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Documentation_Pension Public Safety_Tab 22_04/18/2006
I GRS • One Towne Square 248.799.9000 phone Gabriel Roeder Smith & Company .Suite 800 248.799.9020 fax Consultants & Actuaries www.gabrielroeder.com Southfield, MI 48076-3723 March 28, 2006 The enclosed GRS News Scan and Research Ms a°d otheabenefit professionals to inform our c11e Roeder, Smith & Company We -hope you. find our about important events in the benefits ~ rof ssional activities. information clearly written and useful in y p receive our publications. electronically, send an email to ' To ' web.admin;~.gabrielroeder.com with the message "SUBSCRIBE NEWS- SCAN' ublications via email, send the message in the subject line. To stop receiving our p "UNSUBSCRIBE TTEWS SCAN' in the same way. Please turn to our web site at •~^I^x' aabrielroeder.com for other publications related to pensions. and benefits. • Sincerely, ~~ Paul Zorn Director of Governmental Research Enclosures • • March2006* The following news summaries were developed by Gabriel, Roeder, Smith & Company to inform clients and other benefit professionals of news in the benefits industry. Our thanks to Mary Ann Vitale for her. diligent work ` on this issue. Ta receive this -publication electronically, send an email : to web admin(c~aabrielroeder.com with the. message "SUBSCRIBE NEWS .SCAN" in the subject line. To stop- receiving this publication. electronically, send the message "iJNSUBSCRIBE .NEWS SCAN" in the same manner. Copies of this. and other benefit-related publications are available. on the GRS web site. at wLvw Qabrielroeder.com Wisconsin Legislative Council Publishes Public Retirement Systems Study In December 2005, the Wisconsin Legislative. Council. published its "2004 Comparative Study of Major Public Employee Retirement Systems." The biennial survey covers retirement benefits fof general employees and teachers in 85 large public retirement systems. Conducted since 1982, the study provides information about retirement benefits, employer and. employee contributions, actuarial methods and assumptions, plan funding, and other relevant topics. In 2004, the systems covered more than 17.0 million active and retired participants. The number of active • ' i ants ew 2 rcent from 2002 to 2004, while the. number of retirees increased 8 percent for the same panc~ p gr Pe period. The ratio of active members to retirees declined from 2.38 in 2002 to 2.24 in 2004. In 2004, e average funded ratio was 84.8 percent. Funded ratios were distributed as follows: • 11 percent of the plans had funded ratios of 100 percent or more; • 55 percent had funded ratios of 80 to 99 percent; • 26 percent had funded ratios of 60 to 79 percent; • 6 percenthad funded ratios of less than 60 percent; and • 2 percent had funded ratios that were not determined. The study is available on the Wisconsin State Legislature website at: h //wtivw leQis state wi us/lc/~ PUBLICATIONS/Other%20Publications/Reports%20By%20Subiect/Emulo yment%20and%200ccupations/04comparstudy.~ Iowa House Approves Bill to Phase Oat Tales on Social Security and Pensions On January 31, 2006, the Iowa House passed legislation (H.F. 2045) to gradually phase out state income taxes R Jamie Van Fossen (R), on Social Security and retirement income over five years. The bill's sponsor, ep. introduced the legislation to address concerns that elderly residents were being driven out of the state due to income tax on retirement benefits. He introduced similar legislation last year. 'The authors of these news summaries aze not attorneys and. the statements made are not intended as legal advice or opinion. Qualified legal counsel should be consulted to ensure plan provisions and documents comply with applicable laws and regulations. ~ 2006 -Gabriel Roeder Smith & Company rage 1. 3/38/2006 - 'dents have a limited tax exemption on pension and retirement income for the first omco s -Currently, Iowa rest ed filers. Additionally, 50 percent of Social Security be in 2047, an for single filers and first $12,000 -for marri for all. taxpayers. Under H F. 2045, these exe uPd be exempt fio tax. Over~thc next. fouryears, t 6ona120 percent of pension or retirement income wo ear unti12011 when the state tax would be t from tax would. increase 20 percentage points per Y income exemp ion and retirement incomes completely eliminated on pens ' a ers age 65 and so rovides for a broader exemption from mCO a net t income of $36 5000 otr le safor s gle filers and .The bill al P have t nsion and Social older would be exempt from state income tax if they $48,000 or less for married filers. In ,calculating net income, all otherwise tax-exemp Pe Security income would be included. 'slative Fiscal Services Div_ ision, the estimated cost for the state would According to a fiscal note by the Legs _ e first ear of implementation, increasing to about $210 million in lost revenue each year be $18 million in th Y late. after the phase-out was comp searching .for . e at: h ://www.le 's.state.ia.us/as x/CooI-IC is la ]3ills.htm by H.F. 2045 is avuhtil "HF2045 " U.S. Cities Report Fiscal Conditions Improving a e of Cities released the results of its survey, City Fiscal Conditions On January 25, 2006, the National Le gu roved in 2005 for the first time found that, for the majority of cities, fiscal conditionso ~ their .cities'- fiscal conditions in 2005. The. study ercent of surveyed city finance officers rep When only 19 percent since 200E In 2005, 63 p ticall from the 2003 survey, . improved from the previous year. .'This is up drama Y im rovements. During the past year almost 50 percent of U.S. cities ra~see ~26 per n~ s' reported similar p 48 ercent) and increased property eluding increased fees and charges for city services ( P nt of the surveyed officials predicted their. cities ~1~ anarconlcerns ~o~ng to fiscal yeaz 2006, 59 perce meet their financial needs. However, -city officials were cautious due Leal estate cmarlcets. Officials also from slowing ressure on employee about possible property tax revenue declines resulting u ward p identified several factors that could. negatively affect city budgets, including p ublic safety needs, necessary. infrastruct~e ~Provements, and wages,. rising health care costs, increasing p increased pension and benefit costs. data -was based on a 'Lea e's annual survey has been conducted since 1985.. In 2005, th a~ deythat the data should be The 8u o ulations of 10,000 or more. The Leagu s stems and state laws sampling of 276 cities with P P functional responsibility, accounting y considered in light of variations in tax authority, which influence city revenues and expenditures. urve findings are available on the National League of Cities' website at: The s Y ~ iscalcondbrfDS. df h ://www.nlc.or content/Files/RMP Health Insurs-nce Survey of Older Americans in Bab Boomers. Commonwealth Fund released its report Health a° esr50 too64 (i.e.gthe "boomers")' On January 20, 2006, the g older adults g The analysis examined health insuramoderate incomes. The survey found that the health care expenditures of and focused on those with low and Danger adults. aging boomers are more than double those of y • 3/28/200G 2006 -Gabriel Roeder. Smith & Company ...Paget Among the key findings for working older adults: 62 ercent have been .diagnosed with at least one of six chronic medical conditions (such as high • P blood pressure, high cholesterol or arthritis). a 'T'hose with low or 20 percent are uninsured or .have had trouble obtaining medical cove~ag . moderate incomes are significantly less likely t odd tmmeowhen they were uninsured.tTlus~'~ lso those surveyed with incomes under $25,000 rep 000 and $39,999. the case for 33 percent of those with incomes between $25, • 55 ercent of those with individual coverage-spent more than $3,600 per year compared to only 16 P to er- rovided health care coverag percent of those with eirip y P 66 percent are. concerned that they will not be able to afford needed medical caze in the future.' • er risk of experiencing adverse health conditions. Older adults without adequate health insurance have a high nstable health coverage and high out-of-pocket health care costs ma ave for etirement g To address these U the abili of workers to s increasing medical debt,-..and jeopardizing ublic olic solutions: issues, the survey also examined support for several p P Y ablishin .new Medicare savings accounts for long-term caze and other non-covered health care Est g expenses; llowin individuals to enroll in Medicaze before age 65, plus a tax crediabilih Insurancecto be om~e A g eriod for those on Social Security Dis ty • Eliminatingthe two year waiting p eligible for Medicare.: ver 70 ercenf of those surveyed said they would be interested in ~nvo enroll in Med care before ge 65; in a O P Medicare savings account. The same percentage said they would hke t e at: h ://v,~~,~,.cmwf.or usr doc/884 Collins hlt covers e a in bab boomers. f • The study is availabl EBSA Re~'iews SEC. Docu-uents Regarding Conflicts of Interest for Pension Consultants Febru 3, 2006, Assistant Secretary of Labor Ann L. Combs relee seardtment of Labor's (DOL) Employee On ~7' NTp, confirming the D p George Miller (D-CA) .and Edward Markey (D- ) _ Benefit Security Administration (EBSA). review of Securities antt~ 1eh onded to the issuessraised bylMiller regazding the fiduciary duties of pension consultants. Combs P and Mazkey on conflicts of interest for pension consultants. d SEC re late pension consultants' activities in accordance with s admienisthering and nforcing The DOL an gu definitions, authorities and sanctions. EBSA is.the DOLct geRISA) ~° conjunction with the IRS .and PBGC. Title I of the Employee Retirement Income Security ~ laws such as the Investment Advisers Act of The SEC is responsible for administering and enforcing security 1940 (Advisers Act). e letter Combs explained the different fiduciary definitions under the Advisers Act. and ERISA. She ~ th ension consultant who is a registered investment adviser is clarified that under .the Advisers Act, a P under ERISA. considered a fiduciary, but may not be a fiduciary Title I of ERISA specifies that benefit plan fiduciaries must act predanerson to beta Among other provisions, in the interest of the plan's participants. and beneficiaries. Gena tivyties~su h as exercis g discretionary fiduciary to the: extent he or she engages in certain "fiduciary. or control over the management of a plan or its assets, ~thOUave sufficient authority or control over • authority ERISA does not consider registered investment advisers who do not assets to be fiduciaries unless they render investment advice with respect to plan assets for a fee or other plan Page 3 3/28!2006 ~~ 2006 - Gabriel Roeder Smith & Company compensation. She stated that a consultant's .status as a fiduciary depends on the particular facts and circumstance of the case. m interest" and that transactions between a plan -• However, she added that an investment adviser is a "party and a party in interest are prohibited under ERISA except ,under certain specified .circumstances. A plan fiduciary who hires or retains a -service provider must a ease ~atrid ea propriaepservices with reasonable service providers meet ERISA's requirements for n ary P compensation. - Assistant Secretary Combs' letter includes a fact sheet with tips to help plan fiduciaries select and monitor investment advisors and other investment consultants. It is available at: http //mar ev house ¢ovldoes/finan~elDOL%20Resnonse%20Letter%202.1.06.ndf Deficit Reduction Act Increases PBGC Premiums - - On February 8, 2006, President Bush signed the Deficit Reduction Act of 2005 (D1tA). According to the Congressional Budget Office, the Act will reduce direct federal spending by $39 billion over the 2006-2010 period, with over half of the reductions coming from changes to the Medicare and Medicaid programs (S 1.1.2 billion), federal student loan programs ($8.3 billion), and the Pension Benefit Guaranty. Corporation (PBGC) ($3.6 billion). In an effort to ensure the long-term solvency of the PBGC, the Actanucrease~OPB GC premiums for private- sectorpension plans. Effecrive for plan years beginning on or after J ary , The annual flat-rate premium will increase from $19 to $30 per participant for single employer plans and from $2.60 to $8.00 per participant for multiemploycr plans; The additional variable rate premium for underfunded pension plans will remain at $9 for every • $1,000 of unfunded vested benefits; and, When a company transfers its underfunded pension plan to the PBGC, a new termination premium of $1,250 per participant will be payable annually for three years after plan termination. Several professionals specializing in private-sector pension plans have cotes Dallas Salisbauryupres de t of the effect on private pension plans. BNA's Pension`these increases,rcombined with changes in the variable rate Employee Benefit Research Institute, as saying included in the new Bush budget, will be wei Benefits Counc 1, said he epected Congress to pass a meore ahead." ,James Klein, president of the American comprehensive bill that would supersede the PBGC provisions in the DRA. - Source: BNA Pension & Benefits Reporter, February 14, 2006. C:RS Updates Social Security Reform Issue Brief On January 23, 2006, the Congressional Research Service updated its Sociaarlid the Bush Admin stration have Congress. According to the report, over the past several months Congress been focusing on budget reconciliation, federal relief foor osal wase S cl 02,athe Stop thettRaid oneSotc a Social Security reform. The most recent legislative p p lus Social Security Security Act. This legislation would establish voluntary personal accounts funded by sure tax revenues -with reductions in traditional Social Security benefits based on the assets accumulated in the personal accounts. Other Social Security reform proposals included iii the report were: - - Bipartisan Retirement Security Act -creating mandatory individual accounts funded by payroll taxes • - and modifying traditional Social Security benefits. Pace 4 3/2$12006 ©2006 -Gabriel Roeder Smitii & Company b - Individual Social Security Investment Program -creating voluntary personal- investment. accounts financed by redirecting payroll taxes and modifying traditional Social Security benefits. - Social Security Forever-Act -requiring workers and employers to contribute 3 percent of earnings - the a as- ou-ore uirement under the Balanced • above the taxable wage. base 'and extending P Y- Y 8 . q Budget and Emergency Deficit Control Act. «GROW 'accounts for workers born - Growing Real Ownership for Workers Act - to create voluntary after 1949 and applying surplus Social Security revenue to the accounts. Source: BNA Pension & Benefits Reporter,. February 14, 2006. Seventh Circuit Rejects Retirees' Claim to.Trial on Lifet'une Health Benefits On February 8, 2006, the U.S. Court of Appeals for the Seventh Circuit ruled that retirees of the Ameren Corporation were unable to show that a "patent or lateenefi bi8~i so doingathe appeals lcourt ~affirmeg d ~e agreements that would entitle them to lifetune health b district court's .summary judgment and found that the retirees were not entitled. to a trial on then :claim. (Barnett v. Arneren Corp., 7 Cir., No. OS-1496, 2!8/06). . both of which had a longstanding practice Ameren was created in 1997 through the merger of two companies, ute existed at both companies, of providing health benefits to retirees. For at least a decade, an ongoing disp with management. claiming the right to change or terminate health care benefits and retirees claiming them as lifetime benefits. While some changes were made to retiree health benefits before 2003, the changes did not provoke a lawsuit. . In 2003, however, retirees sued when Ameren announced they. would have to Pae t2hse retirees aclrnowledged insurance premiums and 50 percent of then dependent s premiums by 2009. W~l r they :claimed the the governing bargaining agreement did not unambiguously create a lifetime benefit, • agreement had "patent and latent ambiguities" that would entitle them to a trial on their claim. The retirees argued that a patent ambiguity existed in a 1993 Stipul d othat for~1995 and "all subsequent y a °' retirees "vested service" to be eligible for retiree health care an would be required. to pay 20% of the monthly ~e a meementpprovidedf other. benefits that had not been argued that a latent ambiguity existed because gr changed by Ameren. After hearing the arguments,. the District Court for the Southern Distract of Alinois found no ambiguities and granted summary judgment to Ameren. In reviewing the- case, the appeals court noted that the 1993 Stipulation was. foaction as ma be necetssary to Supplementary Agreement (SA) providing that the company would take such. Y modify and to continue for the life of-the on° removin referencets toe`the yearr1995 and all subsequent Moreover, the SA rephrased the benefit provisi 8 . years." Given that the SA allowed the company to change or terminate the benefits, the appeals court ruled that the benefits were not vested. The appeals court also rejected the retirees' claim of latent ambiguity, holding that health benefits do not vest simply because a company had not reduced them in the past. The decision is available at: httu //caselaw lp findlaw com/data~/cires/7th/451496n.vdf Colorado Senator Introduces PERa Reform Legislation On Jan 31, 2006, Colorado Senator David Owen introduced Senate Bill 06-162 to lifWrm the ~rtea by ~' Public Employees' Retirement Association (PE}tA). Senator Owen reported that lus P the governor and state treasurer and would reduce PERA's $11 billion shortfall more rapidly. than the-other proposed legislation. Under SB 06-162, the'legislative changes would: • page S , 312$12006 ©2006 -Gabriel Roeder Smith & Company • Increase the retirement eligibility age and service requirements f~Ce a ~e65 3,This age ~ld regazdless of age, 30 years of service at age 60, or 5 years of se g 1 2007 also apply to current members under age 40 who aze not_ vested as of January , • Prevent annual cost-of-living increases in monthly benefits for new-hires unless PE1tA is overfunded • roved b at least two-thirds of the board. and the increase is app Y • Allow new hires to join a defined contributiori plan rather than the defined benefit plan. • Replace the 16-member board of trustees with an 11-memdb~ PERA ~ tuber and retireescand four the state auditor, the state treasurer, five members elect y members appointed by the governor. • Require PERA to hire an internal auditor. • Require the state attorney general, rather than in-house counsel, to provide legal advice to the boazd. SB 06-162 has been assigned to the Senate State Veterans and Mo ~ 's ation/20061e a latilonlstmailable by _-_~vera/a~ selecting "Senate Bi1106-162" at: httU //www ~~-~~° or° Colorado PERA Proposes Pension Reform Package the Colorado Public Employees' Retirement Association (PERA) proposed a package of In late 2005, artici ants-while improving the actuarial legislative reforms intended to protect the benefits of c ~S~ pfor current (`"Tier 1'~ members and create a soundness of the fund. The proposal would limit sp second tier ("Tier 2''') defined benefit plan for employees hired on or after January 1, 2007. r current articipants, retirement benefits aze calculated as 2.5 percent o0 o~ewould lmmutSaspiking~bY Fo P ears of salary.. Th P P times years of service, with HAS based on three Y tightening the limit on salary increases included in HAS. This change would be effective for benefits on or after January 1, 2009. •For new articipants hired after December 31, 2006, Tier 2 refuueo enthere would belno guazlant edc o -of- P In adds , percent of HAS, with HAS based on five years of salary. rcent living increases after retirement, unlike. Tier 1 ~'~' Zazwould be 7 percen of pay,~compazednwieth 8 Pee' nt for COLA. Moreover, employee contributions for Tie Tier 1. Also, for current FERA members under age 45 and for new members, the proposal would linut PERA's subsidy for retiree health premiums. 2006 Colorado Senator Paula Sandoval introduced pension reform to V tetrans (and Military On February 6, , containing many of PERA's provisions. The bill has been assigned to the Senate St Affairs Committee and can be found at: h ://www.co era.or era/about/le 'slation/20061e islation.stm by selecting "Senate Bi1106-174." -Bush Administration Proposes HSA Policy Initiatise in Fiscal Yes~r 2007 Budget On Febru 6, 2006, in his budget proposal for fiscal year 2007, P ealth careucos s and reduce the number of az5' to expand health savings accounts (HSAs) as a way to constrain uninsured. HSAs are designed to help individuals save for heal~~s exThe estimated cost of the new HSA savings accounts combined with high-deductible health plans ( ) .incentive would be $156.1 bilfion over 10 years. The proposal would: • ise the maximum annual HSA contribution to equal the out-of-pocket limit for the participants' ~ this would increase the maximum. amount contributed to a health HDHP. If implemented in 2006, savings account from $2,700 to $5,250 for individual coverage and from $5,450 to $10,500 for fame y • coverage; ~' - .Prorate the maximum HSA contribution based on the number of months the individual is eligible for HDHP coverage; " Page 6 3/28/2006. ` C~ 2000 -Gabriel Roeder Smith & Company • Allow a refundable tax credit for a portion of after-tax contributions made to an HSA. The tax credit would be the lesser of -15.3 percent of a taxpayer's after-tax contribution to the HSA or 15.3 percent of wages subject to employment taz~s. The purpose of the tax credit would be to offset employment i taxes on the HSA contributions; • Provide a tax deduction applicable to the premium costs for the HDHP. The proposal also includes a modified tax credit for low- and moderate-income taxpayers. While a previously proposed low-income tax credit would have applied to a broader range of health insurance :products, the _ current proposal would only apply to HSA-eligible HDHPs. The proposed maximum credit would be $1,000,' for individual coverage and $3,000 -for family coverage, up to 90 percent of the HDHP's premium (and further limited-based on the-individual's annual income). One-third of the credit could be used. to fund the HSA and the rest topay the insurance premiums. Currently, the insurance industry. estimates about 3 million people are enrolled in HSA-compatible HDHPs. According to the Administration, nearly 37 percent of thosewere purchased by people who were previously uninsured. -The Administration predicts that with the proposed policy changes, 21 million HSAs will exist by 2010, compared with, l4 million HSAs otherwise. Source: BNA Pension & Benefits Reporter, February 14, 2006. GASB .Announces New Pension Research Project In January 2006, the Governmental Accounting Standards Board (GASB) added a new project to its re§eazch agenda. Responding. to concerns. about the funded status of state and local .pension plans, the project is intended to open. up a broad discussion .regarding accounting and financial reporting for governmental retirement benefits,. Specifically, the project is designed to review GASB Statement. No. 27, Accounting for • Pensions, by State and Local Governmental Employers, regarding its usefulness for: • Assessing the financial implications of governmental pension benefits and of managerial decisions regazding those benefits; and • Making decisions about the value of benefits, proposed changes in benefits, and funding of benefits. Although not discussed in the project description, the project will likely examine pension accounting issues currently under review by the Financial Accounting Standards Board (FASB), including: the appropriateness of asset smoothing methods, selection of actuarial assumptions, and inclusion of the unfunded actuarial liability on the face of the financial statements. In conducting the study, the GASB will request comments from government officials, retirement system boards and staff, plan members, actuaries, auditors, bond analysts, investors, and taxpayers. The GASB expects that conclusions drawn from this project would also be applicable to other postemployment benefits. The project is described in the GASB's First-Third 2006 Technical Plan and is scheduled to continue through December 2007. The Technical Plan is available at: http://www.gasb.or tech/techplan.pdf • 3/28/Z006 ©20116 -Gabriel Roeder Smith & Company Page 7 Gard Roeder smith & company Research connrlta~ 6c nauaries Memoxandum RE: Methods-for Stabilizing Public Retirement Plan Contribution Rates FROM: Paul Zom and Brian Murphy. DATE: March 28, 2006 A major goal in actuarially funding a retirement plan is to accumulate monies in a systematic manner so that contribution rates remain reasonably stable and the funds can earn long-term investment returns.. Stable contribution rates are an important component in funding retirement plans, since they ,help governments budget effectively for plan contributions. BACKGROUND l:n the early years of state and local.retirementplan.development, asset levels were very low, and investment volatility did not affect contribution rates to any great extent. During those years, it was common for plans to invest funds very conservatively, principally in government bonds or other Iugh,quality fixed .income instnunents. Investment return assumptions w,,ere low, perhaps in the 2% to 4% range, and contribution rates were high, but relatively stable. As time passed, asset levels grew and investment practices changed with a higher: portion of assets. being placed in common stocks.. Accordingly,. asset allocations became more aggressive and investment return assumptions rose to the 7% to 9% range .Contribution rates dropped remarkably but, as asset levels grew, the rates became more volatile.. During the 1980s and 1990s, contribution rate volatility was not seen as a problem since strong investment returns meant contribution rates were falling. Serious up-side volatility in contribution rates became an issue following the poor equity returns that affected most investors from 2000 • through 2002. When plan sponsors moved heavily into common stock investments and increased assumed rates of return, they were making a fundamental trade-off: low but stable investment returns were exchanged for higher but more volatile returns. Unfortunately, because the tradeoff was made gradually over time, the volatility tffect was not immediately apparent. It now seems unlikely that many pension plan sponsors will want to .reverse the trade by moving away from common stocks and lowering the assumed investment return rate to 4% or 5%. Doing so would help stabilize employer contribution rates, but would require a major contribution rate increase or a major decrease in retirement system benefits, or both. Moreover; it would also sacrifice some of the higher returns that are believed to be available in the equity maikets, even when measured on a risk- . adjusted basis. Given that the tradeoff is not likely to be reversed, ,what can be done to stabilize contribution rates? To mitigate the effects of .short-term investment fluctuations on contribution rates, actuaries currently use a number of techniques, such as asset smoothing and amortizing unfunded actuarial gains and losses over long periods. These methods have worked well for most of the past 25 years when significant declines in investment returns have been relatively short-lived. For most of those years, investment volatility was largely on the up side, and was viewed as good news.' Pension contributions could be reduced or benefits increased, or (in some cases) both.. Some employer contribution rates went to unnaturally low levels, below the plan's ~ During the 1980s and 1990s, state and local governments benefited substantially from funding their retirement plans. According to the U.S. Census Bureau, public-sector retirement plan investment earnings totaled $1.65. trillion from 1981 to 1999, or approximately two-thirds of all plan receipts. As a result, the funded ratios of public plans grew from an average of 81% in 1990 to 104% in 2000; and employer contributions rates declined from an average of 14.4% of payroll to 10.6%, as shown in Public Pension_Coordinating Council surveys. ®Gabriel Roeder Smith & Company Page 1 3/28/06 - . a oll, 5 exam le, in one plan with a normal cost rate of 25 % of p Yr e em foyer contribution rate to be reduced to 2% of payroll. rural cost" rate? As a somewhat extreme P ~gh funded ratio permitted th P ,r event in 2002 was a shock to financial markets .and an ~~ stocks fell approximately 43%, the ..The stock market decline from 2000 through far a company ent losses, higher Over those three years, the value of U.S. g fuses that were built U.S. history. • ~ decline since the Great Depression. Because of the investor 9~d ~ fund retirement plans. In particular, asset sure largest and most sustain a result, pension plans that. had taken contribanuU~'oge employer contributions were re ost overnight. As e contribution rate to drop to very low levels were faced with large Per up ut the 1980s and 1990s evaporated slur holidays or had allowed th increases in contribution rates. a roll now requ1feS ~asonable for fan mentioned earlier with°a contrib do istnot ne°cessari y u Under these circumstances, the_p er ear. While a 40 /o contra an employer contribution rate of o 0°of a yoll (especially given• the investment declines u ~ ~ rat button fan's actuarially determined Annual Req a plan whose normal cost a factor of 20 the P or investment results and the need fort luck 2002), it is an orcrease by ovemments, making , ARC). Unfortunately, the same a Teduce tax revenues for state and local g pension contributions also tend to come up with the higher contn'butions. ~ al smoothing ,methods may traditional actuari from being ficant and prolonged investment decline occurs, articularly if a plan is moving When a signi contribution rates - P ernselves, be sufficient to sta~btltze rder to help governments stabilize ethods,uas discussed in this not, by th ,. •~derfunded. In ° ate the large "overfunded t0 being additional ,stabilization m and other retirement plan professionals are studying techniQue would be able. t meet th~GASB's related While it is unlikely that any smoothing and simultaneously memorandum. of this decade ( . investment losses tha4 ~~ adre several mS~u'°~ that can help. accounting standards ), FOR EVAI,pATING CON.I.~B~'iON STABILIZATION METHODS • CRITERIA es. In order to make an in advantages and disadvantag have vary g ainst relevant criteria. These include: Different contribution stabilo~~ t mo ° aze ore p~oular methods ag informed decision, it is imp 'button rates that aze predictable and stable from year to Stability: Does the method produce contra d the promised year? ~ show for contribution, rates that aze sufficient to fun Sufficiency: Does the meth ded actuarial liabilities benefits? - contribution rates amortize th ratan] f ins? GASB Compliance: Will the resulting standaz.~ for governor P er nor lower than the riod allowed under the accounting within Pe roduce contribution rates that are neither hi pptimum Rates: Does the method p financial over along-term Period? necessary s the method produce contribution rates and other underlying Reasonable Results: Doe measures that appeaz reasonable to objective observers? f benefits earned by plan members as a result of members' service to the ~ A pension plan's "normal. cost" is the cost o s, it is r during the cuaent year.. ded" and "underfunded" aze used f ~n~'investmentedeclinet>llusditratc P~ employe a er, the terms overfuii 3 Throughout this P P fan liabilities, respectively. As the re ater than or less than p ater than liabilities to bbe`o~a ~nded°, a yew ~m now assets that are gre P with assets that aze ~ ded" today may inaccurate to consider retirem Shift ddenly. p- plan that is "overfiui could exceed the assets" since asset values may ~ or<s could show and vice versa. a eriod used to amortize the plan's anfunded actuarialloacems financ ~ rep In extreme situations, ~tlie GASB for financial reporting purposes. If so, the emp Y • ~cimum established by m the goveminent's financial statements.. page 2 a net pension obligation as a liability • ®Gabriel Roeder Smith & Company 3/28/06 The remainder of this memorandum discusses the advantages and disadvantages of eight methods that. could ~tentially help to stabilize contribution rates. Table icomparesthe- methods with the previously mentioned ~ criteria. • CONTRIBUTION STABILIZATION METHODS Fixed Contribution Rates Probably the most straight-forward approach to stabilizing contribution rates is to set contributions at a fixed percent of payroll. Currently, this approach is followed by several state and local retirement systems, where .employer and (often employee) contribution rates are legislatively fixed at a given percent of payroll. In order to maintain contributions that are sufficient to fund the plan, actuarial valuations allow the_amortization period to .vary, up to the maximum amortization period established by the Governmental. Accounting d GASB tandards Boar ( ) s .The advantage of a fixed contribution rate is that it is dv~ 18~ is that the fixed rate probably cannot be contributions in most, .but not all,.circumstanees., One d>sa g set at a level that factors in the risks of extreme market declines. If these risks are not factored in, investment declines, like those from 2000 through 2002, could cause the plan's funded .ratio to fall and thereby increase actuarially determined contributions. If the. actual contributions are not adjusted to -equal the actuarially .determined contributions, the result could be an additional accounting liability for the employer. Perhaps a fixed contribution rate could be set at a level that factors in the risk of e~t ~ e k~ ~ly ~~ able so, there would be less need to change the rate, but its level might be too high Po given the fiscal pressures governments typically face. While there may be jurisdictions in which such a solution would work, it might be impossible in other jurisdictions. . Limiting Annual Changes in Contribution Rates Another method for limiting fluctuations in employer contributions is to limit the annual change in contribution rates, either by legislation or through the rete m waiild t covide that con ~bution rates cou d approach, state statutes (or local. ordinances, plan. provisions, ) P not increase by more than a specific amount (e.g., one-half of one percent) from one year to the next. The advantage of this approach is that contribution ratesdVanan~ eas than thenlimited contribution rate canhange slowly accommodate. changing circumstances. The disc g could be less than the actuarially determined rate, possibly requiring ev6 n larger future increases in employer contributions, and possibly producing an additional accounting liability. Funding Corridors Under this approach, employer contribution rates remain fixed while the plan's funded ratio is within an established range,' and change when the ratio falls outside of the range. For example, employer contributions could be fixed while the plan's funded ratio is between 90% and 110%. However, if the ratio falls below 90% (or above 110%), the contribution rate is adjusted to amortize the underfunded (or overfunded) liabilities over a set period (e.g., 30 years). A plan could also use multiple corridors in order to amortize the liabilities over different periods.. In the above example, if the plan's funded ratio fell below 80%, the unfunded actuarial liabilities might be amortized over 20 years. s An asset-liability study that forecasts the effects of projected future investment returns. on plan contributions would be • helpful for setting optimal fixed contribution rates in light of investment volatility: 6 See footnote 4. • page 3 3/28/06 ®Gabriel Roeder Smith & Company ' a roach is that it stabilizes contribution rates while allowing adjustments that reflect The advantage of this pp d against plan underfunding or overfunding. the plan's funded. status. Consequently, it helps to g~ ince the contribution rate is changed to reflect current circumstances; tt is unlikely baste on what .Moreover, s term. gowever, unless the contribution rate is initially be set too high or too low over the long corridor, an additional accounting liability could be created. would be required at the low end of the funding ht re ire a sharp adjustment when the comdor boundary is A disadvantage is that the contribution rate mig very low (e g , 70%) significant unfunded liabilities `could crossed. For example, if 'the lower boundary ded liabilities would likely result in a build up before it is reached. Once crossed, the amorh?ation of t not be possible to achieve. sharp increase in the. employer's contributions, which migh Asset Value Corridors - Asset smoothing is used in the laps to reduce the effect of yeaz-to-yeaz mvestment Another corridor approach is used d local 1e= amen P asset smoothing. and losses in the year actuarial valuations of many state an zin all investment gains fluctuations on employer contribution rates. Instead of recogni g duall ically over athree- to five-year us annual gains and losses gra Y~ tYP they occur, asset smoothing recogni riod, thus dintintshmg the effect of market fluctuations on contribution rates. pe effectivel for -most of the last 25 years. However, when large investment has worked Y ° st cantlY Asset smoothing rolonged period,-the smoothed value of assets can diverg gnifi declines (or -increases) occur over a p ant of. smoothed and market asset values, below from the market value. To protect against the misalignm orridor may be established. For example, the smoothed -value could be prevented from gonag value c 90% or above 110% of the market value. roach is that it allows asset smoothing but maintains asset values relatively close to An advantage to this app lan's funded ratio and contribution rate from being based on uentl it revents the p e is that the plan is exposed to market market values. Conseq Y~ p • ,assets values that might be seen as unrealistic. A disadvantag fluctuations when the boundary is crossed. Extending Asset Smoothing .Periods eriod over which extended successive periods of market declines also lengthens the p Asset smoothing during osses are factored into contribution rates. Whilentlusmreduces the volatility of contribution rates, tt crease: Several governments have recently investment 1 also prolongs the period over which employer coitn ~e1OC~ifornia Public Employees' Retirement System extended their asset smoothing periods. For examp ears to 15 years. ~ Moreover,.it widened its (CalpgRS) has lengthened its asset smoothing period from 3 y 'ts for establishing the actuarial value of assets S ~ XOectedOto reduce annuallvolatility in asset comdor lttr-t combined with several other change , P 120% of mazket value. This, employer contributions by more than SO%. sins and e of extending the smoothing period is that smaller portions of annual investment g The advantag s The disadvantage is aze incorporated in the contribution rate. Smcet tha~ed bg prpor mazket upswing extend over at eas~a losses s would be mt g Y full economic cycle, mazket downswing different from the market value, consequently sen g that the smoothed value could become significantly oundtng fundu-B nals about plan funding. For example, when the market value exceeds the smoothed value or conflicting stg an extended period, history shows that pre esurWhenl the mazket valuer ise less than rthe smoothed value for an pressures when markets reverse. Moreov , "March 15, 2005. The other changes ~ CaIPERS Press Release, "CaIPERS Advances Employer Rate Stabilization P an, ear eriod (instead of 10% per year), establishing a minimum include amortizing gains and losses over a rolling 30 y P 'on rate for all employers equal to one-half of normal costs, and establishing "stabilization accounts" to serve • contnbutt - reserve funds. page 4 ® Gabriel Roeder Smith & Company 3/28/06 criticism that reality is being ignored. In this situation, establishing an extended period, there may be the set-value corridor would help to address these issues. Asset Allocations that Min$nize Investment Volatility of this paper. „ eoff' that was discussed at the beginnuig~t to different al step toward undoing the trail Various asset classes are subj. This method is a parti asset allocations do_ not Volatility. in investment return is a function of asset allocations. lan assets can be "matched" es of returns and have different correlatio ~ ~ en volatility ~Mer ~~, P ~ rang the can be used to diminish er contributions. guarantee returns, Y s that further reduce the. volatility of employ with plan liabilities in way ~ ' ' ssibly saving the plan to reduce _ advantage of this approach is that it addresi ~t ~s~`~1~h ~ mat reduce risk are ~lyZlOwer risks An from large- investment losses. A disadvantage ~ to the allocation may tion needs to be reconsidered. return. However, if the current alloca h is taken, themves~ent return effects of asset allocation changes on while increasing returns. If this app a' an asset-liability study wouldbe helpful for examining the Y , Ag i-, investment returns. nkin Emp1oY~ Contributions to the Plan's Financial Position Li 8 e with,the . ution rates are fixed by statute or local ora~ ~ aan11 of the invanestment risk. In most cases, employee contnb to er sponsoring the pl be done. plan's financial status. Consequently, the emp Y e lens adjust employee contribution rates to reflect inv u tine ~n~ utions fo th`e Yeaz (ag., However, som P ercentage of req either by requiritg emPlOYu contributions to b dui ad ustments. 40% of the normal cost), or by making more gra ach is that it distributes the cost of the ~ane~Thisclowers the average costto • An advantage of this appro population, .including those who duectly benefit from the retiremen p taxpayers (although increasing it for plan members). ected financial to ee contribution rates may result in unexp ~ employee One disadvantage is that large increases in emp Y increases to compensate. Moreover, fences, pressure on active employees, who may then call for salary to went. In these circums they. may .act as a disincentive. for emp Y contribution rates aze already ~'~cting and retaining qualified employees. the employer may have difficulty Linking Retirement Benefits to the Plan's Financial Position is to link retirement benefit „kith plan members the costs of investment volatility rovide cost-of--living Another method for sharing state and local retirement plans p adjustments with the plan's financial position. Many rotecting benefits from inflation: In some adjustments (COLAs) to retirees and beneficiaries as a means of P s or aze-made on an ad hoc basis when the cases, these adjustments are liilced to the plan's investment earning ' 'on is 'udged sufficient to finance the COLAs. This allows a portion of the benefits to e plan's financial positi 3 directly related to the fmanc~al health of the plan. roach mightcombine a relatively uld be extended further. For example, a flexible defined benefit app This co 1% of final average salary p~ year of service) with a variable benefit based on aranteed benefit (e.g , roach is currently applied by some state and local low gu !ans. investment. performance or other factors. Tins aPP that have hybrid plans or that combine defined benefit and defined contribution p are shared governments lan's financial position is that the costs of market dec e ~ that if the An advantage of linking benefits to the p artici ants, while also sharing the benefi h~nflationtretirees eand benetfi carieswould likely see with plan p P market decline is prolonged, or comes at a time of g • an erosion of the purchasing Power of plan benefits. Page 5 ® Gabriel Roeder Smith & Company 3128!06 .Stabilization Reserves ~ `~ Some state and local governments maintain pension stabilization reserves in order to supplement government contributions in times of fiscal stress s During times when the government's revenues exceed projections, the ovemrnent would make contributions to the stabili onsn ~~dtabilizaUonofund would be drawn. down to g retirement benefits. When rcvenues fall short of pro~ecti , offset some or all of the government's required retirement plan contributions, ante a of stabilization reserves is :that they.. allow governments to set aside funds during good An adv g economic times when government revenues exceedanex~ec ~ ~t Mess therfunds a~ held forf the exclus~ ive in establishing thc fund and its reserves. A dtsad g purpose of stabilizing employer contributions, they may be used for other. purposes. -Some state laws. may also restrict the investment of such reserves, causinganth~ eto~e~tr~~e~ay b~II~t~ultrtol build s~~ ~t earned by the plan's investments. Another disad g stabilization reserves in the first place. There is often pressure to put the funds to "better use" elsewhere. CONCLUSIONS tment declines that occurred from 2000 through 2002 put signify erred at aotime whendmany The roves governments to inciease their retirement plan contribution rates. s PP ovemments weze facing significant additional fiscal stress. C~tribut on rafts, additional efforts are~°°r"' g to er in place to .mitigate short-term fluctuations in emp Y underway to address the effects of larger and longer-term market shocks. memorandum addresses several such methods that may be used d end on the individual Circumstances This advantages and disadvantages, and the extent to which of techni Vues based on the plan's specific situation. • of the plan. The best approach would be to use a variety q a lar er erspective, there are general guidelines that will help ensure a stable and well-funded From g P retirement plan. Plan sponsors and their advisor~eS are badothe plan willhave surplusescthat an be used excessively when times are good. That way, when to dampen the need for increases in contribution rates. In addition, labor groups and their ;~reseDSOrs to should understand the risks associated with pension funding. They can help by encouraging p spo with their membership to encourage sound plan design and fund the plan appropriately and by working reasonable benefit levels. Overall, a .balanced approach should be applied, even though it may take considerable discipline. s Care should be taken to establish the reserve in a wa~that fe h-e Tteserved assetsoare held within the pension htrust, they same time accounts for them outside of the pennon oses. This might undermine the purpose of holding them m • could be considered pension assets for valuation pure reserve. page 6 3/28/06 ~ ®Gabriel Roeder Smith & Company Table l: Comparison of Contribution Rate Stabilization Methods In extreme Rate Could be May not situations, too low or too Generally not Stable by incorporate risks amortization high; responsive to definition.. of extreme market periods may assetAiability extreme dedines: exceed GASB study would be situations. re uirements. useful. In extreme Stable, with May not s sftuations, Allows for slow Generally slow measured incorporate risk amortization adjustments in to respond to changes. of extreme market periods may rates... extreme . declines. exceed GASB . situations. uirements. Can. be set to Rate could be Sudden Allows for ensure too low or too adjustment Stable until contribution rate compliance with -high; when corridor coRidor boundary adjustment when _ GASB asset/liability boundary is is reached. boundary is amortization study would be reached may reached. period ' useful generate re uirements. concern. Rates vary from Compliance with Possible year to year but Contribution rates GASB Contribution misalignment of impact of would reflect amortization rates would vary smoothed and investment volatility benefit requirements. period as necessary. market asset dam ned. requirements. values. If equity Effort to May help to Shift from equities investment dampen stabilize to fixed income This approach return is greater volatility contributions by investments would would not affect than risk .addresses dampening ~~~-~ likely increase GASB contributions fundamental ~ _ investment contributions. compliance. would be higher cause of - volatility. than. necessary. contribution fluctuations. Volatility shared Extreme with plan Contribution rates This approach Contribution situations may members; may ~. ~ ~ £~~, .reduce upward would reflect benefit would not affect GASB rates would vary e require large. "~ i as nec ssary:. contributions ,, pressure on requirements. compl ance. from members. ~~' benefits. Lin k(ri` Rate increases 61:lr~rlio Contribution rates This approach Contribution Extreme situations.may .~ ,„ mitigated through $enofll's ~ ~ would reflect would not affect rates would vary result in partially variable benefits. benefd requirements. GASB compliance. as necessary. significant benefit loss. Stab(I~tidr<- ;, If reserves are 12eserve's - • ~ ~ Stability would Sufficiency would held in the pension trust, they Funds held Political support ~~ ti ~[ z .~- depend on depend on could be outside the pension trust required to maintain S x - accumulated ~ ~ accumulated considered plan mi ht earn lower 9 sufficient reserves. reserves.. assets for returns reserves. _ valuation . ` _ u ses. 3/28/06 ® Gabriel Roeder Smith & Company Page l Gabriel Roeder Smith & Company One Towne Square 248.799.9000 phone R Consultants & Actuaries Suite 800 248.799.9020 fax Southfield, MI 48076-3723 www.gabrielroeder.com r J January 31, 2006 The enclosed GRS News Scan and Research Memo were developed by Gabriel, Roeder, Smith & Company to inform our clients and other benefit professionals about important events in the benefits industry. We hope you find our information clearly written and useful in your professional activities. To receive our publications. electronically, send: an email... to web.admin~igabrielroeder.com with the message "SUBS(..RIBF,. NEWS SCAN" in the subject line. To stop receiving our publications via email, send the message "UNSUBSCRIBE NEWS SCAN" in the same way. Please turn to our web site at www.gabrielroeder.com for .other publications. related to pensions and benefits. Sincerely, `~~~.... Paul Zorn Director of Governmental Research Enclosure • The following news summaries were developed by Gabriel, Roeder, Smith & Company to inform clients and other benefit professionals of_ news in the. benefits industry. Our thanks to Mary Ann Vitale for her diligent work on this issue. To receive this publication electronically, send an email to web.admin~ct kabrielroeder earn with the message "SUBSCRIBE NEWS SCAN" in the subject line. To stop receiving this publication electronically, send the message "iJNSUBSCRIBE NEWS- SCAN" in the same manner. Copies of this and other benefit-related publications are available on the GRS web site at www. ~abrielroeder.com. .IRS Updates Tederal-State Reference Guide On December 5, 2005, the Internal Revenue Service (IRS) announced an update of Publication 963, the Federal-State Reference Guide, providing guidelines for state and local governments regarding Social Security and Medicare coverage, and related payroll tax withholding for state, local, and Indian tribal government employees. Publication 963 is available on the IRS's website at: http:/; ~a-ww.irs.gov/pub!irs- pdf'n963.ndf. I)OL Issues Final USE;ItI~A Regulations On December 19, 2005, the U.S. Department of Labor (DOL) finalized regulations implementing the Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA). USERRA is a federal law that establishes employment and reemployment rights for employees who voluntarily or involuntarily leave their civilian jobs to perform military service. The final rule covers both pension and group health plans as defined in the Employee Retirement Income Security Act (ERISA). Generally, employees who return to their jobs after military service have the right to the same seniority, status, pay and benefits they would have attained had they not been on military leave, provided certain criteria are met. Under USERRA, employers are prohibited from discriminating against employees on the basis of veteran status, military service or application for military service. Additionally, the DOL published final regulations requiring employers to provide employees with notice of USERRA's rights, benefits and obligations to be posted where employers normally place notices for employees. Both regulations became effective on January 18, 2006. The final USERRA regulations and Notice of USERRA Rights and Benefits for use by private sector and state government employers are available respectively on the DOL's website at: httn:%i~~-ww.dol ~lovf'vet`-`reus~fedreg%final~USFRRA Final Rul~pdfand httn:!w~~•w.dol.t;ov:'vet5%nro~ramshiserra:~i!SFRRA Privatendf • ~ The authors of these news summaries are not attorneys and the statements made are not intended as legal advice or opinion. Qualified legal counsel should be consulted to ensure plan provisions and documents comply with applicable laws and regulations. Il3l,`?{)Ilfi ~'% 2(i{}(i - Gal~rica, Idoeder, Sanith & Compan}' P:~};r 1 January 2UU6~ • senior citizens who are ineligible for Medicaid. Currently, the PACE program costs the state $415 million to operate, but the Medicare Part D federal subsidies are expected to reduce the state's expenses. Under the agreement, the state will identify and qualify four or five Medicare prescription drug plans (out of 29 available statewide) that will coordinate with PACE. Source: Bureau of National Affairs, Pension and Benefits Reporter, December 13, 2005. RNA Publishes Special Report on Protecting )<9edicare :Part D Plans Against Fraud,l~`aste and Abuse On January 10, 2006, BNA's Pension & Benefits Reporter featured a special report on protecting Medicare Part D plans. The report was written by Kirk J. Nahra, a partner with Wiley Rein & Fielding LLP, specializing in health care, compliance, privacy, information security and insurance fraud issues. Despite concern about fraud, waste and abuse (FWA) throughout the Part D implementation process, the Centers for Medicare and Medicaid Services (CMS) had not issued FWA guidance before the January 1 start date of the Part D program. In an effort to protect Part D plans from fraudulent practices and meet anticipated CMS . requirements, Nahra outlines the top ten steps necessary for implementing an effective FWA compliance plan. The report also focuses on integrating internal and external anti-fraud efforts. The Sky is Falling, the Feds are Coming.• Top 10 Tips for Protecting Part D Plans is available to Bureau of National Affairs subscribers at: httpa~bna.com ~V9.ichigan Court Rules Co-npan}~ Cannot F..liminate Promised Retiree Health Penefits On December 22, 2005, the U.S. District Court for the Eastern District of Michigan ruled that a Michigan company cannot eliminate health benefits for retirees age 65 and older, or for their surviving spouses and eligible dependents (Cole v. ArvinMeritor, E.D. Mich., No. 2:03-ev-73872, 12/22/05). Additionally, the court • found that the company unlawfully reduced and cancelled retiree health benefits in 2003 and 2005. The judge's injunction ordered reinstatement of benefits prior to the reductions and required the employer to make full payment of health benefits costs for retirees, surviving spouses, and dependents. The case involved an auto parts supplier in southeastern Michigan. In 1962, the firm entered into a contract with the United Auto Workers (UAW) establishing employer-paid health benefits for retirees. These benefits were improved and expanded in later agreements. Then, in 2003 and 2005, the company unilaterally canceled retiree dental and vision coverage, while increasing deductibles, co-payments, and out-of-pocket expenses. It also announced it would eliminate health benefits starting in 2006 for retirees age 65 or over and for their spouses and dependents. In response, the UAW and several retirees sued the company under Section 301 of the Labor Management Relations Act (LMRA) and Sectiom 301 of ERISA. By granting the injunction,. the judge cited precedents in both the district and Sixth Circuit courts, referred to as the Golden-Meridian precedents, whereby eligibility for retiree health coverage was directly related to pension entitlement. The court concluded that the "explicit language of the agreements ties retiree health benefits to pension status and specifically promises, without time limitation, that the health benefits `at the time of retirement...shall be continued thereafter' for the duration of retirement." The court also established that the employer's promise to provide lifetime retiree health benefits was confirmed over several decades in numerous documents such as collective bargaining agreements and summary plan descriptions. The court rejected the company's argument that the contracts limit retiree health benefits to the durational clauses of the agreements and found that "general durational clauses do not override specific promises of lifetime benefits." The company is planning to file an appeal with the U.S. Sixth Circuit Court of Appeals. • Source: Bureau of National Affairs, Pension and Benef is Reporter, January 10, 2006. lf`3Ii200fj ~`- 200(, -Gabriel, It±~eder, Smith u Company Page 3 • 1RS Issues Letter Ruling on Purchasing Service Credit Through 403(b) and 4S7(b) Transfers On September 20, 2005, the IRS issued a private letter ruling (PLR 200550042) regarding service credit purchases provided by a governmental plan. The IRS was asked to rule on two key issues: (1) whether the plan's definitions of "other service" and "summer months service" constituted "permissive service credit" as defined in the Internal Revenue Code and (2) whether the service could be purchased with direct trustee-to- trustee transfers from 403(b) or 457(b) plans without the transfer being included in the employee's gross income. The letter was issued to a governmental retirement system that administers several .contributory defined benefit retirement plans for state employees (Plan X),-state police officers (Plan Y), county employees, school boards, and local governments (Plan Z). Plan X provides that any employee participating in one of more of the plans administered by the system prior to July 15, 2002, who has accrued at least 48 months of service at age 65 (or at ]east 60 months of service if under 65) and who has at least 180 months of total service may purchase up to five years of "other service" credit that is not otherwise purchasable under the plans. Plan X also provides that employees of schools, school boards, of institutions of higher education participating in Plans X or Z, and who receive credit for less than 12 months of service each year, may purchase the additional "summer months service" credit (up to 3 months) needed to total one year. Moreover, for employees who have service credit prior to July 1, 1992, half of the cost of the service credit may be paid by the employer. Code § 415(n)(3)(A) provides that. "permissive service credit" means service credit recognized by a governmental plan for purposes of calculating a participant's benefit, which the participant has not received under the plan, and which the participant may only receive by making a voluntary additional contribution which does not exceed the amount necessary to fund the benefit attributable to the service credit. After discussion with the IRS, the system revised its provision for purchasing "other service" to allow it only if the purchased service corresponds to a period of employment (in the public or private sector) that was not previously credited under the system. Given this change, the IRS agreed that the plan's definition of "other service" constituted permissive service credit under Code § 415(n)(3)(A) since it relates to an actual period of employment for which the member has not received credit under the plan and which the member could only purchase by making an additional voluntary contribution to the plan. The IRS also ruled that "summer months service" constituted permissive service credit, since the member would not otherwise have received credit for the additional months of service under the plan. Furthermore, the member must make an additional voluntary contribution to receive the service credit. Regarding service credit purchases through direct trustee-to-trustee transfers from 403(b) or 457(b) plans, the IRS found that since "other service" and "summer months service" are permissive service credit within the meaning of Code § 415(n)(3)(A), amounts transferred from a 403(b) arrangement or a governmental 457(b) plan through a direct trustee-to-trustee transfer are not includible in a member's gross income at the time of the transfer, to the extent that such transferred amounts are used to pay the member's cost associated with purchasing the service credit. It should be noted that private letter rulings are only directed to the taxpayer requesting them and may not be used or cited as precedent. • 1;31/3(106 ~~ 2iJ{l{i - i;ahriel, lzoede~•, Smith ~ C'oaupan~~ Yi~ge S Cabric! Roeder Smith a. Company ~^~'R~ C,onsulcancs 8c Acruaries \J Research Memorandum January 31, 2006 From: Paul Zorn, Director of Governmental Research Subject: Age Discrimination and Disability Retirement: Recent Developments On September 19, 2005, the U.S. Sixth Circuit Court of Appeals ruled that disability retirement benefits paid. to certain Kentucky state and county employees did not violate the Age Discrimination in Employment Act (ADEA) (EEOC v. Jefferson County Sheriff's Dept, 6`~ Circuit, No. 03-6437, 9/19/05). The Sixth Circuit covers Kentucky, Michigan, Ohio, and Tennessee. The case is of interest because it examines two fundamentally different perspectives on what age discrimination means with regard to retirement and disability benefits. The case stems from an Equal Employment,Opportunity Commission (EEOC) claim filed by a deputy sheriff in Jefferson County. Upon applying for disability benefits from the Kentucky County Employees' Retirement System, the deputy was informed he was ineligible for disability benefits because he was older than the plan's normal retirement age. Under the plan's disability provisions, employees who become disabled after normal retirement eligibility receive normal retirement benefits based on actual years of service. However, those who are disabled before. normal retirement eligibility receive additional years of service credit up to normal retirement age (or 20 years of service), but not more than the number of years already worked. As a result, younger workers who are disabled before becoming eligible for normal retirement can receive higher benefits than older workers who are eligible for normal retirement, even with • the same final earnings and actual years of service. In 1999, after investigating the deputy sheriff s claim and attempting conciliation, the EEOC filed suit in the U.S. District Court for the Western District of Kentucky, alleging violation of the ADEA and naming the Jefferson County Sheriff's Department, the Kentucky Retirement Systems, and the Commonwealth of Kentucky as defendants. In deciding the case, the district court applied a previous "materially indistinguishable" Sixth Circuit Court of Appeals ruling (Lyon v. Ohio Education Association and Professional Staff Union, 53 F.3d 135, 6`s Cir. 1995). Lyon v. Ohio Education Association and Professional Staff Union The Lyon case involved a retirement plan sponsored by the Ohio Education Association with an early retirement provision called "Option B." Although eligibility for normal retirement required attaining age 62 or having 32 years of service, under Option B an employee was eligible for early retirement at age 60 with 5 years of service, or after earning 20 years of service. Moreover, additional years of service credit were added to actual years, as if the employee has worked until age 62. As with the Kentucky disability plan, under the Ohio Education Association's early retirement plan an older worker who retired at normal retirement age could receive lower benefits than a younger worker who retired under the early retirement option, even with the same final earnings and years of service. As explained by the Lyon court, there are essentially two forms of discrimination in employment. "Disparate treatment" discrimination occurs when an employer treats some employees less favorably than others because of their race, color, religion, sex, or national origin. "Disparate impact" discrimination ' The author of this memorandum is not an attorney and the information provided is not intended as legal advice or opinion. Qualified legal counsel should be consulted regarding questions about applicable laws and regulations. • ©Gabriel, Roeder, Smith & Company Page 1 1/31!06 • Given that A's disability retirement pension would be almost three times the size of B's, even though they worked for the employer for the same number of years, the Manual concludes that the benefits are unequal. Since the benefits are unequal, the Manual goes on to say that the employer would have to show that it costs as much to pay disability retirement to 55 year olds based on 5 additional years of service as it does to pay disability to 30 year olds based on 30 additional years of service. If an employer cannot Make this showing, it is liable for a violation of the ADEA. ~ Summary: Fundamental Differences As discussed earlier in this memo, the Lyon court held that a benefit based on credit for unworked service to normal retirement age did not have the effect of disadvantaging older workers because of age. Moreover, the court held that any resulting disparate impact reflects the fact that employees who start work at an earlier age accumulate more years of service in reaching normal retirement age. The EEOC disagrees with the Lyon analysis, stating: "Where a benefit plan ties the amount of benefits provided to the number of years it will be before an employee reaches normal retirement age, it is explicitly age-based. This is facial discrimination that does not require additional proof of intent." 2 In concluding its analysis of EEOC v. JefJ'erson County, the Sixth Circuit observed that the case might have had a different result if the Lyon case. was not controlling in the circuit, but added that a different result would have troubling aspects. "Assuming that each worker desires to accumulate aworking-life's worth of retirement benefits, an employer might reasonably want to provide employees with assurance that such a `working life's worth' will be accumulated, against the risk that the employee will become disabled during his or her period of employment." • The Sixth Circuit Court's opinion is at: http:,!!wtivw.ca6.uscourts aov!opinions ndf''O~a0397p-06 pdf ~ U.S. Equal Employment Opportunity Commission, EEOC Compliance Manual, Chapter 3, Section IV, D. October • 23, 2000. 2 EEOC Compliance Manual, Chapter 3, footnote 36. 1131/06 ©Gabriel, Roeder, Smith & Company Page 3