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February 3, 1997

TO: NCTR Members

FROM: Cindie Moore, NCTR Washington Counsel

RE: Request for Assistance to Formulate Legislative Strategy

We are working on a legislative strategy to eliminate the conflict between the right of public retirement system members to purchase service credit under state law and the limits imposed by the IRC Section 415 defined contribution limits. We are developing draft legislation and a rationale for the change. Because changes in the IRC's pension qualification rules can affect retirement systems differently (depending on their individual governing statutes), we would like your feedback on the attached documents before we go forward.

IRS has interpreted retirement system members' purchase of service credit to be an "annual addition" under the Code and therefore subject to the defined contribution limits of Section 415. The provision limits a purchase to the lesser of: $30,000 or 25% of the member's compensation. The $30,000 limit is generally irrelevant because it is based on a compensation of at least $120,000. The 25% of compensation limit is a real concern for the reasons set out in the attached document. Many plans' governing statutes permit retirement system members to buy service credit in an amount that would exceed the limit. These statutes are frequently contractual rights which, once promised to retirement system members, cannot be diminished or impaired. Thus, a conflict between a plan's governing law and the Section 415 limit exists in many states.

Possible solutions to the conflict include a USERRA-type approach for purchases of service (see Alternative A, attached; see explanation of USERRA at footnote 1 in Draft Rationale) and a complete exemption (see Alternative B, attached). Many NCTR members are facing the conflict so we have developed proposed legislation and a rationale to address the current conflict. If you are facing such a conflict in your state, please review the attached draft, provide us with feedback to the questions below (feel free to add extra pages if necessary), and fax your response back to me at 703-243-3495 by Friday, February 7. Once we have your comments, we will proceed in working toward a solution. Thank you very much for your help.

Attachments (3)

Feedback on Proposed Strategy to Eliminate Conflict between Section 415 and State Purchase of Service Credit Guarantees

Name of Retirement System_____________________________________________________

1) With respect to the draft legislation, please consider how either Alternative A or B might interfere with your current state law. If interference may exist, please briefly describe it below.

2) With Alternative do you prefer? ___Alternative A ___Alternative B ___Neither (if so, give us an idea of what would work best for you)

3) With respect to the draft rationale, please review the arguments in it. If you disagree with any argument, feel free to mark directly on the document or in the space below. Add any other arguments you feel we should raise. Thank you very much for your help in developing this proposal.

Alternative A - USERRA-TYPE APPROACH TO PURCHASES OF SERVICE

Section 415 is amended by adding at the end the following new subsection:

(n) SPECIAL RULES RELATING TO THE PURCHASE OF RETIREMENT CREDIT IN STATE AND LOCAL GOVERNMENT PLANS WHICH ARE DEFINED BENEFIT PLANS.--

(1) In the case of an employee contribution to a plan maintained for its employees by any State or political subdivision thereof, or by any agency or instrumentality of the foregoing, which plan is a defined benefit plan, where such contribution is made for the purpose of purchasing retirement credit for qualified public service,

(A) the qualified public service for which retirement credit is being purchased shall for the purposes of section 415 be treated as service with the employer maintaining such plan,

(B) the contribution with respect to qualified public service for which retirement credit is being purchased (other than such service in the year in which the contribution is made),

(i) shall not be subject to any otherwise applicable limitation contained in section 415 and shall not be taken into account in applying such limitations to other contributions or benefits under such plan, with respect to the year in which the contribution is made, but

(ii) shall be subject to the limitations referred to in (i) with respect to the year in which such qualified service was rendered;

(C) Any portion of the contribution representing interest at the rate specified in such plan shall for the purposes of section 415 be disregarded.

(2) QUALIFIED PUBLIC SERVICE.--For the purposes of this subsection, the term "qualified public service" shall mean service with the Government of the United States, the government of any State or political subdivision thereof, or any agency or instrumentality of any of the foregoing, provided the employee seeking to purchase retirement credit for such service shall not be entitled to any benefit attributed to such service from any defined benefit plan maintained by the foregoing other than the plan in which such retirement credit is purchased. Subsection u of section 414 is amended by adding at the end the following new paragraph:

(11) SPECIAL RULE FOR MANDATORY CONTRIBUTIONS TO STATE AND LOCAL GOVERNMENT PLANS WHICH ARE DEFINED BENEFIT PLANS.-- In the case of a payment described in subparagraph (C) of paragraph (8) to a plan maintained for its employees by any State or political subdivision thereof, or by any agency or instrumentality of the foregoing, which plan is a defined benefit plan, the limitations in the last sentence of subparagraph (C) of paragraph (8) shall be disregarded.

Alternative B - EXEMPT PUBLIC SECTOR PLANS FROM D/C RULE

Subsection c of section 415 is amended by adding at the end the following new paragraph:

(8) TREATMENT OF CERTAIN MANDATORY EMPLOYEE CONTRIBUTIONS TO STATE AND LOCAL GOVERNMENT PLANS WHICH ARE DEFINED BENEFIT PLANS.--

(A) In the case of a contribution by an employee to a plan maintained for its employees by any State or political subdivision thereof, or by any agency or instrumentality of the foregoing, which plan is a defined benefit plan, where such contribution is required as a condition of obtaining a benefit attributable to employer contributions for qualified public service,

(i) the limitation in paragraph (1) shall not apply;

(ii) the qualified public service shall for the purposes of section 415 be treated as service with the employer maintaining such plan; and

(iii) the annual benefit attributable to such contribution shall be taken into account for purposes of applying the limitation on benefits described in section 415(b)(1).

(B) QUALIFIED PUBLIC SERVICE.--For the purposes of this paragraph, the term "qualified public service" shall mean service with the Government of the United States, the government of any State or political subdivision thereof, or any agency or instrumentality of any of the foregoing, provided the employee seeking to purchase retirement credit for such service shall not be entitled to any benefit attributable to such service from any defined benefit plan maintained by the foregoing other than the plan to which the contribution described in subparagraph (A) of this paragraph is made.

PURCHASES OF SERVICE IN PUBLIC SECTOR PLANS

This outline has to do with the purchase of credit for public service in public sector defined benefit plans by public employees, using after-tax contributions. (N.B.: It does not relate to making additional contributions to public sector defined contribution plans.)

Plan Provisions

Almost all public employee pension plans are defined benefit plans. The benefit a participant receives at retirement is based upon a formula; typically the benefit is a function of the participants_ years of credited service multiplied by final compensation or final average compensation.

A majority of public sector plans require participants to contribute a portion of their compensation earned from public service on an ongoing basis to help fund the benefits provided. Employee contribution rates vary from plan to plan and averages around 5.5% of compensation. The balance of the cost of benefits is paid for by employers and by income earned from investments on pension trust fund assets.

In addition to crediting public service as rendered on a current basis, many public sector plans have provisions which allow participants to obtain retirement credit for public service rendered outside their current membership. As outlined in I. below, these provisions can perform a variety of functions. They may enable public employees to obtain credit for temporary or part-time public service within a state which was never previously credited because the employee could not afford to be a member of a system at the time the service was rendered. They may allow for the purchase of credit for public service rendered in another state, thereby making that out-of-state service "portable". Finally, they may enable a public employee to obtain a benefit for service with the Federal government, typically service in the U.S. military.

Tax Consequences

Under current law, after-tax contributions to a defined benefit plan are treated as contributions to a separate defined contribution plan and subject to the limitations on contributions in IRC §415(c). The limitations ordinarily pose little problem for public sector plans insofar as they may apply to contributions made by public employees as they render service on an ongoing basis. This is because the limitation thresholds (currently, the lesser of $30,000 or 25% of taxable compensation) are quite high relative to the compensation levels of public employees and the plan percentage contribution rates.

Potential compliance issues, however, may arise where an employee seeks to purchase credit for public service rendered outside his/her current membership. Depending upon the amount of service being purchased, the plan contribution rate, the interest rate charged by the plan, if any, and the period of time over which interest accrues, the contribution necessary to purchase such service could be quite substantial. In addition, there is always the possibility the participant will want to buy the credit in a year in which s/he had little paid service or will want to buy it at retirement by a lump sum payment.

As outlined in II. below, there are very good reasons why public employees should be able to purchase credit for public service with after-tax contributions without having the plan risk violating the IRC §415(c) defined contributions limitations.

I. Kinds of Service Purchased

1. Public Service Rendered While not a System Member.

Certain public employees, particularly employees in part-time or short-term positions, are not required to join a retirement system during their employment. These employees often do not want to join a system because they do not expect to accumulate enough service to qualify for a benefit and/or because they cannot afford the necessary employee contributions. The downside of not joining a system is, of course, that these employees do not earn any retirement credit for their service while it is being rendered.

To alleviate this situation, the laws governing public sector plans sometimes allow participants to purchase credit for such service later in their careers when they become full-time employees or are better able to afford the cost of such purchases. Such laws ensure that employees in these circumstances are eventually able to obtain a benefit based upon all their public service. They are particularly beneficial to female employees who may only work on a part-time basis during the child rearing portion of their lives and may not be able to afford system membership.

The IRC §415 defined contributions ("d/c") limitations may work against these employees, particularly if they are in part-time or low paid positions, by potentially limiting the amount of service which they will be able to purchase. In addition, the limitations fail to take into account the fact that public employees, again often those employees in low paid positions, express the greatest interest in purchasing credit for such service at or near their actual retirement. The d/c limitations potentially bar them from obtaining a benefit from their systems based upon all their public service.

2. Public Service Previously Credited in Another System. A typical example is the purchase of out-of-state public service. Many public sector plans allow participants to purchase credit for prior public employment in another state. This feature is particularly attractive to those participants who did not have sufficient service during their prior employment to vest in the plan in which they may have had membership prior to their relocation.

Allowing for the purchase of credit for out-of-state public service in public employees_ current plans, in effect, makes the prior service in another state "portable". It assures the public employee can obtain a benefit from his/her current plan which is based upon his/her entire career of public service.

Again, the IRC §415 d/c limitations may work against the salutary purposes of these provisions by potentially limiting the amount an employee may contribute to his/her current plan in order to obtain credit for his/her prior out-of-state public service.

3. Other Public Service.

Many public employee retirement systems have provisions allowing for the purchase of service with the Federal government, particularly military service. For example, many public plans allow veterans to purchase credit for their military service on a basis which is far more liberal than required by USERRA. These provisions again assure that the benefit the employees eventually receive is based upon all their public service. In addition, in the case of military service, they alleviate any adverse impact military service might have had upon the employees_ career and ability to accumulate pension savings. As described above, however, the IRC §415 d/c limitations may potentially defeat those salutary goals.

II. Arguments in Support of Eliminating the Conflict Between Purchases of Service Under State Law and the IRC §415(c) Limitations

1. Portability

As indicated above, the provisions of public sector plans allowing for the purchase of retirement credit for public service facilitate "portability" of public service. They allow a public employee to get a benefit which is based upon service for which the public employee did not elsewhere earn any service credit or where s/he left employment before accumulating any meaningful benefit. If s/he is not able to purchase credit for that service, the person will likely never receive any meaningful benefit or even no benefit at all for the service.

2. Lack of Incentive for Abuse Relief is only sought with respect to contributory public sector defined benefit plans. These plans provide the same benefit formula to all participants regardless of their level of compensation. Higher paid public employees have no incentive to stuff large amounts of money into these plans because their benefit is determined by the benefit formulas of system which are applicable to all employees. In any event, the opportunity to make contributions only exists if the employee had public service elsewhere for which s/he is not entitled to a benefit from another defined benefit plan.

3. Sympathetic Cases

Purchase of service credit rules, in fact, typically benefit persons with interrupted careers, such as women who leave public employment to have their children or who must move from one state to another because their spouses have taken new employment. As discussed above, they also allow for the purchase of credit for service previously rendered in low paid and part-time public jobs at the time when the participant could not afford to join a system. Again, if this service cannot be purchased, these employees will likely never receive a retirement benefit for this service.

4. Retirement Credit is Purchased with After-tax Dollars

The Federal Government is not harmed by permitting the purchase of credit for prior public service. These purchases are made with after-tax contributions. In other words, the money public employees use to purchase credit has already been taxed.

5. Allowing the Purchase of Credit Raises Revenue

Participants in public sector defined benefit plans typically do not know how much money they will need for retirement until they begin to plan for retirement. As a result, members will often only consider whether they should purchase credit for prior service at or near retirement. Allowing purchases at that time, in fact, redounds to the benefit of the Federal Government because it increases member_s taxable benefit following retirement. By contrast, any tax loss with respect to interest on amounts contributed would typically be for a short time.

6. Special Situations

Recent tax law changes provide certain relief for mandatory employee contributions pursuant to USERRA. These provisions, however, overlook the fact that USERRA is intended to be the minimum obligation employers must have to returning veterans. If an employer wants to be more liberal and, for example, allow for the purchase of credit for military service beyond the USERRA deadlines or where there was no interruption of service in the first instance, why should the tax laws be less accommodating for the purchase of such credit?

7. Congress Never Intended to Discouraging Purchases of Credit

The IRC §415 d/c limits were enacted by Congress in an effort to stem the use by highly compensated employees of d/c plans to shelter excessive amounts of current compensation from taxation. It is not at all clear that Congress ever expressly considered whether and how these limitations were to apply, if at all, to the salutory provisions of public sector plans allowing for the purchase of credit for public service. As already noted, these provisions are typically available to any public employee without regard to his/her rank or level of compensation. They enable public employees to obtain a defined benefit based upon all their public service and facilitate portability of public service.

8. State Contractual Guarantees of Pension Benefits

A number of states have provisions allowing for the purchase of service credit which conflict with the enactment of the IRC §415 d/c limitations. These provisions may be subject to constitutional and/or statutory provisions which prohibit their impairment by subsequent legislation. In such cases, the plan may be unable to comply with the d/c limitations but may be forced to accept the employee contributions even if they are in excess of the d/c limitations. A change in the d/c limitations would avoid any potential conflict.