Public Retirement Systems and the Pandemic: Part III – the Litigation Risk of Employer Disaffiliation or Withdrawal

June 3, 2020Alerts

The ongoing COVID-19 pandemic has presented public retirement systems with significant financial challenges that may cause some employers to attempt to disaffiliate or withdraw, leading to disputes about their ability to leave or the amount of withdrawal liability.

This litigation risk is in addition to the risk associated with two common approaches plan sponsors may adopt to lower costs:

  • Reducing current retirees’ COLA, covered in Part 1 of this series, which includes an introduction to retirement systems and their funding
  • Modifying other pension benefits for current retirees and active members, which we covered in Part 2.

As with the previous two alerts, this installment in the series is intended to provide only general information and does not address every potential concern. Disaffiliation is a product of state law, and varies widely across the country and even within a state based on the type of employer that is attempting to withdraw. Given the complex legal landscape, employers contemplating withdrawal or retirement systems facing a request by an employer to withdraw should consult with legal counsel about the facts and circumstances of their specific situation.   

What is disaffiliation/withdrawal?

Disaffiliation is the process by which an employer withdraws from a multi-employer public pension system. Sometimes this is called withdrawal or termination of affiliation. There is a corollary body of law about private employers withdrawing from multi-employer private pension plans under ERISA. This alert will not cover that topic, which Fox partner Michael McNally has detailed extensively in his e-book, Multiple Employer Pension Plan Withdrawal Liability.

Why have employers sought to disaffiliate from public retirement systems?

In the past, employers sought to leave under the belief that they could provide comparable retirement benefits to their employees at a lower cost to themselves by adopting a defined contribution 401(k) plan in which their employer contributions were capped and employees would be responsible individually for their investing decisions. This contrasts with defined benefit plans in which plan sponsors are seen as the ultimate guarantors of the promised benefit and responsible to backfill any funding gap.

More recently, employers have had additional reasons for contemplating withdrawal. First, there has been increasing scrutiny of retirement systems’ unfunded liabilities. Many plan sponsors have increased employer contributions as one part of the effort to pay down the unfunded liability. Public employers have sometimes resisted those mandated contribution increases as they attempt to balance their own budgets.

Second, the Governmental Accounting Standards Board (GASB) changed its reporting requirements for public employers and now requires them to disclose their share of the retirement system’s unfunded liability in their annual financial reports. Although GASB’s disclosure requirement does not mean that public employers must pay the disclosed amount, the mere act of requiring the disclosure of what can be a very large number has caused some employers to voice an interest in withdrawing.

The final reason for withdrawal is privatization. Occasionally, certain public employers such as public hospitals, social service providers or sanitation departments, are privatized. Under the Internal Revenue Code, privatized, formerly public entities often cannot continue to participate in the public retirement system without jeopardizing the plan’s qualified status as a public retirement plan. Thus decisions by public employers to privatize or spin off certain public entities can lead to a need or desire to disaffiliate that entity’s employees from the public retirement system.

Is disaffiliation from my plan permitted?

It is important to recognize that the default position is that withdrawal is not permitted. We estimate that at this time 19 states have banned disaffiliation. Some states banned disaffiliation as a result of court cases that date back decades. For example, an Arizona court held in 1943 that employers could not withdraw from public retirement systems, as did a New York court in 1935 and an Ohio court in 1938. Some states, including Delaware, Hawaii, Iowa, Kansas, North Carolina, Oregon, Virginia and Washington, barred disaffiliation by statute. Other states confirmed disaffiliation was barred in published opinions by the state’s attorney general.

The reasoning by these courts, legislatures and attorney generals is that an election to join a public retirement system is irrevocable and that allowing employers to withdraw their employees when it is convenient for them imperils the very notion of a multi-employer, multi-generational public retirement system. A New York appellate court summarized this reasoning in 1935, stating,

Clearly the Legislature intended this [public retirement] system to be permanent. It gave counties, cities, villages, and towns the right of election to come in. It is significant that it gave them no power to withdraw. The apparent purpose being to create a permanent Retirement System, the power to withdraw cannot be implied. If it is, a municipality may repeatedly elect to come in or withdraw.

N.Y. State Emps.’ Ret. Sys. v. Bd. of Supervisors, 283 N.Y.S. 405, 418 (N.Y. Sup. Ct. 1935) (emphasis added).

In several other states — including Nevada, Pennsylvania, Wisconsin, Michigan, Georgia, New Jersey and Massachusetts — we have located no guidance in the form of statutory provisions, attorney general opinions or common law as to whether disaffiliation is permitted or prohibited. That these states, which are some of the most populous in the nation, have not yet resolved whether a public employer can withdraw indicates how unsettled this area of law remains.

In another half dozen states, disaffiliation is severely limited. Texas allows municipalities to withdraw if they have no active employees within the plan — a precondition that seems impossible to meet unless a municipality was winding down operations. Several plans allow only a single, highly specific type of public employer to withdraw (such as a hospital or sanitation provider) when the employer is being privatized.

In states that permit withdrawal, employers may not simply announce that they will no longer participate in a multi-employer public retirement system and let the announcement alone serve to terminate their affiliation with the plan. Rather, the system’s plan document (which is often state law in the case of a statewide system) will detail the steps necessary to withdraw. In many of those states, only certain employers can withdraw. For example, many states allow local governmental entities to withdraw from the state retirement system but do not permit state agencies or public K-12 schools to withdraw.

If disaffiliation is permitted, what are the steps to disaffiliate?

Every state statute is different, but the most common steps that an employer must complete to withdraw are:

  • Employer decision to withdraw
  • Employee vote to approve the withdrawal
  • Application/notification to the retirement system
  • Accounting of liabilities
  • Payment of liabilities
  • Handling of existing member accounts

Not every state statute contains all of these elements and requirements will vary by state, so it is incumbent on counsel involved with disaffiliation to study and understand all of the requirements of that particular jurisdiction. Because the default position is that the employer’s decision to join is irrevocable, the employer must comply with all of the steps or it will remain in the plan. An employer cannot simply ignore a step (for example to hold a vote of its employees to confirm they approve the withdrawal) and expect to proceed seamlessly with a disaffiliation.

What litigation has arisen around disaffiliation?

As discussed above, disputes about disaffiliation have led multiple states to find that employers cannot leave at all. Because there remain multiple states where it is unclear if employers can withdraw, one element of litigation in those states concerns the baseline question of whether that state’s law even permits withdrawal.

Beyond that gateway issue, employers have litigated whether they must comply with all elements of the withdrawal statute and what is the consequence of failing to do so. In Colorado, a municipality attempted to privatize its public hospital and leave the state retirement system without complying with any of the steps to disaffiliate, including payment of its share of the plan’s unfunded liability, which was estimated at $190 million. After several years of litigation, a court held that the hospital had to comply with the statutory withdrawal procedure, including payment of the withdrawal liability. The result was the city and hospital paid $190 million to the retirement system to facilitate its withdrawal.

In Texas, a dispute arose when a city attempted to privatize its convention center workforce. It attempted several methods to accomplish the privatization, which would have had the effect of a partial withdrawal from the municipal retirement system. Each time, the retirement system insisted the privatization was void and the employees remained members of the system. In the end, the Texas Supreme Court sided with the retirement system, finding that the system has final authority as to its membership and the municipality’s attempt at privatization was void.

What are the key considerations involved in such litigation?

A major source of dispute in withdrawal litigation is the calculation of the withdrawal liability. In the current era of large unfunded liabilities, this is both the reason many employers desire to leave and the key sticking point in the withdrawal process. 

Actuaries play a major role in the litigation. Disputes can arise over whether to treat the system’s actuary as a retained expert (setting up a dueling expert situation with the employer’s retained actuary) or an occupational expert (with fewer burdens on the actuary) or not to treat them as an expert at all. There may be disputes about whether the system’s actuary’s calculation of the withdrawal liability enjoys a presumption of being correct that the withdrawing employer must overcome by a specified quantum of evidence.  

The parties may dispute the assumptions used by the system’s actuary in calculating the unfunded liability.  For example, is the withdrawing employer’s liability calculated using the plan’s assumed investment rate of return of perhaps 7% or an annuity rate of 2%? The difference between those rates could triple or quadruple the calculated liability.

If a plan or state statute does not permit disaffiliation but an employer wants to leave, what can happen?

Because the default is for an employer to remain in the plan, it will be incumbent on the employer to arrange a solution permitting withdrawal. That could involve going to the state legislature and securing a new statute permitting withdrawal. This has been the genesis behind some of the existing state statutes that permit only certain employers to withdraw (and for an employer to only be able to withdraw for a certain period of time).

In Colorado, a public university was not initially permitted under state law to withdraw from a retirement system. However, the university worked with the legislature and negotiated a withdrawal from the state retirement system that involved a unique, one-off statutory scheme, grandfathering certain employees and providing for a gradual withdrawal over time.  The process has now been ongoing for two decades.

How might the pandemic affect the trend of disaffiliation from public retirement plans?

The pandemic and corresponding financial stress will add to the level of interest among certain public employers to disaffiliate from multi-employer pension plans. This could lead to more litigation as employers attempt to leave or resist paying the withdrawal liability calculated as the cost for leaving.

It is also likely to lead to more employers negotiating with legislatures and retirement systems to gain the ability to leave. This could be in the form of one-off legislation pertaining to a specific employer leaving the plan, even in a state where disaffiliation has never occurred or has been banned. It could be in the form of allowing an employer to disaffiliate in a structure not previously contemplated under law. It could involve an employer grandfathering its existing employees in the plan but not allowing new employees from that employer to join the plan. This and many other permutations are possible and would be subject to negotiation among the many stakeholders involved.

Finally, the financial crisis increases the likelihood of public entities going bankrupt or shutting down. That begs the question of whether a public entity is disaffiliating if it has no employees left? Systems will have to analyze what recourse they have if a public entity winds down and has no money left to pay its withdrawal liability. The next ten years may find courts and state legislatures across the country confronting these issues.