Can we fix the “California rule” for public-employee pensions?

February 6

This is the fourth post in a series on the “California rule” and constitutional protection of public-sector employee pensions, based on the White Paper I’ve written for the Federalist Society. I introduced the issue in Monday’s post and went through the California caselaw and federal constitutional issues in Tuesday’s post. You can read those posts for an introduction to the issue if you’re unfamiliar with it, but the short version is that in California (and some other states), the courts give constitutional protection not only to the amount of public employees’ pensions that has been earned by past service, but also to employees’ right to keep earning a pension based on rules that are at least as generous for as long as they stay employed.

I don’t think there’s anything unconstitutional about this: either the California rule is a state rule of contract definition that merits deference for federal-law purposes; or it’s merely a super-protective rule of California constitutional law, which California courts are entitled to adopt as a matter of their own constitution. Nonetheless, I believe the rule is a bad idea: while protecting pensions accrued based on past work is reasonable; protecting the current rules into the future is far less so. In Wednesday’s post, I discussed policy arguments against the rule. Today, I’ll be discussing how one might fix or work around the California rule.

*     *     *

In short, the California rule distorts what the salary/pension mix would otherwise be given employer and employee preferences and given the tax code as it is. Because underfunded pensions are a popular form of deficit spending, public employee compensation may already be too pension-heavy, and the rule makes it more so by freezing pensions in times of retrenchment. The incentive effects of the rule, given the political economy of government employment, may well exacerbate this tendency. And the possible theoretical reasons for preferring a pension-heavy mix don’t go very far in justifying this particular distortion.

How much leeway to modify public pensions does a “fiscal emergency” offer? Not much. As the Allen rule says, one can modify pension rights before retirement for the sake of flexibility in light of changed conditions, but the changes must be reasonable, which means both that they need to have a relation to pension theory and must compensate for disadvantages with comparable advantages. Clearly, merely reciting the need to shore up pensions is insufficient, and arguments in favor of COLA caps that “the ‘integrity’ of the pension system is strengthened when it can be determined with certainty what the obligations of the system are” likewise are insufficient.

In United Firefighters, the Court of Appeal rejected the contention that the modifications were necessary to preserve the soundness of the system because it held that the fiscal crisis was caused by the government’s own conduct in inadequately funding the system: “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.” The same may even be true when the crisis is created not by government officials but by a tax-limiting voter initiative like Proposition 13.

And even if the modifications are justified by sound pension theory, this doesn’t prevent the government from having to offer compensating advantages. So the ability to modify pensions seems to be of little help in resolving a fiscal crisis.

Moreover, the California rule probably doesn’t conflict with the federal Constitution—it’s a state rule for finding contracts in statutes that merits federal deference. Even if it doesn’t merit federal deference, it represents a valid rule of California constitutional law, which California courts would explicitly adopt as a matter of state law if pressed. So we shouldn’t look to the U.S. Supreme Court to fix it.

So what fixes are available?

1. A flexible definition of benefits. One possibility would be to expressly reserve flexibility in the statutory definition of pension benefits. For instance, in International Ass’n of Firefighters v. City of San Diego (Cal. 1983), the San Diego charter provided that employee and city contributions to the retirement fund would be “computed upon the basis of actuarial advice designed to estimate the funding needed to accrue a guaranteed retirement allowance upon retirement.” Because the actuarial advice provision was part of employees’ vested rights from the start, changes in contribution rights based on this advice—far from impairing anyone’s rights—were in fact made pursuant to the employees’ rights.

Similarly, in Pasadena Police Officers (which I discussed in Tuesday’s post) the Pasadena charter, which set contribution rates according to actuarial assumptions, was amended to alter those assumptions. That amendment didn’t violate any vested contract rights, since conformity with actuarial assumptions had been made a condition of pension contributions from the start.

2. Short-term contracts. Perhaps providing benefits by the terms of short-term contracts (rather than by statute) could preserve government flexibility to modify pension terms prospectively. If pension terms are enshrined in memoranda of understanding—perhaps the result of collective bargaining with public-employee unions—that expire at a certain time, it seems hard to argue that the employees have acquired any vested right to compensation, benefits, pensions, or anything else beyond the term provided. The relevant governmental unit would then be able to alter pension terms in subsequent memoranda.

This theory (while sound for salary and other benefits) might be on shaky ground in the case of pensions. In Legislature v. Eu (Cal. 1991), the California Supreme Court held that, in the case of legislators, the right to earn pension rights on the same terms begins when the legislators first begin their service, even though legislative terms may have begun and ended since then. Similarly, a superior court judge remains entitled to earn pension rights on the same terms even if he is then appointed to the court of appeal: “The coach ticket punched in the 1964 appointment to the superior court continued to be good for passage in the parlor car of the court of appeal. His retirement destination was the same.”

Perhaps these cases can be distinguished because the legislators’ and judges’ benefits were provided by a non-sunsetting statute, and perhaps one can acquire a vested interest in the continuation of rules provided by a publicly available, non-sunsetting statute but not by a memorandum of understanding that expires by its own terms and that may not even have been renegotiated yet. But the coach ticket-parlor car metaphor quoted above suggests that the only thing that matters is that the employee remains in the same retirement system.

3. State constitutional amendment. Another possibility would be a state constitutional amendment abolishing the California rule and establishing that pension statutes only entitle the employee to that portion of the pension accrued so far. In fact, there is such a proposed amendment, which should be on the ballot as an voter initiative in 2014. (I’ll discuss it further below.) Given past California caselaw, this would probably itself count as a law impairing the obligation of contracts (this may depend on how precisely it’s phrased), so it would be valid only for employees hired after the date of the amendment.

4. Changing state caselaw. Another, more long-term, possibility would be to alter the California rule by a pattern of anti-California-rule appointments to the state supreme court. While a reversal of the California rule through caselaw looks similar to a reversal by constitutional amendment, the caselaw route seems more likely to be viewed as an acceptable adjustment of the definition of contractual rights, and (always provided the court stays within the federal-law deference zone) less likely to be seen as an (unconstitutional) impairment of contracts. Though the idea that judicial decisions could impair contracts once had some currency, in modern times “no court has shown any interest in reviving the idea.” Thus, an appellate court in Massachusetts has allowed detrimental changes without comparable new advantages, and this doesn’t seem to have been challenged as a judicial impairment of the state’s contract obligations.

5. Privatization. Another possibility—which alleviates the problem but doesn’t solve it structurally—is to pursue privatization and outsourcing. Firing state employees is constitutional, and providing pensions and retirement plans for the contractors’ employees will be left to the private employers. Those private pensions, if offered, will have to be ERISA-compliant, which alleviates problems of underfunding; and in any event, the state won’t be on the hook for anything beyond the current contract price.

6. Defined-contribution pensions. I would add (though I didn’t mention this in my White Paper) that switching from defined-benefit to defined-contribution plans would make many of these issues moot. A defined contribution plan is essentially just an investment account that earns whatever it earns based on the amounts contributed. COLAs aren’t an issue, and employee contributions can be made voluntary. (The government employer’s contributions are unprotected by the California rule in any case, so the employer would remain free to vary its contributions.) Defined-contribution plans also have the advantage that they’re always fully funded by definition, so disguised deficit spending or unsustainable promises to employees become more difficult if not impossible. Note, though, that since defined-contribution plans are riskier for the employee than defined-benefit plans, the employer may have to pay for the shift to defined-contribution plans through higher wages or more generous benefits.

These are all possibilities for treating pension benefits just like other aspects of compensation: as something earned over time and not guaranteed for the future. In addition to being more rational as a public-employee compensation policy, abandoning the California rule would also give governmental units in California, and wherever else the rule has been adopted, flexibility to deal with changing circumstances.

*     *     *

The day before yesterday, while browsing the web, I became aware that there was a voter initiative in the works to repeal the California rule. Here’s their website, here’s the full text of the amendment, and here’s their one-page summary. (This is all from the proponents, of course; I’ve found a summary by CalPERS, the California Public Employees’ Retirement System. One doesn’t expect CalPERS to necessarily be on the side of the initiative proponents, so you might choose to read CalPERS’s summary as being potentially more objective. Nonetheless, note that CalPERS “has not [yet?] adopted a position on the proposed measure.”) Apparently the initiative was proposed by a group of California mayors; the first one listed is Chuck Reed of San Jose.

§ 4 of the initiative adds Art. VII, § 12 to the California Constitution:

  • § 12(a)(1): “From the effective date of this Section, to the extent any government employer confers its current employees with vested contractual rights to pension or retiree healthcare benefits of any kind, such rights shall be earned and vested incrementally, only as the recipient employee actually performs work, and only in proportion to the work performed, subject to the vesting periods established by the applicable plan.” This is the important language that repeals the California rule with respect to current employees and newly granted benefits and allows pension rules to be changed prospectively: any future rules haven’t vested.
  • § 12(a)(2): “Nothing in this subsection shall affect pension or retiree healthcare benefits earned and accrued for work already performed by employees or retirees.” So all pensions currently accrued based on work done so far are protected.
  • § 12(b): “For any government employee hired after the effective date of this Section, to the extent any government employer confers these employees with vested contractual rights to pension or retiree healthcare benefits of any kind, such rights shall be earned and vested incrementally, only as the employee actually performs work, and only in proportion to the work performed, subject to the vesting periods established by the applicable plan.” This repeals the California rule with respect to future employees.
  • § 12(c): “Any action by a government employer, labor agreement or voter initiative prior to the effective date of this Section shall not be found to have created a vested contractual right to future pension or retiree healthcare benefits before such work is performed by employees, unless the specific language of the underlying action, agreement or initiative expressly states that such benefits are vested or are otherwise irrevocable.” This repeals the California rule with respect to current employees and benefits granted in the past. For instance, the fact that the government passed a statute (or a municipality passed an ordinance) defining pension rules, and people took the job knowing these benefits, doesn’t create a right to those benefits’ continuing into the future. In practical effect, this seems to take away the entitlement that current workers have (under current law) to the continuation of future benefits. (Maybe this still protects benefits granted before 1955, because the action that created a vested future right was performed by the California Supreme Court in Allen; but at least anything granted by a government after 1955 is covered.)
  • § 12(d): “Nothing in this Section shall be construed as conferring or vesting any rights or benefits on government employees not expressly granted by the government employer.” This is just preventing the language in this amendment itself from implicitly granting any extra rights.
  • § 12(e): “The terms of a pension or retiree healthcare benefit plan for work not yet performed may be amended through a labor agreement, an action by a legislative body, or an initiative, referendum or other ballot measure initiated by the voters or by a legislative body. Any such amendments to pension or retiree healthcare benefits made by a legislative body, whether by legislation or by placing a measure on the ballot, shall comply with applicable collective bargaining laws.” So this explains that (and how) pensions can be amended prospectively.
  • § 12(f) gives courts “exclusive jurisdiction to consider and adjudicate all disputes regarding laws relating to pension or retiree healthcare benefits enacted or proposed through an initiative, referendum or other ballot measure.” Not sure what exactly this is doing: maybe preventing state administrative agencies (or possibly arbitration boards created by collective bargaining agreements?) from adjudicating such disputes.
  • § 12(g)(1) protects labor agreements currently in effect, but regulates labor agreements entered into for the purposes of avoiding the Act.
  • § 12(h) makes clear that employee pension contributions are part of the compensation package and can be amended.
  • § 12(i) allows government employers, if they find that a pension plan is substantially underfunded or if they declare a fiscal emergency, to do various emergency actions like reducing the rate of accrual of pension benefits to be earned in the future, reducing future cost-of-living adjustments, increasing the retirement age, requiring larger employee contributions, or otherwise reducing or modifying benefits. The government employer has to make factual findings justifying the reasonable and necessity of these measures. All these measures can only apply to future work. They’re subject to collective bargaining if they’re within the mandatory scope of collective bargaining. And any such actions can be amended to take into accuont changes in circumstances.
  • § 12(j) provides that government employers have to make a stabilization report if the plan’s assets are less than 80% of its liabilities; the report should specify actions designed to achieve 100% funding within 15 years while preserving basic government services, and has to be available for public review and subject to public hearings.
  • § 12(k) again makes clear that the entitlement to benefits earned in the past continues, even for plans that have been modified, frozen, or terminated.
  • § 12(l) says the power to amend plan terms can’t be limited by labor agreement, statute, etc.
  • § 12(m) says government employers and pension boards have to promptly implement this Act.
  • § 12(n) says this Act prevails over contrary provisions of the state constitution or state law.
  • § 12(o) is a definition section.

Interestingly, § 9 of the initiative allows the proponents of the initiative to defend the initiative in court if the state doesn’t want to. But it has extra language to respond to the U.S. Supreme Court’s holding in Hollingsworth v. Perry that initiative proponents don’t have standing:

(b) In the event that the proponents are defending this Act in a legal proceeding because the State has declined to defend it or to appeal an adverse judgment against it, the proponents shall:

(1) act as agents of the people and the State;

(2) be subject to all ethical, legal, and fiduciary duties applicable to such parties in such legal proceeding; and

(3) take and be subject to the Oath of Office prescribed by Article XX, section 3 of the California Constitution for the limited purpose of acting on behalf of the people and the State in such legal proceeding.

This is an interesting initiative, and I welcome readers’ thoughts on it. I’ll have some more to say about it in tomorrow’s post.

Sasha Volokh lives in Atlanta with his wife and three kids, and is an associate professor at Emory Law School. He has written numerous articles and commentaries on law and economics, privatization, antitrust, prisons, constitutional law, regulation, torts, and legal history.
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