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November 11, 2000Client Alert

The $200 Million Employer Credit Account - Why the Supreme Court Should Sustain It

On October 4, 2000, the Wisconsin Supreme Court heard oral argument in the case of Wisconsin Professional Police Association, Inc., et al. v. Lightbourn, et al., Case No. 99-3297-OA. The petitioners in the case challenge various portions of 1999 Wisconsin Act 11, which made significant changes to the Wisconsin Retirement System ("WRS").

One of the provisions of Act 11 challenged in the lawsuit is a $200 million employer credit account established within the employer reserve. Act 11 provides that $200 million of the $ 1.236 billion of investment earnings on existing employer contributions will be used to establish contribution credits for employers. Credits are first applied to an employers' unfunded liability, and excess credits are used to make payments for the employer's required annual employer contributions under the WRS. Under Act 11, employer contributions will not be required until the employer credit account is depleted.

The petitioners claim that this violates the contract rights of WRS participants, and "takes" the participants' property in violation of the Wisconsin constitution. These claims, however, evidence a misunderstanding of the rights of WRS participants, and the flexibility reserved by the legislature to modify various aspects of the Wisconsin Retirement System, including the method of funding.

The Rights of WRS Participants

The WRS was created and operates pursuant to Chapter 40 of the Wisconsin Statutes. WRS participants (active and inactive employees and annuitants) are granted certain contract rights and property interests in the Wisconsin Retirement System. Rights exercised and benefits accrued to an employee under Ch. 40 for service rendered are due as a contractual right, and cannot be abrogated by any later legislative act. Contrary to the position taken by the petitioners in the lawsuit, however, these rights do not extend to every single provision of the WRS. For example, while the right to receive benefits for prior service is protected, the method of funding those benefits is not.

Under § 40.19, the legislature specifically reserves to itself the right to amend or repeal by statutory changes all or any part of Ch. 40. WRS participants specifically have no right to further accrual of benefits or future exercise of rights for service rendered after the effective date of any change in retirement benefits. In addition, the statute specifically allows the state to require participants to forfeit specific rights and benefits as a condition for receiving new rights and benefits of equal or greater value.

In addition to protection of benefits for services already rendered, the WRS participants are also entitled to have the monies in the retirement trust funds to be used for proper purposes - that is, to pay for retirement benefits. Prior case law also suggests that WRS participants have a protected property interest in the "integrity" of the trust funds, measured by the actuarial soundness of the funds. In this lawsuit, the parties have agreed that implementation of Act 11 - including the establishment and use of the $200 million employer credit - will not render the trust funds financially troubled or actuarially unsound.

Funding the Wisconsin Retirement System

The WRS fixed retirement investment trust contains three primary reserves: the employer reserve account, the employee reserve account and the annuity reserve account. The monies in each of these accounts is ultimately used to fund WRS benefits to participants. Employee contributions (which are primarily paid by WRS employers) are deposited into the employee reserve account. Employer contributions are deposited into the employer reserve account. When a WRS participant retires and takes an annuity, monies are taken from the employer and employee reserve accounts and deposited into the annuity reserve, from which payments to the retiree are then made.

In addition to the three reserves, there is also an account into which the gains and losses on the reserves are maintained. This transaction amortization account ("TAA") holds those gains and losses, which are currently distributed on a pro rata basis to the employer, employee and annuity reserves at an annual rate of 20% of the balance in the TAA. The effect of distribution of the gains and losses in this manner is to "smooth out" contribution rates to fund the system.

Upon retirement, an annuitant will always receive the higher of a money purchase or formula benefit amount. The amount of money in the employer reserve does not affect the amount of the annuity which an annuitant is entitled to receive.

The obligations of the WRS and the amount of funding necessary to pay those obligations is calculated periodically by the actuary retained by the Employee Trust Funds Board. The employer contributions are not a predetermined amount, but rather a "sum sufficient" amount calculated after the actuary figures the employee contributions and anticipated investment earnings from the trust funds.

Employers pay for two types of obligations when they make payments to the employer reserve. One is for the benefits connected with employees' current service. The other is for the benefits connected with employees' past service. The latter obligation can arise when an employer chooses to join the WRS and wants its employees to have credit for services previously rendered, or when the legislature retroactively enhances retirement benefits for services previously rendered - thus creating a liability for past service. The past service liability is referred to as "unfunded liability" or "UAAL."

Unfunded Liability or "UAAL" - A Moving Target

WRS unfunded liability is currently approximately $2.2 billion. Employers make annual payments to reduce their unfunded liability based upon a percentage of payroll. Employers also pay interest on their unfunded liability.

However, the unfunded liability of WRS employers is not an absolute, unchanging amount. The obligations of and funding for a pension plan are both based upon assumptions which change over time. To determine the obligations of the trust fund, those assumptions include how many participants will receive WRS benefits, what their salaries will be (since this influences formula benefits), and when they will retire. To determine the funding necessary to pay these obligations, those assumptions include the rate of return on trust fund investments. The Employee Trust Funds Board retains an actuary to review these assumptions regularly, and as a result adjustments are made to the employers' contribution rates.

Also as a result of these changing assumptions, employers' unfunded liability has been recalculated several times. In 1989, when the assumed rate of investment return increased from 7.5% to 7.8%, unfunded liability was recalculated using the new assumed rate. As a result, the aggregate unfunded liability of all employers was reduced by $90,589,521. In 1991, when the assumed rate increased from 7.8% to 8.0%, unfunded liability was reduced by $59,477,500. In 1994, when the across-the-board salary increase assumption changed from 5.6% to 5.3%, aggregate unfunded liability of all employer was reduced by $85,117,420. Act 11 creates § 40.05(2)(cm), which confirms that the unfunded liability will continue to change as a result of changes in actuarial assumptions.

Unfunded Liability - A "Fictitious Debt"?

Not only is the amount of employers' unfunded liabilities subject to adjustment (just as contributions for current service are influenced by actuarial assumptions which respond to changes in the WRS experience); there is an argument that the unfunded liability does not really exist at all. According to the Joint Survey Committee Report on 1999 A.B. 495 (which was ultimately enacted as Act 11), the unfunded liability measured now at approximately $2.2 billion is really a "fictitious debt." According to the Report:

The $2.2 billion in current "Unfunded Accrued Liability" charged against Wisconsin's public employers exists only because state statutes require the use of an archaic definition of Unfunded Accrued Liability known as the "Frozen Initial Liability Cost Method." Very few, if any, other states still use this method. Most use some version of the "Entry Age Cost Method," under which Wisconsin's public employers would actually have a fully funded retirement system - meaning no "Unfunded Liability" at all. It may seem like accounting sleight-of-hand, but the truth is that the only reason this $2.2 billion debt exists for the employers is that this archaic cost method is still written into statute. . . This debt is only a debt because the law says it is. There is no logical reason whatever to believe in it.

(Emphasis in original). According to the Report, the WRS employers' liability is overstated by $2.4 billion. This confirms that while there is a protected interest in adequate funding to pay contractually-promised benefits - an interest which is not threatened by implementation of Act 11 - it is appropriate to maintain flexibility on calculating and funding benefit obligations.

The Wisconsin Supreme Court's prior decisions support this analysis. The court has already concluded that contributions to a pension fund for past service do not constitute a "debt" of the employer. In Columbia County v. Board of Trustees of Wis. Retirement Fund, 17 Wis. 2d 310, 116 N.W.2d 142 (1962), the court held that payment of contributions based upon past service credits is a contingent liability. The amount of the obligation at any given time is not absolute. Id. at 328. As the court acknowledged, "[t]he amount of the obligation to finance the pension involves so many variable factors that the obligation of [an employer] must be redetermined each year on an actuarial basis in the light of changing contingencies." Id. at 329.

The Columbia County court explained:

The obligation for past service credits is not ascertainable for any period of time except for the convenience of making payments during a given year. The best that can be said is that the obligation is to pay some amount which varies. Such an obligation is distinctly different in nature from a bond issue or a contracted obligation whereby the obligor has received the consideration, the principal amount is certain, and is to be paid over a definite period of years, in stated amounts.

The computations used by the plaintiffs for the amount of prior-service credits contributions and called an absolute obligation are but book or audit figures only and do not represent the total amount and, in fact, are and will be in excess of the actual payments by the county over the years. Even the obligation of the county based on the actuarial reports, while more accurate, does not represent the actual payments which will be required to meet the terms of the pension fund in operation. Thus the prior-service credit obligation is uncertain and indefinite in amount and necessarily will continue to be so.

Id. at 329-330.

The same analysis applies in the case currently before the Court. WRS unfunded liability is a moving target, not an unchanging obligation of employers to the trust funds.

A Question of Timing - Credit Me Now, or Credit Me Later

The most significant flaw in the argument of those who challenge the $200 million employer credit account is their assumption that the employers are getting an "extra" $200 million. This is simply not true. The $200 million was always destined to be deposited into the employer reserve. Investment earnings held in the TAA are distributed proportionately among the employer, employee and annuity reserves. The $200 million employer credit account was created out of the employer reserve account's share of the investment earnings held temporarily in the TAA. Even the petitioners acknowledge that the $200 million are earnings on the employer reserve account.

What the petitioners don't like is how the credit account monies are credited after they are deposited in the employer reserve. Without Act 11, those monies would have been deposited into the employer reserve, and the Board actuary would have taken them into account in setting employer contribution rates - for both current and unfunded liability. Eventually, those monies - like every other dollar of investment earnings recognized into the employer reserve - reduce the contribution required by the employers. Why? Because the employers simply contribute the dollars needed but not provided by employee contributions and investment returns. So each dollar of investment returns reduces the employer contribution by $1. Usually that dollar reduction is taken over an actuarial period, like 40 years, and is itself subject to additional reduction or increase based upon factors such as changing investment results. Act 11, however, allows that $1 reduction to be credited immediately to the employer.

The obligation of the WRS employers to provide actuarially "sum sufficient" funding for the WRS is unchanged by Act 11. The only change is whether the employers are allowed the benefit of the investment earnings immediately, or whether they are allotted the benefit of those investment earnings over time. The parties agree that the Trust Fund is actuarially sound, that it is not financially troubled, and that implementation of Act 11 by itself will not make it so. Thus, the security of the fund is not threatened by the proposed application of the $200 million credit account.

The Employer Credit Account Should be Sustained

The Wisconsin Supreme Court has long acknowledged the importance of the public pension system, including its ability to respond to and accommodate changing economic realities. "[O]ne of the most effective methods to obtain qualified personnel is to provide them with security, and one of the best ways to provide security for an employee is through an adequate pension." State ex rel. Singer v. Boos, 44 Wis. 2d 374, 384 (1969). The WRS grants participants certain contract and property rights to receive benefits, to have trust funds used for proper purposes, and to have an actuarially sound system. The WRS also grants the legislature the right to change the WRS, including how the system is funded. Act 11 enhances benefits, and provides fiscally responsible methods to pay for those benefits - including the $200 million employer credit account. The account should be sustained, consistent with the directive of § 40.01(2) of the statutes to ensure fulfillment of benefit commitments to WRS participants at the lowest possible cost.

Michael Best & Friedrich LLP represents the respondents in the WPPA case. For more information, please contact Robert W. Mulcahy at rwmulcahy@michaelbest.com or 414.225.2761.


First Printed with Wisconsin Counties - November 2000 Issue

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