DEPARTMENTAL APPEALS BOARD
Department of Health and Human Services
SUBJECT: The Massachusetts DATE: April 6, 1989 Executive Office
for Administration and Finance Docket No. 88-154
Decision No. 1034
DECISION
The Massachusetts Executive Office for Administration and Finance
(Massachusetts, Commonwealth) appealed a decision by Region I upholding
a Division of Cost Allocation (DCA, Agency) determination that certain
payments made by Massachusetts into its pension reserve fund during
fiscal years (FYs) 1985 and 1986 be excluded from the fringe benefit
rate calculation for the Commonwealth's state-wide cost allocation plan
for FYs 1987 and 1988. DCA determined that all costs in excess of
pay-as-you-go costs for the base years should be excluded, resulting in
a lower fringe benefit rate and a consequent reduction of federal
financial participation in the Commonwealth's pension costs for FYs 1987
and 1988 of approximately $32.2 million.
The issue presented in this case is whether the allowability of these
contributions is governed by the pension system under which
Massachusetts was officially operating in the years in question, the
pay-as-you-go system. Massachusetts argued that during this time it was
moving from a pay-as-you-go system to a fully funded system, and that
DCA was unreasonable in refusing to recognize the full amount of
contributions that were made during this transitional period.
We conclude that Massachusetts was officially on the pay-as-you-go
pension system at the time the disputed contributions were made and that
DCA was reasonable in concluding that claims for pension plan
contributions in excess of those sanctioned by that official system
could not be credited to those years for purposes of calculating
federally reimbursable pension costs for those years. Under the
applicable cost principles, accounting standards, and Department
policies, the Agency can not properly recognize as pension costs
contributions made outside of the official pension system. While on the
surface it may appear that the Agency is engaging in an overly technical
labelling exercise which is penalizing the State for its approach to
addressing the problems it had with its pension system, this is simply
not the case. To require the Agency to recognize as pension costs
contributions not made in accordance with an actuarially sound official
system subjects the Agency to the possibility that the federal
contribution via the fringe benefit rate could be manipulated upwards at
will. These were in essence voluntary, extra contributions to the state
pension funds that were not subject to any such plan to assure
sufficient control over their eventual disbursement. The point is not
that the State is precluded from changing from one system to the other
but that to do so it must adopt an official, actuarially sound system.
Although Massachusetts later enacted a state law, officially changing
Massachusetts to a fully funded system, which contained provisions for
an orderly transition that would satisfy applicable requirements, it may
never have passed such a law. The character of the earlier
contributions does not change for the years in question based on these
later events.
Accordingly, we agree that these disputed contributions are simply not
recognizable pension costs for the years contributed, and we uphold this
disallowance in its entirety.
Background
The two types of pension funding systems with which we are concerned in
this case are the pay-as-you-go system and the fully funded system.
Under pay-as-you-go, a state appropriates each year the amount needed to
cover only actual pension obligations for that year. In a fully funded
system, a state makes payments, based on an actuarially-determined
estimate of the pension obligations accrued during the year, into a
reserve fund whose proceeds are used to meet ongoing pension
obligations. Thus, rather than appropriating funds to pay a pension to
someone who is already retired or expected to retire during that year
(pay-as-you-go), the state appropriates funds sufficient to ensure that
it will be able to pay a pension to a current employee who will draw a
pension at some time in the future (fully funded).
Under Office of Management and Budget Circular A-87 (OMB A-87), made
applicable to this case by 45 C.F.R. 74.171, costs must be accorded
consistent treatment through application of generally accepted
accounting principles appropriate to the circumstances. OMB A-87, Att.
A, paragraph C.e. Employee benefits in the form of employers'
contributions for pension plans are allowable provided such benefits are
granted under approved pension plans and are distributed equitably to
grant programs and to other activities. OMB A-87, Att. B, paragraph
13b. Chapter 6-30 of the Grants Administration Manual (GAM) sets forth
"the Department's policy on the extent to which the costs of grantee
pension plans may be charged to [HHS] grants," i.e., it identifies which
pension plans are approved by HHS. GAM 6-30-00. Section 6-30-30 A.
provides that:
The costs of grantee pension plans may be charged to [HHS] grants
to the extent that such costs meet the standards prescribed in the
Department's cost principles and are determined in accordance with
the provisions of paragraphs B. through E. of this Section.
Section 6-30-30 B. provides:
Defined-Benefit Pension Plans
Except as otherwise provided in paragraph E. of this Section,
pension costs under a defined-benefit pension plan shall be
determined and assigned to each grantee fiscal year in accordance
with the provisions of Accounting Principles Board Opinion Number
8, "Accounting for the Cost of Pension Plans," issued by the
American Institute of Certified Public Accountants. (emphasis
added)
(APB Opinion No. 8 essentially describes a fully funded pension plan.)
Section 6-30-30 E. provides:
Pay-as-you-go Method
Pension benefits paid by a grantee directly to, or on behalf of,
retired former employees (or their beneficiaries) may be charged to
[HHS] grants in the year in which such payments are made, provided
that the grantee follows a consistent policy of treating such
payments as expenses in the year of payment.
The following description of the facts of this case is not in dispute.
Like many states, Massachusetts historically used a pay-as-you-go
system. Under such a system, although the Commonwealth always paid all
of its current pension obligations each year, it continuously accrued an
unfunded liability for pension payments owed to employees who earned
rights to future pension benefits during the course of their employment
during that year. According to the Commonwealth, its officials and
lawmakers became increasingly concerned during the 1970's about this
huge unfunded liability, estimated to be several billion dollars.
Massachusetts began taking steps to reduce the unfunded liability by
establishing a pension reserve fund and earmarking certain revenues to
be deposited into the fund. In addition, with this goal in mind, its
Retirement Law Commission conducted periodic actuarial evaluations of
the state pension system in 1983 and 1987 that calculated the level of
future payments required to achieve full funding over a reasonable
future period. However, legislation committing Massachusetts to
conversion to a fully funded pension system was not signed into law
until January 12, 1988, to take effect July 1, 1988. According to the
Commonwealth, the Pension Reform Act of 1987, St. 1987, c. 697, "binds
the Commonwealth to eliminating the unfunded pension liability within 40
years and makes that commitment legally enforceable by employees and
retirees." Appeal brief, p. 7.
The expenditures at issue here were appropriations in FYs 1985 and 1986
that, according to counsel for the Commonwealth, were intended "to phase
in efforts to eliminate the unfunded liability." Appeal brief, p. 7.
Specifically, the Massachusetts Legislature appropriated $64.25 million
in FY 1985 and $167.5 million in FY 1986 for deposit to its pension
reserve fund. Massachusetts claimed these amounts as part of its
pension costs in those years for use in calculating the pension rate to
be used in FYs 1987 and 1988. DCA disallowed the amounts that exceeded
the pay-as-you-go costs. DCA maintained that the applicable GAM
provisions established that a state may use either a fully funded system
or a pay-as-you-go system, but did not recognize contributions under a
hybrid system. The Agency contended that the Commonwealth was
"admittedly" on a pay-as-you-go system when these contributions were
made, so that only amounts properly claimed under that system were
allowable. It further argued that a fully funded system required
"systematic" payments, and that these payments were not systematic.
Massachusetts argued that its pension contributions reflected steps
toward a fully funded system and were not subject to Agency rules for
pay-as-you-go contributions. Instead, the Commonwealth contended that
its contributions were properly included under the general Agency rules
for defined-benefit plans, which included the GAM sections cited by the
Agency. Specifically, Massachusetts maintained that its contributions
during FYs 1985 and 1986 met the criteria in GAM section 6-30-30 B. In
addition, Massachusetts claimed that disallowance of these costs would
deter states from fiscally prudent funding of pension systems, would
violate cost allocation principles calling for consistent treatment of
federally assisted and other programs, and would constitute an
impermissible federal intrusion into a state's fiscal management
decisions.
Analysis
We first examine whether, as the DCA argued, the GAM sets forth an
Agency policy that allowable pension costs are limited to those based
either on a fully funded system, or on a pay-as-you-go system. The
structure of the applicable provisions clearly indicate that the
first-choice system is a fully funded system based on APB Opinion No. 8,
but that a pay-as-you-go system can be accepted. Section 6-30-30 B.
These systems are mutually exclusive; APB Opinion No. 8 explicitly
provides that the pay-as-you-go method is not an actuarial cost method
and is not acceptable under that opinion. APB No. 8, Paragraph 24.
There is simply no GAM or APB Opinion No. 8 provision permitting a
hybrid system such as proposed by Massachusetts. The APB opinion does
allow for an orderly transition to a fully funded system, such as, for
example, the transition envisioned by the Pension Reform Act of 1987,
but, as we discuss below, the contributions at issue here were not part
of such an official transition. The GAM's preference for systems
conforming to APB Opinion No. 8, which is apparently the generally
accepted accounting standard for an actuarially-based pension accounting
system, is supported by the overriding principle derived from OMB A-87
that generally accepted accounting principles should be used where
possible in measuring pension costs to be allocated to federal grants.
Consequently, we find that the DCA was reasonable in interpreting the
applicable policy as not recognizing contributions made under a hybrid
system that did not conform to Massachusetts' legally established
system.
Moreover, contrary to the Commonwealth's assertions, GAM Section 6-30-30
D. does not authorize a hybrid system. This provision is separate from
GAM 6-30-30 B., the section that specifically names only two types of
defined-benefit systems that the Agency will recognize. Section 6-30-30
D. simply states that pension costs will be assigned to a fiscal year
only to the extent that such costs are funded not later than 6 months
after the end of that year, and that amounts funded in excess of the
costs assigned a given fiscal year shall be applied to future fiscal
years. It does not create a right to allocate payments that are not
made under one of the two sanctioned systems; on the other hand, this
provision does appear to authorize assignment of these contributions to
later years, as the Agency has proposed (see fn 1).
Thus, the question becomes: under which system were the disputed
contributions made? Massachusetts admitted that the contributions at
issue here were not based strictly on either system; it argued instead
that since they were prudent steps in its conversion from one system to
the other, these contributions could be accepted as contributions under
the system it ultimately adopted, rather than the pay-as-you-go system.
Alternatively, the Commonwealth contended that the Agency had not shown
that these questioned contributions did not satisfy the requirements of
APB Opinion No. 8 and the GAM.
In reviewing these contributions, DCA concluded that the Commonwealth
was officially on the pay-as-you-go system at the time they were made,
and calculated Massachusetts' allowable pension costs accordingly. The
Agency's conclusion that Massachusetts was on a pay-as-you-go system was
based on statements from Massachusetts' Budget Director and its
independent auditors.
Although the Commonwealth argued that the statements of its Budget
Director and independent auditors should not be read to mean that all of
its contributions were made under a pay-as-you-go system during the
period, Massachusetts admitted that its system during that time was at
least partially pay-as-you-go. Appeal brief at 15. Moreover, it did
not establish that it officially adopted another pension system until
the Legislature formally adopted one as law. While it is clear that
during the relevant period certain Massachusetts policymakers favored a
fully funded system, and were taking steps to achieve that goal, at the
time the contributions were actually made the Commonwealth was
officially on a pay-as-you-go system. Indeed, we note that the
appropriations bills that provided for the deposit of these funds into
the pension reserve fund did not provide for their disbursement under
either system or specify that the purpose of these contributions was to
reduce the unfunded liability or to effect a change in pension systems.
In fact, although a proposal by the Governor to change pension systems
was introduced in 1985 (appeal brief at 6), that legislation failed to
pass. Thus, Massachusetts clearly did not formally adopt a fully funded
pension system until its Pension Reform Act, effective July 1, 1988.
Massachusetts also claimed that its interim pension plan system
conformed to APB Opinion No. 8 and criticized the DCA determination as
creating out of certain language in APB Opinion No. 8. an unauthorized
requirement for "systematic" contributions. To the extent that DCA
may
have been requiring, as a condition for recognizing the system as a
fully funded system, that the Commonwealth's pension contributions equal
the exact amount necessary for full funding of the unfunded liability,
Massachusetts may be correct in asserting (appeal brief at 20-24) that
the classification of its contributions to a particular system should
not be governed by their amount. See GAM 6-30-30 D. To the extent,
however, that DCA meant by "systematic" that contributions had to
be in
accordance with a recognized, official system, we agree.
Massachusetts attempted to categorize its contributions for these years
as having been made "with reference to the cost of fully funding the
pension system, as established by an actuarial study prepared in 1983 by
the Retirement Law Commission." Appeal Brief at 20. However, the three
appropriations bills comprising these contributions contained or
referred to language that "Said amounts may be expended, subject to
appropriation, only pursuant to an actuarial plan developed by the
actuary within the division of public employee retirement
administration," rather than referring to the particular actuarial study
cited by Massachusetts, which was already in existence when these bills
passed. See St. 1985, c. 140, section 75 and section 2, item 0612-1510
(FY1986) and St. 1986, c. 206, section 32 (FY1987) (appeal file, app.
VI). The subsequently enacted Pension Reform Act of 1987 specified that
actuarial plans should be prepared in accordance with generally accepted
accounting principles and provided for their use in determining annual
funding for the newly adopted pension plan. St. 1987, c. 697, section
59 (appeal file, app. V). We therefore conclude that these
contributions did not satisfy the requirements of paragraph 17 of APB
No. 18 that "the annual provision for pension cost should be based on an
accounting method that uses an acceptable actuarial method."
The fact remains that these contributions were special appropriations
made outside of the official pay-as-you-go system. Indeed, the Budget
Director emphasized the serendipitous nature of these contributions in
her July 16, 1987 letter to the DCA:
Let me state at the outset that funding the state's retirement
system on an annual basis amortized over a given period of time
[i.e., fully funding the pension plan] is certainly a prudent
method of minimizing the burden of increasing pension costs.
However, there is currently no requirement, either through statute
or by legal obligation, which binds the state to pay actuarial
costs as they accrue. Actuarial costs are not recognized as fixed
costs and, as a result, appropriations for unfunded pension
liabilities tend to increase in years when surpluses are
anticipated and decrease in years when the reverse is true. Until
[the] Massachusetts Legislature mandates by law a fixed funding
schedule, actuarial costs will, from time to time be underfunded.
Although regrettable, this is an inherent part of the governmental
appropriation process as presently constituted.
App. Ex. 35 at 1-2. Thus, we conclude that the DCA properly refused to
include amounts in excess of those allowable under the currently
applicable pension system. The federal government has agreed to share
in pension costs assigned to a given year by an approved pension plan;
it has not consented to share in a state's sporadic contributions to a
reserve fund that lacked any official method of assigning benefits to
employees.
Massachusetts advanced several policy arguments in favor of allowing
these contributions. These arguments were:
that disallowance of these costs will deter states from fiscally
prudent funding of pension systems, will violate the principle that
cost allocation rules ensure consistent treatment of federally
assisted and other programs, and will constitute an improper
intrusion on a state's power over its fiscal management. . . .
Appeal brief at 29. All of these contentions, however, rest on the
assumption that the federal government will refuse to recognize the
contributions in any way. In light of the Agency's proposed
negotiations to determine how these contributions may be allowed in
future years on an actuarially acceptable basis, this assumption is
faulty, and the policy arguments therefore fail. Moreover, having found
that the applicable standards support the Agency's position, we would
not overturn this disallowance based on these policy considerations,
even if they were valid.
Conclusion
Based on the forgoing analysis, the disallowance is upheld in its
entirety.
________________________________ Judith A. Ballard
________________________________ Norval D. (John) Settle
________________________________ Cecilia Sparks Ford Presiding
Board