of CalPERS investments and funding policies.
In addition, funds in a 115 trust can be applied to pay down specific portions of an agency’s CalPERS liabilities. For example, with the permission of CalPERS, it is possible to use 115 trust funds to pay down the agency’s unfunded actuarial accrued liability – that is, the typically large portion of CalPERS liability that represents unfunded benefits for past service that has consistently increased due to improvements in mortality and underperformance of investments. This may make sense if an agency’s projected cost of paying off such liability is much larger than its normal cost (i.e., the cost for the current year’s benefit accruals). An agency wishing to pay down specific portions of its overall CalPERS liability should obtain help from an outside actuary and may want the advice of outside benefits counsel.
A number of providers offer a “pre-packaged” 115 trust for these purposes. You should carefully evaluate what you’re getting and what you’re paying. At a basic level, most such providers will give you a template 115 trust along with an IRS private letter ruling that was obtained for another taxpayer. Although a PLR is a valuable assurance that the language of the trust will work for this purpose, it is important to note that any PLR issued can only be relied upon by the taxpayer(s) who originally applied for and received the PLR. Your fee arrangement is also important. Many 115 trust providers will charge an ongoing fee (typically, a percentage of trust assets) for use of their documents and arrangement. Much of this is to reimburse them for their upfront cost of drafting the trust and obtaining the PLR. Obtaining your own PLR and trust can be expensive (likely in excess of $25,000). However, if your provider is charging a number of basis points on trust assets as its fee, you need to analyze whether you may be overpaying (over time) for the services provided. You can do the math.