PUBLIC SECTOR PENSIONS: ISSUES AND ANALYSIS R. Theodore Clark, Jr. Partner, Clark Baird Smith LLP, Rosemont, Illinois

Transcription

1 PUBLIC SECTOR PENSIONS: ISSUES AND ANALYSIS R. Theodore Clark, Jr. Partner, Clark Baird Smith LLP, Rosemont, Illinois Pension Crisis Too Big for the Markets to Ignore -- Bloomberg, March 24, 2017 Will Looming State and Local Government Pension Crisis Bankrupt the U.S.? Investor s Business Daily, October 14, 2016 Pension Fund Problems Worsen in 43 States Bloomburg, June 30, 2017 The U.S. Census Bureau reports that there are approximately 4000 public sector pension retirement systems in the U.S., of which 227 are state-administered systems and 3,771 locallyadministered systems. According to the Census Bureau, collectively these pension systems have: $3.86 trillion in assets 14.7 million active (working) members and 9.9 million retirees $266.1 billion in benefit distributions annually Pension and Retirement Benefits Public Sector vs. Private Sector Based on BLS survey data, there is a dramatic difference between the type of pension benefits provided to workers in the private sector versus those provided to workers in the state and local government sector, as evidenced in the following table: TYPE OF PENSION OR RETIREMENT BENEFIT PRIVATE INDUSTRY, FULL-TIME WORKERS 1 Defined Benefit 21% 3 93% Defined Contribution 72% 37% STATE/LOCAL GOVERNMENT, FULL-TIME WORKERS 2 1 BLS, National Compensation Survey, March 2016, Table 2 (Retirement benefits: Access, participation, take-up rates, private industry workers). 2 BLS, National Compensation Survey, March 2016, Table 2 (Retirement benefits: Access, participation, take-up rates, State and local government workers). While the total for state and local government workers for both defined benefit and defined contribution exceeds 100%, some employees have access to both a defined pension benefit and a defined contribution benefit. The same is true in the private sector. 3 Of the private industry workers who participate in a defined benefit plan, 38% percent are participating in either soft freeze or hard freeze plans. BLS defines a soft freeze plan as one in which [n]ew employees are not allowed in the plan but benefit accruals may continue for existing employees and a hard freeze plan as one in which participants stop accruing benefits on the date the plan is frozen. BLS, National Compensation Survey, March 2016, Table 5 (Defined benefit retirement plans: open, soft, and hard freeze plans, private industry workers). 1

2 Although the BLS does not publish data on the dollar amount of the pension benefits that workers in private industry and in state and local government receive, 4 BLS does collect and publish quarterly a report entitled Employer Costs for Employee Compensation, which includes the amount per hour that employers both private and public pay for pension and retirement benefits for their employees. The following table sets forth this cost information 5 : TYPE OF PENSION OR RETIREMENT BENEFIT PRIVATE EMPLOYERS, COST PER HOUR Defined Benefit $0.59 $5.01 Defined Contribution $0.75 $0.39 Social Security $1.54 $1.60 TOTAL COST PER HOUR $2.98 $7.00 STATE AND LOCAL GOVERNMENT, COST PER HOUR The foregoing review of the most recent BLS retirement data unquestionably demonstrates that state and local government employees have an overall retirement package that is far superior to what employees in private industry receive. 6 For better or worse, these facts support the contention being made in many different quarters that the retirement benefits received by state and local government employees are too generous and should be scaled back to something more 4 Since I could not find any such data on the BLS web page, I spoke with a BLS economist who confirmed its non-existence. He directed my attention to the employment cost information that BLS does collect and publish for economic fringe benefits that includes the cost per hour that employers both private and public pay for pension and retirement benefits. The Pew Center in a 2007 study reported that the pension benefits paid by the median public sector defined benefit plan were more than double the median private sector defined benefit. Pew Center on the States, Promises with a Price: Public Sector Retirement Benefits, 2007, at p U.S. Department of Labor, Bureau of Labor Statistics, Employer Costs For Employee Compensation, March 2017, Tables 3 and 5. While BLS cautions that [c]ompensation levels in state and local government should not be directly compared with levels in private industry due to differences from factors such as variation in work activities and occupational structures, those differences surely do not come close to accounting for the nearly 100% more per hour that state and local government pays for pension and retirement benefits over what private industry pays. Id., Technical Note, at p As the New York Times editorially observed on February 7, 2011, Dozens of states give pension and health benefits far more generous than in the private sector. 2

3 reasonably in balance with the private sector, especially given the tremendous unfunded pension liabilities. Estimates of Unfunded Public Sector Pension Liabilities The magnitude of the unfunded public sector pension liability varies depending on the source of the information. For example, the Pew Charitable Trusts in an April 2017 report entitled The State Pension Funding Gap: 2015 placed the gap at $1.1 trillion in fiscal year 2015, the most recent year for which complete data are available, and added that it represents an increase of $157 billion, or 17 percent, from Moody s Investors Service in October 2016 reported that poor investment performance and insufficient contributions will cause the total unfunded liabilities for U.S. state public pensions to increase by 40% to $1.75 trillion through fiscal And the underfunding crisis is as bad if not worse among many large local governments. Thus, in a November 2016 report Moody s Investors Service stated that the [u]nfunded pension liabilities for the top 50 local governments ranked by outstanding debt have more than doubled over the last decade, and 32 of those municipalities now have higher pension liabilities than debt. 8 The unfunded liabilities vary greatly from state-to-state and municipality-to-municipality. The worst-funded US state currently is New Jersey, closely followed by Kentucky and Illinois. By the end of 2016, New Jersey had a $135.7 billion deficit in its pension funds $22.6 billion more than the year before while Illinois gap grew by $7.6 billion. It should be emphasized that estimates of the size of the public pension liabilities depend critically on the rate of return used to make the calculation. As a Forbes columnist noted in an July 1, 2016 article 9 : If the Actuarial Standards Board enacts recommendations from its Pension Task Force, actuarial valuations for state and local government pensions will report unfunded liabilities of over $5 trillion and funding ratios of just 39 percent. The public pensions industry will hate it, but those figures are the best available measures of the costs of public employee retirement plans PR_ Biggs, 3

4 Among the contributing causes to the public sector pension funding crisis is a steadily declining ratio of active employees who make contributions to pension plans and annuitants who are receiving pension benefits. Thus, between 2002 and 2015, the ratio declined from 2.43 to As the National Association State Retirement Administrators observed: 10 A lower ratio of actives to annuitants results in costs to amortize a plan s unfunded liability over a relatively smaller payroll base, which increases the cost of the plan as a percentage of employee payroll. Thus, although a declining active-annuitant ratio does not, by itself, pose an actuarial or financial problem, when combined with a poorly-funded plan, a low or declining ratio of actives to annuitants can result in relatively high required pension costs. Not surprisingly, since unfunded state and local government pension liabilities are a major cause of concern, pension reform has been a primary focal point of attempts cope with unfunded pension liabilities The move towards defined contribution public sector pension plans Eight years ago the Social Security Administration reported that there was a long-term trend of pensions switching from defined benefit (DB) (i.e., a lifetime annuity typically based on years of service and final salary) to defined contribution (DC) (e.g., 401(k) plans, where the worker invests a certain amount, often with a match from the employer, and can access the money upon retirement or under special conditions). 12 The percentage of workers covered by a traditional defined benefit (DB) pension plan declined steadily from 38% in 1980 to less than 20% in In contrast, the percentage of workers covered by a defined contribution (DC) pension plan has been increasing over time. From 1980 through March of 2017, the proportion of private wage and salary workers participating in only DC pension plans increased from 8% to 37%. Most of the shift has been in the private sector, although there has been some movement toward defined contribution plans in the public sector. 10 National Association of State Retirement Administrators, Public Fund Survey, Summary of Findings for FY 2015 (December 2016). 11 The National Conference of State Legislatures ( NCSL ) is an excellent source of information on pension reform legislation being considered or enacted by the various state legislatures. Thus, the NCLS website notes: Current legislation on pensions and retirement is available in a searchable database. You can search pensions and retirement bills by topic, primary author, state, bill number, status or keyword. The database was last updated in February See

5 The following summarizes the cconcrete steps that some states have taken to move toward the private sector model of defined contribution pension/retirement plans rather than defined benefit plans: In 2005, Alaska put all new employees in a defined contribution plan. In 2008, Georgia enacted a hybrid retirement system for new hires whereby they are offered both a defined benefit plan and a defined contribution plan, the latter of which employees can opt out of after 90 days. 13 In 2010, Utah replaced its traditional defined benefit plan with one that offers newly hired employees a choice between a defined contribution plan or an arrangement that combines features of a defined benefit and defined contribution plan. In 2011 Michigan required new or non-vested general state employees to participate solely in a defined contribution plan; vested employees were given the option to either pay a higher contribution or convert to a defined contribution plan. In 2017 Pennsylvania passed a bipartisan state pension reform package that included the following elements: 14 o Prospectively, state employees will have the option of several side by side options, including two defined benefit/contribution hybrids and a 401(k)-style plan. o Newly hired employees can choose to participate solely in the defined contribution plan. o Current employees can remain in the existing defined benefit plan, but they may also opt for one of the hybrids or the 401(k) plan. o Starting in 2019, every newly employed state and school district employee will be required to be a plan with a defined contribution component. Georgia, Rhode Island, Tennessee, and Virginia have also established hybrid plans. Kansas and Kentucky passed legislation to set up cash balance plans. Louisiana also enacted a cash balance plan, but it was ruled unconstitutional Id., at p. 4. According to the Pew Center, the defined benefit part of the hybrid plan provides about half of the payout of the existing plan and a defined contribution plan requires a mandatory 1 percent employee contribution and employer match. Id See, Retired State Employees Association v. State of Louisiana, Docket No CA-0499 (La. S. Ct., June 28, 2013). 5

6 Despite the foregoing legislative actions at the state level, the percentage of public sector employees still covered by defined benefit plans has not significantly decreased. 2. Establishment of Two-Tier Plans with Significantly Less Generous Benefits Any number of states have or are considering adopting two-tier plans in which the Tier 2 pension benefits are significantly less generous than those received by current retirees and employees who were employed before the effective date of the new Tier 2. The following is a summary of some of the new two-tier pension plans adopted by a variety of states: Pennsylvania established a new two-tier plan for participants in its Public School Employees Retirement System. Thus, new hires will receive a reduced pension benefit of 2% per year of service versus the 2.5% that grandfathered employees are eligible to receive per year of service. Missouri enacted legislation that requires participants in the State Employees Retirement System who are hired on or after January 1, 2011 to make an employee contribution of 4% of salary; employees hired before January 1, 2011 are not required to make any employee pension contribution. Illinois enacted pension reform legislation that establishes a new two-tier structure for most of its major pension systems, with a significant reduction in the new Tier 2 benefits. The following is a comparison of the Tier 1 and Tier 2 pension plans for police officers and firefighters employed outside of the City of Chicago: ILLINOIS POLICE/FIRE PENSIONS TIER 1 Maximum earnings used to compute benefit- -$245,000 unless hired prior to January 1, 1996 Benefit formula Salary attached to rank at retirement Normal retirement age 50 Maximum benefit 75% Annual adjustment after retirement 3% per year, compounded; commences at age 55 ILLINOIS POLICE/FIRE PENSIONS TIER 2 Maximum earnings used to compute benefit- -$106,800, adjusted annually by the lesser of 3% or 1/2 of CPI-U ($112,408 for 2017) Benefit formula Average annual salary based on high 8 within past 10 years Normal retirement age 50 Maximum benefit 75% Annual adjustment after retirement Lessor of 3% or CPI-U, not compounded; commences at age Reductions in Annual Adjustments to Retiree Pension Benefits Most state and local government public sector pension plans have provisions that provide for annual adjustments based on either a set percentage or a formula. In the past ten years many states reduced, suspended, or eliminated the annual adjustment, as evidenced by the following: Colorado passed legislation effectively eliminating the COLA adjustment for 2010 and limits the COLA adjustment to 2% in 2011 and future years, unless PERA experiences a 6

7 negative investment return, in which case the COLA will be calculated as the lesser of the inflation from the preceding 3 years or 2 percent. 16 Minnesota either eliminated or reduced the annual adjustment formula for current retirees until the plans are 90% funded. 17 South Dakota reduced the COLA adjustment for 2010 to 2.1% from 3.1% and thereafter the adjustment will vary from 2.1% to 3.1% depending on the ratio of the system s funded market value. 18 Utah capped the pension COLA adjustment to a maximum of 2.5%, with the proviso that CPI increases above 2.5% will accumulate and will be applied to the COLA adjustment when the CPI is less than 2.5% 19 Wisconsin, even though it has one of the best funded public pension systems in the country, replaced its standard cost-of living increase with a dividend that is paid to retirees if investment returns are positive. 20 In June 2011, New Jersey as part of a major restructuring of the state s public employee pension and health benefits, eliminated automatic cost-of-living adjustments for pensioners. 21 Kentucky reduced or eliminated the COLA adjustment for firefighters and police officers based on the pension funding status and the annual pension payment received by the retiree. 22 Pennsylvania enacted legislation (53 P.S (d)) that provides that COLA shall not be made unless the pension fund is actuarially sound and is able to maintain the increase and allowance to retired members. 16 Upheld in Justus v. State of Colorado, 2014 CO 75 (Colo. S. Ct., October 20, 2014). 17 Upheld in Swanson v. State of Minnesota, No. 62-CV (District Court, 2nd Judicial District (June 29, 2011). 18 Upheld in Tice v. State of South Dakota, No (2012). 19 NCLS 2010 Pension Report, at p Pew, at p Upheld in Berg v. Christie, 137 A.3d 1143 (N.J. 2016). 22 Upheld in Puckett v. Lexington-Fayette Urban County, 833 F.3d 590 (6 th Cir. 2016). 7

8 4. Increases in Employee Contributions Numerous states increased employee contributions for all employees or employees after a specified date, including the following: Colorado increased the employee contribution from 8% to 10.5%. Minnesota increased the employee contribution by 3% of salary. Mississippi increased the employee contribution from 7.25% to 9%. Missouri for the State Employees Retirement System provides that employees hired after January 1, 2011 make an employee contribution of 4% of salary; employees hired prior to January 1, 2011 are not required to make any contribution. Vermont for its Teachers Retirement System increased the employee contribution from 3.45% to 5%. Virginia increased the employee contribution for all employees except public safety and EMT from 5.57% to 7%. Wisconsin increased the state employee contribution from 5% in 2010 to 6.8% in 2017, Florida changed from a noncontributory system for state employees to one requiring employees to make a 3% contribution. Legal and Constitutional Challenges to Public Sector Pension Reform Legislation In the last 10 years there has been a virtual onslaught of litigation nationwide over the constitutionality of pension reform legislation. In addition to a wide variety of state law challenges, most of these law suits have alleged constitutional violations under the Contract Clause, both in the U.S. Constitution and/or parallel clauses in most state constitutions. 23 While the current weight of authority has upheld the constitutionality of the legislation, a critical factor in many cases is whether pensions are given protection in the state s constitution or otherwise by virtue of the pension law, i.e., does it create a vested or contractual right? The following is a summary of decisions from the state and federal courts. A. Cases Upholding Pension Reform Legislation 1. California To respond to pension spiking, the California Legislature passed the California Public Employees Pension Reform Act of Intended to prevent employees from boosting their 23 An excellent source for information on the legal/constitutional challenges to pension reform legislation is the website created by the Laura and John Arnold Foundation that tracks judicial developments on a state-by-state basis. See 8

9 pension benefits, this Act eliminated the option to purchase at cost up to five years of nonqualifying service credit, thereby allowing purchasers to increase their pension benefits upon retirement by increasing their years of service. In California Fire Local 2881 v. California Public Employees Retirement System, 7 Cal.App.5 th 115 (2016), a California Appellate Court upheld the constitutionality of the Act, ruling that the State could make the change without providing offsetting benefits. On April 12, 2017, the California Supreme Court granted review. 24 In their appeal, the petitioners assert that the option to purchase additional service credit was a vested right and, as such, the legislature s elimination of the right would be permissible only if the legislature (i) could show that it was necessary to preserve and maintain the existing pension system; and (ii) provided an offsetting comparable pension advantage in its absence. In a related case, which the California Supreme Court has likewise granted review, the California Appellate Court in Marin Ass n of Public Employees v. Marin County Employees Retirement Ass n, 2 Cal App 5 th 674 (Cal. App. 2016), review granted, Case No. S237460, modified the so-called California Rule, ruling as follows: [W]hile a public employee does have a vested right to a pension, that right is only to a reasonable pension not an immutable entitlement to the most optimal formula of calculating the pension. And the Legislature may, prior to the employee s retirement, alter the formula, thereby reducing the anticipated pension. So long as the Legislature s modifications do not deprive the employee of a reasonable pension, there is no constitutional violation. The petitioners in these two cases place substantial reliance on an earlier California Supreme Court decision in Allen v. Board of Administration, 34 Cal.3d 114, 120 (1983), in which the court ruled that [a]ny modification of vested pension rights must be reasonable, must bear a material relation to the theory and successful operation of a pension system, and when resulting in disadvantages to employees, must be accompanied by comparable new advantages. This holding is sometimes referred to as the California Rule. Decisions in these two cases are not expected until sometime in Stay tuned. 2. Colorado The Colorado Supreme Court in Justus v. State of Colorado, 2014 CO 75 (Colo. S. Ct., October 20, 2014), upheld COLA reductions, holding that the providing for cost-of-living adjustments does not establish any contract between PERA and its members entitling them to perpetual receipt of the specific COLA formula in place on the date each became eligible for retirement or on the date each actually retires. In so ruling, the court observed that by its very nature, a COLA is a periodic exercise of legislative discretion that takes account of changing economic conditions in the state and/or nation. Moreover, the court ruled that the pension law 24 The matter is docketed as Case No. S

10 is subject to the presumption that the legislature does not intend to bind itself contractually... unless the legislature provides a clear indication of its intent to be bound. 3. Florida In Williams v. Scott, 2013 FL 520, So. 3d, 2013 WL (Fla. Jan. 17, 2013), the Florida Supreme Court upheld pension legislation that increased employee contributions by 3% and suspended COLA payments. The Court held that the Florida legislature can alter retirement benefits prospectively, reasoning as follows: To hold otherwise would mean that no future legislature could in any way alter future benefits of active employees for future services, except in a manner favorable to the employee. This view would, in effect, impose on the state the permanent responsibility for maintaining a retirement plan which could never be amended or repealed irrespective of the fiscal condition of this state. Such a decision could lead to fiscal irresponsibility. It would also impose on state employees an inflexible plan which would prohibit the Legislature from modifying the plan in a way that would be beneficial to a majority of employees, but would not be beneficial to a minority. 4. Kentucky Kentucky reduced or eliminated the COLA adjustment for firefighters and police officers based on the pension funding status and the annual pension payment received by the retiree. In rejecting constitutional challenges to this legislation, the Sixth Circuit Court of Appeals in Puckett v. Lexington-Fayette Urban County, 833 F.3d 590 (6 th Cir. 2016), ruled that there was no evidence that the legislature was to be bound to the COLA increase. In rejecting plaintiffs contentions that they were entitled to a specific COLA formula, or that the COLA was part of their annuity payments that was protected as an annuity, the court cited recent decisions issued by other courts that also found that COLAs are not protected by contract. 5. Michigan In 2011 Michigan enacted pension legislation that gave vested general state employees (i.e., hired before April 1, 1997) the option to either make a 4% contribution (previously no contribution was required) or convert to a defined contribution plan; excluded on a prospective basis the inclusion of most overtime in the computation of pension benefits, and required nonvested and new employees to participate in a defined contribution plan. The reform legislation was upheld by the Michigan Supreme Court in Michigan Coalition of State Employee Unions v. State of Michigan, Docket No (July 29, 2015), entirely on the grounds of its interpretation of the state s constitution and state employee retirement law. Although the state s constitution prohibited the legislature from changing rates of compensation, the court concluded that the term rates of compensation was not understood by the ratifiers of the 1963 constitution to include fringe benefits such as pensions; rather, the common understanding of the term at that time was that it included only salaries and wages. 10

11 6. Minnesota Minnesota either eliminated or reduced the annual adjustment formula for current retirees until the plans are 90% funded. This legislative change was upheld in Swanson v. State of Minnesota, No. 62-CV (District Court, 2nd Judicial District (June 29, 2011). In its opinion granting summary judgment for the State, the court stated in relevant part: [S]tatutes are not contracts absent plain and unambiguous terms that show an intent to contract... Plaintiffs claims fail because they rest on a fundamental disagreement with the Legislature s policy choices... this is not a debate for the court to join... the court would threaten the balance of powers between the legislative and judicial branches by second-guessing this legislative wisdom. 7. Missouri In Firemen s Retirement System v. City of St. Louis, No CC00006 (Missouri 22nd Circuit Court, 2013), the Missouri Court of Appeals affirmed without an opinion the Circuit Court s decision upholding legislation adopted by the City of St. Louis based on the following reasoning: [T]he ordinances establishing the dual plan system do not impair vested rights or the obligation of contract... On the contrary, the ordinances generously preserve benefits which were not vested as of Feb. 1, 2013, and ensure that benefits vested as of that date are protected and will be paid by the FRS.... The contracts clauses operate in the past, not the future. Only the FRS benefits in existence as of Feb. 1, 2013, are subject to constitutional protection, to the extent they were vested at that time. In the court s view, there is no authority in Missouri for the proposition that a public employee, once hired, is permanently entitled to pension benefits under plans in force at the time of hire, when the plans themselves do not so specify. The city at all times reserved the right to amend or repeal the FRS ordinances. Although this case was appealed, the Missouri Supreme Court declined the application for transfer and appeal on February 3, New Hampshire In 2011 New Hampshire enacted wide-ranging pension reform legislation that, inter alia, increased the required employee contribution, tied the COLA to the funding status of the pension fund, lowered the maximum benefit, and reduced the multiplier from 2.5% to 2.1%. Relying in part on decisions from courts in Michigan, Florida, and Alabama, in which courts held that a state legislature had the right to alter benefits prospectively, the Supreme Court of New Hampshire in Professional Firefighters of New Hampshire v. State of New Hampshire, Docket No (NH S. Ct., Dec. 10, 2014), ruled that the pension law had not unmistakably guaranteed a contractual right to a fixed contribution rate. Accordingly, the Supreme Court 11

12 reversed the lower court s finding that members who had been employed for more than 10 years had a vested contractual right to retirement benefits and a fixed contribution rate. Moreover, because the Federal Constitution affords the plaintiffs no greater protection than does the State Constitution, the court denied the plaintiffs challenge under the U.S. Constitution as well. 9. New Jersey In Berg v. Christie, 137 A.3d 1143, (N.J. 2016), the New Jersey Supreme Court in a 6-1 decision upheld the state s authority to suspend COLAs. The Court ruled that a fixed COLA was not contractual in nature because the relevant legislation lacked the unequivocal intent to make the COLA a non-forfeitable right. 10. South Dakota This legislative modification to the COLA adjustment provision was upheld by the court in Tice v. State of South Dakota, No (2012). In rejecting plaintiff s contention that the COLA reduction violated the contract clauses of the South Dakota and U.S. Constitutions, the court ruled that [t]here is no written contract between plaintiff and defendants that sets forth the terms, responsibilities, or respective contract rights between the parties. Additionally, no provision within the South Dakota Constitution has been cited by the plaintiff which would create a constitutional entitlement to any particular cost-of-living adjustment. 11. Texas Van Houten v. City of Fort Worth, 827 F.3d 530 (5th Cir. 2016), cert. denied, 137 S. Ct. 600 (2016), involved a challenge to a Fort Worth, Texas, ordinance that reduced the multiplier used to calculate pension benefits for firefighters by one-half percent (from 3 percent to 2.5 percent); determined retirement pay by using the highest five years instead of the highest three years; and eliminated overtime from pension calculations. At issue was whether Article 16, Section 66, of the Texas Constitution, which protects the impairment of retirement and disability benefits accrued by members of a non-statewide retirement system, prohibited the changes. The Fifth Circuit held that Section 66 s prohibition on the reduction of accrued retirement benefits is limited to those benefits that are both vested and earned. Thus, the court held that Section 66 permitted prospective changes and modifications to the pension plans in question. Relying in significant part on the Fifth Circuit s interpretation of Section 66 in the Van Houten case, the Texas Court of Appeals for the Fifth District in Eddington et al. v. Dallas Police and Fire Pension System, No CV (December 13, 2016), upheld a change in the DROP interest rate, holding that the interest rate was not among the benefits protected by Section Washington In 2011 Washington eliminated COLA adjustments. In Washington Education Association v. State Retirement Systems, Docket No. No (Wash. S. Ct., Aug. 14, 2014), the Washington Supreme Court held that since the Legislature reserved the right to repeal the 12

13 COLA benefit when it was originally enacted, the subsequent repeal of that benefit did not impair any existing contract rights of state employees. The court noted that [t]he state actuary estimates that the repeal of [COLA adjustments] will save the state over seven billion dollars over the next 25 years. 13. Wisconsin In Stoker v. Milwaukee, 2014 WI 130, 359 Wis. 2d 347, 857 N.W.2d 102 (2014), the Wisconsin Supreme Court upheld Milwaukee County s ordinance that reduced prospectively the pension benefit from 2% per year of service to 1.6%, reasoning as follows: Stoker does not have a vested right to have the 2% multiplier apply to her thenunearned post-2011 service. In other words, Milwaukee County could so amend the formula and apply it prospectively because that prospective application does not "diminish or impair" benefits accrued from service credits already earned. B. Cases Invalidating Pension Reform Legislation in Whole or in Part 1. Arizona The Arizona Constitution provides that [m]embership in a public retirement system is a contractual relationship that is subject to Article II, 25, and public retirement system benefits shall not be diminished or impaired. Article II, 25, provides, among other things, that [n]o law impairing the obligations of a contract shall ever be enacted. Despite these provisions, Arizona enacted legislation that increased the employee contribution from 7% to 10% and changed the COLA adjustment formula for calculating future increases for members of the pension system covering elected officials and judges. Virtually identical legislation was enacted for the state s other pension systems. In Hall v. Elected Officials Retirement Plan, et al., No. CV T/AP (Arizona S. Ct., Nov. 10, 2016), the Arizona Supreme Court ruled as follows: [T]he Bill s change to the benefit increases formula violates the Pension Clause because it diminishes and impairs the employed members pension benefits. The Bill s changes to the benefit increases formula and the contribution rate also violate our holding in Yeazell because the Legislature cannot unilaterally change the terms of the members pension contracts once their rights to those terms have vested at the beginning of the members employment. 2. Illinois In 2013 the Illinois General Assembly passed wide-ranging pension reform legislation that, among other things, included a reduction of the annual COLA increase for current and future retirees, the implementation of a cap on the pensionable salary for certain members, and 13

14 the increase of the retirement age required for eligibility in the retirement system. Illinois, unlike most states, has a constitutional pension protection clause that provides as follows: Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired. In a consolidated appeal of multiple lawsuits challenging the constitutionality of this legislation, the Illinois Supreme Court unanimously ruled that the legislation was unconstitutional. In re Pension Reform Litigation, 2015 IL (IL S. Ct., May 8, 2015). The Court stated: [T]here is simply no way that the annuity reduction provisions in Public Act can be reconciled with the rights and protections established by the people of Illinois when they ratified the Illinois Constitution of 1970 and its pension protection clause. Moreover, the Court rejected the State s argument that the legislation was a necessary exercise of its sovereign power to respond to difficult economic times. The Court found that the circumstances presented by this case are not unique, given cyclical downturns, including the Great Recession and the existence of less drastic means that could have been utilized to address the State s fiscal woes. What is particularly important to understand about the Court s interpretation of the Illinois pension protection clause is that it not only protects the pension benefits already earned but it also means that any benefits that were in place when employees became members of the retirement system cannot be prospectively modified or impaired. In effect, the only remaining option is to adopt pension reform legislation that is only applicable to employees hired after the effective date of the legislation. This is in marked contrast to pension reform decisions in some other states that have upheld prospective reductions in benefits that have not already been earned. 3. Oregon In 2013 Oregon enacted legislation that eliminated the income tax offset benefits for nonresidents retirees and modified the COLA for employees covered by under the Public Employees Retirement System (PERS). In the Moro v. State of Oregon, 357 Or. 167, 351 P.3d 1 (OR S. Ct., Apr. 30, 2015), the Oregon Supreme Court held that COLA modification violated the State Contract Clause since it impaired retirees contractual right to receive the annual COLA for benefits earned prior to the amendments effective date. Thus, insofar as they apply retrospectively to benefits earned before the effective dates, the COLA amendments impair the PERS contract and violate the State Contract Clause. However, the court upheld the legislation with respect to benefits earned on or after the effective dates of the amendments. In the absence of specific contract rights outside the PERS statutes, the COLA amendments do not violate the state or federal Contract Clauses when applied to benefits earned on or after the effective dates. Finally, with respect to the legislative provisions that modified nonresidents right to receive an income tax offset, the court held that nonresident petitioners have no contractual right to receive the income tax offsets. 14

15 Pensions and Collective Bargaining The problem of unfunded pension liabilities is real and will not disappear anytime in the foreseeable future. While most of the focus on pension reform has been on legislation, there is also a collective bargaining component in those states where employees have the statutory right to engage in bargaining. 25 While there are definite limitations on what employers can do at the bargaining table to reduce pension costs, an employer s hands are not completely tied. Even though only the state legislature in most states can establish benefit levels, employers still have the right to negotiate over compensation elements that determine pension benefits. As the Massachusetts Labor Relations Commission in City of Springfield and IAFF Local 648, MUP (Mass. LRC), observed: While the types of compensation to be included in the determination of retirement benefits is governed by [Massachusetts law] and not subject to bargaining, the actual amount of retirement benefits is a function of the amount of compensation a retiree receives over a specific period of time. Thus, negotiations over wages (indisputably a mandatory subject of bargaining) directly influence the level of retirement benefits an employee receives under [the Massachusetts pension law]. Among the actions employers might consider include the following: Reduce the rate of increase in the salaries that are used to compute pension benefits Avoid/reduce/hold the line on longevity pay 25 As far as this author knows, every state has enacted pension laws that cover state employees. Most of these state statutes also specify the pension benefits for employees of the state s units of local government, either under the same statute that covers state employees or under one or more statutes specifically designed to cover local government employees. Where there is an applicable state law governing employee pension benefits, pensions are normally not subject to collective bargaining. For example, the Iowa provides that [a]ll retirement systems shall be excluded from the scope of negotiations. The Iowa Supreme Court held that this provision encompassed any proposal that directly augments or supplements the benefits a public employee would receive under a retirement system under other provisions of the Code, noting that to hold otherwise would ignore and work to defeat a strong public policy underlying uniform retirement systems and pensions for public employees in this state. City of Mason City v. Public Employment Rel. Bd., 316 N.W.2d 851 (1982). However, in situations where the retirement and pension benefits for some or all local government employees are not specified by state law, pensions and retirement benefits would normally be deemed to be a mandatory subject of bargaining, assuming the state has an applicable public sector collective bargaining law mandating negotiations over wages, hours, and other terms and conditions of employment. See, e.g., Detroit Police Officers Association v. City of Detroit, 319 Mich. 44, 214 N.W.2d 803 (1974). 15

16 Reduce or eliminate compensation items that are included in the earnings used to compute pension benefits Reduce salaries for new employees, i.e., propose a two-tier salary structure if the salary structure for existing employees is deemed overly generous Avoid limitations on employer s right to outsource work; using subcontractors reduces the number of employees who are pension participants and thereby reduces an employer s pension costs Moreover, given the vast cost of funding pensions, employers should make every effort to get full credit at the bargaining table and in interest arbitration for the dollars that they are expending on pensions and, as a result, reduce the overall cost of wage and benefit improvements. As Arbitrator Marvin Hill noted in a 2011 interest arbitration case 26 : There is an additional consideration in salary and benefit analysis that rarely gets mentioned in interest arbitrations, but will demand more consideration in the future pension obligations of the government entity. Although the Village has not entered an inability-to-pay argument regarding pension obligations, defined-benefit pension costs that increase with salaries should be recognized as an increased obligation on a government employer. Is Bankruptcy the Ultimate Solution to Unfunded Pension Liabilities? At the outset of the Great Depression there were more than a few predictions that raised the specter of widespread municipal bankruptcies. For example, one publication in 2010 ran the following headline: New Michigan Governor Says Hundreds of Cities Could Go Bankrupt In Next Four Years. 27 And, at an investment conference in January 2011, JPMorgan Chase & Co. CEO Jamie Dimon said that [t]here have been six or seven municipal bankruptcies already and I think unfortunately you will see more. 28 But perhaps the most widely reported prediction was Meredith Whitney s 2010 prediction on 60 Minutes that there would be massive defaults of hundreds of billions of dollars in the municipal bond market. However, as reported by Governing Magazine in September : 26 Village of Schaumburg and IAFF (Arb. Marvin Hill, 2011), at p , n Business Insider, November 19, 2010, at as last updated September 14, See also, Tracy Gordon, Michael Lens, Paavo Monkkonen, Larry Rosenthal, Exuberance & Municipal Bankruptcy: A Case Study of San Bernardino, 16

17 Nationally, bankrupt municipalities remain extremely rare. The majority of filings have not been submitted by bankrupt cities, but rather lesser-known public authorities and other narrowly-defined special districts throughout the country. In Omaha, Neb., more than a dozen sanitary districts have filed for bankruptcy, accounting for nearly a quarter of all Chapter 9 filings since Of the five biggest municipal bankruptcies to date, 30 all but one Orange County, California, in 1994 have occurred since 2010, to wit: Jefferson County, Alabama (2011) Stockton California (2012) San Bernardino County, California (2012) Detroit, Michigan (2013) It is important to emphasize that only units of local government not States can use Chapter 9 to file for bankruptcy, but only if such a filing is permitted by state law. 31 Currently, only about half the states authorize Chapter 9 bankruptcy filings. Although States cannot utilize Chapter 9, there have been suggestions from time to time that Congress should amend the Bankruptcy Code to permit a state to file for bankruptcy. For example, Bloomberg columnist Peter Coy in a January 21, 2016, article entitled The Case for Allowing U.S. States to Declare Stockton & Vallejo, CA (draft dated May 1, 2017), Exuberance.Bankruptcy.pdf: Early doomsday predictions of a wave of municipal failures nationwide happily failed to pan out. Nearly every city suffering severe fiscal challenges, and their creditors, by and large found a way to avoid Chapter 9. Cities adjusted debt, cut spending, reduced service delivery and expectations, found new revenue, utilized rainy-day resources, and negotiated refinancings. They weathered the storm, and federal stimulus and the recovery ultimately buoyed municipal balance sheets. But in a very few places including some in California - the losses were unmanageable, the debt burden unwieldy /#322d97aa78a0. 31 For an outline of State Statutes Authorizing Municipal Bankruptcy, see K&L Gates, National Association of Public Pension Attorneys, Annual Conference, June 26, 2015, archived at For a color-coded state-by-state map that provides information on whether municipal bankruptcies are authorized by state law, see 17

18 Bankruptcy, argued that the strongest argument for state bankruptcy is that it clearly signals to bondholders that they could lose money if a state behaves badly. 32 Bankruptcy may be an option for some municipalities that are unable to negotiate their way out of debt, but it is not necessarily a panacea. While Vallejo, California, got some relief via Chapter 9, 33 it reportedly cost Vallejo $9.5 million in legal fees. 34 As a result, some observers believe out-of-court negotiations yield better results. 35 Conclusion In an unusually large number of states and local governments the issue of unfunded pension liabilities is a fact of life and it will continue be a long time to come. To deal with this funding gap, a substantial number of states, as well as local governments, have enacted pension reform legislation, virtually all of which seeks to change pension programs to reduce unfunded liabilities. These efforts have led a virtual onslaught of legal and constitutional challenges. As the discussion of the case law above demonstrates, the resolution of these lawsuits is largely dependent on whether a state s constitution and/or pension laws are viewed as creating a contractual or vested right to the preexisting benefits. If a court finds, as a goodly majority have to date, that there is no such contractual or vested right, then it is likely that the legislative body s right to make the changes in question will be upheld. On the other hand, if a court finds that there is a contractual or vested right, then it is likely that the changes will be invalidated. Regardless of the status of law in each jurisdiction, the need to cope with unfunded pension liabilities of defined benefit pensions in a wide variety of states and units of local government will continue to be a major challenge for all affected parties. As the Pew Charitable Foundation Trust noted in its April 2017 report, the currently existing substantial funding gap will require policymakers in many states to choose from often difficult options: paying more into state pension plans and potentially crowding out other spending in their budgets, or letting funding levels drop and pushing costs into the future While Vallejo was not successful in negotiating concessions with its employee unions prior to declaring bankruptcy, Mayor Osby Davis said, Bankruptcy got us what we needed: we got to adjust collective bargaining agreements. 34 Bloomberg, Vallejo s Bankruptcy Failure Scares Cities into Cutting Costs, December 14, See See also, Greenhut, Vallejo s Painful Lessons in Municipal Bankruptcy, Wall Street Journal, March 26, Id. 18

19 19