Summary of H.F. 308 (Eastlund); S.F. 616 (Lourey)

H.F. 308 (Eastlund); S.F. 616 (Lourey) authorizes a current Minneapolis employee with MERF coverage, born on June 13, 1953, to purchase service credit in MERF for a period or periods of temporary employment with the city during 1975 and 1976 by making a full actuarial value payment to MERF by October 1, 2003 or prior to retirement, whichever is earlier.

Background on Service Credit Purchases

Every legislative session the Legislative Commission on Pensions and Retirement (LCPR) reviews requests for service credit purchases in Minnesota public pension plans, either in the form of special legislation or general legislation. In considering these requests, the LCPR has generally been guided by the following statement in the LCPR’s Principles of Pension Policy. The applicable principle, II.C.10., reads as follows:

10. Purchases of Prior Service Credit

If the situation involves Minnesota public or quasi-public employment, if the pension fund is not harmed by the purchase, if the purchase does not raise broader policy concerns, and if the purchase does not violate equity considerations, the LCPR generally recommends that the bill be enacted.

In 1999, the LCPR heard and recommended to pass several general law service credit purchase provisions for teachers. Those provisions were unusual in that they departed from the usual requirements for service credit purchases. Teachers who were vested members of their pension plan (had at least three years of covered service) were able to purchase service credit in the plan for service or periods of time for which the individual did not have service credit. The purchase requires payment at full actuarial value, a concept that is described below. Purchases are allowed for uncovered periods of military service, out-of-state teaching service, maternity leaves or breaks in service for which service credit was not previously received, parochial or private school teaching, Peace Corps of VISTA service, charter school teaching service, and prior uncovered teaching service at the University of Minnesota. The provisions are coded in Teachers Retirement Association (TRA) statutes as Sections 354.53 through 354.541. Similar provisions, including one for previously uncredited part-time teaching service, are coded in law for first class city teachers as Sections 354A.097 through 354A.104. These sections are set to expire on May 16, 2003. Other sections which included provisions for some other pension plans passed a year or two later. These deal with military service credit purchases and family leaves of absence. These are also set to expire in 2003.

The provisions are unusual by applying to whole classes of individuals rather than requiring individual legislative review. Some of the service permitted to be purchased has no connection to Minnesota (such as the out-of-state teaching provisions, or in some cases the military service credit purchase provisions), or are not public or quasi-public employment (such as the purchases of service for parochial or private school teaching service).

The Legislature’s motivation for passing legislation that departed from past established policy may have been that the provisions were viewed as temporary measures to deal with short-term employment situations. Alternatively, the Legislature may also have felt that past policy needed to be revised. The Legislature was also given repeated assurances that the provisions would not cause financial harm to the pension funds because in theory the purchase price was expected to cover the additional liabilities that were created, at least on average.

Background on the Current Situation

H.F. 308 (Eastlund); S.F. 616 (Lourey) applies to an employee of the City of Minneapolis who remains an active MERF member. The covered individual was hired by the city on a full-time permanent basis in 1977. The bills are a purchase of service credit request. The covered individual is seeking special legislation to authorize a purchase of service credit for a period during 1975 and 1976 in which the individual was employed by the city but in temporary employment. Laws from the period indicate that temporary employment positions were excluded under law from retirement plan coverage.

Temporary Employment Positions: MERF Law

A copy of relevant MERF statutes from 1976 is attached. For purposes of MERF law, employees are divided into a contributing class and an exempt class. The contributing class is the MERF-covered employees. These are the employees authorized to make contributions to the plan and who are eligible for benefits under the plan. The exempt class is not eligible to contribute to the plan and does not accrue service credit toward benefits. Section 422A.09, subdivision 3, clause (4), indicates that persons employed on a temporary basis as laborers and in similar occupations and who work less than 1,000 hours are in the exempt class. If the eligible individual under these bills was correctly categorized as a temporary employee, it appears that the city and MERF treated the individual consistent with the law at the time that the temporary employment was provided.

Full Actuarial Value Service Credit Purchases

If the LCPR and the Legislature pass a special law service credit purchase request, the standard payment procedure is to require payment of the full actuarial value of the service credit. Under that process, if the payment is correctly computed, the cost of the service credit is equal to the expected additional value of the retirement annuity that occurs due to the service credit purchase. In other words, there should be no net monetary gain to the individual due to the service credit purchase. From a financial standpoint, it is worthwhile to make a service credit purchase only if the employer or the fund provide a subsidy.

Possible Sources of Subsidy, Cost Shifting

On a few occasions, the LCPR has required the pension fund to provide a subsidy by specifying in law a service credit purchase price which is less than the full actuarial value. This procedure may be used if the LCPR concludes that the pension fund, through a failure to follow applicable law or other administrative error, harmed the individual. While LCPR staff does not have considerable information on the situation covered by these bills, the situation as described suggests that MERF administrators did not err or create any harm to the eligible individual. This would argue against using any methodology, assuming the Legislature approves any form of service credit purchase, which does not fully compensate the pension fund for the additional liabilities created by the purchase.

At times the LCPR has required payment of the full actuarial value as indicated by the full actuarial value computation (found in Minnesota Statutes, Section 356.55), but has required the employer to cover a large portion of that cost on behalf of the employee. This approach is used when the LCPR concludes that the employer harmed the individual and the employer should provide compensation for that harm. Under these arrangements, to receive the service credit the individual is required to pay the member contributions that would have been made at the time, plus interest, and the employing unit is required to pay the remainder of the full actuarial value. In this manner, the pension fund is not harmed because it receives the full actuarial value of the service credit purchase, through a combination of payments by the individual and the employer. In the case covered by these bills, it appears that the city followed applicable law and did not cause harm to the individual, suggesting that requiring the city to cover a portion of the full actuarial value may not be appropriate in the this situation.

Full Actuarial Value Method Issues

If the pension fund does not receive the full actuarial value of a service credit purchase, the contributors to the plan subsidize the purchase. The liabilities of the plan must be covered in the long run and, if the purchase price of a service credit purchase is less than the resulting liability, assets to cover those added liabilities must come from some other source. This will occur whenever a service credit purchase is approved which does not require payment of the full actuarial value. It will also occur when the intention is to require a full actuarial value payment, but the methodology is flawed, resulting in underestimates of the true cost. When the methodology underestimates the true cost, more liability is created than the pension fund will receive in assets when it receives the purchase payment amount.

The method currently used to compute the full actuarial value purchase price of a service credit payment is found in Minnesota Statutes, Section 356.55. This provision, enacted in 1998, temporarily replaced another computation for full actuarial value (found in Section 356.551), which tended to produce higher estimates of the cost. Section 356.55 is set to expire on July 1, 2003, at which point Section 356.551 will again be the applicable provision unless the expiration date on Section 356.55 is delayed by some legislative action during this session. Perhaps the original method overstated true costs, and the newer method provides a more accurate picture. It may also be the case that the old method was more accurate, and the new method tends to create subsidies.

LCPR staff has had increasing reservations about the newer computation found in Section 356.55. It seems to create subsidized purchases in certain circumstances. More generally, there are reservations about both methodologies given recent investment markets. Built into the computations is an assumption about the rate of return that the pension fund will receive on the money after the payment is received and prior to retirement. The larger that expected return, the lower the purchase price will be. Section 356.55 assumes an 8.5 percent return, while in the case of a purchase of service credit in MERF, Section 356.551 would assume a 6.0 percent return. In recent years, either estimate greatly exceeds the return that public pension funds have been able to earn. This is likely to lead to subsidies for service credit purchases that were made in recent years, at the expense of the other contributors to the applicable pension funds.

Even if there is no explicit subsidy that can be detected, there is in all cases a shift of risk from the individual to the public employer or employer who provides the plan. In effect, the individual is purchasing an annuity provided by the employer. The purchase payment is made and in exchange receives guaranteed monthly payments for life. If all goes well, that will not be a particular burden on the employer. If there are difficult investment markets, however, the employer must find the resources to cover the monthly benefits that have been promised.

Issues Specific to MERF

There is some risk to the state under this draft language. In the specific case of MERF, if there is a flaw in the methodology that leads to a service credit purchase price which is less than the full cost, some of the burden for any unfunded liability may shift to the state. Under law, MERF-contributing employer payments toward MERF unfunded liabilities are largely composed of a contribution of 2.68 percent of payroll, plus $3.9 million. Any required contribution toward unfunded liabilities in excess of those employer-mandated payments is picked up by the state, but not to exceed $9 million in any year. The most recent actuarial work for MERF (July 1, 2002) indicates that required state contributions for the year toward MERF’s unfunded liability is $6.6 million. Total state contributions over the years to help retire MERF unfunded liabilities are approximately $170 million.

MERF has a 30-year-and-out provision, permitting individuals who are credited with 30 years of MERF service credit to retire with an unreduced pension regardless of age. It is likely that the individual covered by this bill draft is seeking additional service credit to permit retirement sooner than would otherwise be the case. This would work against recent MERF and city efforts to discourage MERF-covered employees from leaving service. In large part that effort is motivated by an effort to minimize a cash-flow problem. MERF has been closed to new members for many years, and is quickly losing its remaining active members to retirement. At the time of retirement, Minneapolis is required by law to provide the full required reserves to fund those pensions for the remaining expected lifetime of the retirees. These amounts must be transferred from the employer’s account in the Active Fund (in which the assets for active members are held and invested) to the Retired Fund within MERF. If the assets in the account are not sufficient to make the transfer, the city is required by law to deposit additional money in the account to cover the transfer.

By discouraging retirements from MERF, the city delays the need to deposit additional funds above those required by the funding requirements found in the MERF actuarial report. Over the next few years the city will be expected to make considerable additional deposits in MERF to cover these transfers. All active members are predicated to retire by 2008. To obtain funds for these transfers and for many other needs within Minneapolis, the city recently approved selling bonds.

Similar Prior Situations

The LCPR heard two cases in 2000 similar to the current one. Both were recommended to pass (Laws 2000, Chapter 461, Article 19, Sections 9 and 10). Both dealt with Minneapolis employees who had periods of temporary city employment prior to being hired in a permanent position. Under law that applied when these individuals provided the temporary service, the city correctly excluded them from pension plan coverage. Under the 2000 legislation, the two individuals were permitted to purchase MERF service credit for the period of temporary service. The individual covered by the current bill draft is a coworker of one of the individuals covered by the 2000 legislation, and he is seeking comparable treatment.

The cases that passed in 2000 met some of the usual requirements found in the LCPR’s policy statement for purchases of service credit, quoted previously. The employment periods being purchased were periods of service to a public employer, Minneapolis, and the employment was of the general nature of public employment. The purchase was at full actuarial value. Therefore, the purchase did not involve a subsidy from others, assuming that the full actuarial value methodology does produce an accurate estimate. However, the purchases may not have been consistent with notions of equity and fairness, which is one of the criteria in that policy statement. The periods of excluded service were properly excluded under law. The individuals were treated properly under the laws in effect during those periods and consistently with other employees in those same excluded employee categories. The authority granted to these two individuals under the 2000 legislation may have created a fairness issue for others. These two individuals were given a right not extended to other similarly situated individuals.

The two cases in 2000 laws are a precedent for permitting a service credit purchase for a period of employment with a public employer that had been properly excluded from the pension plan under then-existing law. Continued movement in this direction may undermine the excluded employee provisions. Public pension plans have both included employee provisions and excluded employee provisions. Individuals in the included employee provisions are plan members who earn service credit in the plan through the required ongoing contributions deducted from their paychecks. Individuals in the excluded employee categories are not covered by the plan. The excluded employee category typically includes employees working for the public employer who, due to other law, are covered by other public pension plans; or who are short-term, intermittent employees; or who are consultants retained by the employer or employees of that consultant; and various other groups. By allowing some excluded employees to purchase service credit, in effect there will be a category of included employees who are members on favorable terms, and a category of individuals who are conditionally included. If an individual in this latter group pays the purchase price he or she can be in the plan for that service, but on less favorable terms than the individuals covered by the included employee provisions.

Pension Policy Issues

H.F. 308 (Eastlund); S.F. 616 (Lourey) authorizes a current Minneapolis employee with MERF coverage, born on June 13, 1953, to purchase service credit in MERF for a period or periods of temporary employment with the city during 1975 and 1976, by making a full actuarial value payment to MERF by October 1, 2003 or prior to retirement, whichever is earlier.

Pension policy issues are:

Need for Justification for Change. The issue is whether there is sufficient need or justification for legislative action on this issue. If the purchase price is an accurate estimate of the liabilities that will be created, which a full actuarial value service credit purchase is supposed to be, legislative time will be spent to produce an outcome which leaves the individual financially no worse off and no better off than he currently is. There is, however, a downside. Enacting the bill would further undermine excluded employee provisions and creates a risk of harming the state and the city if the purchase price is not an accurate estimate of the true cost to the fund. Reservations about the method used to estimate full actuarial value, including issues specific to bad investment markets, were discussed above.

Consistency with City Actions; City Support. MERF retirements have added to financial stress in the City of Minneapolis due to the need to provide MERF with sufficient assets to cover the transfers to the Retired Fund at the time of retirement. This draft may provide an incentive for an individual retire earlier, creating an earlier need for sufficient transfer assets, and approving this request is likely to encourage others to seek similar treatment. The individual covered by this draft is seeking the same treatment that was approved in the 2000 legislative session for a coworker. The city and MERF for the last year or more have tried to discourage individuals from retiring. The LCPR may wish to hear testimony from the city to determine whether the city is comfortable with this bill draft, and whether the city would like to have a local approval clause added.

Scope. The issue is whether this is the last active MERF member with prior uncredited service for temporary city employment, or whether there are others who will seek similar treatment.

Consistency with LCPR Policy. The issue is whether H.F. 308 (Eastlund); S.F. 616 (Lourey) are sufficiently consistent with LCPR policy on service credit purchases. That determination is difficult because of recent departures from longstanding policies in this area. These departures, discussed previously, may be due to a decision to bend existing policies to deal with short-term situations prior to a return to use of longstanding policy, or the change may reflect a more permanent shift. The situation described in the draft does meet a few of the policy guidelines for a service credit purchase that were quoted above from the LCPR pension policy statement. The employment clearly has a Minnesota connection and was provided to a public employer. The payment is at full actuarial value, which is unquestionably an attempt to avoid any subsidy from the plan (from the employees, city, and state which finances this plan), but there are increasing reservations regarding whether the method in law is capable of producing sufficiently reliable estimates of the full actuarial value. If there is a clear problematic area, it is that the service credit purchase is for a period which was properly excluded from coverage under MERF’s membership laws. However, the Legislature did pass provisions during the 2000 legislative session for two other MERF members in identical circumstances.

Cost Issues. The issue is the price of the service credit purchases and whether the individual will undertake the purchase given that cost. The LCPR may choose to limit consideration of the proposal if it is unlikely that the individual will pursue the purchase. The individual indicated when contacted by LCPR staff that MERF estimated the cost at $60,000, and that he was willing to pay that amount.

Employer/Plan Liability Issue. The issue is whether MERF or the employer harmed the individual and should be required to subsidize the purchase. Unless information is provided which indicates that MERF or the employer failed to follow law and thus harmed the individual, there is no basis for requiring MERF or the employer to subsidize the purchase. Without a subsidy, there is no financial gain to the individual from the purchase assuming the full actuarial value payment is correctly computed.