Pension Reform Act Implementation Issues

Transcription

1 Pension Reform Act Implementation Issues Thursday, May 9, 2013 General Session; 9:00 10:30 a.m. Robert A. Blum, Hanson Bridgett Cepideh Roufougar, Jackson Lewis League of California Cities 2013 Spring Conference Meritage Hotel, Napa

2 Notes: League of California Cities 2013 Spring Conference Meritage Hotel, Napa

3 PEPRA IMPLEMENTATION SELECTED ISSUES Bob Blum Hanson Bridgett LLP 3/31/2013 On September 12, 2012 Governor Jerry Brown signed what he called "sweeping pension reform" PEPRA or the California Public Employees' Pension Reform Act of PEPRA was generally effective on January 1, In many respects, PEPRA changes the rules for providing public employees with pensions. Employers, employees, unions, retirement systems, and now the courts are working to understand and implement the new rules. This article comments on implementation of selected parts of the new PEPRA rules with an emphasis on CalPERS because a high percent of local public agencies contract with PERS for retirement benefits. A. Guidance for Interpretation One of the more challenging parts of implementing PEPRA is that no one agency has authority or responsibility for interpreting and issuing regulations or other guidance for this statute 1. Moreover, the legislative history is sparse. Many California cities are members of CalPERS, so guidance issued by PERS will control their implementation of PEPRA. Other retirement systems, such a those governed by the County Employees' Retirement Law ("CERL") may follow PERS' interpretations, but are not required to do this 2. Therefore, on key issues, there ultimately may be different interpretations of the same statute. To date, however, only PERS has issued broadly applicable implementation rules on a number of issues. B. New Hires and Reciprocity 1. Legacy ("Classic") Members or New Members and Reciprocity Starting in 2013, when an employer hires an employee who is eligible for pension benefits the employer must determine if he/she is a "legacy" member of the retirement system (or "classic" in PERS terminology) or a "new" member. Generally, legacy applies when the employee was previously a member of the system as an employee of the same employer, when the employee was previously a member of the system with another employer and had a break in service of no more than 6 months, or was a member of another system and is "subject to reciprocity" when hired 3. 1 This contrasts with federal pension legislation where depending on the constitutional source of the enactment power there are at least three federal agencies that issue regulations, often in coordination with each other. 2 The leading technical corrections bill, SB 13, would give explicit authority to each retirement system to interpret and issue regulations to implement PEPRA. Proposed Government Code sec (h). However, SB 13 says that it is "declaratory of existing law" so at least some believe that retirement systems already have this authority. 3 Govt Code sec (f). 1

4 Whether legacy or new makes a big difference for the employer and employee. If legacy, essentially the member is treated as employed before 2013 with all the benefits provided to employees in that group, and if new, the lower PEPRA benefits and potentially higher member contributions apply. As a practical matter, "subject to reciprocity" will be the key issue for many employees who move between public employers. Reciprocity is established, generally, by contract with PERS and PERS maintains a list of reciprocal systems 4, which includes all systems governed by the CERL as well as a number of 'independent" systems. However, not all independent systems have contracted for reciprocity. 2. PERS Proposed Regulations on Reciprocity PERS has issued proposed regulations defining who is "subject to reciprocity". These rules require that the individual leave service credit and contributions with the prior system, start membership with PERS within 6 months of "permanently separating" from the prior employer with the former system, and have "permanently separate[d]" from the prior system before entering PERS membership 5. For other systems, this proposed regulation can be read to insert the name of the system instead of PERS and it would work for them also. There should be no surprises with these rules and they essentially repeat the pre-pepra reciprocity rules. However, PERS has added a new wrinkle. 3. Demonstrating Reciprocity Who Is Responsible A key question is how does PERS or the employer know that an individual is in fact subject to reciprocity. PERS solves this problem by putting the responsibility on the employee. The employee must self-certify his/her status as a member of a reciprocal system and provide this certification to the employer. The employer in turn provides it to PERS, noting not that the employer has checked or validated the employee's certification but only stating key dates: eligibility date with the agency, original hire date with the agency, and the date the form was given to the employee and the date it was received from the employee 6. The new rule and an important one is that PERS requires the employee to file this selfcertification within 10 business days of employment. That should not be difficult, right? Not so. Many county retirement systems have found for decades that new employees do not claim reciprocity until years after employment and sometimes not until just before retirement. This delay does not make much sense because under prior law as under PEPRA - a member's contribution rate can be lower under reciprocity than if new. If prior experience is a guide, we will find that many employees fail to file this certification on time. This failure will occur in large agencies where employment is decentralized to divisions as well as in smaller agencies that are challenged to keep up with day to day work because of budget cutbacks. 4 On the web at 5 Proposed PERS reg (2/20/13). 6 A copy of the PERS self certification is attached to this article. 2

5 4. Failure to Meet the PERS 10 Day Requirement What happens when an employee files the certification later than PERS requires? Will PERS refuse to recognize reciprocity and refuse to provide the benefits that the employee is entitled to as a legacy member? PEPRA does not allow this. If it were to try to provide only new member benefits and not classic member benefits, PERS may have a difficult time in litigation, especially since other retirement systems have successfully dealt for decades with the issue of delayed notification of reciprocity. In litigation, an employee also may claim that the employer failed to properly notify him/her that this certification was required, and claim that the certification form was never received from the employer. In this case, the employee would claim recompense from the employer for any lost benefits. Additionally, PERS would likely defend by blaming the employer for any failure because PERS does not control the certification process. 5. Failure By The Employee to Correctly Certify What happens when the employee files an incorrect certification wrongly claiming that he/she is subject to reciprocity? Apparently the employer may perhaps, must - accept the certificate as accurate and valid and provide it to PERS 7. PERS apparently will accept the certificate and will treat the employee as classic. Member contributions will be made as if the employee was in fact a classic member; employer contributions also will be computed and paid on that basis and benefit estimates/ reports may be provided to the employee on that basis perhaps for the rest of his/her career. Yet when the employee retires, he/she may not be treated as classic by PERS. When the mistake is innocent 8, which is quite likely, the employee will be in for a shock. Retirement as planned may no longer be possible the benefit will be lower and back contributions plus interest could be owed. Of course, the employee is only entitled to the benefits due under the law, but at a minimum the process can create some very unhappy employees. 6. Consider Taking These Steps As in so many cases, sound process and good records demonstrating the process was met will be the key to avoiding or reducing problems. PERS agencies should consider requiring the selfcertification form be submitted before completing the hiring process, should record in the personnel file when it was provided and received, and should consider at least doing a quick review of the form to see if the answers make sense. Non-PERS agencies should check their retirement systems' process and may wish to consider adapting a modified version of the PERS form for their own use if the system does not provide one. Taking these steps will help the employee and give the employer records needed to deal with a claim that it failed to inform the employee of the PEPRA rules. C. Member Contributions 1. Transition Rules For New Members 7 The instructions to the form say "the employer will enroll the new employee into CalPERS membership though mycalpers based on the information provided on the [form]." 8 The PERS form is not clear and can be confusing to many. 3

6 PEPRA generally requires that new members must pay contributions equal to at least 50% of the normal cost rate for their pension benefit. However, if "the terms of a contract, including a memorandum of understanding" that is "in effect on January 1, 2013" "would be impaired" by this requirement then it will not apply until that contract expires, is renewed, amended or extended. 9 There are several issues including these: what contracts are included in this provision; when is a contract impaired and who determines that; to whom does this rule apply. What contracts are covered -- There is some indication that system administrators are treating this section as applying only to MOUs. For example, PERS requires that the employer provide a certification of MOU Impairment but does not have a similar certification for other contracts 10. Certainly most of the contracts in question will be MOUs. But PEPRA is not limited to an impairment of MOUs. PEPRA explicitly states that this transition rule applies to "a contract, including a memorandum of understanding". The question then is when might there be contracts other than MOUs that establish member contribution rates for unrepresented employees. The Supreme Court has set standards for when a contract may be established between an agency and its employees in Retired Employees Association of Orange County, Inc. vs County of Orange 11 ("REAOC"). Whether there is a contract depends on the facts and circumstances including, per REAOC, the facts that accompanied the passage of the relevant ordinance or resolution. Generally, with respect to employee compensation there is a strong presumption against actions by a governing board creating a contract, as opposed to establishing a policy which is subject to revision and repeal. There is a very heavy burden on the employee (or retiree) who claims the existence of a contract to overcome this presumption. A contract for the unrepresented therefore can only be established under the REAOC standards. Agencies should be wary, however, of trying to extend the existence of a contract to the unrepresented in an effort to moderate member retirement contributions. In many vested rights issues, the first inquiry will be whether there is a contract that was impaired. An extension by an agency of what constitutes the making of a contract regarding member contributions could be used by a plaintiff in trying to establish the making of a contract in other areas of compensation. Impairment Prohibition of an "impairment" of contract is the term used in the contract clauses of both the California and federal Constitutions. Additionally "substantial impairment" is required for a contracts clause violation 12. However, there is a fair question whether the constitutional standard of impairment applies to this transition rule. 9 Govt Code sec (f). 10 A copy of the certification is attached to this article Cal. 4th 1171 (2011) 12 E.g., San Diego Police Officers' Association v. San Diego Employees' Retirement System, 568 F.3d 725 (9th Cir. 2009). 4

7 In context, it would seem more likely that in the particular PEPRA transition rule impairment is both targeted and easy to define. This is a transition rule for one purpose to allow previously agreed to member contribution rates to continue until the term of a contract expires. It is therefore reasonable to conclude that if the PEPRA rule for new members would require higher contributions in any amount from new employees than does the existing contract, there would be an impairment for purposes of PEPRA. This is an easier standard to meet than the constitutional standard. If this were not the case then, e.g., employers and unions could be put into unnecessary conflict for years. Also, the amount of member contributions could be uncertain for years beyond the end of the contract. That, in turn, could cause problems for the retirement system administration and funding. This type of conflict and uncertainty and interference with system administration surely was not contemplated by the Legislature when it enacted this transition rule. Who makes the determination PERS has left the decision to each contract agency on whether there is impairment and has done this through the agency certification form. (PERS has also warned that in 2013 it intends to issue regulations regarding the MOU certification process and that amendments to the form may be required.) Certainly it is not up to PERS to make decisions about the existence or meaning of employment relationships between an agency and its employees. Nor should PERS want to interpret the meaning of MOUs which often are not a model of clear drafting. Other retirement systems would be wise to follow PERS' lead on this issue. Even though PERS has left the decision to each agency, the agency should be prepared to work with PERS on this issue when PERS audits its records. As in other areas, each agency that wishes to use this transition rule should carefully document the basis for its decision. To the extent that, e.g., an MOU is ambiguous a careful memorandum explaining the basis for the agency's decision should be drafted and maintained. Again, however, an agency should be wary of the basis for interpretation of an MOU, or other contract,because it could be used against the agency in interpretation of other disputes about compensation. For example, if an MOU is silent on or obliquely refers to member contributions and the agency decides that the member contribution rate was established by "contract" rather than by "policy" and the basis for the decision is, e.g., extraneous evidence such as job postings, there could be an attempt to use that same type of extraneous evidence against the agency in a later vested rights dispute involving employee compensation even though in a later dispute it might not otherwise be relevant or admissible. 2. Negotiating Higher Member Contributions For legacy members, employer paid member contributions (or EPMCs, using PERS terminology) can be reduced or eliminated by negotiation for represented and by the usual process to establish compensation for the unrepresented 13. Under PEPRA, EPMCs are prohibited for new members In its FAQs on PEPRA, the Q/A added 11/15/12 states that Govt Code secs and allow EMPCs to be reduced or eliminated. 14 Govt Code sec (c). 5

8 PEPRA allows employers to negotiate for contribution rates that are higher than the mandated 50% of normal cost rate for new members. 15 Employers can negotiate higher contribution rates for legacy members as well. Under prior law, agencies could only bargain to share the cost of "optional benefits", which were listed by PERS. Under PEPRA, an agency and its bargaining units may broadly agree to share the cost of employer contributions. There is no need to tie cost sharing to optional benefits. Additionally, there is no need for cost sharing to be the same for all bargaining units, as was the case before PEPRA 16. Now cost sharing can differ bargaining unit by bargaining unit. However except for a special rule applicable in 2018 and discussed below, generally cost sharing cannot be imposed after impasse 17. Moreover, cost sharing is not limited to normal cost. Any costs can be shared under the new rules including sharing the cost of amortizing the unfunded accrued actuarial liability 18. Again, this can be agreed to unit by unit. Additionally, starting January 1, 2018, if there is impasse on cost sharing then PERS agencies and employers that participate in 37 Act plans may impose the requirement of paying one-half of normal cost on bargaining units 19. This would apply to legacy members, of course, because new members currently must pay this amount. There are limits on the amount that can be charged to legacy members under this rule: no more than 8% of pay for miscellaneous PERS members, 12% for policy and firefighters, and 11% for other local safety; different limits apply to the 37 Act systems. D. Return To Work By Retirees 1. New Limits PEPRA establishes new limits on the ability of retirees to return to work with an employer that participates in the same retirement system from which he/she retired. 20 If the limits are not met, then the retiree must be reinstated in the retirement system, which will often mean that benefits are suspended, member and employer contributions are required, and interest must be paid on missed contributions. To avoid reinstatement, services cannot be more than 960 hours/year for all employers in the system, the rate of pay must not be less than the minimum nor more than the maximum paid to other employers performing comparable duties divided by to get an hourly rate. Also the retiree cannot have received unemployment insurance compensation for the 12 months before employment. 15 Govt Code sec (e) 16 Govt Code sec (e) and sec as amended by PEPRA. 17 Govt Code sec and The 2018 rule appears to apply only to PERS and 37 Act systems, not to any "independent" systems. 18 Govt Code sec (e) 19 Govt Code sec and Govt Code sec

9 Moreover, a retiree may only be rehired during an emergency to prevent stoppage of public business or because he/she has skills needed to 'perform work of limited duration." Additionally, unless the agency certifies that the employment is necessary to "fill a critically needed state employment position" or meets other narrow criteria, there must be a gap of 180 days between date of retirement and hire Day Gap Start date -- The 180 day count starts on date of retirement 21. However, the date of retirement is ambiguous. It could mean the last day worked; the last day on payroll if, for example, the employee "runs out" accrued leave; the date that payment of retirement benefits begin; etc. In many cases, the day after the last day worked will be the day as of which retirement benefits are calculated so this issue would not be of substantial concern. Nevertheless, PERS has made clear that it will enforce the 180 day gap rule so PERS should provide a precise date from which to compute 180 days. Employee or contractor status Under prior law, true independent contractors were treated differently than employees for the return to work rules. Generally, if a retiree was an independent contractor, then the return to work and reinstatement rules did not apply. That distinction generally is not relevant under PEPRA. PEPRA provides that a retiree "shall not serve, be employed by, or be employed through a contract directly by, a public employer [in the same system from which the individual retired]." 22 The prohibition of "serve" and of "employed through a contract "directly" makes clear that status as an employee or independent contractor does not limit PEPRA's return to work prohibitions. An open question is whether a retiree who works as a contractor in any capacity comes within the prohibition. This is because PEPRA applies to services if "employed by a contract directly" by a public agency. The application of this phrase is unclear. Perhaps it means that this prohibition does not apply if a public agency obtains services of a contractor through a large staffing agency (sometimes called an employee leasing agency) and that agency assigns the retiree to provide services even though the public agency did not request or otherwise make known that it wanted a person with skills and experience that would lead to placement of a retiree from the agency. On the other hand, if the public agency tells the staffing agency to provide someone with skills that can only come from a retired public employee perhaps this is sufficient to be employed by a "contract directly": With an unclear statute where the result depends on particular facts, employers would do well to be cautious in obtaining contractor services. It might be safest to, e.g., direct a staffing agency not to provide a person who could violate the 180 day and other rules. There is one perplexing question under this part of PEPRA. If the retiree is in fact an independent contractor under all laws, including the common law, yet if PEPRA requires reinstatement in PERS, how does reinstatement occur? PERS does not provide benefits for independent contractors. In fact, if PERS were to do this, it could lose its tax qualified status 21 Govt code (f) ["for a period of 180 days following the date of retirement"]. 22 Govt Code sec (b). 7

10 because tax qualified retirement plans can only provide benefits for employees. Therefore, if PERS is zealous in applying the new PEPRA rule, it could adversely affect PERS and all of its members and participating employers including the State. Transition rule PERS has made clear that the 180 day gap does not apply to retirees who were providing services before It only applies to retirees who seek employment after that date. This suggests that employers should not terminate arrangements with their retirees who were on the payroll before Yet PEPRA also says that retirees can return to work without reinstatement to "perform work of limited duration". These two rules seem to be at odds. Information from retirees The 180 day gap does not seem to apply just to the particular agency to which services are provided. Reinstatement is required unless there is a 180 day gap after retirement from all agencies with the same system. Therefore, if a retiree works for, e.g., 2 days within the 180 day period for PERS employer 1 and immediately after the 180 day period (not taking into account those 2 days) works for PERS employer 2, it appears that the retiree must be reinstated and employer 2 could be on the hook for contributions plus interest even though employer 2 did not know about employer 1. Employer 2 (and any employer for that matter) can protect itself by requiring a certification from the employee that he/she meets the return to work rules. It would be best if the certification set out the rules explicitly one by one and required initials from the employee showing compliance with each. Also employers may wish to consider whether they can obtain indemnification from the employee if this certification is incorrect and the employer is thereby penalized with higher costs. E. Defined Contribution Plans 1. What defined contribution plans can be provided Prior law still governs, so PERS employers can only provide a deferred compensation plan (such as a "457(b) plan") or a money purchase pension plan (commonly called a "401(a) plan) 23. PERS law does not allow public agencies to provide "profit sharing" plans, which are much more flexible for both members and employers and are allowed by the Internal Revenue Service. Under the tax law, an employer does not have to have "profits" to provide one of these plans; the terminology is more than 70 years old and no longer accurately describes these plans. Under PEPRA legacy members should be able to participate in whatever defined contribution plan is provided by the employer. Additionally, new members should be able to participate n whatever defined contribution plans are provided by the employer. The only limits in defined contribution plans in PEPRA are on contributions to such plans by employers for new members, as discussed below Govt Code sec and PEPRA does limit the defined contribution plans for new members in one other way. If the employer maintained only defined contribution plans before PEPRA and wishes to continue and only-dc plan program, then new members may only participate in the pre-2013 plan or a formula that conforms to PEPRA. Govt Code (e). 8

11 2. Contribution limits for new members Under PEPRA, new members are subject to limits on contributions by employers to defined contribution plans 25. While some have read PEPRA as applying these limits to all plan members, that seems to be incorrect. The limits only apply to contributions relating to "the pensionable compensation limits in subdivision (c)" of section Subdivision (c) only applies pensionable compensation limits for calculating the benefits for new members. Therefore, the rules that apply limits on employer contributions for defined contribution plans only apply to new members. It also is important to note that the limits only apply to employer contributions for new members, not to employee contributions. The most reasonable reading of this rule is that contributions that are taken from the employee's pay are not employer contributions. This conclusion may seem obvious, but in light of the tax laws, it is not. For income tax purposes, a contribution is pre-tax if it is an "employer" contribution. Therefore, the Internal Revenue Code uses linguistic twisting to turn into employer contributions what are in reality employee contributions. The fact that this is the (convoluted) rule of the federal tax laws should not affect the reality for purposes of PEPRA that money withheld from an employee's pay and contributed to a defined contribution plan is employee money, not employer money. For example, some agencies allow new hires to make a one-time irrevocable election to defer part of their pay on a pre-tax basis to a 401(a) plan. If this is done properly, the IRS will treat the contribution as pre-tax and therefore as an employer contribution. For PEPRA it should be an employee contribution. PEPRA includes a parity rule for employer contributions to a defined contribution plan for new members. The contribution to new member accounts using compensation above the PEPRA pensionable compensation limit cannot be greater than the contribution, as a percent of pay, to fund retirement benefits for employees below the compensation limits. Take a simple example, suppose that the 401(a) plan is only for employees with compensation over the pensionable compensation limit and suppose that limit is $113,000. Suppose also that the employer's rate of contribution for all new member's PERS benefits is 8% of pay. In this case, the employer could contribute 8% of pay on compensation over $113,000, and no more. Suppose, instead, that all employees with compensation less than $113,000 received a 401(a) contribution of 4% of pay. In this case, the employer could contribute 12% of pay (8% + 4%) to the defined contribution plan for new members with compensation over $113,000. However, the leading technical corrections bill, SB 13, apparently would change this rule of parity. Unfortunately, SB 13 is quite unclear. Here is the problem, The proposed rule would provide that employer contributions to a defined contribution plan shall not exceed the employer's contribution rate required to fund the defined benefit plan for income subject to the limit in section (c). Section (c) provides that no employer contributions for new members may be based on "total pensionable compensation that "exceeds the amount specified in Section 401(a)(17) of [the Internal Revenue Code]." The 401(a)(17) limit is $255,000 for This proposed change can be read in two different ways: (i) as an easing of the existing PEPRA rule so any employer contributions may be made to defined contribution plans as long as they are not based on compensation over the 401(a)(17) limit, or (ii) as a tightening of the existing PEPRA rule so only the rate of contribution for the PEPRA defined 25 Govt Code sec (g). 26 Id. 9

12 benefit plan can be used for defined contribution employer contributions over the pensionable compensation limit. If the second reading is correct this could provide a substantial incentive to drop defined contribution plans for lower paid employees 27, which would not seem to be good policy Part time, seasonal and temporary employees Many agencies do not participate in social security. To avoid this, however, they must provide a sufficiently substantial retirement program for each of their employees for every day of employment. This requirement is met automatically for every employee who is a PERS member because the PERS formulas are sufficient. (The new 2%@ 62 formula also is sufficient.) However, many part time, seasonal or temporary employees are not covered by PERS or other systems for retirement. For these employees, most agency employers have established defined contribution plans with a total contribution formula of 7.5% of compensation up to the social security wage base.(often split between employer and employee). Because PEPRA requires a defined benefit plan with a defined formula for each new member, there were questions about whether the defined contribution only program could be continued for part time, seasonal and temporary employees. This question was raised in particular because the grandfather provisions in PEPRA for defined contribution plans did not seem to be broad enough to cover this situation. 29 Nevertheless, we understood that there was no intent on enacting PEPRA to disrupt the defined contribution only programs for part time, etc. employees. The section of PEPRA providing that this Act does not " provide membership in any public retirement system for an individual who would not otherwise be eligible for membership under that system's applicable rules or laws" was cited as the basis for this conclusion. 30 Clearly that explanation left some still unsettled about defined contribution only programs for any employees. Therefore, the leading technical correction bill to PEPRA, SB 13, would amend section (e) to make clear that an employer can choose to provide only a defined contribution plan. F. Conclusion This article describes some of the many questions that must be resolved for PEPRA to be implemented, and it may take years before implementation is settled. During that time, employers may wish to carefully consider the risks of alternative interpretations and what actions they can take to mitigate their risks. 27 If the only DC contribution allowed for the higher paid is at the DB contribution rate, then there is no incentive to provide a DC contribution for the lower paid to boost the DC rate for the higher paid. 28 Many 401(a) plan are drafted to allow termination, which would therefore generally be allowed under the vested rights rules. 29 See Govt Code sec (e). 30 Govt Code sec (g). 10

13 Impairment or Not: A Brief Overview of the Cases that Allow for Changes to Vested Pension Benefits By: Cepideh Roufougar Jackson Lewis LLP A. Introduction The Public Employees Pension Reform Act ( PEPRA ) made sweeping changes to the pension benefits that could be offered by California s public employers. Gone are the days of increasing pension benefits and pension liabilities and agencies using enhanced pension benefits to entice employees to work in the public sector. In its place are reduced pension formulas and limits on pensionable compensation intended to rein in the future costs of providing defined benefit formula style pension plans. Most of the changes made by the PEPRA apply only to those employees who qualify as new members of a public retirement system. By limiting application of the reform measures to new members, the Legislature significantly limited the scope of any legal challenges that could be made to the PEPRA. As a result, only a handful of lawsuits have been filed challenging application of the PEPRA. These challenges all arise under the terms of the County Employees Retirement Law of 1937 ( 37 Act ) and allege an impairment of a vested right. This paper discusses the general principles considered by the courts when a vested right is alleged to have been impaired, including when and what type of changes can be made to pension benefits. It also provides a brief overview of the PEPRA related lawsuits that have been filed to date. B. Pension Benefits as Contractual Obligations Generally, the offer of a pension benefit to a public employee is an offer that is based on contract principles. 1 This is because pension benefits constitute an element of compensation. As such, an employee begins to earn rights to the pension as soon as the employee performs services for the employer. 2 Thus, the right to a pension benefit vests upon acceptance of employment. 3 The fact that the employee may not receive or utilize the pension benefit until the employee has completed a specified period of services does not prevent a contract from forming between the employer and the employee as to these benefits or prevent these benefits from being vested benefits. 4 1 Miller v. State of California (1977) 18 Cal.3d 808, Miller v. State of California, supra, 18 Cal.3d at p Dryden v. Board of Pension Commissioners (1936) 6 Cal.2d 575, As used herein, contract does not refer to a written document such as a collective bargaining agreement or describe an employee s right to continued public employment. Rather, it is a contract in the form of identifying the rights of an employee to receive and the obligations of an employer to pay the salary and/or benefits which have been earned. (See Kern v. City of Long Beach, (1947) 29 Cal.2d 848, )

14 Once formed, this contract between a public employer and an employee creates an obligation that is protected by the provisions of the state and federal constitutions. 5 In Kern v. City of Long Beach, the California Supreme Court described the formation and prohibitions against the impairment of this contract as follows: It is true that an employee does not earn the right to a full pension until he has completed the prescribed period of service, but he has actually earned some pension rights as soon as he has performed substantial services for his employer. [Citations.] He is not fully compensated upon receiving his salary payments because, in addition, he has then earned certain pension benefits, the payment of which is to be made at a future date. While payment of these benefits is deferred, and is subject to the condition that the employee continue to serve for the period required by the statute, the mere fact that performance is in whole or in part dependent upon certain contingencies does not prevent a contract from arising, and the employing governmental body may not deny or impair the contingent liability any more than it can refuse to make the salary payments which are immediately due. 6 As a vested right, the courts have held that pension laws are to be liberally construed to protect pensioners and their dependents from economic insecurity. 7 This is because the courts have recognized that [a] public employee s entitlement to a pension is among those rights clearly favored by the law. 8 C. Making Changes to Vested Pension Benefits Recognizing the protected status of pension benefits, the courts have identified two circumstances under which an employer may make modifications to a vested pension benefits. The first circumstance is when both parties agree to the change. After all, there is no impairment of a contract if both contracting parties agree to change the contract terms. 9 The second circumstance in which a change is allowed occurs when, prior to the time of retirement, the employer makes reasonable modifications to maintain the integrity of the pension system. 10 This second circumstance requires a case-by-case evaluation, in which the court will consider two factors: (1) the reasonableness of the modification; and (2) the effect of any disadvantage stemming from the modification on the pensioner. This 5 See U.S. Constitution, Article I, Section 10, clause 1, which provides that no State shall pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts ; California Constitution, Article I, Section 9, which states A bill of attainder, ex post facto law, or law impairing the obligation of contracts may not be passed. 6 Kern v. City of Long Beach, supra, 29 Cal.2d at p. 855 (emphasis added). 7 United Firefighters of Los Angeles City v. City of Los Angeles (1989) 210 Cal.App.3d 1095, citing to Hittle v. Santa Barbara County Employees Retirement Assn. (1985) 39 Cal.3d 374, Id. 9 Mulcahy v. Bardin (1932) 216 Cal. 517, Betts v. Board of Administration of PERS, supra, 21 Cal.3d at 864.

15 test for evaluating the permissibility of modifications to pension benefits was articulated by the California Supreme Court in Allen v. City of Long Beach Determining the Reasonableness of a Modification In evaluating the reasonableness of a pension modification, the courts will review the modification to determine if it bears some material relation to the theory of a pension system and its successful operation. 12 In other words, the courts will look to see if the justification for the modification relates to considerations internal to the pension system, e.g., its preservation or protection or the advancement of the ability of the employer to meet its pension obligations. 13 One court has held that changes that are based solely on a desire to reduce costs associated with providing a particular benefit do satisfy this material relationship requirement. In United Firefighters of Los Angeles v. City of Los Angeles, the City attempted to place a 3% cap on the amount of any cost-of-living increases provided by the City s pension plan. 14 Previously, cost of living increases were based on changes in the Consumer Price Index and were not subject to any maximum increase. Two employee organizations challenged the 3% cap, asserting that it impaired a vested right. Notably, in enacting this cap on cost of living increases, it does not appear that the employer provided any offsetting comparable advantage to affected employees. In finding for the employee organizations, the court in the Los Angeles case considered whether the cap was reasonably related to the theory of a pension system. The court determined that the sole legitimate purpose of a cost of living adjustment is the preservation of a retiree s standard of living. 15 The court found that, since the placement of the cap had a tendency to lessen a retiree s economic security, impairing rather than preserving his or her standard of living, it was not reasonably related to the theory of a pension system. 16 Although, the employer attempted to counter this argument by asserting that the cap was necessary due to rising pension costs, the court was not persuaded. The Court stated that a public entity cannot justify the impairment of its contractual obligations on the basis of the existence of a fiscal crisis created by its own voluntary conduct. 17 Instead, the court found that the employer could have sought other alternatives to address these costs, such as through taxation or other means which did not involve the impairment of a contract Allen v. City of Long Beach (1955) 45 Cal.2d 128, Allen v. Board of Administration (1983) 34 Cal.3d 114, Claypool v. Wilson (1992) 4 Cal.App.4th 646, United Firefighters of Los Angeles City v. City of Los Angeles, supra, 210 Cal.App.3d Id. at p. 1113, citing to Allen v. Board of Administration, supra. 16 Id. at p Id. at p. 1113, citing to Sonoma County Organization of Public Employees v. County of Sonoma (1979) 23 Cal.3d 296, Id. at p

16 2. Modifications that Result in Disadvantages to Employees In addition to evaluating the reasonableness of a modification, the courts will also evaluate the modification to determine if it results in a disadvantage to employees. If there is a disadvantage, then the courts will look for some offset that will address the disadvantage. This is because the courts have held that changes in a pension plan which result in disadvantage to employees should be accompanied by comparable new advantages. 19 In conducting this analysis, the courts must focus on the particular employee whose own vested rights are involved. 20 Thus, the courts will consider evidence of the effects of the modification and resulting benefit on the particular employees whose vested rights are involved in determining if the modification is permissible. 21 Applying these requirements, the courts have upheld certain modifications to pension benefits of employees. For example, in Townsend v. County of Los Angeles, the court upheld a change in the mandatory retirement age from 70 to 65 because age reduction was offset by an increase in the percentage of benefits provided for each year in service, resulting in enhanced benefits. 22 In Barrett v. Stanislaus County Employee Retiree Association, the court upheld a requirement that employees who were reclassified from miscellaneous to safety members pay arrears contributions. The court found that the payment of the arrears was outweighed by the benefit of receiving the enhanced retirement benefits available to safety members. 23 Finally, in Amundson v. Public Employees Retirement System, the court upheld a modification which resulted in a later retirement age, finding that it was offset by the advantage of a decreased employee contribution and a substantially higher pension on retirement. 24 C. Restricting Current Employees from Earning Future Benefits There are several cases that specifically address modifications that restrict the ability of current employees to earn future pension benefits. It is likely that these were the cases that were foremost in the minds of the Governor and the California Legislature in enacting PEPRA, which is why the PEPRA primarily makes changes to the pension benefits to be earned by new members to a retirement system and does not diminish the future benefits that can be earned by current members. 1. Kern v. Long Beach and Related Cases Beginning with the cases that stem from the same pension plan modifications that were at issue in Kern v. Long Beach, supra, there are four cases that discuss the impact of 19 Betts v. Board of Administration of PERS, supra, 21 Cal.3d at 864 citing to Allen v. City of Long Beach, supra, 45 Cal.2d at Id. citing to Abbott v. City of Los Angeles (1958) 50 Cal.2d 438, Allen v. City of Long Beach, supra, 45 Cal.2d at 131; Allen v. Board of Administration (1983) 34 Cal.3d 114, Townsend v. County of Los Angeles (1975) 49 Cal.App.3d Barrett v. Stanislaus County Employee Retiree Association (1987) 189 Cal.App.3d Amundson v. Public Employees Retirement System (1973) 30 Cal.App.3d 856.

17 those modifications on the pension rights of current employees. Three of these cases were issued before the decision of the California Supreme Court in Allen v. Long Beach, which set forth the two-factor test for evaluating modifications to the benefits promised to current employees, and one was issued afterwards. All four cases are based on the same set of core facts. The City Long Beach passed a charter amendment repealing pension benefits. Before this amendment, the City provided firefighters and police officers with a pension benefit equal to 50% of salary after 20 years of service. Employees had the opportunity to earn an additional pension of equal to 1 2/3 percent of salary for every year worked after 20, up to a maximum pension of two thirds of salary after 30 years of service. In repealing these pension benefits, a saving clause enacted. This savings clause provided that any employee who had at least 20 years of service at the time the amendment was enacted, and who retired within five years of amendment, shall be paid a pension of such percentage of his salary as he would have been entitled to receive had he been retired on the effective date of this amendment. 25 In Kern v. Long Beach, the court held that the repeal of pension benefits did not apply to an employee who was just shy of satisfying the requirement for 20 years of service and becoming eligible for benefits. However, Kern v. Long Beach did not address the benefits of those employees who had 20 years or more of service. Instead, the court addressed the rights of employees with 20 or more years of service in subsequent cases. In Palaske v. Long Beach, the employee had 20 years of service on the effective date of the amendment repealing pension benefits. The employee continued to work for the City for another two years after the amendment went into effect, for a total of 22 years of service. At retirement, the employee sought benefits equal to 50% of salary for 20 years or service, plus an additional 1 2/3 percent of salary for each year after 20. The City denied the request and only those benefits that had accrued at the time that the retirement amendment went into effect. The court agreed with the City and denied the request for additional benefits. In finding for the City, the court relied on Kern v. Long Beach, stating: it appears that it was within the power of the city to modify its pension plan to provide that on and after the effective date of the amendment an employee who was entitled to retire might do so or not, as he saw fit, but that if he chose to continue as an employee he could not thereby earn any additional pension above that to which he was entitled on the effective date of the amendment. As stated by the Supreme Court, the employee has a vested right only to a substantial or reasonable pension. His contractual right to such a pension has not been impaired by legislation which, operating prospectively, merely withdraws any right or option to earn a bonus by continuing in employment after he has become eligible for retirement Palaske v. Long Beach (1949) 93 Cal.App.2d 120, Id at p. 132.

18 Some 18 months after Palaske, the court in Albion Allen v. Long Beach evaluated the pension rights of employees who did not have 20 years of service at the time that the amendment repealing pension benefits was enacted. 27 Relying on Kern and Palaske, the court in Albion Allen held that the maximum benefit that these employees could earn is 50% of salary upon achieving 20 years of service. 28 In Allstot v. Long Beach, the court was, for a third time, asked to evaluate the pension rights of employees following the repeal of the charter amendment that provided for pension benefits. The court again affirmed its prior holdings and determined that employees were only entitled to receive those benefits that already accrued at the time the repeal when into effect. Thus, employees were prohibited from accruing additional benefits for time served after pension benefits were repealed. 29 Following Allen v. Long Beach, and some nine years after the Kern decision, there was yet another case involving the benefit rights of employees following the City s repeal of pension benefits. In Houghton v. City of Long Beach, an employee had 24 years of service at the time the repeal went into effect. However, the employee ultimately retired from employment with over 30 years of service. At retirement, the employee sought pension benefits equal to 2/3 of salary. The City denied the request and only paid him benefits equal to 50% of salary for his first 20 years service, plus 1 2/3 % of salary for each of 4 years of service that been completed before the repeal went into effect (for a total benefit so 56% of salary). The court, relying on its prior cases, continued to hold that employees had no right to accrued additional pension benefits for service after the amendment repealing pension benefits went into effect. Notably, in each and every one of these Long Beach cases, the court was presented with a situation in which an employee was precluded from earning additional benefits after reaching eligibility for retirement. The issue was the effect of the repeal on the payment of the additional 1 2/3 % for each year of service after 20 years. The courts were not presented with a situation involving elimination of the core benefit, which was a pension equal to 50% of salary after 20 years of service. Elimination of the core benefit had been discussed and held to be impermissible under the Kern decision. 2. More Recent Case Law Although the four Long Beach cases discussed above have not been overturned, they have been criticized. In Pasadena Police Officers Association v. City of Pasadena, the court stated that Palaske and the three related cases cannot be reconciled with the comparable new advantage test set forth in Allen v. Long Beach. 30 In the Pasadena case, the court held that an attempt by the employer to cap cost of living increases was impermissible. 27 Albion Allen v. Long Beach (1950) 101 Cal.App.2d Id. at p Allstot v. City of Long Beach (1951) 104 Cal.App.2d Pasadena Police Officers Association v. City of Pasadena (1983) 147 Cal.App.3d 695, 705.