Financial pressures and equity considerations require that the state rethink how it provides retirement security to its employees. Under the Massachusetts constitution, major changes could only be applied to new employees. An important first question in thinking through change options for new employees is: What does federal law require the state to provide to employees?
Under the Social Security Act, employers and employees must pay payroll taxes. However, members of a state or local retirement system are exempted unless the state agrees to put them into Social Security. The definition under federal law of a “retirement system” thus defines the minimum pension plan that a state must offer if it is not going to also pay Social Security taxes. Specifically, Section 210(a)(7) of the Act, basically defines employment that is subject to Social Security withholding to exclude state employment. Section 210(a)(7)(f), however, carves out an exclusion to the exclusion, making state employees subject to Social Security if they are not members of a retirement system. This section basically leaves the definition of a retirement system up to the Secretary of the Treasury, referencing Section 218(b)(4), where the term is defined only very generally. Note: Section 3121(b)(7)(f) in the Internal Revenue Code is Section 210(a)(7)(f) of the Social Security Act as codified.
The Treasury regulations defining a “retirement” system appear in the Code of Federal Regulations at 26 CFR 31.3121(b)(7)-2. For a version of this section with highlighting, click here. In essence, these regulations require that a state provide either:
- a defined benefit comparable to the Social Security benefit for a person based on their earnings history;OR
- a defined contribution plan based on any combination of employer and employee contributions equal to a total of at least 7.5% of base earnings.
- A defined contribution plan must pay reasonable interest on the contributions. The “Applicable Federal Rate” for long term debt, currently 3.53%, is deemed reasonable interest in an example in the regulations.
- Wages in excess of the Social Security wage base may be excluded. See “Note re definition” below.
As to the defined benefit option, the question of whether a defined benefit is comparable to Social Security is complex. Social Security computes benefits based on lifetime eligible earnings (indexed to inflation). Most state and local plans compute benefits based on the highest years of an employee’s compensation multiplied by a percentage and then multiplied by the years of service. The treasury authored IRS Revenue Procedure 91-40 to provide safe harbors for state plans.
- A typical pension benefit would meet the safe harbor if it provided a single life annuity computed as 1.5% of the highest three years of compensation for each year of service to a person retiring at 65.
- An atypical pension plan based on the high 15 years of compensation would need to provide 2% for each year of service.
- The maximum creditable years of service may be limited to 30.
- Pensionable compensation may be limited to base pay below the Social Security contribution and benefit base.
- Pensionable compensation may be capped at a level below the contribution and benefit base, but the minimum percentage applied per year of service must be increased by the overall ratio for employees in the plan of total compensation below the Social Security base to total pensionable compensation. This formula requires that employees, on average, receive benefits at the minimum percentage defined in the safe harbor while allowing a plan to favor lower-income employees with a cap.
Note that pursuant to Section 218, a state always has the option of joining the Social Security system pursuant to a voluntary agreement.
- IRS Federal-state Reference Guide, Publication 963, November 2009. This publication provides a good history and overview of the relationship between social security and public retirement systems. See especially Chapter 6 and Chapter 13 (FAQ’s, 2 and 26 through 34).
- IRS Public Employer Tax Guide, July 2007
- Social Security Online page regarding social security for state and local government workers. See also this SSA page.
- IRS online page regarding social security for state and local government workers.
- The Social Security Administration’s general page for state local government employers.
Note re definition: The regulations and revenue procedure cited above were authored in 1991 and refer to Section 3121(x)(1) of the Internal Revenue Code as if it defined the social security wage base. This is an outdated statutory reference. Sub-section (x) of TITLE 26, Subtitle C, CHAPTER 21, Subchapter C, Sec. 3121 now refers to a different quantity pertaining to wages paid to domestic help. In 1991, when the references were authored, Subsection (x) of Section 3121 as last amended by the P.L. 101-508, the Omnibus Budget Reconciliation Act of 1990 then pointed to the contribution and benefit base determined under section 230 of the Social Security Act. This reference was in place from November 5, 1990, when P.L. 101-508 enacted, until August 10, 1993, when P.L. 103-66 enacted. The Social Security mandate for state and local employees was also added by P.L. 508. See the amendments list for the Section 3121 and check Thomas for the public laws.