On August 31, 2012, the Legislature passed a pension reform bill, AB 340, which will make substantial changes to pension benefits for new members hired after January 1, 2013, as well as some changes that affect current employees. AB 340 will enact the California Public Employees’ Pension Reform Act of 2013 (PEPRA) and will also amend various sections of the Education and Government Codes, including the County Employees Retirement Law of 1937 (1937 Act). For the most part, savings from AB 340 will come far in the future, as the majority of the changes apply only to newly-hired employees and none of these changes affect employers’ unfunded pension liability. Below are a few of the important provisions of AB 340. The firm will also be issuing a white paper soon regarding this development.
PEPRA applies to all public employers except the University of California, charter cities, and charter counties (except to the extent they contract with CalPERS). AB 340 also amends sections of the 1937 Act; these amendments affect charter counties that have a 1937 Act retirement system. Thus, the only retirement systems not affected by AB 340 are the UC Retirement System and independent systems established by city or county charter.
Provisions Affecting Post-January 1, 2013 New Members
The major provisions of the reform are:
1. the new pension formulas increase the retirement age and reduce the benefit factor;
2. the maximum compensation used to calculate pension benefits is capped; and
3. employees will always be required to contribute at least 50% of the normal cost to fund the benefit.
Retirement Formulas Effective January 1, 2013 for New Members
For new non-safety members, a 2% at 62 formula will apply, with a maximum benefit factor of 2.5% at age 67. Currently a majority of PERS agencies have 2% at 55 for their non-safety employees, with members reaching the maximum benefit factor of 2.418% at age 63.
For new safety members, the legislation provides for three possible formulas: 1.426% at age 50, with a maximum benefit factor of 2% at age 57 (Basic); 2% at age 50, increasing to 2.5% at age 57 (Option 1); or 2% at age 50, increasing to 2.7% at age 57 (Option 2). The default formula will be the formula which is lower than but closest to the current benefit formula at age 55. Since most public agencies have adopted a 3% at age 50 or 3% at age 55 formula, the default formula for over 90% of public employers will be the highest of the formulas, Option 2.
After January 1, 2013, agencies can bargain for a lower safety plan, but implementation of a lower plan can only be attained through mutual consent. (Ironically, this takes away a management prerogative that existed before AB 340 – the right to implement a second tier unilaterally after exhaustion of impasse procedures.)
Additionally, PEPRA appears to restrict the ability of charter entities to modify benefit formulas. Under PEPRA a public employer may not adopt a new defined benefit formula unless it is the same as those in PEPRA or is certified by the retirement system’s chief actuary and approved by the Legislature.
Calculating the Pension Benefit
Only the employee’s regular, recurring pay may be used to calculate a pension benefit for new hires. Under CalPERS, uniform pay and certain one-time pays that are currently part of final compensation will now be excluded. Also excluded from the calculation is any “compensation paid to increase a member’s retirement benefit,” as determined by the retirement board (i.e., anything which arguably spikes compensation). The 1937 Act amendments are similar, except that pensionable compensation includes payments for up to 12 months of leave accrued and paid out during the period used to calculate the employee’s final average compensation, as well as termination pay earned and payable during that period.
Final compensation for calculating the pension benefit will be determined by averaging highest annual compensation over a consecutive 36-month period. Currently, a minority of local agencies uses a 3-year average; most use highest compensation over a 12-month period.
For employees subject to Social Security, the amount of final compensation cannot exceed 100% of compensation subject to Social Security taxation, which for 2012 earnings is $110,100. For those employees not participating in Social Security; final compensation cannot exceed 120% of that amount, currently $132,120. Combined with the new prohibition against offering any additional private defined benefit, many agencies have expressed concern that this cap could lead to difficulties recruiting and retaining higher level management and professional employees.
Employee Contributions for Current & New Members
The central tenet of the legislation’s approach to employee contributions is a standard that all public employees should contribute at least 50% of the normal cost of their pensions, and that employers cannot pick up any of the employees’ required share. Normal cost, put simply, is the present value of the increase in the retirement benefit attributable to the current year. The reality of this new standard may be that new members could be required to pay more than 50%, while current members likely will not.
New members must pay an initial contribution rate that is the greater of “at least” 50% of the normal cost for the new plan, or the current contribution rate of similarly situated employees. Although “similarly situated employees” is not defined, likely it means members of the same group or class of employment, in which case new members could pay the same contribution rate as current members, even if it is higher than 50% of the normal cost of the new retirement plans. This contribution rate will go into effect on January 1, 2013, except that if under a current MOU an employer is picking up the employee contribution (EPMC) for members hired before January 1, then new members will also have EPMC, and their required employee contributions will not go into effect until the MOU expires. However, once the MOU expires, new members will be required to pay the full employee contribution, and this requirement cannot be evaded or delayed through a contract extension.
While employers and unions can agree to cost-sharing above 50% at any time, the required employee contribution for current members cannot be increased to 50% of the normal cost until January 1, 2018, unless the Union agrees to increase the rate sooner. And in practical terms – again, absent union agreement – the employee contribution might not ever be increased to 50% of the normal cost because the legislation limits imposed employee contributions under the PERL to 8% of pay for miscellaneous and 12% for police and fire (11% for other safety); the legislation contains similar limitations for 1937 Act systems. For many employers, these contribution rates may not equal 50% of the normal cost for current plans, and will not mandate an increase for miscellaneous employees with enhanced retirement formulas who already pay 8%. As to existing provisions for EPMC, current members could be required to pick up the employee contribution through negotiations, but the legislation is unclear as to whether this could be imposed prior to 2018. The Governor’s Office asserts the intention is to permit unilateral implementation of the full employee contribution.
Finally, a note about cost-sharing of the employer contribution. Employers and unions are still free to negotiate beyond a 50% employee contribution rate – i.e., cost-sharing of the employer’s contribution. The legislation clarifies and streamlines the process for parties to negotiate cost-sharing above 50% of the normal cost under Government Code section 20516 by eliminating the requirement that such cost-sharing be tied to an enhanced retirement formula; it also clarifies that a public employer cannot unilaterally impose cost-sharing of the employer’s contribution.
Ban on “Airtime” Purchases
Technically, airtime purchases are not supposed to result in increased costs to the employer because the employee is required to pay the actuarially-determined present value. In reality, airtime purchases have likely contributed to some volatility in employer rates because some underlying assumptions turn out to be incorrect (for example, in addition to lower investment returns than previously projected, assumptions on age at death were recently revised upward). Whatever the true impact, effective January 1, 2013, these airtime purchases are prohibited. CalPERS believes that eliminating airtime purchases for current members could be subject to legal challenge as an impairment of vested rights, but you can still expect a run on applications for airtime purchases before the end of this year.
Other Noteworthy Provisions
- No more “pension holidays” – the total contribution (employee + employer contribution) must equal the full normal cost for the plan year except under very limited circumstances
- No more retroactive increases – future benefit increases apply only from the date of the increase
- The health benefit vesting schedule for unrepresented employees cannot be “more advantageous” than the schedule for represented employees and retirees
- Public employees convicted of certain felonies forfeit pension benefits earned after the date of the commission of the felony
- A non-safety retiree cannot work as a retired annuitant within 180 days after retirement date, except under specific circumstances
- Public safety members who are retired for service disability before the minimum retirement age may collect their earned benefit amount if it is over the 50% benefit provided for disability retirement (i.e., their benefit may be increased beyond what is currently permitted)
A product of lengthy negotiations between the governor and the legislature, the new pension law is poorly drafted, and will undoubtedly lead to significant litigation over the meaning of various provisions. The Governor’s office has suggested there will be “clean up” legislation next year; we should be on the lookout for changes that can be made to clarify and simplify the current language.
To be sure, there are some positive developments in the area of new employee benefits. For the most part, the new tiers are significantly below the benefit amounts currently being negotiated as part of two-tier arrangements around the state. In addition, by eliminating current provisions making cost-sharing of employer contributions very complex and burdensome, the legislation opens up the possibility of voluntarily-bargained agreements for cost-sharing above the mandated employee contributions.
The price of achieving these gains however, has been considerable. The legislation strongly reflects union hostility toward professional and managerial employees – in particular with respect to caps on pensionable contributions for new employees and the health care provisions. These may undercut the ability of government to recruit top quality talent in the future – particularly if the language limiting supplemental defined contribution plans remains in place.
Perhaps more significant, the legislation does not permit unilateral implementation of any significant changes in contribution rates. In addition, the legislation gives local governments little if any relief in the area of short and mid-term costs. Establishing a threshold of 50% of normal cost sharing (or 8% and 12% in CalPERS) in 2018 reflects either a misunderstanding or callous indifference to the current financial crisis that pensions have precipitated. At a minimum, the legislation should have increased the mandatory employee contribution by a few percentage points, unequivocally eliminated employer “pickups” of the employee contribution for current employees, and not relied upon “half of the normal cost” as its polestar in light of the fact that so much of employer costs are due to unfunded liabilities.
Finally, the legislation does not provide structural reforms in CalPERS governance. The Governor has said he will pursue a constitutional amendment to add greater – and less biased – expertise to the CalPERS Board. Time will tell whether this promise comes to fruition.
Overall, this legislation suggests that the limits of the legislative process have been reached. While increased employee contributions would have been very helpful, in the end, the real challenge is to address the rising cost of future benefits for existing employees. Of course, this raises complex vesting issues; still, a citizen initiative taking a run at these issues now seems all but inevitable.
 New members are those hired on or after January 1, 2013 who either did not participate in a California retirement system before then or who did but have a six month break in service before being hired. The six month break in service does not apply to state or school employees that move within state or schools respectively.
Jon Holtzman, Partner