What's Happening with Normal Retirement Age Regs? An Update

As things currently stand, in just over 10 months, governmental pension plans will be required to comply with regulations issued in final form by the Internal Revenue Service (IRS) in 2007 dealing with distributions from a pension plan upon attainment of normal retirement age.   The IRS and Treasury have stated for the last several years that they would address serious public plan concerns with these regulations as they relate to the use of service as a component in determining the earliest age or date when a participant can retire with an unreduced benefit.  However, despite very recent assurances that this long-awaited “fix” was imminent, there still has yet to be a formal release issued.  Many state legislatures are already meeting, and if changes are required to be made, time is running out.  While it is still hoped this issue can be resolved through the regulatory channel at Treasury and the IRS -- thus obviating the need for state changes -- Federal legislation has now been introduced in the House of Representatives to resolve the problem.  But there is no guarantee that Congress will act on such legislation before the end of this year.

Background

These so-called Normal Retirement Age (NRA) regulations were made applicable to private plans immediately upon their issuance in May of 2007, but public plans were given two years to make any necessary amendments to their laws and regulations.  Thus, the NRA regulations were originally to have been effective for plan years beginning on or after January 1, 2009, for governmental pension systems.   This effective date has been extended twice, and is now set to take effect for plan years beginning on or after January 1, 2013.

The IRS regulations reflect a change made by the Pension Protection Act (PPA) of 2006 that provides an exception to the general plan qualification rule that pension benefits can be paid only after retirement.  This PPA exception permits a pension plan to commence payment of retirement benefits to an employee who is not separated from employment at the time of such distribution (known as an “in-service distribution”) as long as the employee has attained age 62.

However, the IRS also used this opportunity to (1) “clarify” that a pension plan is also permitted to make such in-service distributions after the participant has attained “normal retirement age;” and (2) provide rules on how low a plan’s normal retirement age is permitted to be.  

Specifically, the new regulations require a pension plan’s normal retirement age to be an age that is ”not earlier than the earliest age that is reasonably representative of the typical retirement age for the industry in which the covered workforce is employed.”  This is an effort by the IRS to prevent a normal retirement age from being set so low as to be a subterfuge to avoid the qualification requirements that, essentially, the benefit be truly related to retirement.

Several safe harbors are also provided in the regulations:

·    a normal retirement age of 62 or later (or age 50 or later, in the case of a plan in which substantially all of the participants are qualified public safety employees) is deemed to pass muster;

·    a normal retirement age lower than 55 (or 50 in the case of public employees) is presumed not to satisfy the requirement unless shown otherwise on the basis of facts and circumstances;

·    a normal retirement age that is at least 55 but below 62 is presumed to be acceptable based on a “good faith determination of the typical retirement age for the industry in which the covered workforce is employed that is made by the employer.”     

Significantly, the 2007 regulations do not provide a safe harbor (or other guidance) with respect to a normal retirement age that is conditioned (directly or indirectly) on the completion of a stated number of years of service, as is the case with many if not most public plans.   In a notice (IRS Notice 2007-69) issued in August of 2007, the IRS and Treasury explained that the reason for this is because they expect that a private sector plan under which a participant’s normal retirement age changes to an earlier date upon completion of a stated number of years of service typically will not satisfy the ERISA vesting rules (found in Section 411 of the Internal Revenue Code). 

But what about public plans?  While the IRS noted at the time that sponsors of governmental plans were not subject to these Section 411 vesting rules, they nevertheless asked governmental plans to submit comments on whether normal retirement age under such a governmental plan may be based on years of service.  

Specifically, they asked for comments on:

·    whether and how a pension plan with a normal retirement age conditioned on the completion of a stated number of years of service satisfies the requirement , in order to be a qualified plan under IRC Section 401(a), that a pension plan be maintained primarily to provide for the payment of definitely determinable benefits after retirement or attainment of normal retirement age; and

·     how such a plan satisfies the pre-ERISA vesting rules.

Public Plan Issues

Many governmental plans define normal retirement “age” as more a normal retirement “date.”  That is, the plan formula provides the time or times when participants qualify for unreduced retirement benefits under the plan, often based wholly or partly on years of service.  

If the IRS decides that the use of a normal retirement age conditioned (directly or indirectly) on the completion of a stated number of years of service does not meet the plan qualification standards described in IRC Section 401(a) and/or does not meet the pre-ERISA vesting rules, then all governmental pension plans will be required to specifically define a normal retirement age as a single “age.”   This could prove to be very difficult to do, particularly when a participant can reach normal retirement age by satisfying one of several age and service combinations.   Selecting an age that is higher than the lowest age would likely impair the constitutionally protected rights of the participants to any benefit conditioned on normal retirement.  Selecting an age that is lower than the highest age could impact the actuarial cost of the plan.

Furthermore, even where there may be a true normal retirement “age,” if it is less than age 62, then the safe harbors that the IRS provides will be inadequate in many ways.  For example, it is very unclear how “the typical retirement age for the industry in which the covered workforce is employed” would be applied in the diverse public sector setting.

NCTR and NASRA filed lengthy formal comments with the IRS in December of 2007 in response to these issues, underscoring that governmental pension plan sponsors have, for many decades, conditioned eligibility for normal retirement benefits on the completion of a stated number of years of service and many have defined normal retirement age as the time the participant becomes eligible for normal retirement.   Indeed, prior to these new regulations, there was no reason to believe that such a practice was prohibited, at least for governmental plans, and in the past, the IRS has routinely approved service-based normal retirement ages through the determination letter process.

NCTR, NASRA and other public sector organizations have also held numerous meetings with the Treasury Department and the IRS over the last several years to discuss the issues with the regulations as currently drafted, the most recent of which was on January 26, 2012.

Current Status

Treasury and the IRS continue to say that a resolution of the issues involving the NRA regulations is “imminent.”  Furthermore, in our last meeting with them, they suggested that they thought the public sector would be generally pleased with the outcome, although no details were shared as to what that outcome might look like.

Here is a somewhat educated guess.  First, in response to increased pressure to complete the processing of determination letters from Cycles C and E, some of which are apparently being held up over this matter, a statement could be forthcoming that will allow the issuance of such letters with the understanding that, based on a final resolution of the regulations,  results could be different going forward.   For example, the log-jam might be broken for all but plans with NRAs based wholly on service, (perhaps with an exception for public safety plans)? 

Then, revised regulations applicable to governmental plans would be issued for comment, with an extension of the effective date of 1/1/2013 in order to accommodate this process.  The reason for this prediction is that in answer to repeated inquiries, we have been told that whatever is proposed will not be in final form, as were the regulations for the public sector in 2007, and that comments would be sought.

In the meantime, there is now legislation introduced in Congress that would address this issue as well.  The legislation is HR 3561, the Small Business Pension Promotion Act of 2011, introduced by Congressmen Ron Kind (D-WI), Jim Gerlach (R-PA), and Richard Neal (D-MA) on December 5, 2011.  All three are members of the House Ways and Means Committee, to which the bill has been referred. 

The legislation is primarily designed to adjust regulations for required distributions from employee pensions, allowing certain deductions for contributions to individual retirement accounts (IRAs), and permitting companies to contribute more to pension plans without penalties.   Congressman Kind describes it as helping to “put our small businesses on a level playing field with larger corporations by providing small business employees access to retirement and pension accounts as well as tax deductions related to those accounts, in the same sense as those available to larger, corporate employees.”

In addition, the legislation contains a provision to address problems with the 2007 NRA regulations as applied to rural electric cooperatives.  While NCTR and other public sector organizations continue to hope that our discussions with Treasury and the IRS will lead to a productive regulatory resolution to our concerns in this area, we felt that we could not permit a bipartisan piece of legislation sponsored by three members of the Ways and Means Committee to advance with provisions related to the workings of the normal retirement age regulations that did not also address our specific concerns. 

We therefore worked with the three Congressmen’s offices to include language dealing with this problem in Section 7(a)(2), “SERVICE-BASED RETIREMENTS IN GOVERNMENTAL PLANS”.  We also made sure that Treasury and the IRS were aware of our efforts and that we in no way were indicating that we believed that discussions with them should not proceed.   In a letter from NCTR and 18 other national organizations to Congressman Kind offering support for his bill, this point was stressed:  “Our representatives have been working with the IRS and other Treasury Department officials for the last several years in an effort to favorably resolve this matter, and understand they may soon be modifying the regulation.  While we hope the full extent of our concerns will be addressed, nevertheless, with the pending application of the IRS regulations now less than one year away, we greatly appreciate your readying legislation to properly remedy the harmful effects of the pending regulation.”     

The goal of the governmental plan provision in HR 3561 is to ensure the following:

1.         State and local retirement plans may have service-based normal retirement ages, either implied or implicit.  Service-based normal retirement ages include, but are not limited to, a specified length of service (i.e., 30 years), combinations of years of service and age (such as the rules of 80 or 90), and requirements that participants reach a specific age and meet a years of service requirement (i.e., reach age 60 with 10 years of service or 65 with five years of service).

2.         The Treasury Department must amend its regulations on normal retirement age to:

a.  Recognize that the definition of normal retirement age for state and local 
     retirement plans  is found in state and local law;

b.  Provide that a governmental plan with a normal retirement age conditioned on the completion of a stated number of years of service (i) satisfies the requirements of Internal Revenue Service Regulation §1.401(a)-1(b)(1)(i) that a pension plan be maintained primarily to provide for the payment of definitely determinable benefits after retirement or attainment of normal retirement age, and (ii) satisfies the pre-ERISA vesting rules; and

c.  Provide that the safe harbor provisions found in the May 2007regulations solely relate to in-service distributions, so as to not supersede the state and local-based definitions of normal retirement age, and must additionally recognize the unique nature of state and local retirement plans and their workforces.

In summary, although time is running short, it does appear that the Treasury Department and the IRS are aware of the legislative pressures facing public plans, and will soon release for comment proposed new regulations dealing with the meaning of “normal retirement age” as applied to governmental plans.  It may well be that this release will be accompanied by another extension of the application of the regulations in order to accommodate this process.  While it is still unclear as to what the new regulations will contain, Treasury has been provided with the language of the Kind bill, and has also been provided with the above “plain English” description of what the public sector intends to accomplish with this language.  While they did not state agreement with it, they did not react negatively.

Difficult tea leaves to read, but it does appear that there could soon be movement on this front, and if there is not, or if it falls far short of what has been discussed over the last several years, legislation is now in the hopper that would address the problem.  While it will be difficult for such a bill to advance this year as a free-standing bill due to the impact of the fall elections on the legislative process, it should be reintroduced in the 113^th Congress, when tax reform legislation is likely to advance, regardless of the outcome in November.

·         NCTR/NASRA 2007 Comment letter on NRA Regulations

·         HR 3651

·         Letter to Congressman Kind Supporting HR 3561

GASB Update: Report by the Center for Retirement Research at Boston College, entitled “How Would GASB Proposals Affect State and Local Pension Reporting"

The recent report by the Center for Retirement Research (CRR) at Boston College, entitled “How Would GASB Proposals Affect State and Local Pension Reporting,” contains an appendix that has been creating some confusion and concern.  Specifically, Appendix B shows a column listing the year in which each of the 126 plans covered in the report will run out of money.   As I noted in my posting, these dates are not actual projections by CRR of when a plan will become insolvent.  

In an effort to further clarify the situation, PensionDialog discussed these dates with CRR and has posted its interview, which notes that: 

• These dates are not reflective of an ongoing plan, and are intended only for use in implementing GASB’s particular liability concept; 
• The methodology used to calculate the “run-out” dates was GASB’s, based on an accounting method that does not accurately portray all aspects of an ongoing plan; and
• Purported exhaustion dates previously developed by CRR in March of 2011 (and also found in Appendix B) present a “worst-case” scenario.

 The full interview can be found here.

Happy Holidays? 3% Withholding Law Repealed and State Legislature Opposes PEPTA, but New JEC Report Suggests Stormy Weather Ahead

PRESIDENT SIGNS REPEAL OF 3% NON-WAGE WITHHOLDING LAW

As expected, on November 16, 2011, the House of Representatives agreed to the Senate’s changes to H.R. 674, legislation to repeal the imposition of a 3 percent withholding on each payment of $10,000 or more for property and services made to vendors by governmental entities, including public pension plans.  Five days later, on November 21^st, President Obama signed the bill into law (PL 112-056).

Adopted at the last minute in 2006 in conference committee, and delayed on several occasions thereafter, the withholding requirement was to have begun applying in 2013 to all payments made by most governmental pension plans for goods or services, but not benefits.  The withheld amounts were to be a credit against the tax liability of the recipient of the payment, and were to be shown on an information return after the end of the tax year, similar to backup withholding or withholding on wages.

Repeal of the withholding requirement was one of NCTR’s major legislative goals, as it would impose administrative burdens, increased technology costs, and could also result in higher prices as vendors attempted to deal with its impact.  Efforts to do away with the mandate therefore began almost as soon as it became law.  These were led by the National Association of State Auditors, Comptrollers and Treasurers (NASACT).  

However, despite significant advances toward repeal, it was not until the Chamber of Commerce made it a priority and flooded Congressional offices with letters from businesses large and small calling for terminating the requirement that interest in repeal began to increase substantially. 

And when doctors realized that the definition of government contractors would include physicians who bill Medicare for health services, things really began to pick up.  (While most individual payments for physicians would not reach the $10,000 per payment threshold imposed by regulation, some health practices aggregate claims, and could therefore exceed that threshold.)  The American Medical Association and several other healthcare organizations warned Congress that the withholding requirement would cause cash-flow problems at practices and facilities if it were to be implemented.

In addition to repeal of the withholding mandate, the new law provides:

•  tax credits for veterans hiring; 
•  a Treasury study of tax delinquency among Federal contractors; 
• a technical clarification about the application of the existing federal levy program to reflect Congressional intent that payments for property can be levied along with payments for goods and services.

The repeal is expected to “cost” the Federal government about $11 billion in lost revenues that would have been gained by the withholding provision.  This loss was offset by closing what was considered to be a coverage loophole in the “Patient Protection and Affordable Care Act,” the Obama healthcare reform law passed in 2010.  Under that law, some people with annual incomes up to about $60,000 might have become eligible for Medicaid when the program expands in 2014 because the healthcare reform law did not count Social Security benefits toward Medicaid income eligibility.  The withholding repeal fixes this and the revenue that will be saved by this Medicaid modification will then be used to offset the loss from the withholding repeal.

PEPTA UPDATE:  STATE INSURANCE LEGISLATORS ADOPT RESOLUTION OPPOSING PEPTA, BUT JOINT ECONOMIC COMMITTEE STAFF REPORT HINTS AT POSSIBLY MORE CONGRESSIONAL REVIEW

At their annual meeting in November of 2011,  the National Conference of Insurance Legislators (NCOIL) approved a resolution in opposition to the “Public Employee Pension Transparency Act" (PEPTA), introduced as H.R. 567 in the House of Representatives by Congressman Devin Nunes (R-CA) and in the Senate as S. 347 by Senator Richard Burr (R-NC).  (NCOIL is an organization of state legislators whose main area of public policy concern is insurance legislation and regulation. Many legislators active in NCOIL either chair or are members of the committees responsible for insurance legislation in their respective state houses across the country.)

New NCOIL President Senator Carroll Leavell (R-NM), the sponsor of the resolution along with NCOIL Past President Representative Kathie Keenan (D-VT), said that the bill had “big brother undertones” that are “too much for those of us that have worked hard in the states to protect the retirement security of our constituents and to make sure hard-earned taxpayer dollars are used wisely.”  Senator Leavell said that “We do not need the distant Federal government to insert itself into state and local pension plan decisions.”

The action by NCOIL’s executive committee came three days after their Financial Services & Investment Products Committee voted fifteen to one in support of the resolution following a presentation by NCTR’s Director of Federal Relations encouraging them to oppose PEPTA and answering legislators’ questions concerning the Federal legislation.  The Financial Services Committee also approved a 2012 charge to monitor state and federal pension reform initiatives, so the issue will remain on their radar.

In addition to opposing PEPTA, the NCOIL resolution calls on Congress to let state and local officials manage their own unique pension systems.  Among other things, the resolution argues that PEPTA would unnecessarily inject the Federal government into the administration of state and local pension plans and would threaten funding for state and local government projects by conditioning continued tax benefits for government bonds on plan compliance with new federally directed reporting requirements.

As far as PEPTA’s current status is concerned, there have been no further hearings dealing with the subject in the House of Representatives since the May 5, 2011, hearing on “Transparency and Funding of State and Local Pension Plans” by the House Committee on Ways and Means’ Oversight Subcommittee.  That was the fifth hearing in the House in 2011 that examined the PEPTA legislative proposal either directly or indirectly.  There were no Senate hearings on the subject in 2011.

H.R. 567 has a total of 51 cosponsors; none have signed onto the bill since May 10, 2011.   In the Senate, S. 347 has 8 cosponsors, with the latest, Senator Kirk (R-IL) having signed up on July 27, 2011.   As 2012 will be the second session of the 112^th Congress, the two bills are still pending and do not need to be reintroduced. 

While no further action has yet to be scheduled, the Republican staff of the Joint Economic Committee (JEC) issued a staff commentary in December of 2011 entitled "States of Bankruptcy Part I: The Coming State Pensions Crisis."   Relying almost exclusively on work by Professors Joshua Rauh and Robert Novy-Marx, this report claims that " a number of plans are projected to run out of money in just over five years based on private sector accounting standards" and that the combination of massive unfunded pension liabilities and poor economic policies "are setting many states up for a Greek-style fiscal death spiral."  The report concludes by stating that "the state pension crisis is virtually unavoidable" but that the federal government's role in "bearing the burden of irresponsible states" can be mitigated through "preemptive actions that will help prevent a taxpayer bailout of state pension systems," no doubt a lightly-veiled reference to the “PEPTA" legislation.

Senator Jim DeMint (R-SC), a member of the JEC, also was quoted in the press in connection with the GOP staff report, saying that “The deeper we get into this research, the clearer it becomes that federal legislation may be necessary to force states to use honest accounting, fix their pension debt and protect taxpayers from the mother of all bailouts."  In addition, the JEC commentary also notes that there will be “future reports” that will examine “the prospects for pension reform (including promising measures to confront existing unfunded liabilities and to establish fully sustainable pension plans).”  This suggests that another round of Congressional hearings on state and local governmental pensions could be in the works, perhaps in connection with these subsequent JEC Republican staff reports.

·         NCOIL Press Release on Opposition to PEPTA

·         NCOIL Resolution Opposing PEPTA

·         JEC GOP Staff Commentary on State Pensions

GASB Update: Latest News on Overall Process; Two Views of Proposed Reforms

The Governmental Accounting Standards Board (GASB) still appears to be on track for a final decision by the middle of 2012 on its proposed changes to governmental pension reporting and accounting rules contained in the Exposure Drafts issued earlier this year, but there are some signs that changes in response to the results of the field testing process, and the concerns of cost-sharing plans, may yet be possible.   In the meantime, two recent studies provide contrasting views of the likely results of the proposed changes as they now stand.  The first, a working paper by Robert Novy-Marx, concludes that under the GASB rules as proposed, a governmental pension plan can improve its funding status “literally by burning money.”  The second, a brief produced by the Center for Retirement Research at Boston College (CRR) finds that employers and plan administrators should be prepared for funded ratios reported in their financial statements to decline sharply under the new GASB rules, but that “[p]olicymakers should not let new numbers throw them off course.“  

Current Status of GASB Proposals

In response to its Exposure Drafts containing proposed changes to the accounting and financial reporting for pensions by plan sponsors and to the financial reporting for pension plans by the plans themselves, GASB received 645 comment letters, including the letter prepared by NCTR, NASRA and NCPERS, which was signed by over 130 executive directors, administrators and trustees of 109 State and local government retirement systems.

In addition, GASB held three public hearings at which 33 organizations and individuals testified.   Three user forums were also held, with 19 participants, including representatives of citizen groups, bond rating agencies, academics, financial analysts and research organizations. 

Finally, field tests were held.  These were designed to obtain information about one-time and ongoing preparation time and costs associated with the proposals in the Exposure Drafts; to identify difficult-to-understand provisions of the Exposure Drafts; and to receive feedback on the methodology employed by field test participants on certain proposals in the Exposure Drafts.  Field test participants were also asked to provide pro forma note disclosures and required supplementary information and details of the calculation methodologies used to determine the discount rate—specifically, their projections of benefit payments and plan net position.

In a memo to the GASB board members, staff summarized the results.  According to this memo, GASB received results from 18 participants, including 3 single-employer Plans; 3 single employers that also report plans; 3 multiple-employer agent plans; 2 agent employers; and 7 multiple-employer cost-sharing plans. 

As noted, participants in the field test were asked to provide estimates of time and cost related to both initial implementation efforts and ongoing efforts that would result from the Exposure Draft proposals.  (For purposes of the field test, it was requested that the estimates of time include only internal staff time and that cost estimates include out-of-pocket expenditures (such as consulting fees), software acquisition, and system changes but not include costs associated with staff time.)  The results varied dramatically.  Initial implementation time ranged from 2 hours for one agent employer to 56.000 hours for one cost-sharing plan.

Similarly, implementation costs varied tremendously, from a low of around $3,000 for one cost-sharing plan to as high as $18 million for another cost-sharing plan.   This was then compared to current costs under existing GASB rules, which were much, much lower, underscoring the impact of the proposed GASB changes.

The staff memo also details many of the specific concerns with various aspects of the Exposure Draft that participants identified, as well as the methodologies used in the calculation of (1) the weighted-average expected remaining service life of active employees and (2) the proportionate share of collective totals of employers in cost-sharing plans. 

The memo concludes with issues that arose from the field tests and which “will be considered in the redeliberations of the Exposure Drafts,” including:

• Concerns about increased internal costs and external actuarial and audit costs, particularly in multiple-employer plans in which employers have different fiscal year-ends.  GASB staff notes that “Specific concerns were expressed regarding the valuation of assets without market prices and the determination of other changes in plan net position that currently are evaluated only annually”
• Applicability of the proposals to hybrid plans and plans in which defined contribution pensions may be converted to annuities 
•  Request for additional guidance related to proprietary funds and entities that use regulatory accounting
• Request for clarification regarding the projection of benefit payments in circumstances in which employees provide services to multiple employers that participate in a plan or in which employee contributions are greater than service cost
• Request for additional guidance related to plan reporting of investment types, pensions of the plan’s own employees, and presentation of a statement of plan net position
• Concerns about proposed plan note disclosures, including issues related to the separation of investment expenses from returns in the calculation of return on plan investments, difficulty in obtaining or calculating rates of return on a money-weighted basis, and a general concern about the volume of disclosures.

All of this suggests that these “redeliberations” may well result in changes to the Exposure Draft, although it should also be noted that , based on the projected GASB work plan,  the final voting on the Exposure Draft is still scheduled for the May-June, 2012, time frame.   In other words, the “fast-track” still appears to be in place.

Cost-Sharing Plans

One area of the proposed changes in the GASB rules that has been particularly worrisome has been those related to the manner in which cost-sharing plans will be required to allocate their net pension liability, pension expense, and deferred outflows of resources and deferred inflows of resources  to their participating employers.   The impact of this aspect of the proposed GASB changes on employers who participate in cost sharing plans could be devastating. 

For example, in a recent article on the specifics of the cost-sharing proposal as it applies to employers, David Powell with the Groom Law Group stresses that “If these proposals are finalized without change, participating employers will need to substantially revamp their accounting systems at considerable expense.”   Compliance is expected to be the responsibility of the employer, he explains, “and the retirement system's ability to provide assistance in many cases may be limited.”  Powell warns that this “may leave the burden of compliance on the contributing government employers” and not the plans – a point that many plan sponsors have yet to fully appreciate.

NCTR continues to believe that cost-sharing plans constitute a form of insurance and that the costs should not be allocated to the individual employers, and has made this point consistently in comments filed with GASB.   Nevertheless, for now, GASB appears to be set on its allocation approach.

Accordingly, a number of cost-sharing plans have formed an ad hoc group, the Employer Cost-Sharing Coalition, which has filed separate comments with GASB focused solely on this issue.   These comments, prepared by the Groom Law Group, argue that:

• There is a lack of a clear relationship between the arbitrary proportionate share and actual liability
• Varying and uncertain rules in different jurisdictions means that actual liability of a cost-sharing employer for plan underfunding, however measured, will often be difficult or impossible to predict with any certainty; thus, it is not a faithful representation of the potential liability. 
• Instead, plan underfunding and other information could be disclosed in notes with a description of any rules in the jurisdiction for determining employer liability for underfunding. 
• Comparability to the new FASB multiemployer rule also justifies this approach.   (In 2010, FASB had initially proposed a rule similar to the one GASB has proposed, to be applicable to private sector multiemployer plans, but changed its mind because of cost concerns; because the actual payment in the future might be limited by legal constraints; and because the estimate of a liability did not represent the amount an employer would actually have to pay.)

This new approach, which has reportedly been received with much interest by GASB staff, as well as the comments from the field testing conducted by cost-sharing plans, may be having an impact.  For example, GASB has now indicated that, at its March, 2012, meeting, it will consider the creation of a working group to assist the Board with regard to cost-sharing matters. 

Hope springs eternal.

Novy-Marx Working Paper

Robert Novy-Marx is an Assistant Professor of Finance with the Simon Graduate School of Business at the University of Rochester, as well as a member of the National Bureau of Economic Research, which published his new paper.  It is entitled “Logical Implications of GASB's Methodology for Valuing Pension Liabilities,” and in it, Novy-Marx argues that GASB does not really provide a valuation method.  He notes that a valuation method should recognize that “more is more,” in the sense that adding a dollar to any given set of assets and liabilities increases the set’s value.  Furthermore, he says that a valuation method should also assign a unique value to a given set of assets and liabilities.

But the GASB methodology for accounting for net pension liabilities “does not satisfy either of these conditions,” he asserts.  GASB instead gives different “valuations” for the exact same assets and liabilities when they are partitioned differently among plans, he argues, and moreover, since the marginal valuation of assets can be negative under GASB, then in such cases, GASB would allow a plan to improve its GASB funding status literally by burning money.

For example, he claims that GASB, while recognizing that cash and bonds are valuable assets, nevertheless “penalizes a plan for holding these, by forcing it to recognize a larger liability.”  Thus, he says, destroying a dollar (i.e., reducing its cash or bond holdings by a dollar while holding all other asset holdings fixed) reduces a plan’s assets by exactly a dollar, but can reduce its GASB liability by more than a dollar.  “In these cases plans can reduce their GASB recognized underfundings by destroying assets,” he concludes.

Finally, Novy-Marx insists that GASB’s methodology for accounting for liabilities has an equivalent alternative formulation.  “The explicitly prescribed procedure, which entails discounting a plan’s liabilities at the expected return on its assets, is completely equivalent,” he argues, “to one in which a plan’s liabilities are discounted at rates that reflect the liabilities own risks, but the plan’s stock holdings are valued at more than twice their market values.”

CRR Brief

The CRR brief is entitled “How Would GASB Proposals Affect State and Local Pension Reporting?”  It  takes a look at the GASB proposals and focuses on those elements dealing with valuation of assets and liabilities, namely (1) plan assets would no longer be smoothed but rather valued at market; (2) liabilities would be discounted by a blended rate that reflects the expected return for the portion of liabilities that are projected to be covered by plan assets and the return on high-grade municipal bonds for the portion that are to be covered by other resources; and (3) the entry age normal/level percentage of payroll would be the sole allocation method used for reporting purposes.  CRR examines these effects by first determining funded ratios based on current GASB standards and then funded ratios calculated using the market value of assets.  Next, CRR combines market assets with liabilities discounted by the blended rate to demonstrate the full impact of GASB’s proposed changes.

Looking at the effect of the change from an actuarially smoothed l value of assets to a market value, CRR finds that the aggregate funded ratio using market assets was only 67 percent in 2010 compared to 77 percent using actuarial assets.  “[P]olicymakers should be prepared for a sharp decline in funding if GASB introduces this change,” the CRR brief concludes.

Next, looking at the new blended rate for determining liabilities, CRR found that the aggregate funded ratio of state and local plans (based on 2010 numbers) would have decreased from 77 percent to 53 percent under the GASB plan.  

Thus, CRR finds that the GASB proposals “will sharply reduce the reported funded levels of public sector plans.”  However, CRR also stresses that it would be “unfortunate if the press and politicians characterized these new numbers as evidence of a worsening of the crisis when, in fact, states and localities have already taken numerous steps to put their plans on a more secure footing.”   The Brief concludes that “[r]eforms need to be done carefully and thoughtfully, remembering that pensions are an important part of the total compensation of public sector workers.”   

The CRR brief also makes a number of other observations that are very similar to those made by NCTR and its members in connection with the GASB exposure drafts.  For example, CRR says that there will be implementation problems, the main one being with GASB’s proposed blended rate.  It will require a complicated calculation based on a number of assumptions, including assumptions not only about plan returns but also about future contributions from the government and from employees.   “These contributions may or may not come to pass,” CRR observes, and “[o]ne can imagine extended disputes about the validity of the underlying assumptions.”

CRR also criticizes the new GASB discounting proposal because the data it will produce will fail to provide meaningful measures of government obligations and be inconsistent across states and localities and over time. 

Finally, the CRR brief is worried about the impact on the annual required contribution, or ARC.  First, the move from actuarial to market value of assets and the new liability measure increase the unfunded liability and thereby the required amortization payment, CRR notes.  Then, a blended discount rate will raise the normal cost.  Therefore, CRR cautions that “reported” ARCs are likely to increase substantially but employers may likely continue to use the traditional actuarial smoothing techniques to calculate their ARCs for funding purposes.  As NCTR has warned, there could be an unfortunate and confusing disconnect between the reported number and the number being used for funding.

Next, CRR is also worried about what they refer to as the “disciplinary role of the ARC” and the likelihood that it will be undermined.  Specifically, they point out that in states with statutory contribution rates, they will no longer technically be required to calculate an actuarial ARC.  “This change not only represents a loss in analysts’ ability to assess how close plan contributions are to those required to keep the system on track,” CRR notes, “but also creates an escape valve that states could use as ARCs rise beyond reach:  introduce a statutory rate and dispense with ARC calculations.” 

In an effort to address some of these concerns with the loss of the ARC, NCTR and other national public sector organizations, in conjunction with the public plan actuarial community, are holding preliminary discussions to determine what could be a possible alternative and how its uniform use could be encouraged.

One final note regarding the CRR brief:  appendix B of the brief contains a “run-out” date for 126 public pension plans.  It is well to note that CRR has reassured Keith Brainard, Research Director of the National Association of State Retirement Administrators (NASRA), that these dates are not actual projections of when the plan could become insolvent.   According to CRR, these dates “are not reflective of an ongoing plan, and are only intended for use in implementing GASB’s particular liability concept.”  As Keith puts it, “in other words, these dates are based on an accounting basis, not a funding basis.” 

•  NCTR/NASRA/NCPERS Comment Letter
• GASB Field Test Staff Memo
• Employer Cost-Sharing Coalition Comments
• Groom Law Group Article on GASB Impact on Cost-sharing Employers
• Novy-Marx Working Paper
• CRR Issue Brief

House, Senate Passes H.R. 674 Repealing 3% Non-Wage Withholding Requirement; Treasury, IRS Move to Define “Governmental Plan;" and Teacher Benefits Under the Microscope

Some good news for a change:  The House, Senate Vote to Repeal 3% Withholding Law.

After always seeming to be the messenger of gloom and doom, I actually have some good news to report for a change.  Both the House and the Senate have now voted to repeal the 3% non-wage withholding requirement set to begin applying in a little over a year to all Federal and state governments and their agencies, including their pension plans.  (Political subdivisions of a state, as well as their instrumentalities, would be excluded if they made less than $100,000,000 in payments annually.)  The withholding requirement would not apply to pension payments made to retirees and other beneficiaries, but it would apply to all payments made by a pension plan for property or services.

To read more about the Repeal of the 3% Withholding Law; the Treasury,IRS' Move to Define “Governmental Plan;" and Teacher Benefits Under the Microscope CLICK HERE

Ways and Means Holds Hearing on Nunes Bill; New CBO Report Complicates Matters

Following a series of hearings before other House Committees, the subject of public pension accounting and the so-called “Public Employee Pension Transparency Act” (PEPTA), sponsored by Congressman Devin Nunes (R-CA), finally came before the House Ways and Means Committee in early May. The hearing is significant because this Committee – unlike the others which have held hearings to date -- has legislative jurisdiction over the Nunes bill, and could actually send it to the floor of the House for a vote. To complicate matters, the Congressional Budget Office (CBO) released an issue brief on “The Underfunding of State and Local Pension Plan” the day before the hearing. The CBO document discussed investment return assumptions and was quickly seized upon by Nunes and his supporters as endorsing the need for the disclosure of the market value of liabilities (MVL). Nevertheless, the next step for the Nunes legislation is unclear. However, GOP insistence that an increase in the nation’s debt ceiling must be linked with a blueprint for significant deficit reduction has placed the issue of pensions in the crosshairs, and there is some concern that this could open the door for the Nunes bill as a part of a debt-limit deal.

House Ways and Means Committee Hearing

On May 5, 2011, the Oversight Subcommittee of the House Ways and Means Committee held a hearing on “The Transparency and Funding of State and Local Pension Plans.” A stated purpose of the hearing was to explore whether “enhanced transparency in the reporting of the financial health” of public plans was warranted, and to review H.R. 567, the Nunes PEPTA bill.

Subcommittee Chairman Charles W. Boustany, Jr. (R-LA), began by saying that whether the underfunding of State and local pension plans is $700 billion or over $3 trillion, “it is a serious concern for workers and retirees, for State and local governments, and for taxpayers in general.” Boustany charged that “There is growing consensus that accounting standards for public sector pensions encourage state and local governments to overpromise, underfund, and take on risky investments by discounting guaranteed future benefits against unrealistic rates of return.“ He also stressed that since some have raised the specter of a Federal taxpayer bailout to cover the unfunded liabilities of public pension plans, “it is important for the Subcommittee to review this issue and to consider possible approaches to ensure that no such Federal taxpayer bailout is ever needed.”

Congresswoman Lynn Jenkins (R-KS) was much more candid, saying that she found it “a bit ironic that Congress, which doesn’t have the political will to take action to fix Social Security, is here today talking about our great concern with state and local government pensions.” She said that she wasn’t sure “if any of us have great credibility on the issue.”

Democrats on the Subcommittee raised strong objections to the hearing. The Ranking Member, Congressman John Lewis (D-GA), asserted that “Republicans have set their sights on the teachers who educate our children, police officers who keep our communities safe, and first responders in moments of crisis.” “They are not the cause of the current economic situation” Mr. Lewis said. “They are simply hard-working Americans trying to retire with dignity and escape poverty as they age,” he stressed.

Congressman Jim McDermott (D-WA) agreed. “Let’s be clear,” he said, “there is no problem with most state-run pensions.” Although Mr. Boustany claimed that public plans are legitimate reasons for federal concern because the Internal Revenue Code “subsidizes retirement savings and gives preferential tax treatment to state and local debt,” Mr. McDermott said that there is “no federal role in state-run pensions.” McDermott charged that Republicans were using the hearing simply as a “political tool to attack the middle-class workers who teach the children of wealthy people, and the cops and firefighters who keep them safe, and the workers who pick their trash.” There is no pension problem, he said; the Republicans just “want to attack unions.”

Congressman Ron Kind (D-WI) picked up on this anti-union theme, discussing the recent events in Wisconsin involving collective bargaining. He also chided Republicans for their support of the Nunes legislation, saying “You know, for the party that claims to be the party of less government in Washington and more responsibility at the state, proposing this one-size-fits-all approach is contrary to even, I think, your principles.”

Mr. Kind also entered into the record a letter opposing the Nunes bill from Dave Stella, Secretary of the Wisconsin Department of Employee Trust Funds (ETF). Congressman Kind specifically quoted from Mr. Stella’s letter, in which the Wisconsin retirement system director warned that "contrary to what the proponents of the legislation suggest, the issue is not a current lack of transparency and disclosure. It's simply an effort to justify a federal takeover of areas that are the financial and regulatory responsibility of state and local governments."

Finally, Congressman Javier Becerra (D-CA) underscored what he called a “disconnect between what we're doing here in Washington” and what the American public feels. Mr. Becerra pointed out that a recent public survey by the National Institute on Retirement Security (NIRS) found that the vast majority of Americans believe that the disappearance of pensions has made it harder for them to achieve the American dream. He noted that 81 percent said that they think Congress should make it a higher priority to ensure that more Americans -- not less -- can have a secure retirement. Congressman Becerra’s questioning of witnesses also helped to clarify that the state of Illinois was not seeking a federal bailout of its pensions.

Witnesses in favor of the Nunes legislation included the Treasurer of Colorado, Walker Stapleton, who is also a trustee of the Public Employees’ Retirement Association (PERA) of Colorado; Josh Barrow, a Fellow with the Manhattan Institute for Policy Research; Jeremy Gold, an actuary and one of the most vocal advocates of financial economics and MVL (who goes so far as to insist that public pensions should not invest in equities); and Robert Kurtter, Managing Director, U.S. Public Finance, for Moody’s Investors Service. The sole witness who spoke against the need for the Nunes bill was Iris Lav, Senior Advisor with the Center on Budget and Policy Priorities (CBPP).

Treasurer Stapleton, stressing that he was the only elected official on the COPERA board, was very critical of COPERA’s assumed 8 per cent rate of return, calling it “unrealistic and unachievable.” He also argued that since approximately 25 percent of COPERA’s portfolio is currently invested in fixed-income products (yielding about 4 per cent), this means that the rest of the portfolio must return closer to 10 percent in order to average an overall return of 8 percent. “The only way to achieve this unrealistic return is to take outsized market risk, further exposing our public pension plans to more volatility,” Stapleton argued.

Treasurer Stapleton said that the Nunes legislation “makes a lot of sense.” In addition, in response to a question from Congresswoman Jenkins asking if Stapleton, as an elected state official, thought it was fair that the Nunes bill conditioned a state’s continued ability to issue tax- exempt bonds upon the filing of certain information about state and local pension plans to the Internal Revenue Service, Stapleton answered “Absolutely.”

Josh Barrow of the Manhattan Institute for Policy Research agreed that that the discount rates used by public pension plans are “unreasonably high,” and supported what he called the “enhanced transparency” that he said would be provided by the Nunes legislation. He also recommended that pension plans should annually issue five-year projections of employer contribution rates.

Jeremy Gold, not surprisingly, testified in favor of the use of MVL to measure liabilities and generally endorsed the Nunes bill. However, he suggested several changes to the legislation, including substituting the use of unadjusted Treasury rates to measure MVL in lieu of the bill’s 24-month averaging and segmenting of Treasury rates. He also said that some of the required restatements of 20 year projections would be expensive and the disclosures they provided would be “uninformative at best and may actually be misleading and counterproductive in the decision-making context.”

Robert Kurtter of Moody’s Investors Service said that the Nunes legislation would increase access to, and comparability of, public pension plan data. However, he also said that by “requiring an employer to make multiple disclosures, using different calculation methods and in different places, about the same set of assets and liabilities could increase the complexity of disclosures and the time required to analyze the information.” Finally, he said that Moody's comments “should be not be taken as an endorsement” of the legislation.

Ms. Lav, with the CBPP, called the Nunes legislation “a solution in search of a problem.” She said that the bill “would be likely to increase public confusion, could spook bond markets, and could lead states and localities to cut spending for education and other key areas — or raise taxes — more than necessary.” She said that the Nunes legislation “also would create a new federal bureaucracy to regulate something that should be ‘regulated’ by market forces.”

Ms. Lav underscored that “underfunding problems of most state pension systems can be addressed with relatively modest increases in state and local contributions from employers and employees, along with a set of sensible, moderate changes in benefits.” She also warned that moving state and local employees from defined benefit to defined contribution plans — which she called “an objective that some of the sponsors of H.R. 567 have said they would like to accomplish” — would not address the funding problems public pension systems currently face. “On the contrary,” she testified, “it generally would raise annual costs by making it harder for a state to pay down the existing liabilities for employees still in the defined benefit plan, because that plan would include fewer employees and fewer contributions going forward, while requiring additional contributions for the employees in the defined contribution plan.”

Congressman Nunes, while not a member of the Oversight Subcommittee, also attended the hearing as a member of the full Ways and Means Committee. Afterwards, he said that the hearing made a “powerful case” for Congressional action. Mr. Nunes also claimed that there “is near unanimity among financial economists that public pension accounting reforms are needed.” Furthermore, he claimed that “No compelling arguments against the bill were made” during the hearing.

New CBO Report On Public Pension Plans

The day before the Ways and Means Committee hearing, the Congressional Budget Office (CBO) released a new issue brief entitled “The Underfunding of State and Local Pension Plans.” The brief discusses the chief alternative approaches to assessing the size of pension funding shortfalls – (1) the guidelines issued by the Government Accounting Standards Board (GASB), which compute liabilities by discounting future benefit payments using a discount rate based on the expected rate of return on the plans’ assets; and (2) what CBO unfortunately refers to as the “fair-value method,” which claims to measure the market value of the liability, often known as MVL.

(The CBO was founded and is funded by Congress. Its purpose is to provide objective, nonpartisan, and timely analyses to Congress to aid in economic and budgetary decisions. By law, CBO is also required to produce a cost estimate and mandate statement for every bill reported by a Congressional committee. As such, it is a well-respected organization both on and off the Hill, and its staff of economists and public policy analysts are highly regarded.)

The CBO report was the proverbial “mixed bag.” It did not directly endorse the use of a particular approach to assessing governmental pension liabilities, and it noted that the market-value approach would likely increase volatility, making budgeting for the required contributions more difficult. Finally, CBO found that “most state and local pension plans probably will have sufficient assets, earnings, and contributions to pay scheduled benefits for a number of years and thus will not need to address their funding shortfalls immediately.”

However, CBO also found that the MVL approach “more fully accounts for the costs that pension obligations pose for taxpayers.” Furthermore, the brief said “Most of the additional funding needed to cover pension liabilities is likely to take the form of higher government contributions and therefore will require higher taxes or reduced government services for residents.’

Not surprisingly, Congressman Nunes quickly claimed that the CBO report “supported the conclusions and testimony” presented by Republican witnesses at the Ways and Means hearing. He also said that “According to CBO, fair valuation (such as the reforms included in the Nunes bill) offers a more complete picture and transparent measure of the cost of pension obligations.”

Many in the media also seized on the CBO report as an endorsement of the MVL method of measuring unfunded pension liabilities as well as the Nunes bill. For example, Pensions and Investments ran a story entitled “CBO: Public Pension Plans Should Change Reporting, Contribution Methods,” while Governing magazine announced “CBO Endorses GOP’s Methods for Pension Projections.”

The CBO issue brief will clearly be used to support any effort to have the Nunes legislation adopted. It is therefore important that opponents of this legislation have something with which to rebut such efforts. NCTR is therefore in the process of finalizing a letter to the CBO raising a number of concerns with the issue brief:

• The brief lacks context critical to evaluating the suitability of each approach for the financial statements of state and local governments. For example, the paper describes market-based valuation as “what a private insurance company operating in a competitive market would charge to assume responsibility for those obligations.” However, the brief does not clarify that public pension liabilities are not for sale, state and local governments do not go out of business and are not acquired, and state and local governments can reasonably be expected to outlive any private business that would take over a public trust for profit.

• The CBO statement that market value “more fully accounts for the costs that pension obligations pose for taxpayers,” is purely subjective. One could say with equal or greater validity that the current GASB approach more accurately accounts for the cost of the pension obligation, as it reflects the expected government contributions to state and local pension funds, not what a theoretical insurance company would charge to assume them.

• The brief suggests that market-values are always going to produce a higher liability number. This is not correct. The same market-based measures that inflate pension liabilities in times when interest rates are low, such as now, would mask them during inflationary times. Furthermore, empirical studies of funding patterns under both approaches find that only rather recently, when 30-year Treasury bond yields fell below 6 percent and then declined to nearly 4 percent, did the market-based approach produce a higher liability than existing governmental plan methodologies. In the 1980s, when 30-year Treasury yields were high (almost at 14%), the market-based approach produced a dramatically smaller liability.

• Conjecture contained in the issue brief that public pension underfunding will “likely” lead to increased taxes or reduced government services, and that the federal government might be asked to assist with funding, is completely subjective, inappropriate for a CBO analysis, and at a minimum should have been qualified. For example, State and local governments, their plans and their employees, working through their legislative and regulatory structures, have responded to public pension underfunding by making an unprecedented number of changes to benefit levels, employee contributions, or both, in an effort to avoid increased taxes or cuts in service. Also, NCTR and other national organizations have gone on record numerous times, including in recent testimony before Congress, that state and local government retirement systems do not require, nor are they seeking, Federal financial assistance.

The Senate

The Senate companion measure to the Nunes bill, introduced by Senator Richard Burr (R-NC) as S. 347, has yet to be the subject of any Senate hearings, either in the Senate Finance Committee to which it was referred, or elsewhere. Furthermore, according to meetings with Senate Democratic staff, none are planned.

Nevertheless, of the bill’s seven GOP cosponsors, five were members of the Finance Committee when the bill was originally introduced: Senators Grassley (R-IA), Kyl (R-AZ), Coburn (R-OK), Ensign (R-NV) and Thune(R-SD). Furthermore, Senator Burr has just recently been named to the Finance Committee as well, meaning that a majority of the Republicans (6 of 11) are now cosponsors. Reportedly, they are pressuring the Committee’s Ranking GOP member, Senator Orrin Hatch (R-UT), to obtain a commitment for a hearing from the Finance Committee’s Chairman, Senator Max Baucus (D-MT).

Senator Baucus does not appear to be so inclined. However, it is difficult to imagine, given the wide range of issues that he and Senator Hatch will be working on together in the days ahead, such as the deficit reduction package to be made a part of the debt ceiling hike, that Senator Baucus would refuse a hearing on the bill if Senator Hatch seriously pressed him for one. Also, while Senator Hatch has not indicated support for the Burr legislation, he has previously stated on the Senate floor that it is his intention, “as Ranking Member of the Finance Committee, to find a way to address the public pension crisis.”

Therefore, a hearing on the legislation in the Senate is not entirely out of the question.

Outlook

The House Ways and Means Committee hearing on the subject of the Nunes legislation was significant for a number of reasons. First, it was held before the Oversight Subcommittee, which does not have legislative authority to consider legislation. Some believe that this is a clear sign that senior Ways and Means Committee Republicans such as Congressman Pat Tiberi (R-OH), the Chairman of the Select Revenues Subcommittee which is technically the Subcommittee with legislative jurisdiction over the Nunes bill, are not interested in seeing the legislation advance.

However, others point out that the fact that the hearing was held anyway – over the objections of Subcommittee Democrats who called for “regular order” – demonstrates the strong support for the legislation among the House leadership. The fact that Ways and Means has now arguably held a hearing on the legislation could also make it much easier for the bill to be brought up before the full House on its own, or as an amendment to another piece of legislation.

Some think that this other piece of legislation to which the Nunes bill could be attached might be the deficit reduction package which Republicans insist be agreed upon before they will vote for an increase in the debt ceiling. Such a package is now the subject of top level negotiations between President Obama, Senate Majority Leader Harry Reid (D-NV), and Senate Minority Leader Mitch McConnell (R-KY).

This idea of using the deficit reduction package as a vehicle for the Nunes legislation was floated as early as April by none other than Grover Norquist, president of Americans for Tax Reform and a big supporter of the Nunes bill. In an interview in Time, Norquist said that “There should be a requirement that structural reform takes place before Republicans give Obama more money to spend and borrow” by increasing the debt ceiling. When asked what such structural reform would look like, Norquist responded:

“One reform that people have talked about is, at the lowest level, a vote on a constitutional amendment to require a balanced budget, and require a two-thirds vote to raise taxes. Another would require local and state governments to have complete transparency in their pension obligations, so the city of Chicago, for example, would have to tell the people they borrow money from what obligations they have on pensions.”

More recently, a number of pension-related issues have become the focus of the deficit reduction package. For example, in May, the Washington Post reported that Republicans had proposed saving more than $120 billion over the next decade by requiring the Federal civilian workforce to contribute six percent of their salary toward their pensions, or more than seven times the 0.8 percent they contribute currently. President Obama’s bipartisan fiscal commission had also endorsed the idea, calling the Federal system “out of line” with the private sector, and reportedly, Federal pension reform seemed to have support from both the right and the left in these earlier negotiations.

There are also reports that the Pension Benefit Guarantee Corporation (PBGC) could see its premiums increased as part of the deal. One proposal is to determine a company's premium by its overall financial condition, but the Chamber of Commerce and other business interests are expressing "serious concern" with the proposals.

Finally, there now appears to be a proposal on the table to eliminate indexing in the tax code related to retirement savings, which would raise revenue without obvious tax increases. According to Brian Graff, executive director of the American Society of Pension Professionals and Actuaries (ASPPA), ideas that are being considered are to decrease the Section 415 annual contribution limits to defined contribution plans from $49,000 a year to $20,000 a year or 20 percent of pay, whichever is lower. Another idea is to change the Section 402(g) limits) to eliminate catch-up contributions and to cap Section 401(k) annual contributions at from $10,000 to $14,000.

If pension “reforms” remain a focus of the deficit reduction “side-bar” legislation, this could provide the perfect opportunity to also slip in the Nunes bill, as Norquist has suggested. An agreement on the debt ceiling must be reached by August 2, 2011, in order to avoid a Federal default. Negotiations on the debt limit being led by Vice President Biden fell apart recently when the GOP insisted that higher taxes could not be allowed as part of the deal.

• Ways and Means Committee Hearing Statements and Transcript

• CBO Issue Brief on Public Pension Underfunding 

Repeal of 3% Non-Wage Withholding Requirement Appears Possible

Following the active engagement of the U.S. Chamber of Commerce and 125 other trade associations in a grassroots effort to repeal the 3% withholding tax, now scheduled to take effect on January 1, 2013, there now appears to be a good chance that Congress might finally do away with the burdensome requirement. According to the Chamber, a private-sector study has estimated that the 3% withholding requirement could cost Federal, state and local governments as much as $75.2 billion in implementation costs during the first five years after it takes effect and NCTR, NASRA and other public sector groups have been fighting for years to obtain repeal. However, the potential impact of the provision on small business cash flows and their ability to finance new jobs seems to have finally done the trick. A repeal amendment is currently pending in the Senate, and repeal legislation in the House of representatives has 176 cosponsors.


The 3% withholding requirement was a last-minute provision (Section 511) added to raise revenue during the 11th hour of conference negotiations on the “Tax Increase Prevention and Reconciliation Act” of 2006. It requires Federal, state, and local governments and their instrumentalities to deduct and withhold 3% of any payment for property or services. There is a small entity exception for political subdivisions and their instrumentalities that make less than $100,000,000 in payments annually.

The withholding requirement was originally to take effect January 1, 2011, but was delayed for one year in the 2009 American Recovery and Reinvestment Act, and then was once again pushed out a year (until January 1, 2013) in the final Internal Revenue Service (IRS) regulations issued in May of this year.

Implementation of Section 511 presents a number of significant challenges to State and local governments. For example, the sophistication of systems necessary to capture and report the required data vary greatly between governmental entities, and many may not have the resources, capacity or staff to undertake the required withholding and remittance. In addition, there are costs to purchase or retrofit existing payment and procurement systems, which are particularly unwelcome given state and local government fiscal situations at present.

Repeal efforts in the past have run afoul of the revenues that would be lost as a result. For example, in 2009, the Congressional Research Service reported that eliminating the provision would cost close to $11 billion over 10 years. However, the costs of implementation to businesses and governments are estimated to be much higher. For example, the Department of Defense (DOD) prepared a report for Senate and House Armed Services Committees that anticipates DOD costs to comply will be over $17 billion for the first five years alone, presenting a net revenue loss for the Federal government based on just this one agency’s expected costs. The Chamber of Commerce claims that a private-sector study has estimated that the 3% withholding requirement could cost Federal, state and local governments as much as $75.2 billion during those first five years.

Legislation has once again been introduced in the Congress to eliminate the provision. For example, H.R. 674 has been offered by Congressman Wally Herger (R-CA), and currently has 176 cosponsors in the House of Representatives. In the Senate, Senator Scott Brown (R-MA) has introduced S. 164, which is cosponsored by 17 other Senators and seems to be the Senate bill garnering the most attention.

House Ways and Means Chairman Dave Camp (R-MI) has also said that he wants to explore a repeal , and that it could possibly be included as part of a larger tax bill that he said could be moving later this year. In addition, on May 26th, the House Small Business Committee’s Subcommittee on Contracting and Workforce held a hearing entitled “Defer No More: The Need to Repeal the 3% Withholding Provision.” No one testifying, nor any Member of Congress attending the hearing, opposed the repeal of the 3% withholding requirement.

The House Small Business Committee Chairman, Congressmen Sam Graves (R-MO), and Mick Mulvaney (R-SC), chairman of the House Small Business Subcommittee on Contracting and Workforce, also have written an op-ed entitled “Stop Withholding Small-Business Payments” that was published in the June 20th issue of Politico. In it, they stressed that many small-business government contractors work for less than a 3 percent profit margin. “Withholding 3 percent of their payments may force some of these companies out of the public-sector market - or out of business entirely,” they warned. This would result in “a loss of jobs, a loss of competition and higher costs to taxpayers,” the two pointed out.

Currently, there is an effort underway on the Senate floor to pass repeal of the provision. Senator Brown, along with Senators Olympia Snowe (R-ME), James Inhofe (R-OK), and David Vitter (R-LA), filed an amendment (No. 405) to S. 782, the Economic Development Revitalization Act of 2011, to repeal the 3% withholding provision of the IRC on June 9th. Since then, Senators Ayotte (R-NH), Barrasso (R-WY), Begich (D-AK), Enzi (R-WY), and Moran (R-KS) have cosponsored the amendment. The amendment is still pending, as the Senate has yet to complete business of the underlying bill. It would pay for repeal using “unobligated funds” as the offset.

NCTR and NASRA have joined with other governmental organizations, spearheaded by the National Association of State Auditors, Comptrollers and Treasurers (NASACT), in sending a letter to Chairman Camp urging prompt action. In addition, NCTR has signed onto a statement of support submitted for the record on the Small Business Committee hearing. The Chamber and more than 1,000 organizations, individuals and business from all across the country have also written a letter to all members of Congress, calling the 3 percent withholding provision onerous and asking them to support the Brown amendment.

Although repeal is finally looking like a real possibility, the IRS’s Office of Federal, State and Local Governments will hold a free, one-hour webcast on July 14th that will address a number of questions concerning implementation of Section 3402(t), the section of the Internal Revenue Code implementing repeal,

• Who must perform Section 3402(t) withholding?

• What payments are subject to Section 3402(t) withholding?

• What are the exceptions to Section 3402(t) withholding.

So for you pessimists (realists?) out there, registration instructions for the webcast can be found here.

• NASACT Summary of IRS Final Regulations

• IRS Final Regulations

• House Small Business Committee Hearing

• NCTR, National Organizations Statement for Record

• Graves/Mulvaney Op-Ed

• Chamber Letter