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Spotlight on the Pension Predicament

By Mark Johnson, Ph.D., J.D.

 

Law360, New York (April 26, 2011) -- Public (municipal, county, school district, state) pension costs are headline news across the country as cities, states and counties acknowledge the extent of unfunded liabilities confronting taxpayers.

States face a $1 trillion budget gap in unfunded pension, health care and other retirement benefits, according to the Pew Center on the States. While states have set aside $2.35 trillion for future retiree benefits as of the end of fiscal year 2008, according to a Pew report, it is far short of the $3.35 trillion needed to fully fund the cost of promised benefits.

This article will compare and contrast the treatment of pension and benefit obligations under The Employee Retirement Income Security Act of 1974 for private sector plans with the treatment of public plans.

Common Goals of a Secure Retirement

Protecting the financial future of America’s workers is the shared goal of pension plan sponsors in both the public and private sectors. The promise of future payments in the form of retirement funds or “other post-employment benefits,” like retiree medical plans or dental coverage, help to attract and retain qualified employees.

Traditionally, public sector jobs carried a higher level of perceived benefits, with the recognition that public employers could not pay as much salary as comparable private sector positions.

Federal v. State Oversight

ERISA is a federal law that sets minimum administrative, disclosure and fiduciary standards for most pension and health plans in private industry. An estimated 483,000 private participant-directed account plans hold almost $3 trillion in assets, according to the U.S. Department of Labor.

As federal legislation, ERISA establishes consistent guidelines across all 50 states. ERISA disputes that result in litigation are brought in federal courts, where they are resolved by a judge and not a jury.

ERISA does not apply to state and local government plans, however, in part due to the potential for conflict between federal and state authority. The result is a lack of uniformity across the states for pension management rules. Litigation involving state pension plans will be brought in state courts, where the dispute is likely to be subject to a jury trial.

Pension Funding Levels Vary with Accounting Assumptions

ERISA requires that pension benefits be adequately funded and that the pension funds be maintained separately from an employer’s operating assets in a carefully controlled trust. The determination of proper funding levels varies significantly between public and private plans, due in part to differing accounting standards.

The Government Accounting Standards Board sets guidelines for public pension accounting and financial reporting, while the Financial Accounting Standards Board governs pension accounting under Generally Accepted Accounting Principles.

Corporate pension funds must calculate future pension obligations using a low risk-adjusted interest rate, typically 6 percent. This is not the case for public pensions. New Jersey, for example, applies an 8.25 percent discount rate to calculate unfunded pension liabilities. Using this measure, the state estimates an unfunded accrued liability of $53.9 billion as of December 2010. The same obligation, calculated with lower interest rates used by corporate pension funds, would be considerably higher.

Higher interest rate assumptions overvalue the pension, which results in governments underfunding the plan. This is particularly important with public plans, since future benefits historically are derived from investment income and government (employer) rather than participant (employee) contributions. Now that public plan participants are being asked or required to accept salary reductions and/or increased existing contributions to improve funding levels, fierce objections are being raised by public employees and their unions.

Public Pension Funds Have No PBGC Equivalent

Congress created the Pension Benefit Guaranty Corporation as part of ERISA, with the express purpose of protecting defined benefit pension plans in the private sector. The PBGC is funded not by the federal government, but rather by an annual assessment on plan sponsors that is then pooled to meet future benefit funding needs and the assets of the plans it controls.

When a defined benefit plan sponsor does fail due to bankruptcy or extenuating circumstances, the PBGC assumes responsibility for benefit payments up to a certain level. The PBGC paid almost $5.6 billion in benefits to retirees and their surviving beneficiaries in 2010, for example.

There is no comparable emergency funding mechanism for insufficiently funded public pension plans. The taxpayer is essentially the payer of last resort. This is already happening in many states, where taxes are being raised at the same time that public services are being cut in an effort to increase tax revenues available to pay existing pension obligations.

Future Benefit Protections Vary

“Reservation of rights” provisions included in virtually all ERISA plans allow sponsors to terminate a plan or reduce future benefits at any time, as long as proper notification is provided to plan participants. For example, a plan sponsor is entirely within its rights to terminate a plan six months hence, replace an existing plan with a substitute plan delivering fewer benefits, or reduce future benefit accruals.

Additionally, "Firestone" language widely contained in ERISA governing plan documents and summary plan descriptions (“SPDs”) provides the plan sponsor with discretionary authority to interpret all plan provisions, including eligibility, and resolve all conflicts, discrepancies and omissions. An exception is when a plan sponsor’s action can be demonstrated to be “arbitrary and capricious,” a standard that is extremely difficult to prove. In no event, however, may a private plan sponsor reduce benefits that have already accrued to a plan participant.

Future benefits, i.e. those not yet earned or accrued, known as “expectations,” are not guaranteed under ERISA. State laws may be not quite as clear on the matter of future benefits, and the answer can vary from state to state. Whether protected or not, future benefits represent a much more contentious and litigious issue in government than in ERISA plans.

One common approach by state governments to rein in future pension costs is to grandfather current employees in existing defined benefit plans, while establishing 401(k)-like defined contribution plans for future hires. While this will ultimately save money, states using this approach will receive little financial benefit for years (perhaps decades) into the future.

Complicating factors for state pension funds include the facts that: 1) states generally are laying off rather than hiring workers; and 2) many states are required to recall previous employees when they do increase staffing levels. Reinstated workers are likely not to be considered “new hires,” meaning resumed eligibility for pre-layoff benefits levels.

Florida Governor Rick Scott has proposed a major overhaul of the pension system for public employees. His proposal requires current employees to contribute 5 percent of pay into the system, closes the defined benefit plan to new hires, and ends the "Deferred Retirement Option Program," a practice which permits employees to retire, draw a pension and be rehired in another capacity. Adopting this model by the public sector would produce real economic benefit for plans and taxpayers. The Florida proposal is far more aggressive and realistic than any other plan seriously suggested to date.

Collective Bargaining Complicates Pension Plans Changes

Some private sector pension plans are created through collective bargaining, in which case the dispute may move from the realm of ERISA to labor-management relations.

States involved in the most contentious deficit struggles — Wisconsin, Ohio, Indiana and New Jersey, to name a few — are frequently forced to seek changes in collective bargaining agreements as part of deficit reduction efforts. Given the campaign role that unions typically play in political elections, any changes in collective bargaining rights are often fiercely contested, although some public employee unions recognize the need for significant changes.

One Shared Certainty: Increased Litigation

Approximately 9,000 ERISA litigation matters were filed in U.S. District Courts in both 2009 and 2010, despite the uniform federal guidelines and highly developed volume of precedent cases.

Over 800 of the largest U.S. corporations — including AOL Time Warner, AT&T, Caterpillar, Delta Air Lines and General Electric Co. — have been subject to ERISA class actions, according to Institutional Investor magazine. Plan sponsors have paid more than $4 billion in class action ERISA settlements, according to Washington, D.C.-based Fiduciary Counselors.

This private sector litigation level foreshadows pending public plan disputes. States are now engaged in budget reduction battles at the city council or state legislative level, with governors struggling to get reform proposals passed. Pension litigation will likely ensue from there.

“Pension costs will crush government,” warns a February 2011 report issued by the Little Hoover Commission titled “Public Pensions for Retirement Security.” Writing specifically about public pensions in California, the report notes that the 10 largest California public pension plans face a combined shortfall of $240 billion in 2010.

State pension battles will also trigger voter reactions, as homebuyers start to make purchase decisions based in part on tax rates and unfunded pension liabilities. Similar corporate relocation decisions are likely, as seen in Caterpillar’s recent threat to leave Illinois due to increased tax rates.

--By Mark Johnson, ERISA Benefits Consulting Inc.

Mark Johnson works as an expert consultant and witness on 401(k), ESOP and pension fiduciary liability; retiree medical benefit coverage; third-party administrator disputes; individual benefit claims; pension benefits in bankruptcy; long-term disability benefits; and cash conversion balances.

ERISA Benefits Consulting Inc. provides benefit consulting and advisory services and does not engage in the practice of law.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

 

 

Contact ERISA Expert Dr. Mark Johnson

You can reach Dr. Johnson via email or by phone at 817-909-0778. He is available to confidentially discuss a benefits matter.

 

Click on the link to read about his representative ERISA cases.

 


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