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    California Public Employees' Pension Reform Act (PEPRA): Summary And Comment

    A Summary Of And Comment On Its Effects On Independent Retirement Systems

    Signed by Governor Brown in 2012, California's pension reform legislation went into effect as of January 1, 2013, although certain provisions are not effective until the expiration of the relevant collective bargaining agreement. This article includes commentary reflecting our understanding of the law, based upon numerous unofficial and informal discussions with key legislative staffers.

    What Plans Are Affected?

    PEPRA applies to all "public retirement systems," whether the plan is a defined benefit (DB) plan or a defined contribution (DC) plan, specifically including plans that are governed by section 401(a) of the Internal Revenue Code (Code). It appears that the legislation extends to other plans that defer compensation (e.g., a Code section 457(b) eligible deferred compensation plan and a Code section 403(b) tax sheltered annuity program). However, according to legislative staff, PEPRA does not apply to a plan that consist solely of employee elective deferrals, such as a deferral only Code section 457(b) plan.

    What Employees Are Affected?

    PEPRA primarily affects only "new members" and "new employees." However, some provisions apply to current participants as well.

    A "new employee" means an employee, including one who is elected or appointed, of a public employer who is employed for the first time by any public employer on or after January 1, 2013, and who was either:

    • Not employed by any other public employer prior to that date; or
    • Employed by another public employer prior to that date, but who was not subject to reciprocity between his new employer's plan and another public retirement system.

    A "new member" means an individual who either:

    • Becomes a member of the plan for the first time on or after January 1, 2013 and either (i) was not a member of any other public retirement system prior to that date or (ii) was a member of another public retirement system prior to that date but was not subject to reciprocity between his new employer's plan and another public retirement system; or
    • Was an active member in the plan and, after a break in service of more than six months, returned to active membership in that plan with a new employer.

    How Are New Employees/Members Affected Under A DB Plan?

    New members must have an initial contribution rate of the greater of (i) at least 50% of the normal cost rate for the DB plan or (ii) the current contribution rate of similarly situated employees. The normal cost rate is the portion of the present value of projected benefits attributable to the current year of service expressed as a percentage of payroll.

    New employees may not participate in a plan of replacement benefits for members whose retirement benefits are limited by Code section 415. This prohibition appears to be limited to Code section 415(b) DB replacement plans and not to apply to Code section 415(c) DC replacement plans.

    Employees hired on or after January 1, 2013 cannot participate in a "supplemental defined benefit plan" (not defined).

    A DB plan for nonsafety employees must provide that new members may retire for service after 5 years of service and upon reaching age 52, with a benefit determined by multiplying the member's years of service by a percentage of the member's "final compensation," with the percentage varying from 1% at age 52, to 2% at age 62, to 2.5% at age 67. Similarly, a DB plan for safety employees must provide that new members may retire for service after 5 years of service and upon reaching age 50 under one of three different formula options. However, the statutory formulas are not required if the current DB plan provides a lower benefit factor at normal retirement age and results in a lower normal cost.

    Pensionable compensation of a new member is defined as the normal monthly rate of pay or base pay of the member paid in cash to similarly situated members of the same group or class of employment for services rendered on a full-time basis during normal working hours, pursuant to publicly available pay schedules. The definition contains a special rule for compensation that is deferred and a list of amounts that are excluded from pensionable compensation (e.g., compensation paid to increase a member's retirement benefit under the plan).

    Final compensation used to calculate the benefit paid to a new member is defined as the highest average annual pensionable compensation earned by the member during a period of at least 36 consecutive months immediately preceding the member's retirement (or last separation from service if earlier), or during any other period of at least 36 consecutive months during the member's applicable service that the member designates on the application for retirement. We believe that the second alternative creates issues under Code section 401(a)'s requirement that benefits be definitely determinable.

    The plan cannot take a new member's compensation into account to the extent that it exceeds either:

    • 100% of the Social Security contribution and benefit base in effect on January 1, 2013 ($113,700) for employees subject to OASDI; or
    • 120% of the Social Security contribution and benefit base in effect on January 1, 2013 ($136,440) for employees not subject to OASDI.

    These amounts are to be adjusted for inflation by the plan (or they may be modified by the legislature). However, these limits are not required if the current DB plan provides a lower benefit factor at normal retirement age and results in a lower normal cost.

    The maximum compensation of a new member for any year may not exceed the amount permitted to be taken into account under Code section 401(a)(17), which is $255,000 for 2013.

    If the employer offers, prior to January 1, 2013, a "plan of replacement benefits" for members whose benefits are limited by Code section 415, the plan cannot cover any additional employee group to which the plan was not provided before January 1, 2013.

    If the employer offers, prior to January 1, 2013, a "supplemental defined benefit plan" (not defined), the plan cannot cover any additional employee group to which the plan was not provided before January 1, 2013.

    New members cannot purchase nonqualified service credits (so-called "air time") pursuant to Code section 414(n)(3)(C).

    With the exception of the 50% cost sharing requirement above, most of these changes apply to "new employees" and "new members," regardless of whether they are collectively-bargained and are subject to a pre-existing MOU. Employers must comply with the new requirements and restrictions regardless of whether their unions are willing to discuss them or re-open bargaining.

    How Are Current Members Affected Under A DB Plan?

    Current members are not subject to the new:

    • Benefit formula requirements;
    • Definition of pensionable compensation; or
    • Compensation averaging rules.

    A current member's compensation is not limited to 100% or 120% of the Social Security contribution and benefit base in effect on January 1, 2013, as adjusted for inflation.

    The maximum compensation for any year of a current member may exceed the amount permitted to be taken into account under Code section 401(a)(17), which is $255,000 for 2013, unless the plan is a Code section 401(a) qualified plan in which case the limit is required (although employees who first became plan participants prior to the first day of the first plan year beginning after December 31, 1995 may have a much higher limit – $380,000 for 2013).

    Current members:

    • Need not contribute at least 50% of the normal cost rate for the DB plan;
    • May continue to participate in a Code section 415 replacement plan;
    • May continue to participate in a "supplemental defined benefit plan" (not defined); and
    • Cannot purchase nonqualified service credits (so-called "air time") pursuant to Code section 414(n)(3)(C) unless the application is received by the plan before January 1, 2013.

    How Are All Members Affected Under A DB Plan?

    The plan must provide that any enhancement to a retirement formula or retirement benefit adopted on or after January 1, 2013 applies only to service performed on or after the operative date of the enhancement.

    If a change to a member's retirement membership classification or in employment results in an enhancement in a retirement formula or retirement benefit applicable to the member, the plan must provide that the enhancement applies only to service performed on or after the operative date of the enhancement.

    If a retired person is receiving a pension benefit from a DB plan, the retired person may not serve, be employed by, or be employed through a contract directly by, the employer without reinstatement from retirement (i.e., a suspension of benefits under the DB plan) except as permitted under PEPRA. Legislative staff have informed us that this provision does not apply if the retired person is not being compensated or is working as an employee of a bona fide third party that has contracted with the public employer (other than the retiree's own corporation). PEPRA provides special rules to avoid a suspension of benefits (e.g., emergencies, no more than 960 hours per year, and a requirement of being retired at least 180 days with certain exceptions).

    PEPRA also provides special benefit suspension rules for a retired person who is first appointed after January 1, 2013 to a full-time salaried position on a State board or commission.

    If a member is convicted of a felony for certain conduct, the member will forfeit certain pension benefits, depending on when the member was first employed, elected or appointed.

    The employer's contributions, in combination with the employee contributions, shall not be less than the normal cost rate, although contributions may be suspended when the plan is 120% funded and certain other conditions are met.

    How Are New Employees/Members Affected Under A DC Plan?

    A new member:

    • May participate only in the DC plan that was in place before January 1, 2013 "or a defined contribution plan or defined benefit formula that conforms to the requirements" of PEPRA.
    • Does not have a vested right to continue to receive the employer contribution to the DC plan.
    • A new member's compensation is not limited to 100% or 120% of the Social Security contribution and benefit base in effect on January 1, 2013, as adjusted for inflation.

    How Are Current Members Affected Under A DC Plan?

    A current member might not have a vested right to continue to receive the employer contribution to the defined contribution plan.

    How Are All Members Affected Under A DC Plan?

    If the employer also maintains a DB plan, any employer contributions to any employer DC plan above the pensionable compensation limits applicable to DB plans shall not, when combined with the employer's contribution to the employee's retirement benefits below the compensation limit (apparently both DB and DC plans), exceed the employer's contribution level, as a percentage of pay, required to fund the retirement benefits of employees with income below the compensation limits.

    Retiree Health

    The employer shall not provide to an employee who is elected or appointed, a trustee, excluded from collective bargaining, exempt from civil service, or a manager, any health benefit vesting schedule that is more advantageous than that provided to other employees, including represented employees, of the same employer who are in related retirement membership classifications.

    Both the legislative staff and CalPERS agree that this provision was not intended to apply to current employees because it could violate their vested rights to certain retiree health benefits. We have been told that a clarification of this point will be included in corrective/clarifying legislation that is currently in the works.

    For more information, please contact Jeff Chang or Ken Ruthenberg at
    (916) 357-5660 or by e-mail at jcc@seethebenefits.com or kwr@seethebenefits.com.