Examining the control state and local governments have over public pension plans

State and local governments have the sole authority under the law to establish retirement benefit plans for their employees. As the legal plan sponsor, each government has the right to determine the retirement benefits provided, the structures and policies for funding the benefits promised, the investment of the retirement plan’s assets, and the governance and administration of the plan.

This authority is in the very nature and purpose of being the plan sponsor in the first place. A good technical resource describing this authority can be found in the Public Pension Governance Series published by the National Association of State Retirement Administrators (NASRA).

However, the scope of the plan sponsor authority over public pension plans can get confusing when state and local governments take on the complex and often thankless task of reforming the defined benefit pension plans they sponsor. Attempts to change public pension benefits, funding, investment, and governance structures and policies are frequently met with pushback from plan participants, retirees, and, in some cases, even the trustees and system staff administering the pension plan. 

The pushback can take the form of political opposition during the legislative process and, sometimes, in the form of litigation. The outcomes of these processes vary from state to state, leaving plan sponsors often uncertain as to what can be done to move forward with needed public pension reform.

It is necessary to know where the boundaries of permitted change really lie. The reality is that state and local government policymakers have more latitude than many realize, and it is vitally important to resist any encroachment by third parties and stakeholders on the authority of the public pension plan sponsors to design and manage the plan, particularly when changes are necessary in response to changing circumstances to business objectives of the plan sponsor.

The boundaries of pension reform can be best understood by becoming familiar with the basic rules of pension trust creation and administration, particularly the rights and responsibilities of the three major parties involved:

1. The state or local government acts as plan sponsor and “settlor” of the trust holding plan assets;
2. The fiduciary entity is charged with the responsibility of administering the retirement plan and beneficiaries, and
3. The plan participants and beneficiaries. An explanation of these parties and other relevant factors follows.

The Settlor Function 

The legal authority governing how state and local governments can create retirement plans for public employees is primarily found in state constitutions, statutes, and common law. The amount of authority and control can vary somewhat from state to state. But generally, the basic rules for creating pension plans and trusts are not that different.

A state and local government is considered the creator or “settlor” of the public pension plan and trust. Through enabling legislation, the “settlor” sets the initial terms and conditions of the plan and trust and identifies the fiduciary, administration, and investment structures under which the pension plan must be operated.  

While not directly applicable to governmental plans, federal case law under the Employee Retirement Income Security Act of 1974 (ERISA) accepts that “settlor” functions include decisions relating to the establishment and design of plans and the amendment of those plans. Settlor functions are not fiduciary activities.  

The Fiduciary Function 

The settlor sets the fiduciary governance structure in the enabling legislation creating the pension plan and trust. Generally, the settlor designates one or more fiduciaries who are obligated to administer the pension plan and trust consistent with the terms and conditions set by the settlor. The fiduciary entity is usually a board of individual trustees. In most states, the applicable law will require these trustees to conduct their assigned duties for the exclusive benefit of plan participants and beneficiaries but must conform their actions to the terms and conditions of the enabling legislation of the pension trust. The fiduciaries for a plan are not permitted to override the plan sponsor’s directives in the enabling legislation.

The Rights of Plan Participants and Beneficiaries 

The rights of pension plan participants and beneficiaries are determined under state laws applicable to public pension plans. Examples of such provisions include the basic terms of any retirement plan, including eligibility and participation, benefit accrual and vesting provisions, retirement benefit eligibility, and forms of payments. 

Federal Law Implications Are Limited  

The federal Internal Revenue Code (IRC) does require public retirement plans to comply with a few requirements to obtain status as a tax “qualified plan,” including that public pension plan assets be held in trust for the exclusive benefit of plan participants and beneficiaries and maximum benefit limits. Federal law does not otherwise define or regulate the scope of the settlor or fiduciary functions of public retirement plan trusts. None of the minimum participation, vesting, nondiscrimination, or funding rules apply to government plans.

Pension Benefit Reductions

Reductions of pension benefits for current employees and retirees create the most problems for plan sponsors and give rise to the most litigation, given that accrued public pension benefits are almost ubiquitously protected from diminishment by federal and state constitutional provisions related to contracts.

This helps explain why most public pension reform involves prospective benefit design changes for future hires, as described below.

Courts in different jurisdictions have come down on one side of the issue or another to different degrees based on interpretations of federal and state laws on the participant contract or property rights to the earned and accrued pension benefits.

In some states, the contract or property rights of current employees, even for future service, go well beyond what exists for private sector employees under ERISA. A good summary of how the courts have viewed various proposed changes to plan design and funding can be found here, here, and here. The lesson in these cases is to get good legal advice before reducing plan benefits, even for future service, for existing employees and retirees.

Benefit Changes for New Hires 

None of this litigation, however, has ever challenged the right of state and local governments as the plan sponsor and “settlor” to set the terms and conditions for the benefits initially or to make changes for new hires. The plan sponsor is always free to design the retirement plan as it wants to, as long as accrued benefits and (depending on the jurisdiction) the rights to future benefit accruals are not impaired. 

Changes to the Pension Plan’s Fiduciary Structures 

The right of the public pension plan sponsor to alter the fiduciary and governance structure for a plan is also not in question. Again, this is a principal feature of being the settlor of the plan and trust. State or local governments can change the makeup of the fiduciary entity charged with administering the pension plan—typically a board of trustees—at any time.

For instance, Arizona Senate Bill 1428 in 2016 created a new tier of pension benefits for public safety personnel statewide and also included an overhaul of the composition of the governing board designed to enhance its financial expertise and better balance the interests of employers, employees, and taxpayers (see section 11 here).  

Changes to Public Pension Funding Policy 

State and local governments set the pension plan funding mechanism in the enabling legislation. Historically, most governments set the contribution levels directly in the law. More recently, this contribution method has been considered too rigid to ensure the proper funding of the pension plan, and plan sponsors have begun to delegate to the pension board of trustees the responsibility for setting required contribution levels based on some form of actuarially determined amount.

If delegated, the plan sponsor has the unrestricted right to set the parameters over how the board of trustees will determine the required contribution levels, including setting the actuarial funding methods, investment return discount rates, and demographic assumptions. 

The plan sponsor can also change its funding policy for any reason it deems appropriate. For example, if a state and local government determines that the actuarial funding methods and assumptions set by an administrative body (e.g., board of trustees) create unnecessarily high or low contribution levels, it has the right to intervene and direct the use of different assumptions and methods to meet the business needs of the plan sponsor and prudent funding needs for the plan.  

Setting Investment Policy for Public Pension Plan Assets 

Generally, as a settlor, the plan sponsor delegates the pension plan asset investment to a fiduciary/board of trustees. The plan sponsor, however, has the right to set the terms and conditions of that delegation for how the pension plan assets will be invested.

The Uniform Prudent Investor Act, which has been adopted in whole or in part by 43 states and the District of Columbia, follows this line of thinking stated in Section 1. (b): “The prudent investor rule, a default rule, may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust…”

Absent some other limiting state law (e.g., constitutional), the state or local government has every right to set the funding and risk-taking guardrails that must be followed to meet their business needs. 

Conclusion

State and local governments have wide latitude to change or modify most aspects of their retirement plans’ design, funding, and administration. This authority is inherent in the very nature of the legislative power and in standard trust and fiduciary laws that define the settlor and fiduciary functions.

Public pension plan sponsors seeking to enact needed reforms to the design, funding, investment, and management of their pension plans should always seek the advice of experts before taking any action and, as noted previously, must be mindful of how benefit reductions for current employees are considered. This is just a matter of prudence in matters of importance. But as plan sponsors, state and local governments should not abdicate their policy control over the plans they create. They should zealously guard against encroachments by other stakeholders and plan fiduciaries.