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State and local government deferred compensation programs.

Since 1979, Section 457 of the Internal Revenue Code (the Code) has permitted state and local governments to offer deferred compensation programs to their employees. This employer-sponsored retirement accumulation vehicle is the single most important voluntary, tax-deferred retirement supplement available to employees of state and local governments.

Section 457 deferred compensation programs have grown to hold approximately $28 billion in assets and be available to as many as 95 percent of the employees who would be eligible to participate. Several factors exist which make these employee benefit programs extremely attractive to local government employers and their employees. The following discussion is intended to briefly describe these deferred compensation programs and provide a review of the programs' benefits to participants and employers.

Deferred Compensation Program

An "eligible deferred compensation plan" of a state or local government (or its agency or instrumentality) complies with Code Section 457 and allows employees to set aside, through payroll deduction, an amount up to 33 1/3 percent of Form W-2 reported taxable compensation or $7,500, whichever is less. (In the absence of any other tax-advantaged employee benefit programs, 33 1/3 percent of taxable compensation is generally equivalent to 25 percent of gross income.)

The contributions and any gains from investments are excluded from federal income tax until paid or made available to the participant. All funds must remain the property of the employer, a tax-exempt entity, until paid or available to the participant.

The Code additionally has distribution provisions, allowing payment of benefits not earlier than separation from service, attainment of age 70 1/2 or due to an unforeseeable emergency and requiring certain minimum distributions.

Program Benefits to Participants

Employees who participate in deferred compensation programs derive three primary benefits: lower taxable income through current deferral, accumulation of tax-deferred assets to produce income in retirement when individual tax rates may be lower and a portable retirement benefit.

Tax Deferral Advantages. The importance of tax deferral to the individual taxpayer cannot be stressed too strongly. Over time, the effect of tax deferral on contributions and earnings results in a significantly larger accumulation of assets than the same savings on an after-tax basis. This is true even for those taxpayers who do not lower their marginal tax rates in retirement.

Deferring compensation from current income tax allows the same dollar amount dedicated to savings to result in a higher immediate investment than an investment made after the current tax liability is paid. Most states follow the federal tax treatment on compensation deferred through Section 457 plans, and this can provide substantial additional savings. Not only does the individual have the advantage of saving more initially, the deferral of taxes on earnings results in higher effective returns being credited during the accumulation phase.

These tax advantages may be particularly important to individuals who lost the deductibility of individual retirement arrangement contributions when the Tax Reform Act of 1986 linked deductibility to adjusted gross income where a single person or either taxpayer on a joint return was eligible to benefit from an eligible employer-sponsored retirement plan.

Accumulation of Tax-deferred Retirement Savings Assets. The Social Security Administration has estimated that for retirees with more than $20,000 of income annually, only 40 percent is derived from pension and Social Security benefits. Thirty-four percent, the largest single component category, comes from investments. Exhibit 1 displays the typical sources of income for more than $20,000 annual income. The tax advantages and convenience of deferred compensation make it a logical building block in an employee's investment portfolio.

The flexibility of schedules available during the payout phase, where an account balance will continue to be tax-deferred until the funds are paid or made available, can be extremely valuable. A participant can design a payment schedule to meet varying needs in retirement. One participant might wish to take a lump sum distribution in order to make a major purchase, such as a boat or a motor home; a public safety employee retiring at a young age and pursuing a second career might use a lump sum to capitalize a new business. Two purposes are suggested relative to Social Security: individuals who retire prior to eligibility for Social Security benefits might take monthly payments designed to carry from retirement to commencement of Social Security payments; employees who have worked under Social Security but who end their careers with uncovered public-sector employment can take payments which make up for the reduction in Social Security payments applied to individuals receiving pensions from employment not covered by Social Security.

An additional advantage in accumulating retirement assets is that deferred compensation is deducted from payroll; employees who lack the self-discipline necessary for a periodic investment program may find that methodical savings can be achieved. Most deferred compensation programs offer mutual funds or investments with similar characteristics where dollar-cost averaging can be accomplished, providing for a lower average share cost over time.

For many employees, participation in a Section 457 plan will be the first significant opportunity they have to make decisions on investment allocation among various asset classes. Some participants will not have had experience with investments that have a high degree of risk and potential for reward. An appropriately structured program will provide employees with the necessary educational component coupled with a range of investment options suitable for retirement investments.

Portability. There are two major sources of shrinkage in pension benefits when an employee has more than one employer over the course of his or her career: vesting requirements and "pre-retirement inflation."

Ninety percent of governmental employees are covered by defined benefit plans, which typically pay a guaranteed benefit at retirement age, based on a formula including the number of years of service and the final average salary of the employee. Nine percent of employees are covered by defined contribution plans, in which accumulated individual participant accounts, based on employer and employee contributions and associated investment earnings, determine the total amount out of which retirement benefits are paid.

Ninety-nine percent of employees in defined benefit plans of state and local governments have "cliff vesting," which provides no guarantee of any retirement benefit until the employee has served a given number of years; 96 percent require five or more years of service before any pension benefits will be paid, 46 percent 10 or more years. Thus, governmental employees who do not remain with an employer for five or more years are therefore likely to receive no retirement benefit for their years of service. A series of short-tenured positions during a career will drastically reduce pension benefits available. Defined contribution plans tend to provide faster vesting schedules than do defined benefit plans.

Pre-retirement shrinkage occurs when a participant separates from employment before retirement age, having earned a benefit payable in current dollars which is not distributable until some years later. Inflation which occurs between the employee's termination and benefit commencement will shrink the effective pension payment.

A full discussion of portability issues is included in Pension Portability and Preservation for State and Local Governments, by Marta V. Goldsmith, published in 1989 by the Government Finance Officers Association and the National Association of State Retirement Administrators.

Program Benefits to Employer

Employers who adopt deferred compensation programs derive an excellent tool for employee recruitment, retention and benefits negotiation that is relatively simple to administer and low in cost to the employer.

Recruitment. Many public-sector employees, particularly mobile individuals in management-level positions, have come to view portable retirement benefits in the form of a deferred compensation program as an expected and vital part of their compensation package. Many employment agreements for key local government staff positions specify annual employer contributions to deferred compensation in addition to any other retirement benefits for which the individual may be eligible. In these circumstances, the availability of a Section 457 plan may be a condition of accepting employment.

Other employees may not have the clout to negotiate a similar compensation agreement but may have become accustomed to the advantages of deferred compensation with other employers. They expect their new employer to provide similar benefits, particularly where the program is viewed as one which may be provided at no direct cost to the employer. An employer without a deferred compensation program will be at a competitive disadvantage in recruiting employees.

Retention. Employers can offer an added incentive for seasoned employees to remain with the organization through contributions to deferred compensation based on longevity. Typically, an employer might contribute $500 annually for each five years of service. While the amount may not be particularly large, the recognition of the value of experienced employees can produce goodwill far in excess of the actual expenditure.

Bargaining Tool. Many employers have used deferred compensation contributions as an effective bargaining tool in employee benefits negotiation. To the employee, an employer contribution or match of individual contributions to the plan can be a demonstrable indication of a growing employer-provided benefit with the receipt of every account statement. While somewhat unusual, there are employers who maintain that eligibility for participation is a negotiable issue, requiring the normal give-and-take at the bargaining table before deferrals are allowed.

Deferred compensation programs provide a particularly effective negotiating tool when employees are bargaining for higher benefit levels or cost-of-living adjustments in defined benefit plans, increases which can be extremely costly to implement for which additional future costs can only be estimated.

Easy to Administer. For on-going operations, deferred compensation programs can be among the simplest employee benefit programs to administer. Many employers utilize outside services to provide program administration and investment options, resulting in efforts to select and periodically monitor the performance of program services. Once installed, the employer is responsible for recurring payroll deductions and contribution remittals to investment providers or third-party administrators.

Low in Cost. Most plans are structured to have no direct cost to employers. Plan costs are generally paid by participants, either directly as a charge against an account or indirectly as a reduction in the investment returns credited to an account.

A comprehensive discussion of deferred compensation plans, including a sample request for proposals for plan administrative and investment services, is available as the seventh in the GFOA Public Employee Retirement Series: Guides for Trustees and Administrators.

KATHY HARM is with client services of the International City Management Association Retirement Corporation.
COPYRIGHT 1993 Government Finance Officers Association
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Harm, Kathy
Publication:Government Finance Review
Date:Feb 1, 1993
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