Who owns public pension fund assets? New York Supreme Court ruling.

Pension funds of public employees have become increasingly visible in recent years with memberships currently estimated at more than 15 million people. These funds provide retirement benefits for state and local government workers, school teachers, college professors, police officers, firefighters and judges, among others. The importance of public pension funds for their members' financial security in retirement cannot be understated. In most states, the public pension is a supplement to Social Security; however, because of the uncertainty attached to the Social Security system, public employees have become more reliant, psychologically if not in fact financially, upon their retirement income from public pension funds.

In those states where public employees do not pay into the Social Security system, the dependency on public pension funds is even more acute. For public employees everywhere who are concerned about the financial integrity of their pension system, any threat to pension funds is unacceptable. Despite the fact that nearly all pension plans are established as trusts for the sole benefit of their members, pension funds recently have begun to feel the effects of economic hard times, as governmental officials search for innovative ways to balance the budget.

At the extreme, pension plans have been viewed as providing governmental financial resources rather than requiring them. A case in point is in California. In 1991, the governor, with the acquiescence of the state legislature, used part of the state's public pension fund to help close a budget gap. To aid in the state's budget problem, the governor used $1.9 billion from the California Public Employees Retirement System (CALPERS) special trust fund. These monies, which were already in the system, were applied to pay a required employer contribution to the general trust fund. Moreover, an attempt was made to abolish CALPERS' 13-member autonomous board and replace it with a nine-member board under the control of the governor. This effort failed, but the governor obtained the right to appoint his own actuary for the fund.

Opposition to these actions led to passage of Proposition 162, "The California Pension Protection Act of 1992," in California's November 1992 general election. Proposition 162 vests exclusive authority over investment decisions and administration of CALPERS with its elected board of administration and prohibits reconstitution of that board without voter approval. As a result of Proposition 162, the operations of CALPERS are now insulated from the influences of the executive and legislative branches of California state government.

The New York Court Case

Another way in which state and local governments have diverted money from pension funds has been by reducing employer contributions, either temporarily or permanently. A precedent-setting decision in a consolidation of three cases(1) (the subject of this article) involved a constitutional challenge by parties interested in New York State's Common Retirement Fund (CRF) to prevent the New York legislature from reducing contributions to the CRF. Specifically, the plaintiffs successfully challenged the state legislature's attempt to change from the aggregate cost method (AC) to the projected unit credit method (PUC) as the actuarial funding method used to determine the annual contributions to be made by New York public employers to the CRF.

The individual plaintiffs were 1) working and retired members of the New York State and Local Retirement System and the New York State and Local Police and Fire Retirement System and 2) officers of the major unions representing public employees. The defendants were the Comptroller of the State of New York, who serves as trustee of the CRF; the New York State and Local Retirement System; and the New York State and Local Police and Fire Retirement System.

The Facts. Prior to July 1, 1940, state and municipal employees participating in the various retirement systems had found their benefits and funding to be at the mercy of legislatures, both state and local, with the guarantee of benefits occurring only at the time of actual retirement; only at retirement did a contractual relationship between the retiree and the former employer come into being. This changed as a result of New York's 1938 Constitutional Convention. After debate, convention delegates stripped the state and local legislatures of much of their power over public employee retirement systems by enacting a constitutional amendment, Section 7 of Article V, which provides:

After July first, nineteen hundred forty, membership in any pension or retirement system of the state or of a civil division thereof shall be a contractual relationship, the benefits of which shall not be diminished or impaired.

In a subsequent case in which a court was required to apply this constitutional provision, the court held that, through the constitutional amendment, the people of New York State conferred contractual protection upon the benefits of the pension and retirement systems of the state and of the civil divisions thereof and prohibited their diminution or impairment prior to retirement. The court ruled that, after the effective date of the constitutional amendment, such systems were no longer "gratuitous"--that is, the systems were no longer subject to modification or denial at the whim of the government. Further, by virtue of the new amendment, the court held that the terms of these systems became contracts; the pension systems thereby acquired vested interests which could not thereafter be diminished or impaired. In sum, the amendment fixed the rights of the employee at the time the employee became a member of the system.

The original language of the pension law did not designate a specific method for funding the CRF, instead leaving that decision to the discretion of the state comptroller. From 1921 until the enactment of Chapter 210 of the Laws of 1990, all New York state comptrollers had exercised that discretion by employing the AC method to determine annual contributions to be made by the governmental employers. The AC method has been described by all parties as fiscally conservative; its use resulted in a reported surplus in the CRF of between seven and nine billion dollars by the late 1980s.

Effective for fiscal years beginning after December 15, 1986, the Government Accounting Standards Board (GASB) began requiring certain public retirement system financial disclosures based upon the PUC method. These disclosure requirements were instituted to provide information about plan funding status and to promote comparability among plans nationwide. However, the GASB explicitly stated that use of the PUC method as the basis for this standardized financial reporting did not mean that the PUC method must be used to determine actuarial funding requirements.

For fiscal 1987, the New York State and Local Retirement Systems reported, using the PUC method, a surplus in pension funds in excess of seven billion dollars. By 1990, the state faced a fiscal crisis and a multibillion dollar budget deficit. One perceived method of easing the immediate fiscal pressure upon the state and local governments was to reduce the required near-term contributions to the retirement systems. This reduction could be achieved if the PUC method replaced the AC method for determining the actuarial funding amount because, as a result of the change, the existing surplus in the CRF would serve in lieu of annual contributions for several years. Estimates were that implementation of the PUC method would reduce or eliminate public employer contributions to the CRF for approximately 10 years. Thereafter, studies projected that the amount required to be contributed to the CRF by public employers would increase dramatically.

The Comptroller of the State of New York vigorously opposed the change to the PUC method, contending that it threatened the integrity of the CRF and was a fiscal gimmick to give the state and local governments the present use of what would otherwise be pension fund money, with any untoward fiscal result being left to be dealt with by future generations. Nonetheless, the legislature enacted Chapter 210 of the Laws of 1990, which mandated 1) changing the actuarial funding method from the AC method to the PUC method and 2) establishing a five-year stock valuation smoothing method as opposed to the four-year method for which the comptroller had opted. The comptroller projected that the new law would deprive the CRF of approximately $800 million in employer contributions for the 1991 fiscal year alone. The legislative mandate, however, required the implementation of the PUC method, and the lawsuits discussed here resulted.

The Issue. A state constitution places many fiscal restraints upon the actions of the state and local governments. Ultimate responsibility for the enforcement of those constitutional restraints lies with the courts. The procedure works if judges look to the words and the intent of the framers of the constitution, rather than being swayed by apparent necessity stemming from a current crisis. In the case of New York's public employees, a contractual relationship had been entered with their employers on July 1, 1940, providing that employee pensions would be funded and secure. A mechanism for providing this security had been in place since 1921. Section 210 of the Laws of 1990 changed that mechanism and, in the opinion of the plaintiffs, jeopardized the security of the CRF. The legal issue was whether such change runs afoul of Section 7 of Article V of the Constitution of the State of New York.

The Decision and the Reasoning. In the view of the Supreme Court of the State of New York, the change did run afoul of Section 7's provisions. The court reasoned that the discretion of the comptroller as trustee is a benefit protected by Section 7 of Article V of the constitution. The primary contention of the defendants, the court noted, was that the method of funding the CRF is a power reserved to the legislature which it has not surrendered to the comptroller and which is not among his powers as trustee. The court noted that this reasoning may have held prior to July 1, 1940. Before that date, no statute directed the comptroller as to a specific method of funding the CRF--but all comptrollers had independently opted to use the AC method.

Prior to July 1, 1940, the legislature could have enacted a statute altering that choice; following the Constitutional Convention of 1938, however, that power was taken away from the state legislature through the enactment of Section 7 of Article V. One of the contractual benefits public employees acquired as a result of this constitutional amendment was the right to an independent trustee empowered with the discretion to protect their retirement funds. Section 210 of the Laws of 1990 was an attempt to deprive public employees of that contract right. This legislation would have diverted assets away from the CRF in order to meet a fiscal crisis without tax increases or cuts in other programs. This conduct is precisely the type the constitutional amendment was designed to prevent.

The Financial Reporting Issue

In the face of the court's decision, an important question is whether the GASB's pension fund financial reporting requirements based upon the PUC method triggered the problem. The AC method seems to produce the more conservative result. Are accounting disclosure requirements in conflict with good jurisprudence?

Pension Attribution Versus Funding. The court's decision requires that a clear distinction be made between pension cost attribution and pension funding. "Attribution" is the process of assigning pension costs to periods (fiscal years) of employee service. "Contribution," on the other hand, refers to the actual payment of assets into a pension plan. The two terms are not synonymous. Amounts attributed as pension costs during a period may or may not be contributed by the employer during the same period.

Actuaries generally recognize two families of attribution methods, the "accrued benefit" and the "projected benefit" methods.(2) The accrued-benefit family of approaches attributes costs by crediting each employee in each year with a distinct unit of pension benefit. The cost of each unit of benefit is then separately computed and assigned to the year in which it was credited. The PUC is a member of this family of actuarial methods. The projected-benefit family of approaches, on the other hand, determines the total cost of financing future benefit payments and allocates that cost back to years of service, either in equal dollar amounts or equal percentages of pay. The AC is a member of this family of actuarial methods. Over time, the total cost of a pension plan is unaffected by the choice of actuarial method.(3) In any given year, however, the choice of funding method may yield very different attributed costs.

In otherwise-identical circumstances, the AC method consistently attributes higher pension costs than does the PUC method during the early years of a pension plan's existence.(4) Conversely, the unit-credit attribution approaches produce actuarial accrued liability measures for individual employees that increase over time at an increasing rate, since later years have less time to earn interest and the probability of payment increases.(5) Since early years of the New York state plan had been funded using the AC method, PUC-based computations yielded the "surplus."

Disclosure of the "Pension Benefit Obligation." GASB Statement No. 5, Disclosure of Pension Information by Public Employee Retirement Systems and State and Local Government Employers, issued in November 1986, applies to defined-benefit public employee retirement systems (PERS). Statement No. 5 provides guidance for making the disclosures considered necessary "to assess (a) funding status of a PERS on a going-concern basis, (b) progress made in accumulating sufficient assets to pay benefits when due, and (c) whether employers are making actuarially determined contributions." Statement No. 5 calls for detailed pension disclosures, including a standardized measure of actuarially estimated pension liabilities.

Statement No. 5 requires that this standardized measure of a PERS' pension liability (termed the "pension benefit obligation") be "the present value of benefits estimated to be payable in the future as a result of employee service to date, computed by attributing an equal benefit amount (including the effects of both projected salary increases and any step rate benefits) to each year of credited and expected future employee service." That is, the actuarial method for calculating the pension benefit obligation should be the PUC.

The need to achieve comparability among entities' financial reporting necessitated the GASB's selection of a single standardized measure of the pension obligation. The GASB weighed the advantages and disadvantages of unit credit as well as other actuarial attribution approaches, concluding that the unit credit approach produces the most appropriate standardized measure of the pension benefit obligation.

However, GASB Statement No. 5 explicitly states that the pension benefit obligation as reported in PERS financial statements "is independent of the actuarial funding method, if any, used to determine contributions to the PERS." Thus, the GASB did not mandate that any PERS adopt the PUC as the basis for computing funding requirements. Since, as was noted earlier, total pension costs over the life of a plan are not affected by the actuarial funding method used, one can see that a plan being funded based on the PUC method, as compared with the AC method, provides for reduced contributions in early years but requires increased contributions in later years. The matter of lowered funding in earlier years led to the New York litigation discussed in this article.

Summary and Conclusion

The New York State legislature attempted to reduce employer contributions to the state pension system under the guise of compliance with financial reporting requirements. The New York Supreme Court recognized the distinction between the requirements of financial reporting and equitable funding of pension obligations and, in an exercise of good jurisprudence, blocked the attempt. By the action of the court, an effort to misapply financial reporting standards to resolve immediate budget problems was thwarted.

The GASB explicitly separated the issues of pension cost attribution and pension contribution methods. The decision by the New York State legislature to equate attribution and funding methods in the case at hand was an expedient interpretation of GASB Statement No. 5, made to reduce payments to the New York State Common Retirement Fund during a budgetary crisis. The "creative" use of the quirks of an alternative actuarial method represent an instance in which a legislative body did not exercise responsible stewardship. The political process and the financial markets provide basic means for monitoring the stewardship of elected public officials. This case illustrates that the courts also play a valuable role in monitoring public stewardship.

NOTES

1 McDermott v. Regan, S.Ct.N.Y. Albany, Ind. No. 4984-90; Guzdek v. Regan, S.Ct.N.Y. Albany, Ind. No. 2166-92; Puma v. Regan, S.Ct.N.Y. Albany, Ind. No. 4985-90.

2 Allen, Everett T., "Pension Plan Design and Funding Considerations," Life and Health Insurance Handbook, Gregg, Davis W., and Lucas, Vane B., eds., Homewood, IL: Richard D. Irwin, Inc., 1973: 544-545.

3 Ibid., 544

4 Scott, Elaine A., Simple Defined Benefit Plans, Homewood, IL: Dow Jones-Irwin, 1989: 12.

5 Governmental Accounting Standards Board, Statement No. 5, Disclosure of Pension Information by Public Employee Retirement, Systems and State and Local Government Employers, Stamford, CT: Governmental Accounting Standards Board, 1986: par 97.

All authors are members of the Department of Accounting and Taxation, Colorado State University, Fort Collins, Colorado. TERRY L. LANTRY is a professor and chairperson of the department. He is a licensed CPA and Attorney at Law. Dr. Lantry is a member of the AAA, the AICPA, the CSCPA and a member of the CSCPA Board of Ethics. He is first vice president of the National Conference on Public Employee Retirement Systems and a member of the Public Pension Coordinating Council made up of GFOA, NTCR, NSARA and A, CPERS. BARBARA K. PARRISH, CPA, an assistant professor, is a member of the AAA and the IIA. She is in the process of defending her dissertation at the University of Arkansas. LAURENCE E. JOHNSON, assistant professor, received his Ph.D. from Texas Tech University and is a CPA. His research interest is in government accounting and is a member of the AAA, the AICPA, the CSCPA and the GFOA.