COUNTY OF SAN MATEO

Inter-Departmental Correspondence

Employee and Public Services

DATE:

February 17, 2005

BOARD MEETING DATE:

March 1, 2005

SPECIAL NOTICE/HEARING:

None

VOTE REQUIRED:

Majority

TO:

Honorable Board of Supervisors

FROM:

John Maltbie, County Manager

Mary Welch, Employee and Public Services

SUBJECT:

Board Report on Additional Retirement Credit Survey

RECOMMENDATION:

1. Accept the report of the survey of California public sector organizations regarding the implementation of the Additional Retirement Credit,

2. Refer this report to the Board’s Legislative Committee with the request that the County propose legislation granting the Board flexibility in the implementation parameters and the ability to adjust the actuarial value for each individual and

3. Defer use of 457 Deferred Compensation funds until there is a favorable ruling from the IRS.

VISION ALIGNMENT:

Commitment: Responsive, effective and collaborative government.

Goal 20: This realizes the goal of assuring that government decisions are based on careful consideration of future impact, rather than temporary relief or immediate gain.

BACKGROUND:

On July 27, 2004, the Board reviewed an actuarial study provided by Mercer on the feasibility of implementing Government Code Section 31658 (AB 55) relating to the purchase of Additional Retirement Credit (ARC) by County employees. Section 31658 provides that active members of retirement systems may purchase up to five years of additional retirement credit upon local county board of supervisor enactment of an enabling resolution. Employees choosing to exercise this option would be required to pay an amount, by lump-sum payment or by installment payments over a period not to exceed 10 years as calculated by an enrolled actuary, sufficient not to place any additional financial burden on the retirement system.

The Mercer study concluded that “the number of assumptions makes it very difficult to guarantee that any service purchase would be ‘cost neutral’” as specified by the section 31658. There were two major issues with implementing section 31658:

1. Critical variables, such as the number of participants, gender, marital status, age at retirement, salary assumptions and changes in benefits could actually add cost to the retirement system.

2. The use of deferred compensation funds, which would be the likely resource for the majority of purchases, had not been approved by the IRS. The County’s Deferred Compensation Administrators indicated that government 457 plans risk the eligibility of their 457 plans if the IRS determines that such transfers are prohibited.

Because of these two major uncertainties, the Board requested that the County survey other public sector organizations to determine the potential impact of adopting this ARC option.

DISCUSSION:

A: Survey Results – 1937 Act Counties / PERS

All of the twenty 1937 Act Retirement systems were contacted to determine if they had adopted the ARC option. San Diego, Alameda and Ventura have rejected the option because of cost concerns. We understand Contra Costa and Orange have similar cost concerns which may prevent them from adopting it as well. Many of the other 1937 systems indicated that they would postpone consideration of implementation until the next scheduled collective bargaining negotiations. Of the 20 systems under the 1937 Act only Los Angeles, San Bernardino and Santa Barbara have implemented the provision. All three of these counties permit the use of 457 funds to pay for the purchase only during the 120 day post-retirement period.

Los Angeles: Los Angeles indicated that 448 individuals have purchased an ARC of which 208 are male and 240 female. They do not have any figures on the number of individuals who have retired. They estimate an annual 5% salary increase and a retirement age of 60. They permit the use of 401(k), IRAs or other tax qualified (non 457) plans to purchase the benefit prior to retirement.

Santa Barbara: In Santa Barbara, a total of 15 individuals have purchased an ARC. Of these, 8 are female and 7 are male. Santa Barbara assumed a 5% annual salary increase in their calculation of the cost estimate. They understood that this estimated annual increase might be high. They acknowledged in this estimate that individuals who purchase the benefit many years before they retire are potentially paying more than necessary for their benefit if their actual salary is lower than their estimated salary. Santa Barbara permits the use of defined contribution plan assets to purchase the benefit. Nine individuals used these assets in their purchase.

San Bernardino: In San Bernardino, a total of 587 employees have requested estimates and 109 individuals have purchased an ARC or are in an irrevocable pre-tax contract to do so. Of the 109, 56 are female of which three are retired. Of the remaining 53 males, four are retired. San Bernardino identified $17,000 in initial costs for the actuarial study and staff support. Because of the number of requests, they have also allocated an accounting technician and Accountant II on a part time basis. San Bernardino used a 5.5% estimated salary increase.

PERS: Unlike the 1937 Act plans, PERS did not require that local agencies adopt the provision of the Additional Retirement Credit. Instead, individuals within PERS agencies were allowed to pursue directly and independently of their employers, the purchase of eligible time. As a result, neither PERS nor PERS agencies capture that information. Nevertheless, PERS provides notification to interested participants (Attachment 1) requiring them to certify that service, public or private must have actually been performed. Additionally, PERS allows individual participating employers to determine whether and under what conditions they will permit the use of 457 funds.B: Risks

Although the survey results did not yield broad information about the cost neutrality of those agencies who have implemented this option, the two major risks identified above can be addressed by our recommendations as identified below.

1. Cost

The County explored the possibility of restricting the commencement of purchase to the 120 days before retirement in order to eliminate the adverse impact of cost variables since final salary, years of service and age are more clearly defined but County Counsel opined that this option maybe subject to legal challenges due to the wording of the statute. The three other counties that have implemented section 31658 have not restricted the time that the purchase can be commenced. In other systems, like Santa Barbara, a participant’s earlier purchase of ARC may reduce the cost to the participant but increases the potential cost to the plan. For example, even though the 5% salary assumption for Santa Barbara purchasers is higher than would likely occur, an individual who is promoted or reclassified and therefore earns substantially more in final salary than was assumed would receive a benefit that was not cost neutral to the retirement system.

The County met with AFSCME and SEIU on February 16, 2005 to discuss the recommendations. The employee organizations requested that the County permit individuals to purchase ARC over a longer period of time and to adjust the actuarial value to assure that there was no cost to the retirement system. We agreed to incorporate their suggestion into the recommendation.

2. Use of Deferred Compensation Assets

There is no clear federal statutory legislative directive regarding the use of 457 funds to purchase an ARC, and the IRS has yet to rule on its appropriateness. Based on the information provided in Attachment 2, we believe the use of defined contribution assets (457 plan funds) is inappropriate until the IRS rules on this subject.

3. Summary

In addition to deferring the use of 457 funds to purchase ARC, our recommendation is to request that the Legislative Committee of the Board propose legislation granting the Board flexibility in the implementation parameters to minimize the above risks that the implementation of AB55 be cost neutral to the plan.

FISCAL IMPACT:

None at this time.

Attachment 1: Notification to CalPERS Participants

IMPORTANT INFORMATION ON TRANSFERS FROM 403(b) OR 457 PLANS

TO PURCHASE ARSC AND THE FEDERAL TAX LAW

Assembly Bill 719 added section 20909 to the Government Code. This new section allows eligible members of the California Public Employees’ Retirement System (CalPERS) to purchase up to five years of Additional Retirement Service Credit (ARSC). ARSC is not based on actual employment with a CalPERS covered employer. Instead, it is “permissive” service credit available to members to increase their retirement by making voluntary, additional contributions.

The Internal Revenue Service (IRS) has not yet issued formal rules on purchases of permissive service credit. Some have suggested that the Internal Revenue Service (IRS) will require the purchase of permissive service credit to reflect some sort of actual “service” in order for in-service, plan-to-plan transfers¹ from 403(b) or 457 governmental plans to be used to pay for ARSC. As a result, CalPERS is acting prudently by requiring members to certify to “corresponding service” before assets from 403(b) and 457 plans may be transferred in-service to purchase ARSC. The corresponding service may be for compensated private sector or self-employment, as well as prior government or military service that has not been credited under the CalPERS plan.

However, there is a slight risk that even with certifying to the “corresponding service,” the IRS may find that in-service transfers from 403(b) or 457 plans are not permissible to purchase ARSC. In this event, CalPERS may be required to take corrective measures, such as reversing the transferred amounts and related earnings back to the transferor plan. Alternatively, the IRS could treat the amount transferred from these accounts as taxable income on the date it was transferred. In addition, the transfers made to the CalPERS defined benefit plan might be treated as after-tax contributions and subject to the $41,000 annual additions limit imposed by section 415(c) of the Internal Revenue Code.

To help CalPERS members achieve the greatest amount of portability of their retirement accounts with the least amount of risk, CalPERS is requesting a ruling from the IRS that amounts may be transferred from a 457 plan to the CalPERS defined benefit plan to purchase ARSC without corresponding service. Therefore, in the interim, CalPERS is including this notice to members so they are aware of the potential risks associated with in-service transfers from 403(b) and 457 plans to purchase ARSC. Members should be aware of these risks, however slight, before electing an in-service transfer of funds from these accounts to purchase ARSC.

1 An in-service, plan-to-plan transfer (also referred to as an in-service transfer) is a direct transfer of assets between retirement plans in which the funds go directly to CalPERS. An in-service transfer allows a participant to avoid current taxation on the amount transferred and, unlike a rollover, it is permitted in the absence of a distribution event (i.e., separation from service, retirement, disability, or death).

Attachment 2: Results of Research on Use of 457 Funds to Purchase ARC

Because the IRS has not formally addressed the issue of using 457 Deferred Compensation funds to purchase ARC, those jurisdictions that have implemented the option have solicited legal opinions.

For 1937 Act systems, the use of 457 funds to purchase of ARC time has been reviewed by a few tax counsels. The consensus appears to be as follows. The member must be an active member to enter into the contract to purchase the ARC time, however, if the County has adopted Section 31485.7 which allows the purchases of time to be completed within 120 days from termination of employment, then the completion of the payment can be made during this 120 post-employment period. (Section 31485.7 has been adopted in this County.) The tax counsels are of the opinion that an active employee cannot use 457 funds during employment for the purchase but believe that “If a distribution and transfer were made from the county’s 457 plan after termination of service to purchase ARC time, this distribution should be allowed under the IRS interpretation of section 457(e)(17)”. The three systems that do allow purchase of ARC each allow the use of 457 funds to complete the purchase during the 120 day post employment period.

PERS acknowledges that if the IRS ultimately rules that 403(b) or 457 funds may only be used to purchase actual service, then those purchases that agencies have permitted under AB 719 will need to be reversed. We contacted the City of Redwood City and were informed that they are not permitting 457 funds to be used to purchase credit nor are they familiar with other agencies who do permit such resources.

Both of the above interpretations differ from some of the Deferred Compensation providers as quoted in the next section.

Hartford, ICMA and Nationwide were again contacted to determine if there has been any change in either their or the IRS’s view of using 457 funds to purchase additional time that was not linked to actual services.

Hartford stated that the PERS service credits “may not satisfy the Code 415(n) limitation exception due to the nature of the ‘service’ to be credited and the fact that an individual need not be employed to effect the purchase.” Hartford goes on to state: “Of note, we understand that the California Public Employees’ Retirement System (CalPERS) will no longer allow for the purchase of service credits unless actual service has been performed and the individual has yet to retire.”

ICMA stated that they continue to “strongly recommend against employers allowing plan participants to use 457 assets to purchase “Air Time” until either Congress passes legislation or the IRS provides formal guidance expressly allowing for these types of purchases.” ICMA does believe it is acceptable to purchase credits within the 120 day post employment period using a rollover of 457 funds.

Nationwide stated that “informally, the IRS has conveyed at various times that governmental 457 plans should not permit the transfer of assets to qualified defined benefit plans for the purchase of air time. Consequently, governmental 457 plans are risking the eligibility of their 457 plans if the IRS determines that such transfers are prohibited. For these reasons, Nationwide is recommending that plan sponsors defer a decision to permit the transfer of 457 assets to purchase air time until the IRS provides formal guidance regarding this issue”.

Until the IRS indicates that the use of such funds is permissible, either through their issuance of guidelines or in a response to PERS’ request for a ruling, employers who permit use of such funds risk plan non-compliance and individual participant taxation.