In a letter addressed to President Obama, 26 members of the United States Senate expressed their support for the private sector retirement savings laws adopted in Illinois and California, and also being considered in other states. In particular, the senators asked that the United States Treasury and Labor Departments resolve three legal issues clouding the prospects of these adopted and proposed state laws.
In important respects, the California statute and the Illinois law are similar. Both mandate that small, private sector employers lacking a workplace pension—such as a 401(k) plan or an IRA deposit arrangement—will automatically be enrolled in a state-run, private sector retirement savings program. These state-managed plans will establish an account for each employee of an enrolled employer. Retirement savings will be withheld from an employee’s paycheck, and will be deposited and invested in the employee’s account, unless the employee affirmatively elects out of the state-run retirement savings plan. The employee accounts established under the California and Illinois laws indicate how far America has come as a defined contribution society that utilizes individual accounts for retirement, education, and medical savings.
There are, however, important differences between the Illinois and California statutes. For example, the California law mandates state-sponsored retirement coverage for firms with five or more employees unless such firms maintain their own retirement savings plans for their employees. The Illinois law only applies to employers with twenty-five or more employees who lack their own 401(k) or similar employer-sponsored plans. The California law provides detailed rules for an employer to supplement employees’ savings contributions with the employer’s own additional contributions. The Illinois statute lacks such rules for supplemental employer contributions.
The senators asked for three specific legal opinions from the Treasury and Labor Departments to facilitate the implementation of these adopted and proposed state private sector retirement laws. The legal questions posed by the senators are more complex than the senators suggest. As I argue in a forthcoming article in the Illinois Law Review, the Illinois statute is, from a legal perspective, better designed to comply with federal law than the California act.
The senators first asked President Obama for a ruling that would ensure the California and Illinois plans “and similar IRA-based programs enacted in the future, are not preempted by ERISA,” the Employee Retirement Income Security Act of 1974. The absence (or presence) of employer contributions distinguishes plans that trigger ERISA coverage from plans that do not. Since the Illinois statute contains no rules to implement employer contributions, the Illinois state-run, private sector retirement plan does not face the prospect of ERISA preemption. However, the California plan will be subject to ERISA preemption whenever employers supplement employees’ retirement contributions with additional contributions.
The senators’ second request to President Obama overlaps the first. In particular, the senators sought a ruling that the California and Illinois private sector retirement savings plans, as well as “similar IRA-based vehicles created by the laws of other states in the future,” will not be “plans” governed by ERISA.
Again, the legally critical factor is the presence or absence of employer contributions. When California employers make supplemental contributions to California’s state-run private sector plan, those employer contributions will trigger ERISA’s coverage. For this reason, in an earlier article, I urged California to repeal the ability of employers to make supplemental contributions to the Golden State’s private sector retirement arrangement.
Finally, the senators asked for a ruling ensuring that the California and Illinois accounts will be individual retirement accounts (IRAs) for purposes of the Internal Revenue Code. Here, once again, the Illinois law is more compliant with federal law than is the California statute.
“Justice Louis Brandeis famously said that the states are laboratories for experimentation.”
The accounts under the Illinois plan qualify as IRAs for purposes of the Internal Revenue Code. Under the Illinois law, the state-managed accounts will be credited with employees’ contributions and investment earnings, and will be debited with investment losses. An Illinois employee’s retirement balance will be whatever amount these contributions, earnings, and losses have grown to (or fallen to) at the time of retirement. Thus, for purposes of the Internal Revenue Code, the Illinois accounts will be IRAs which directly benefit from investment gains and decrease from investment losses.
In contrast, the California law uses what is today known as a “cash balance” formula. The accounts established under the California statute will be governed not by actual investment gains and losses, but by a predetermined formula that will operate independently of the actual investment experience of the state-managed program. As a matter of retirement policy, compelling arguments can be made for the kind of “cash balance” formula promulgated by the California statute. However, under ERISA and the Internal Revenue Code as read today, “accounts” must be directly credited with actual investment gains and charged with actual investment losses. This does not occur under the formula-based California law. Consequently, the cash balance retirement savings arrangements established by the California law will not qualify as IRAs for purposes of the Internal Revenue Code.
Congress could amend the Internal Revenue Code and ERISA to expand the statutory definition of an IRA. Perhaps this would be a wise idea. However, without the amendment of the Code and ERISA, the federal government cannot rule that California’s law creates IRAs within the meaning of the Code since that law uses a “cash balance” formula, rather than actual investment experience, to determine employees’ account balances.
Hopefully, the senators’ letter to President Obama will contribute to an important national debate about a serious problem—namely, the failure of low-income Americans to save for their retirements. The California and Illinois laws represent one possible approach to mandate private sector retirement savings with a state-run plan as the default option. Another state, however, might mandate employers to provide retirement coverage, but require such mandated coverage to be obtained privately, not through a state-managed program. This is the approach President Obama’s budgetary proposals have embraced, thereby mandating private sector IRAs without the government itself managing retirement funds.
But these are not the only options that exist for federal and state lawmakers. Alternatively, a state could choose to supplement, with its own tax credits, the Internal Revenue Code’s tax credits both for employers establishing plans and low-income retirement savers. On the other hand, a state could argue that the subject of private sector retirement savings is exclusively a matter of federal concern. A governor or legislator adopting this approach would elect for his state to do nothing and thereby defer to federal policy.
Justice Louis Brandeis famously said that the states are laboratories for experimentation. The subject of private sector retirement savings is well-suited to such experimentation. To the extent that the senators’ letter to President Obama provokes discussion and experimentation on this important subject, the letter will have performed a useful public service.
Image Credit: “President Obama Talks to the Crew of Atlantis” by NASA HQ PHOTO. CC-BY-NC 2.0 via Flickr.