H.F. 839 (Nelson, M.); S.F. 485 (Rest) amends Minnesota Statutes, Section 353.028, Subdivision 2, a portion of the Public Employees Retirement Association (PERA) law that permits city managers to elect to be excluded from PERA retirement coverage in favor of separate individual deferred compensation program coverage by allowing city managers who previously elected the exclusion to revoke exclusion election and to regain PERA membership for future service as a city manager for that city.

Before 1981, city managers were included in PERA coverage on a mandatory basis if their compensation equaled or exceeded the $425 per month PERA minimum compensation eligibility requirement. In 1981 (Laws 1981, Chapter 254, Section 1), city managers were granted the authority to elect an exclusion from PERA coverage in favor of separate individual deferred compensation program coverage. The legislation was sought by the group of city managers in the state and was supported by the state group of mayors. The International City Management Association (ICMA), a national organization of city managers and related professionals, sponsors a proprietary deferred compensation program through a third party vendor. The argument for the separate pension coverage authority presented in 1981 related to the nature of city manager employment, which generally is characterized by frequent changes of employment between cities in different states. In 1981, PERA had a long vesting period (ten years) and many city managers changed employment more frequently than that. PERA is a defined benefit retirement plan meaning that the ultimate pension benefit is a function of a person’s final average salary and length of service, rather than the contributions made by the person. Defined benefit retirement plans, even when their vesting periods are short, as PERA’s vesting period is now (three years), are not as portable as defined contribution plans, such as the ICMA Deferred Compensation Program.

The exclusion election provision was amended in the 1988 PERA administrative bill (Laws 1988, Chapter 709, Article 5, Section 8) to lengthen the amount of time a newly employed city manager would have to elect the exclusion from PERA coverage to six months from the original 30 days, and to provide for a refund of any employee and employer contributions for the pre-election period, if applicable.

Occasionally in recent years there has been interest in permitting city managers to revoke the election they made to be excluded from PERA-General, but that change has not been adopted.

The General Employee Retirement Plan of the Public Employees Retirement Association (PERA-General) is governed by Minnesota Statutes, Chapter 353, and various other provisions of law. It is a defined benefit retirement plan that provides disability coverage, survivor benefits, and retirement coverage to over 137,000 non-public safety employees throughout the state. PERA-General provides coverage to public employees other than public safety employees who work for the counties, cities, and in non-teaching positions in school districts. PERA currently has over 43,000 retirees and 29,000 deferred retirees. PERA-General assets exceed $11 billion, but liabilities exceed $12.9 billion, creating a funding ratio of 85 percent. Currently, under law the employee contribution rate to PERA-General for a coordinated member is 5.1 percent of pay, while the required employer contribution rate is 5.53 percent of pay.

Being a defined benefit plan means that the retirement benefit is specified by a formula in law. Under these formulas, the average of salary close to retirement (the average of the five consecutive years that provides the highest average salary) is multiplied by a factor (or factors) referred to as accrual rates. An accrual rate is the percentage of the high-five salary that the individual receives per year of service. This result is then multiplied by the number of years of service to determine the benefit. For a PERA-General member who started covered service in one of the larger Minnesota public plans after 1989, the normal retirement age is 66. That is the age at which an individual, following termination of covered service, can receive an annuity without any penalty due to early commencement of the benefit. Under law, a terminated employee may begin drawing annuity as early as age 55, but with a reduction due to early retirement. If a PERA member starts drawing an annuity at the normal retirement age, the accrual rate in law is 1.7 percent (assuming a coordinated member, which means a member who is also covered by the Social Security old age retirement system for the covered employment). If the high-five average salary happened to be $40,000 and the individual had 30 years of service, the annual benefit would be $40,000 x 1.7 percent x 30 years = $20,400.

Defined benefit plans have certain common characteristics. Defined benefit plans place all investment risk on the plan. Whether investment returns are good or bad, the individual is entitled at retirement to the benefit computed under law, and the public employers must provide sufficient resources to cover the benefits. Defined benefit plans favor long-term employees. Individuals who become employees covered by the plan but who leave covered employment after a few years may not vest in the plan and therefore are not entitled to any annuity from the plan, currently or in the future. Under current law, employees are vested when they reach three years of covered service. Even if the terminating employee is vested, if the individual is young and does not have considerable service, the future annuity may have little value. The best option from a financial standpoint may be to take a refund of contributions, which under law is a refund of the employee contributions to the plan plus six percent interest. The contributions that the employer made to the plan for that employee and all investment earnings on the employer contributions, plus any investment earnings on the employee contributions above six percent, remain with the plan. These amounts left in the plan are referred to as turnover gain. Turnover gain helps to provide adequate funding to pay the benefits to those who remain in the plan. Without turnover gain, the required contributions to the plan would need to be higher. Benefits provided by a defined benefit plan are not portable, at least not fully. A fully portable benefit moves with the employee, avoiding harm. The benefit from PERA-General is not fully portable. For a relatively short-service employee who terminates service, a refund may be the best or only option, which, as previously noted, does not make the employee whole. Other terminated employees may chose not to withdraw any money from the pension fund, leaving them eligible for a deferred annuity (an annuity payable years in the future, when the individual achieves at least the minimum age for drawing annuity). This provides some value to the ex-employee, but the value of that deferred annuity is likely to be less than the value the individual would have had for that portion of the individual’s career if he had remained in covered service.

There is a provision in Minnesota public pension fund law called the combined service annuity provision (Minnesota Statutes, Section 356.30). This provision may be used by individuals who are job-mobile within Minnesota public employment, moving from a position covered by one Minnesota public pension plan to a position covered by another Minnesota public pension plan, providing both plans are listed as included plans under the combined service annuity law. Due to the combined service annuity law, the individuals would be treated, when the benefits from the two plans are added together, comparable to the total benefit the individual would receive if all covered employment had been under a single plan. The combined service annuity provision, however, applies only to certain included Minnesota public plans. It has no application if a public employee moves to private sector employment.

While defined benefit plans place all investment risk on the employer, defined contribution plans place all investment risk on the employee. The fate of the individual depends on the terminal value of the account at the time of retirement or disability, which is determined by the cumulative employee and employer contributions and the investment earnings on those contributions. Typically, it is the employee who must make the investment decisions by choosing among the investment options provided through the plan. In favorable investment markets, the individual may do well if he or she makes wise investment choices. If the markets are bad, or even in good markets if the individual makes bad investment decisions, the individual will bear the harm.

Defined contribution plans are fully portable. The individual retains the value of his or her account when the individual terminates employment.

Because of the risk and general uncertainty that defined contribution plans create for employees, the state provides defined benefit plan coverage for most public employees. All Minnesota public employees, however, have access to defined contribution plans as supplemental coverage. An example is the Minnesota State Retirement System (MSRS) deferred compensation plan, which is available to all Minnesota paid public employees. Employees can decide on a voluntary basis whether to create an account in that plan, which they finance through additional employee contributions, to help them save for retirement, healthcare costs, or other purposes. In some situations, employers are also authorized to make contributions to that plan on behalf of employees.

In general, defined contribution plans are used for primary pension coverage only for limited groups of individuals where the group is expected to be highly job-mobile, and/or where the covered employment is expected to be short term. They are also more likely to be offered to highly compensated groups, in part because it is assumed that the individuals are more likely to make good investment decisions and will be better able to live with the outcome, if it is unfavorable, than a member of a lower income group. An example is the Higher Education Individual Retirement Account Plan (Higher Education IRAP), created in 1988, coded as Chapter 356B. This plan was created at the request of educators in the state colleges and university system who contended that they operated in a national job market and were highly job-mobile. A fully portable benefit was a primary consideration for the group, and the Legislature was persuaded to create a defined contribution plan for them. It became clear, however, after a few years had passed that this coverage was not ideal for all members of this higher education faculty group. In current law, a higher education faculty member will have IRAP coverage only if the individual elects IRAP coverage. Otherwise, the default coverage is a defined benefit plan, either the statewide defined benefit teacher plan (Teachers Retirement Association (TRA)), or a first class city teacher plan, if applicable. An IRAP election is irrevocable.

The investment markets influence the pension coverage requests that the Legislature receives because of the investment climate’s influence on people’s willingness to incur investment risk. In the late 1980s and through most of the 1990s, investment markets were strong, often providing investment gains well in excess of long-term averages. In times like those, defined benefit plans do not look attractive. Individuals become convinced that they would be better off if they could have an account of their own to invest, concluding that the terminal value will be considerably higher than the value of the benefit to be offered by the defined benefit plan. Favorable investment markets influenced higher education faculty to request creation of a defined contribution plan for them. The Higher Education IRAP was created, despite concerns that many members of this group were not particularly job-mobile. A few years later, the plan’s coverage was extended to include technical college faculty, who may be less job-mobile than other faculty and seem less likely to operate in a national rather than regional or local job market. In 1994, a similar IRAP was created for certain other professional employees, if they specifically elect that coverage. That plan, coded as Chapter 354D, currently is offered to professional employees of the state arts board, the Minnesota Humanities Commission, and the Minnesota Historical Society, who elect this defined contribution plan coverage in lieu of the applicable defined benefit plan. Similarly, in 1996 Public Employees Retirement Association Defined Contribution Plan (PEDC) coverage was expanded to allow certain physicians who are local government employees to elect PEDC coverage rather than PERA-General.

When investment markets turn bad, it is not uncommon for members of defined contribution plans to question the coverage decisions they made. They fear that the terminal value of their account may be worth considerably less than the benefit provided by a defined benefit plan. Legislators receive requests to allow individuals to transfer coverage to a defined benefit plan, despite the irrevocable election that the individuals made. In some cases these requests are for prospective coverage. In other cases, individuals want the transfer to also apply to the years of service already provided.

When any group is offered an election between defined benefit plan coverage and defined contribution plan coverage, the Legislature has in nearly all cases made that election irrevocable. There are several reasons. An irrevocable election keeps individuals from switching between defined benefit and defined contribution plans. If revocations were permitted, it could create adverse selection problems for the defined benefit plan, particularly if past service is also covered. Individuals who switched from defined contribution to defined benefit coverage after several years of service may be older than the typical new PERA-General entrant, which tends to increase plan normal cost. Also, this group would have made the switch because they intend to stay in covered employment and retire from the plan. For that self-selecting group, the usual assumptions regarding turnover in PERA would be violated, and PERA would eventually face higher than expected liabilities. The individuals may also be seeking to retreat to defined benefit plan coverage during bad markets, coupled with a desire to return to defined contribution plan coverage in good investment markets, which may harm the defined benefit plan.

Pension policy issues include the following:

1. Potential For Future Demands for Buyback. The issue is the potential for future demands for authority to purchase prior service credit for any period of exclusion from PERA. The proposed legislation indicates that the PERA coverage following a revocation of the previous PERA exclusion election would be prospective only, but the provision would leave any affected city manager with a disparity between the person’s total Minnesota public service and the person’s allowable service credit in PERA. Inevitably, in the future, affected city managers who are approaching retirement and who desire to access the "Rule of 90" early retirement provision or other PERA benefit plan that places a premium on long service will seek a future opportunity to purchase PERA allowable service credit for that excluded city manager service. The draft proposed legislation either should clarify that the revocation is also a waiver of any future service credit purchase authority or should include a full actuarial value service credit purchase provision.

2. Voiding an Irrevocable Election. The issue is whether the Legislature should void an irrevocable election. There have been situations where the Legislature has taken that action. However, these actions undermine the law, provide a reason for individuals to not carefully study the nature of pension coverage options that have an important impact on their futures, and lead to more requests for the Legislature to rescue people from the consequences of their actions.

3. Proper Justification for Proposed Change. The issue is why individuals who earlier elected exclusion from PERA-General now want that coverage. The Commission would now have to decide if the request has sufficient merit to permit the coverage change. Perhaps changes in PERA-General since the exclusion was granted now make PERA-General a more appropriate retirement plan coverage for these individuals. Perhaps changes in the nature of city manager employment now makes PERA-General a more appropriate form of coverage. Possibly city manager salaries are increasing faster than those of other public employees, making PERA-General coverage desirable because of the impact of those salary increases on high-five average salaries. If that is the case, PERA-General is advantageous to the individual, but the shift is harmful to PERA-General funding. Another reason some city managers may be seeking the proposed change is the impact that the investment markets have had in recent years on the value of defined contribution plan accounts. Individuals may now value the protection that a defined benefit plan provides. Permitting these individuals to shift to defined benefit plan coverage shifts all investment risk to the employers, who are responsible for funding the defined benefit plan. Given continued bad investment markets, the public retirement fund may not be able to earn the level of returns necessary to avoid pressure to increase contribution rates to support these defined benefit plans. The Commission may also be concerned that city managers who switch to PERA-General coverage under these bills may request another law change at a future date, permitting them to again switch back to defined contribution plan coverage in the future, after investment markets return to normal.

4. Requests for Similar Treatment. The Commission may choose to consider that there are other groups that wish to shift from defined contribution plan coverage to defined benefit plan coverage. If the Commission permits a change for one group, there will be pressure to do it for all. These requests are unquestionably in part due to the bad investment markets. LCPR staff is aware of a group of physicians in the PERA Defined Contribution Plan who desire to revoke an irrevocable election and shift to PERA-General. There are also groups who now have IRAP coverage who desire to shift to defined benefit teacher plan coverage.

5. Continued Advisability of Using the ICMA Plan rather than PEDC. The pension policy issue is the question of the advisability of using the International City Management Association (ICMA) or other deferred compensation arrangements as the alternative pension coverage arrangement for city managers who elect to be excluded from PERA. When the city manager PERA exclusion provision was enacted in 1981, PERA had no defined contribution plan that it administered. PERA now has a defined contribution plan that it administers for elected local government officials and local government physicians. The current existence of a defined Minnesota contribution plan for potential use by city managers who do not want defined benefit plan coverage should be considered with respect to the future operation of this provision.

6. Effective Date. The draft proposed legislation lacks a specified effective date, making it effective on August 1 following passage. The policy issue is the optimal date for pension legislation to be effective. Most pension legislation making benefit changes is effective either immediately upon enactment or on July 1.

7. PERA-General Actuarial Condition, Given Adverse Election Concerns. The issue is the actuarial condition of PERA-General given the possibility of adverse selection that coverage transfers might create. PERA-General’s actuarial condition as of the most recent actuarial valuation, July 1, 2002, is noted below. The plan’s assets are 85 percent of its liabilities (its funding ratio is 85 percent), and the plan has a contribution deficiency of .57 percent of payroll, or $22.9 million.

If comparable changes are permitted in the IRAP plans, there may also be some currently unknown impact on the various defined benefit plans that would provide the new coverage. Those would be the Minnesota State Retirement System General Plan (MSRS-General), TRA, and the three first class city teacher plans. One of those teacher plans, the St. Paul Teachers Retirement Fund Association (SPTRFA) has funding problems, and another, the Minneapolis Teachers Retirement Fund Association (MTRFA) has a severe funding problem.

Amendment LCPR03-097 is a technical amendment. It formats the bill into paragraphs, moves election language, further specifies that all elections must include a statement that the individual will not seek a service credit purchase, and adds an effective date.