Commentary: Learning the language of public pensions

Editor’s note: Attorneys John Stephens and Tim Sesler, two members of Costa Mesa’s Pension Oversight Committee, asked the Daily Pilot to publish the panel’s findings and recommendations. The committee put together a series of three articles that seek to explain and simplify the complex subject matter to residents. This is the third installment.

At a minimum, pension terminology can be challenging. At a maximum, it is outright confusing. In this installment we attempt to define some of the more commonly used pension terminology. By sharing this basic terminology, we hope to expand your understanding of complicated terms in an uncomplicated manner.

CalPERS: Costa Mesa contracts with CalPERS, the California Public Employees Retirement System, to administer pensions for city employees. CalPERS administers pensions for more than 1.6 million active employees and retirees, including state, county and municipal employees, as well as public school and state university employees. While CalPERS is the administrator of our employee pensions, the payments are guaranteed by the taxpayers of Costa Mesa, not CalPERS.

Defined benefit plans: Pensions are referred to as defined benefit plans. DBPs establish a formula for pension payouts based on age, years of service and salary level. Costa Mesa benefit payments are guaranteed for the life of the employee, and if a lesser benefit is selected, for the life of the employee’s spouse. Pension benefits increase annually, and the pension benefits received by retirees are not affected by the investment results achieved by CalPERS.

Defined contribution plans: Retirement plans funded by a set contribution formula, most commonly a percentage of salary, are called defined contribution plans. The most common DCP is a 401(k) plan, which involves employers and employees contributing to an employee account. The employee directs the investment, and there is no guaranteed investment return.

Employee groups: Costa Mesa employees are divided into three groups — safety police (“on the street” police officers), safety fire (“on the street” fire personnel) and miscellaneous (all other city employees, managers, and police and fire administrative employees). Through their bargaining units (union or association representation), each employee group has negotiated its own pension benefit formula.

Pension benefit formulas: Pension formulas are expressed as a percentage of salary for each year of service with a minimum retirement age. In the case of safety police and fire safety employees hired before Jan. 1, 2013, the benefit formula is 3% at 50 (employees hired after Jan. 1, 2013 have a slightly reduced formula). Employees in these classes are eligible to retire at age 50 and receive 3% of their salary for each year of service.

The salary used to calculate the benefit is the person’s highest single year of salary any time during his employment. Take for example a 50-year-old employee with 24 years of service with a highest annual salary of $90,000. Benefit formula = 3% x 24 years = 72% x $90,000 = $64,800 first-year pension benefit. The benefit formula for Costa Mesa miscellaneous employees hired before Jan. 1, 2013 is 2 1/2% at 55.

Service credits: Employees vest service credits after five years of employment, and employees are not subject to mandatory retirement. If they continue working, they continue to accrue service credits (additional years of service).

In the example cited above, if the employee continued to work until age 55, his pension benefit would grow to 3% x 29 years of service, which equals 87% of his highest salary. Employees who retire before the age expressed in their stated benefit formula receive a reduced benefit, and for all employees, the maximum benefit payable is 90% of highest salary.

COLA: All Costa Mesa pensions are subject to an automatic cost of living allowance, or COLA, which increases the benefit annually. Historically, this increase is 2% per year throughout the recipient’s lifetime. If the first-year benefit is $60,000, the second-year benefit is $61,200, the third-year benefit is $62,424 and so on.

Contribution rates: Based on salaries, past and estimated investment returns, and benefit formulas, CalPERS annually establishes the contribution rate for each employee group. The contribution rate is the percentage of salary (for each employee) that Costa Mesa must pay to CalPERS to fund the pension plan for that year.

Contribution rates consist of two elements: normal cost (the amount required to fund the benefit for each working employee) and unfunded liability (the amount required to make up for insufficient prior saving or poor investment return).

Discount rate: Contributions paid to CalPERS are invested to help fund benefit payments. The investment rate of return is called the discount rate. The current CalPERS discount rate is 7.5%, which means that including market fluctuations, CalPERS has concluded it will average 7.5% return on investment per year.

Actuaries: These are financial professionals who make projections on the value of assets based on historical performance, typically on a long-term basis. Some actuaries make conservative estimates and others make liberal estimates. This can lead to a wide disparity in their long-term financial projections.

Smoothing: A process that allows actuaries to apply a consistent discount rate over an extended period of time. In this process, the actuary makes a projection assuming assets that may have dropped in value will ultimately increase in value. Assets that have experienced an unusually high rate of appreciation are reduced in value in this process.

Market value of assets (MVA): The current market value of an investment or group of investments.

Actuarial value of assets (AVA): The projected value of an investment or group of investments as determined by an actuary after “smoothing.”

Funded ratio: The actuaries’ estimate of AVA divided by the projected future cost of benefit payments. If the funded ratio exceeds 100%, the plan is designated “overfunded.” If the ratio is less than 100%, the plan is designated “underfunded.” In 2012, Costa Mesa pensions were underfunded with a funded ratio of approximately 65%.

Unfunded liabilities: The difference between the amount of money that will be required to pay pension benefits and the amount that has been paid by the employer, as determined by CalPERS actuaries, to fund that benefit. Based on MVA, in 2012, Costa Mesa unfunded pension liabilities were $196 million.

PEPRA — Public Employees’ Pension Reform Act: The California law that became effective Jan. 1, 2013 is intended to constrain pension benefits deemed excessive. Most provisions of PEPRA apply only to new employees hired after Dec. 13, 2012, and will not provide immediate savings to employers.

Classic employees: Employees hired before Jan. 1, 2013, whose benefit formulas are not subject the restrictions of PEPRA.

Pension spiking: An intentional, late-career effort to maximize compensation to increase pension benefits. In Costa Mesa, policies to minimize “spiking” are in place.

Employer-paid member contributions: The city and employees both contribute to the cost of pensions. The city also makes employer-paid member contributions (EPMCs), which are payments added to the employees’ highest year of pay for pension benefit calculation purposes.

The Governmental Accounting Standards Board (GASB): This board sets the policies for how public pension plan finances are evaluated and reported. Recently enacted changes by GASB will have a significant upward effect on the contribution rates paid by California CalPERS member agencies including Costa Mesa.

Other post-employment benefits (OPEBs): These are fringe benefits, such as retiree medical insurance paid partially or in full by the employer.