California Pension Reform: A Preliminary Analysis

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1 California Pension Reform: A Preliminary Analysis This memorandum sets out our preliminary understandings and questions for California public sector pension reform under AB 340 and AB 197. It is designed as a guide for discussion and interpretation and certainly is not the last word on this complex legislation. Depending on exactly how the legislative language is interpreted, there are uncertainties, surprises and practical challenges to be resolved. However, employers, unions and retirement systems have very little time to act before the effective date. Therefore we are providing this memorandum now. On August 31, 2012, the Legislature sent AB 340 to the Governor for signature; he signed it on September 12, AB 340 imposes many reforms on the pension and retirement systems provided by public employers. The effective date for most changes under the bill is January 1, (A trailer bill, AB 197 was also passed; this bill makes some corrections to AB 340.) The outline of the changes is clear. Many details are not. This memorandum describes the basic elements of the bill and explores a number of questions under it. There are many questions that will have to be answered by employers and administrators who will have to implement this new legislation in what will be a very short period of time. Published by the Hanson Bridgett Employee Benefits Group HANSONBRIDGETT.COM OVERVIEW 1. Overview Legal Structure The basic legal structure seems to be that all preexisting statutory rules applicable to public retirement plans apply unless AB 340 clearly overrides them. For example, except as provided in AB 340 there is no change in the administrative arrangements of any retirement plan. Also, there generally is no change in the cost of living adjustments ( COLAs ) provided by systems even though these are benefit enhancements. However, even with COLAs there

2 pg 2 SEPTEMBER 12, 2012 PENSION REFORM ALERT are important questions left open by AB 340. for new members, again if this can be done politically. 2. Overview Substantive Rules a. Existing plans and members For the most part, plan benefits in effect on December 31, 2012 for members as of that date are not affected. (For this memo, these are existing plans or existing benefits and existing members or old members, respectively.) There are a number of exceptions discussed below, however, which change the rules to prohibit or restrict the following: spiking (i.e., increasing the final year or years of compensation used to calculate a retirement benefit), airtime (i.e., additional service that can be purchased by members to boost retirement benefits), retroactive benefit increases, supplemental defined benefit plans, increased members contributions for some members and other items after December 31, Because of the January 1, 2013 effective date, there are a number of opportunities, for employers and unions to take action and implement plan changes prior to the end of After 2012, there are still opportunities for providing benefit enhancements for existing members, if they can be done in this political environment. c. Administration 37 Act systems are given new tools to audit the records of their contributing employers, similar to the tools that PERS now has. AB 340 also requires changes in governing documents for retirement plans. d. Exemptions The new rules include a very broad statement of coverage, affecting all state and local public retirement systems and their participating employers, including PERS, STRS, the Legislator s Retirement System, the Judges Retirement Systems I and II, 1 37 Act county plans, independent public retirement systems, and individual retirement plans offered by public employers. The only entities specifically exempted from general coverage by the new rules are entities described in Section 9 of Article IX of, and Sections 4 and 5 of Article XI, of the California Constitution (i.e. the University of California and charter cities and charter counties), except to the extent those entities participate in any retirement system governed by state statute. (For example, if they participate in PERS.) Sec (a)(2). b. New members MORE DETAILED DISCUSSION AB 340 makes substantial changes to retirement benefits for employees who are new hires or new members on and after January 1, Who is new is complicated and there are several situations where a person s past membership in an employer s plan or in another public plan is counted so they are treated as old members. The defined benefit ( DB ) formulas for new members are mandated, limited and lower than many current formulas. The amount of compensation that can be taken into account for calculating benefits is capped at the social security wage base or 120% of the wage base for those not in social security. In some cases, a defined contribution ( DC ) plan can be used to provide benefits on compensation over the new cap. All of the limits noted above for existing members apply to new members, of course. Nevertheless, there are still opportunities for providing benefit enhancements 1. Existing plans and existing members a. Basic Rule for Existing Members Existing employees keep the same retirement benefits that they have under their existing retirement plans as of December 31, There is no change required for, e.g., the DB plan formula, use of 12 months to determine final average compensation, the amount of compensation that may be taken into account (that is, no cap ) or early retirement factors. If wanted, a 1 Certain requirements under AB 340 are not applicable to Judges Retirement Systems I and II, including the requirements pertaining to defined benefit formulas under sections and , compensation limitations under and restrictions against reemployment under See Sections (f) and (i).

3 pg 3 number of changes that enhance benefits may be made for existing members, as discussed below, without regard to the new limits for new members. In some cases, enhancements must be made by December 31, b. Who Is an Existing Member? Under AB 340 if you are not a new member then you are an existing or old member. If you meet any one of the categories below, you are a new member. Otherwise, you are an existing or old member. Thus, to be an existing or old member you cannot be any of the following: (i) First time member of any public retirement system on or after January 1, 2013; or (ii) First time member of a public retirement system on or after January 1, 2013, a member of another system before that date, and not subject to reciprocity under the rules under AB 340; or (iii) Previously an active member in a public retirement system who returned to active membership in that system with a new employer after a break in service of more than 6 months. Cal. Gov. Code sec (f). (All references are to the California Government Code unless otherwise stated.) Here are some questions and examples: What is a retirement system? What is a break in service? E.g., is there a break with a refund but then a redeposit in 6 months? Is there a break with authorized unpaid leave for 2 years? Will the rules be determined plan by plan or will there be uniform rules? What is an active member? What if an employee was covered by an employer s DC plan only and immediately moves to a different employer with a DB plan? What if the employee changes job classifications and moves to a DB plan with the same employer? What if an employee was covered by the employer s separate DB plan, the employer terminates that plan and merges it with PERS, and on return to the same employer the employee is a PERS member? Can reciprocity be added after 2012? Can reciprocity be eliminated? Special Reciprocity Rule: Keep the existing formula. There also is a general reciprocity grandfather rule in AB 340 that a person employed by any public employer before 2013 and who was first employed by another employer on or after January 1, 2013 is treated as an existing member of the new employer s system if he/ she was subject to reciprocity under stated provisions. Sec (c). Questions: What is subject to reciprocity? Is this the same as eligible for or receives reciprocity? Why was this separate, general reciprocity provision needed; what does it add? Also, a new employee is determined under different criteria than new member. If you are not a new employee then you are an existing or old employee. New employee is used sparingly in AB 340. To be an existing employee you cannot be any of the following: (i) First-time employee of any public employer on or after January 1, 2013, never previously employed by any public employer; or (ii) First-time employee of any public employer on or after January 1, 2013, with prior employment with another public employer before and not subject to reciprocity under the AB 340 rules. Sec (e).

4 pg 4 SEPTEMBER 12, 2012 PENSION REFORM ALERT The main difference between existing member and existing employee seems to be category (iii) for existing member. Category (iii) makes, e.g., a PERS member a new PERS member after a 6 month break in active service even if his/her contributions were left with PERS if the individual returns to a new PERS employer. Question: What are the AB 340 effects of being an existing employee but a new member? c. Changes For Existing Members (i) Cost Sharing Expanded - PERS Cost sharing for existing PERS-covered employees is expanded in the trailer bill, AB 197, and addressed in AB 340. AB 340 says that the standard is equal sharing of normal cost between members and employers. Section However, the existing provisions regarding member contributions for existing employees are left unchanged. The member contribution rates for PERScovered employees are currently provided under various sections of the PERS law (e.g which provides normal rates of contribution for school local miscellaneous members. Under AB 197, Section of PERS law is changed to expand the ability of employers and employees to share costs. Currently, allows cost sharing of optional benefits, which have been defined by PERS in detail. Also currently is focused on represented employees and is silent for cost sharing for unrepresented employees, although the practice has been to extend the same cost sharing to both groups. AB 197 expands providing that employers and employees may agree to share the costs of the employer contribution and such cost sharing is not tied to optional benefits. Whereas previously limited the amount of cost sharing to the cost of the optional benefits, the new version of has no such limit. Thus, any agreed-upon cost sharing works under new Prior said that cost sharing had to be agreed to before the optional benefit was adopted; now cost sharing may be implemented at any time. However, impasse procedures cannot be used to impose member cost sharing above required amounts. For unrepresented employees, cost sharing can be established by agency resolution. Cost sharing may differ by bargaining unit or certain other groups. AB 197 has an odd clause that says that PERS may refuse to approve any agreement for cost sharing (that is in a PERS contract) if the arrangement would conflict with the federal tax laws. Since conflict would be difficult or perhaps impossible, it is unclear what PERS concerns might be. Separately, starting on January 1, 2018, if members are not paying 50% of normal cost or if there is not an agreement under 20516, then under new , employers may require members to pay 50% of normal cost, but with an overall limit on the contributions that can be required to 8% for local miscellaneous or school members, 12 % for local police, firefighters, and county peace officers, and 11% for all local safety members other than police officers, firefighters, and county peace officers. Section In addition, there are specific increases in the contribution rates for state bargaining units in new section and related employees that will take effect on July 1, 2013, and July 1, (ii) Cost Sharing Expanded 37 Act Systems Cost sharing for existing 37 Act system covered employees is expanded in AB 340. Section is added under AB 340 to expand the ability of all 37 Act system employers and employees to share costs. Currently, some cost sharing is allowed for 37 Act systems in and some systemspecific sections. Generally, under AB 340 employers and employees may bargain for cost sharing with employees paying all or part of the member or employer contributions, without limit on the amount paid by members. Cost sharing by unrepresented employees is accomplished by resolution or ordinance. Separately, starting on January 1, 2018, if members are not paying 50% of normal cost or if there is not an

5 pg 5 agreement under 31631, then under new , the county or district may require that members pay 50% of normal cost, but with limits on the amount of the increase over the existing normal rate of contribution: 14% over for general members; 33% over for police, fire, and peace officers; 37% over for other safety. For represented employees, good faith bargaining is required but impasse procedures are available. AB 340 says for each of these provisions that they do not modify a board of supervisors or the governing body of a district s authority under law as of December 31, 2012 including any restrictions on that authority to change the amount of member contributions. The meaning of this clause is unclear. (iii) Cost Sharing Other Plans For existing members in other plans than PERS or 37 Act plans, there are no provisions in AB 340 or AB 197 for cost sharing. Cost sharing would be governed by existing law, including the terms of each plan and court decisions. It is likely that each situation would be governed by its particular facts. However, service credit can generally still be purchased for prior government service for certain educational organizations, service for an association of government employees, and military service. Sec (The new rules refer to the rules that exist under Code section 415(n), which governs qualified service credit purchases.) Nevertheless, an official application to purchase other service credit is allowed if the application is received by the system before January 1, Id. This limit suggests that retirement systems may have a fiduciary obligation to quickly inform their members of the pending elimination of airtime and to timely provide information needed by a member to decide whether or not to make a purchase. (vi) New Supplemental DB Plans Eliminated If an employer does not provide a supplemental DB plan as of December 31, 2012, then it cannot ever provide one. Sec If a supplemental DB plan is provided before January 1, 2013 then it cannot be expanded to any additional group after that date. Question: Does the change for cost sharing for PERS and the 37 Act provide an additional basis for new cost sharing for other plans? Here are some questions: What is a supplemental DB plan? (iv) Cost Sharing Pre Tax Contributions It appears that both the PERS and 37 Act cost sharing provisions in AB 340 have been drafted to provide the best likelihood that all contributions paid by members may be made on a pre-tax basis. However, the rules of AB 340 are not sufficient; the federal tax law rules must also be met. Can a new supplemental DB plan be adopted on December 31, 2012? If so, can it provide minimal benefits with a later expansion of benefits if desired in later years? If adopted, is it subject to all of the actuarial and public meeting requirements of section 7507? (v) Airtime Eliminated (vii) Increased Benefits For Future Service Only As of January 1, 2013, airtime cannot be purchased. 2 2 Current state law allows employees to increase their retirement benefits by buying additional years of service credit known as airtime to count as part of their total service credit. Although the employees pay a fee for the privilege and in many cases the amount paid is said to be high enough to cover the eventual payouts, critics of airtime note that the boost can cost taxpayers significant amounts Any enhancement to a formula or retirement benefit adopted after December 31, 2012 can only apply to service performed after the operative date of the enhancement. Sec when the public retirement: system s investment income falls short, as it has in recent years.

6 pg 6 SEPTEMBER 12, 2012 PENSION REFORM ALERT Additionally, if a member changes classification, e.g., from general to safety, any enhancement from the change only applies to future service. Id. However, an increase to a retiree s cost of living adjustment ( COLA ) within existing statutory limits is not an enhancement. The PERS RBP automatically covers all PERS members. The 37 Act requires that every county and district that participates in a 37 Act system adopt an RBP. Here are some questions: Here are some questions: Can increases in formula for prior service be adopted by December 31, 2012? Must every county and district that participates in a 37 Act system be sure to adopt an RBP by December 31, 2012? What happens if this is not done? What is a retirement benefit for this limit? For example, how about increases in serviceconnected disability benefits? Death benefits? Survivor benefits that are funded separately from pension benefits? Making available participant loans from a DC plan? Making available hardship distributions from a DC plan? Making available a new benefit form such as, e.g., life annuities and 20-year-certain benefit forms? (Does it make a difference if the benefit is actuarially equivalent or not?) If the agency is under PERS, is PERS signature to a contract amendment required for the enhancement to be operative? How does the statutory limit rule for COLAs work? Does it apply only to existing COLAs or can COLAs be increased within the existing statutory framework and apply to prior service benefits? (viii) New Section 415 Replacement Benefit Plans Eliminated Does this new prohibition apply to DC replacement benefit plans? As a placeholder, can the employer adopt an RBP with a limit to the benefit provided in excess of the 415 limit? Are there other ways for an employer to establish a new RBP and protect against unexpected expenses? (ix) New Anti-Spiking Rules: 37 Act Systems For existing members of a 37 Act system, AB 340 (as corrected in AB 197) adds new constraints on compensation earnable under the 37 Act. This change does not apply to existing members of PERS. Much of the prohibitions are directed to onetime actions that have led to spiking (significantly increasing) of final year(s) compensation. For example, pensionable compensation does not include the following: conversion of in kind compensation to a cash payment; one-time or ad hoc payments; cash out of unused leave time; overtime pay; bonus on top of normal monthly rate or pay or base pay. Sec (as amended in AB 197). If an employer does not provide a section 415 replacement benefit plan ( RBP ) on December 31, 2012, it cannot provide one. Sec Moreover, even if there is an RBP in existence as of December 31, 2012, it cannot be provided to any additional employee group after that date. (No plan can be provided for new members in any event.) (x) Vested Rights Issues Employers and retirement plans may be challenged under vested rights if AB 340 results in a cutback or limitation or additional cost of benefits for existing members. There are arguments on both sides of this issue and we expect that it will be settled in the courts.

7 pg 7 Note that it appears that the Legislature has concluded that if an MOU includes a provision concerning payment of member contributions, the agreement regarding payment expires at the end of the MOU. Sec (f). AB 340 makes clear that when the MOU expires the new rules regarding cost sharing by new employees apply. existing employees just in case it may be wanted later, in much better economic times; and (ii) If the employer participates in a 37 Act system, adopt a 415 replacement benefits plan with broad coverage. In each case, the employer may also wish to design the plan so there is low risk of adverse effects on the employer. Question: Why does this rule preserve only MOU terms on cost sharing? Should it extend to all elements of pensions that are in any MOU? 2. New Members and New Employees a. Basic Rule for New Members d. Planning Opportunities There are opportunities for employers and unions to negotiate enhanced benefits for existing employees, and for employers to provide enhancements for unrepresented employees. It appears that any action to enhance benefits for existing employees that is taken by December 31, 2012 is in compliance with AB 340. The general effective date of AB 340 is January 1, 2013, and AB 340 does not have a no change rule with an earlier effective date. Additionally, AB 340 makes clear that benefit enhancements can occur after 2012 for existing members. We can find no prohibition in the bill against enhancements for existing members. More directly, section clearly allows enhancements as long as they are for future service. However, AB 340 prohibits moving from 36-month final average compensation under a DB plan to a shorter period for existing employees. Sec Every public employer that provides a DB plan must provide a plan to new members that has a prescribed formula for general members and one of three formulas for safety members. Sec The general member formula is 62 3 with specified reductions for earlier retirement and increased for later retirements up to 67. Sec The safety formulas are 57, 57 and 57, all with reductions for earlier retirement. Sec The safety formula provided must be the one that is closest to, and provides a lower benefit at 55 years of age than the formula offered to similar employees on December 31, Employers and unions that start with a higher formula may agree to a lower formula plan; this cannot be done by impasse. AB 340 includes a similar change to the STRS formula, providing for 62 increasing to 65 special provisions for STRS are included to new section and Question: Are the new formulas only for the employer-provided benefit so that the benefit from employee-mandated contributions is added to the new formula benefit? Moreover, while there is a limit on establishing new supplemental DB plans after 2012 that would provide additional retirement benefits, there appears to be no limit on establishing supplemental DC plans. In addition, there is no limit on enhancing the benefits provided through existing supplemental DB plans. For future flexibility, therefore, agencies might wish to consider taking the following actions before December 31, 2012: (i) Establish a supplemental DB plan with broad scope of coverage and very low benefits for Background: AB 340 provides that the new formulas shall provide a pension at retirement. 3 The references to new and existing benefit formulas in this memorandum are abbreviations of the actual formula. For example, a 62 formula is reference to the standard type of benefit formula in public retirement systems which determines the benefit available to the member (without any actuarial reduction) at retirement by multiplying a stated percentage (i.e. 2%) of the member s final average compensation (for new members, over no fewer than 36 months) at a stated age (i.e. 62), which is multiplied by the member s years of service credit.

8 pg 8 SEPTEMBER 12, 2012 PENSION REFORM ALERT However, existing law for 37 Act systems (see section 31471) and for PERS (see section 21353) states that a retirement benefit is paid as two parts, a pension and an annuity. The employer pays the contributions for the pension; the annuity is provided by member contributions. The pension plus the annuity provides the retirement allowance. The legal theory of AB 340 seems to be that it does not supersede existing law unless clearly done; it is not clear that the existing rules regarding pension and annuity are superseded. In addition, the compensation on which the DB benefit is based cannot exceed the social security wage base ($110,100 this year) or 120% of the wage base for a member who is not covered by social security. Sec A DC plan may be provided on higher compensation, subject to certain conditions outlined in the legislation. employees (except where only a DC plan was provided before 2013 per (e)), then must the required-formula DB plan be provided to, e.g., part time, seasonal and temporary employees who have rarely been covered by DB plans? b. Who is a New Member? See 1. b. above for discussion of definition of Sec (f) c. Exemptions From the New DB Plan Formulas AB 340 provides two specific exemptions from the new DB plan formulas for new employees: an exemption for lower formula plans and an exemption for DC only plans. (i) Lower Benefit DB Plans Question: What happens when an employee moves from no social security coverage to coverage? And from coverage to no coverage, which is possible without a 218 agreement? It is not clear whether employers are required to provide a DB plan to all new employees. AB 340 includes a provision to this effect for new safety members. Sec (e). There seems to be no equivalent provision for general members. However, (e) suggests that a DB plan is mandatory for all new employees. Question: Are the only new members for which a DB plan is mandated safety members? Compare with If the employer provided, before January 1, 2013, a DB plan with a lower benefit factor at normal retirement age that has a lower normal cost than the AB 340-required plan for new members, then the employer may continue to provide this lower cost plan. Also, the new compensation limit will not apply. Sec (d). If a new formula is adopted, then either it must comply with the AB 340 requirement or must meet actuarial conditions, risk and cost conditions, and be approved by the Legislature. Question: Why would an employer ever make a change to a lower cost plan with these substantial hurdles? Instead, why not just provide a new DC plan? Question: If a retirement plan does not allow entry of new members then is it clear that a DB plan is not required for them? Sec (g). Question: If a DB plan is mandated for all new 4 Of course, if an employer maintains a plan under PERS or the 37 Act, then PERS law and that Act will determine if a DB plan must be offered to new employees. (ii) DC-Only Plans If the employer provided, before January 1, 2013, a plan that consists solely of a defined contribution plan the employer may continue to provide that plan instead of the DB plan required by this article. But if the employer adopts a DB plan or formula, then the AB 340 requirements must be met or conditions similar to those in (i) above must be met. Under this exception, new

9 pg 9 members may only participate in a DC plan that was in place before 2013 or a defined contribution of defined benefit formula that conforms to the requirements of this article. Sec (e). Question: Does the DC-only rule apply to, e.g., part time, seasonal and temporary employees when other employees of an employer have a DB plan? employee. Sec Question: What happens to public employer participation in Taft-Hartley multiemployer plans that do not allow only some employees to be covered, and are governed by ERISA which pre-empts California law? Must public employers withdraw and thereby trigger a substantial withdrawal liability? d. Additional Essential Provisions For New Members (iv) No Section 415 Replacement Benefit Plan (i) Cost Sharing The standard is that employees pay at least 50% of normal cost and the employers not pay any part of the employee s required contribution. Sec However, by MOU, employees may pay more than onehalf of the normal cost under stated circumstances; this cannot occur through impasse. Normal cost is defined in terms of the cost of a DB plan. Employee contributions are not adjusted every time there is a change normal cost; adjustments are made only when there is a change of more than 1% of payroll. Questions: No 415 replacement benefit plan may be provided to a new employee. Sec (v) Anti-Spiking Rules AB 340 describes what cannot be included in pensionable compensation for new members. Much of the prohibitions are directed to one-time actions that have led to spiking (significantly increasing) of final year(s) compensation. For example, pensionable compensation does not include: conversion of in kind compensation to a cash payment; one-time or ad hoc payments; cash out of unused leave time; overtime pay; bonus on top of normal monthly rate or pay or base pay. Sec Does mandatory cost sharing for new members also apply for DC plans? Do new employees pay for 50% of the normal cost of the plan as a whole, including the normal cost for any higher benefit formula earned by existing employees, or do they only pay for 50% of the normal cost of their own, lower, benefit formula? (ii) No Airtime Questions: This section gives wide authority to boards of retirement to decide what is inconsistent with the basic rule that pensionable compensation is normal rate of pay or base pay. Does this authority effectively allow, e.g., PERS to demand that contract agencies pay their employees in old-style step rate systems and inhibit newer forms of compensation? The same limits for existing employees on airtime post- December 31, 2012 apply to new employees. Sec Do the anti-spiking rules apply to DC plans? (vi) 36 Month Final Average Compensation (iii) No Supplemental DB Plan No supplemental DB plan may be provided for a new Every DB plan must provide for 36 month consecutive average compensation for new members. Sec

10 pg 10 SEPTEMBER 12, 2012 PENSION REFORM ALERT Question: May a plan use a longer period, such as 5 year average compensation? (ii) No vested right There is no vested right to continue to receive the employer contribution in the future. Id. e. Planning Opportunities Even with the stringent limits on DB plans for new employees there appear to be opportunities to provide substantially higher retirement benefits, depending on the political acceptability of providing higher benefits. An employer can provide the following: supplemental DC plans on compensation over the social security wage base; supplemental DC plans on compensation up to the wage base; and social security coverage for those who are now not covered. (iii) Nondiscrimination in contributions The employer s contribution to the DC plan cannot exceed the employer s contribution (as a percent of pay) required to fund the retirement benefits of employees with income below the compensation limit. Sec (g). Questions regarding the nondiscrimination requirement in (iii): Are contributions to both DB and DC plans aggregated? Under the tax laws, DC plans can provide annual contributions in 2012 of up to $67,000 per participant (or more depending on age and type of employer) through a combination of plans. Especially for younger employees (generally younger than age 44), this level of contributions can provide a very high final retirement benefit, even better than a high formula DB plan with (what formerly were) standard levels of investment earnings. 3. Defined Contribution Plans a. DC Benefits On Compensation Over the Social Security Wage Base DB benefits for new employees are only provided on compensation up to the social security wage base ($110,100 for 2012) or 120% of that amount for a member who is not covered by social security. Sec (c). This limit does not apply to existing employees. AB 340 also provides, however, that contributions may be made to a DC plan for compensation in excess of this limit subject to these stated requirements: (i) Federal law The plan and contribution complies with the limits of federal law. Sec (f). (This probably is a reference to the Internal Revenue Code, although it could also refer to certain employment discrimination laws.) Are contributions for the DB both for normal cost and UAAL? Are contributions for the DB both for existing and new employees? Are contributions to the DB determined whenever there is a new actuarial valuation? Can the contributions to the DB be smoothed out (or normalized?) to avoid, e.g., spikes after there is a sharp drop in asset values as in 2008 and to avoid dramatic drops in years of excellent investment returns? Does this nondiscrimination requirement apply to every DC plan or does it only apply to plans that provide benefits only in excess of the compensation cap? Question regarding the requirement against vesting in (ii): does this rule apply to existing DC plans for existing members? Question regarding DC plans: does this rule apply to: 401(a) plans, 403(b) tax-deferred annuities; 457(b) eligible deferred compensation plans; 457(f) ineligible deferred compensation plans; IRAs (in all their many forms); simple retirement plans governed by the Internal Revenue Code; and all other individual account plans?

11 pg 11 Question: Because the contribution rate under (iii) fluctuates does this prevent employers from having a money purchase plan under the federal tax rules, and if so does this prevent any PERS employer from providing a DC plan under this rule? See section and Compare section for 37 Act employers. b. Supplemental DC Plans While AB 340 prohibits new DB supplemental plans, it does not prohibit new DC supplemental plans. The rules governing supplemental DC plans for employers participating in 37 Act systems are in section The rules governing supplemental DC plans for other employers are in for PERS employers and for all others. These rules are relatively easy to meet. c. Stand-alone Defined Contribution Plans Many public agencies have stand-alone defined contribution plans for groups of employees such as part time, seasonal and temporaries. This is a standard way for agencies to not be required to pay social security taxes for these employees. The issue is whether agencies may continue these plans or whether under AB 340 these employees must now be covered by a DB plan. As discussed above, it is not clear whether AB 340 requires all new employees to be covered by a DB plan or not. Section (e) does require one of the new safety formulas to be provided to all new safety employees. However, this language does not appear in that establishes the new formula for new general members. Instead, only requires that the DB plan that does provide a benefit for these members must use the new statutory formula. There is a substantial difference between requiring participation and requiring that a particular formula be used if there is participation. The only other suggestion that DB plans are required for new employees is in (e) which states that an employer with a pre-2013 DC only plan may continue to provide that plan instead of the defined benefit pension plan required by this article. However that section could be read in conjunction with and and, as discussed, only for safety employees seems to require a DB plan. Therefore it appears that at least one reasonable reading of AB 340 allows agencies to continue DC- only plans. There are practical, operational reasons for this conclusion as well. If employers were required to provide a DB plan to all new general employees, this could disrupt the existing arrangement that is provided by many public agencies for their part-time, seasonal and temporary ( P-S-Ts ) employees. P-S-Ts historically have rarely been members of DB plans and, since 1992, many have been in DC plans to avoid social security coverage. If a DB plan were required for them, these DC plans would be terminated; the administration of DB plans often is significantly more difficult for P-S-Ts than DB plans, so this would add to public agency burdens. d. No Vested Rights Rule Is Unclear Section (f)(1) allows DC plans to provide contributions on compensation in excess of the cap. Section 7522(f)(2) states that a public employee who receives an employer contribution to defined contribution plan shall not have a vested right to continue receiving the employer contribution. Section 7522(f)(2) is in the context of the benefit on compensation over the cap allowed by (f) (1), but subsection (f)(2) is not so limited by its words. Additionally, there is no limit in (f)(2) applying it only to the (f)(1) benefit. Therefore, it is unclear whether AB 340 applies the new no vested right rule narrowly to, e.g., new employees only or to (f)(1) benefits only. e. Application of the Compensation Limit is Unclear- But Is There a Work-Around? It seems clear that a supplemental DC plan may be provided to both existing and new employees. The only limit on supplemental plans deals with DB plans. Perhaps supplemental DC plans with benefits on compensation no higher than the social security wage base may be used in work-arounds to the retirement plan limits.

12 pg 12 SEPTEMBER 12, 2012 PENSION REFORM ALERT 4. New Funding Rule AB 340 establishes a new funding rule for a public employer s pension plan. Sec Under AB 340, the combined employer and employee contributions to the plan must, for each fiscal year, be at least equal to the plan s normal-cost rate for that year. AB 340 permits contributions to be suspended when the funding ratio exceeds 120%, but the conditions required by AB 340 to trigger such a suspension would rarely (if ever) occur. employee s compensation will be subject to the rule? How can the employer determine the potential increase in its PERS contribution rate due to any increased compensation for new hires? AB 340 seems to state that the new rule applies to increased compensation paid before Is this correct? If yes, when and how will PERS determine the increased employer-contribution rate? Also, PERS-participating employers are subject to a new funding rule. Sec The rule applies if an employer creates a significant increase in actuarial liability by paying increased compensation to a nonrepresented employee. The rule doesn t define significant increase, but directs the PERS Board to craft a definition. Under the rule, PERS would assess the cost of the increase to the employer that created it, even if part of the employee s PERS benefit is attributable to PERS-recognized service with other employers. According to the committee report for AB 340, this rule is intended to better allocate the cost of increased compensation among agencies for whom the employee has worked. For instance, assume an employee works for a PERS-participating employer for 27 years, then transfers to another PERS-participant employer at 2X his or hers previous pay for one year. Under a 12 - month final average compensation plan, the employee s benefit for the entire 28 years would be based on the compensation for the second agency. Under the new rule, if the increased compensation causes a significant increase in actuarial liability, PERS would allocate the cost to the second employer by increasing its employercontribution rate. Employers will need to monitor their compensation and hiring practices in view of the rule. A few questions: How can an employer determine whether the 5. Administration - 37 Act Systems Have More Statutory Tools AB 340 gives these additional statutory tools to 37 Act systems: a. Spiking Requires each board of retirement to establish a procedure to determine if an element of compensation constitutes spiking and effectively requires each board to properly administer the procedure. A challenge to a board decision may be made by petition for writ of mandate. Sec b. Audits of counties and districts re compensation Allows each board of retirement to audit a participating employer that does not properly identify the pay period in which compensation was earned regardless of when paid. Sec c. Audits of counties and districts re other reporting Allows each board of retirement to audit a participating employer to determine the correctness of retirement benefits, reportable compensation, enrollment in and reinstatement to the system. Sec The very long relationship between counties and 37 Act systems, with the original administration of the system in the County Treasurer s office, has made it difficult for systems to undertake these audits. Nevertheless, boards of retirement are responsible for proper administration under California law, and additionally administration must comply with the terms of the plan under federal tax

13 pg 13 law. Therefore, while there may be some initial concern about these audits, overall they should become very good for both employers and systems. from prior employment with the reemploying employer or any other employer that maintains the same pension plan; and 6. New Return to Work Rules for Retirees AB 340 restricts a public employer s ability to reemploy a retired person, that is, as a person who (1) previously retired under the employer s pension plan, and (2) is currently receiving a benefit from that plan. Sec Under AB 340, the general rule is that a retired person must be reinstated in the employer s plan upon reemployment. Id. This means that the retired person s benefit payments under the plan would cease, and his or her compensation during the reemployment period would be pensionable thus, the retired person would receive service credit under the pension plan for the reemployment period, and the employer and retired person would have to pay required contributions to fund the corresponding benefits. AB 340, however, provides that reinstatement is not required if the following conditions are satisfied: the employer s appointing power reemploys the retired person either during an emergency to prevent stoppage of public business, or because the retired person has skills need to perform work of limited duration; the retired person s appointment is for no more than 960 hours per calendar year or fiscal year the applicable year appears to depend on the plan s year; the retired person s pay rate must be within the range paid by the employer to other employees performing comparable duties (pay rate for this purpose is hourly and is determined by dividing monthly pay by , which may not make economic sense depending on the circumstances); the retired person must certify in writing to the employer that he or she did not, during the 12-month period preceding the reemployment date, receive unemployment insurance arising the retired person cannot be reemployed within 180 days after his or her previous employment terminated, with limited exceptions for critically needed positions, safety officers, and certain other situations. If these conditions are satisfied, reinstatement does not apply. Id. Thus, the retired person would continue to receive retirement benefits under the employer s plan; he or she would not receive service credit for the reemployment period; and, no plan contributions on the retired person s compensation would be required. Notably, the tax laws also restrict an employer s ability to reemploy a person who retired before reaching his or her normal retirement age under the employer s pension plan. There must be a bona fide separation from service, which is determined under the particular facts and circumstances. Previously, a number of public systems have adopted rules of thumb for bona fide separation, including breaks of 30,60, 90, 120 and 180 days. And, if the employer had pre-retirement agreement to reemploy the person, the termination was not bona fide (regardless of the number of days). However, the new 180-day mandatory hold out period should go a long way to resolve this issue. Further, the new restrictions are similar to those already in effect under the PERS laws ( Secs and ) While there has been much recent legislative activity concerning return to work, AB 340 is the last word of the Legislature and presumably will govern. There are also corresponding changes to return to work provisions for STRS. Sec and Sec Question: Are sections and as amended by SB 1021 more restrictive than AB 340? If so, do these existing sections govern? 7. Miscellaneous Vesting in Health Benefits AB 340 enacts a new non-discrimination rule for health benefits. Sec The rule applies to health benefits

14 pg 14 SEPTEMBER 12, 2012 PENSION REFORM ALERT provided to the following public employees: an elected or appointed person, a trustee, any non-represented person, a person exempt from civil service, or a manager. Under AB 340, health benefits provided to any of these employees cannot have a vesting schedule that is more advantageous than the vesting schedule applicable to health benefits provided to other employees (including represented employees) in related membership classifications. CONCLUSION We have only touched on many of the provisions of this complex new legislation. There are, however, other provisions that we have not addressed in this initial review. As the California public sector community prepares to implement this far-reaching legislation, there undoubtedly will be more questions some of which will not be answered easily or quickly. The next several months of preparation for the effective date of January 1, 2013, will be intense and interesting. A few questions regarding this rule: Does this rule prohibit an employer from providing different health benefits to different groups of employees? For instance, assume an employer provides better health coverage to a non-represented employee than to a represented employee in a related membership classification, but the same vesting schedule applies to both benefits. Is this permitted? What is a related membership classification? Does the rule apply to health benefits provided by an employer to its retirees? How is advantageous measured? For instance, a schedule that 100% vests employees after three years of service is presumably more advantageous to 100% vesting after five years. But is a schedule that vests 20% per year over five years more advantageous than 100% over three years?

15 Hanson Bridgett s Employee Benefits Practice Employee benefits and compensation issues can be complicated and costly for retirement systems, employers and employees. Our Employee Benefits Group is a recognized leader in public employee benefits matters. We represent many public retirement system boards as well as public plan sponsors in matters ranging from negotiating investment contracts to advising on benefits, tax and fiduciary duty questions. We have created innovative programs to solve public agency benefits issues, including obtaining IRS approval for several innovative ways to fund retiree health benefits. The Employee Benefits Group relies on its depth and diversity of experience to work closely with our clients to develop creative and practical solutions. pg 15 For more information, please contact one of our Employee Benefits attorneys: Ed Bernard ebernard@hansonbridgett.com Bob Blum rblum@hansonbridgett.com Judy Boyette jboyette@hansonbridgett.com Nancy Hilu nhilu@hansonbridgett.com Anne Hydorn ahydorn@hansonbridgett.com Christopher Karachale ckarachale@hansonbridgett.com Amber Ward award@hansonbridgett.com Marcus Wu mwu@hansonbridgett.com DISCLAIMER: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Copyright 2012 Hanson Bridgett LLP info@hansonbridgett.com