This is the third in a series of posts about the “California rule” and constitutional protection of public-sector employee pensions. 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 argue that protecting pensions accrued based on past work is reasonable; protecting the current rules into the future is far less so.

Yesterday I argued that there isn’t anything unconstitutional about the California rule: either it’s 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. So, if the legality of the California rule isn’t the problem, what remains is pure policy. So in today’s post, I switch to pure policy and argue why the California rule is a bad idea. The main problem with the California rule is that it distorts the mix between pensions, on the one hand, and salaries (and all other benefits) on the other. It gives some employees a different compensation package than they’d otherwise prefer, and it makes it harder for states with unfunded pension issues to put their finances in order.

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The Pasadena Police Officers court’s holdings (discussed in yesterday’s post) show clearly the ratchet effect of the California rule. California caselaw holds that “a public employee’s pension constitutes an element of compensation and that the right to pension benefits vests upon the acceptance of employment even though the right to immediate payment of a full pension may not mature until certain conditions are satisfied.” Unlike all other terms of public employment, which “are wholly a matter of statute” and don’t “ripen into obligations” protected by the state and federal contract clauses until the moment of performance, “deferred compensation in the form of pension rights has the status of a contractual obligation from the moment one accepts public employment.”

This “vest[ing]” or “contractual obligation” language, by itself, doesn’t tell us what rights vest—for all we know, the right that vests and is protected by the contract might be nothing more than the right to earn whatever pension has been accrued by the work done so far, which starts at 0 when employment is accepted and hopefully rises over time. But the Allen language quoted in yesterday’s post forecloses that interpretation: the right that vests is the right to continue earning as long as one is employed on the terms that applied when one accepted the job.

The pre-1969 retirees holding shows what’s already obvious: that one can also acquire a (vested) right to new and more generous terms that one agrees to later. If this is so, then continuing to work (even without an explicit election) means that one accepts any new and more generous terms that may come into effect over time. If the contribution rate had started at 3% at some point and then been reduced to 2%, the public employees would have accepted the more generous regime by performing services under that regime, and the city would then be precluded from raising the rate back to 3%. So Allen and its progeny show that one even has the right to continue to earn pension benefits on terms no worse than the most generous terms in effect at any time during one’s employment.

But consider what isn’t protected. Salaries of public officials aren’t protected by the Contract Clause, even if a salary reduction will have an indirect effect on the amount of one’s pension. Existing statutory cost-of-living increases to salaries can be revoked as to future contractual terms, but existing cost-of-living increases to pensions can’t. Tenure in office isn’t protected either, though of course statutes could provide protections (like civil service laws) beyond what’s constitutionally required. Thus, in Miller v. State (Cal. 1977), the California Supreme Court held that the state could validly reduce the mandatory retirement age from 70 to 67. (This had the effect of limiting an employee’s pension, since he could no longer work and accumulate benefits for the extra three years, but this sort of limitation was lawful: recall that, though pension rights vest on day one, “the right to immediate payment of a full pension may not mature until certain conditions are satisfied.”)

Only the pension rules that apply to employees have a special status. But this seems strange: the conditions of any job include present compensation, future compensation, job security, and all sorts of other dimensions like the difficulty of the workload, the quality of the health plan, the generosity of vacation allowances, or the availability of parking. Employees take their compensation in a combination of all of these components. Why privilege pensions over everything else—holding that, on being hired, one acquires a vested right to the continuation of pension rules, but not a vested right in the future state of anything else?

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First, let’s take a step back and examine why there are fringe benefits at all. It’s reasonable to believe that employees pay for any benefits they receive in the form of lower wages, and not every employee will particularly value every benefit offered. So why don’t employees take everything in cash and buy the benefits themselves? Why don’t employees find their own parking, pay for their own food, buy their own health insurance, invest in their own IRAs?

The most basic reason for employers to provide some benefits is that the benefit can’t be bought elsewhere, firms differ in their cost of providing the benefit, and workers differ in how much they value the benefit. For instance, any job comes with a particular risk of injury; one can’t separate the risk of injury from the job itself; firms might be able to reduce the greatest risks at relatively low cost; and employees might place a relatively high value on that risk reduction. A firm will thus profit by reducing the risk and extracting some of the value of the risk reduction from the employee; equilibrium occurs when the firm’s cost from reducing an additional risk equals an employee’s benefit from that additional risk reduction. To top it off, workers differ in how risk-averse they are, so a sorting process will occur, where the most risk-tolerant workers gravitate to the riskiest jobs and the most risk-averse workers tend to choose the safest jobs. The same goes for fringe benefits like putting high-ranking employees in corner offices, or providing generous vacation allowances.

Sometimes a benefit can be separated from a job—health insurance and pensions are two examples. It still makes sense for an employer to offer the benefit if he can do so more cheaply than the employee can. Individual health insurance plans are more expensive than employer-provided health insurance because of adverse selection. Buying insurance is a signal that one expects to use the insurance, so insurance companies selling individual health plans can count on having to reimburse a lot of medical expenses—and price their premiums accordingly, which leads to high-priced insurance for the sick and widespread non-participation by the healthy. But one doesn’t usually choose one’s workplace primarily for insurance reasons, so an insurer covering a whole workplace can expect a less biased sample of workers—not a random cross-section of society, since the particular workplace will attract a particular type of person, but at least a sample that isn’t as biased toward the sick. Premiums will thus tend to be lower in employer-provided health plans because of the reduced adverse selection problem.

Pensions may also exhibit this effect, at least if they’re defined-benefit rather than defined-contribution pensions. Defined-contribution pensions could be just as well bought on the open market, since they’re essentially just investment accounts that earn whatever they earn. But with defined-benefit pensions, which are more common in the public sector, the financial risk is borne by the pension provider. Here, too, individuals are more likely to buy their own defined-benefit pension (i.e., an annuity) if they expect to live longer, which again leads to high prices for those who expect to live longer and widespread non-participation by those who don’t.

Another major driver of employer-provided benefits is tax preferences. Whatever can be characterized as, say, a “no-additional-cost service” (such as free plane trips for airline employees when seats are available) or a “working condition fringe” (such as office space) or a “qualified transportation fringe” (such as on-site parking) doesn’t count as gross income to the employee; neither do employer contributions to health plans. If the employee had to pay for these benefits himself, some (like parking or air travel) wouldn’t be deductible at all; some (like trade or business expenses) would only be deductible to the extent that total miscellaneous aggregate deductions exceeded 2% of adjusted gross income; and health insurance premiums paid outside of an employer-provided plan would only be deductible to the extent they exceeded 10% of adjusted gross income. Under these circumstances, small wonder that employees and employers choose to structure their compensation to include some employer-provided benefits. The tax advantages magnify the pre-existing advantages to employer provision of health benefits and pensions discussed above.

All these factors lead to some equilibrium mix between salary and other benefits. The California rule, under which pension rules are protected but salary, job tenure, and other benefits aren’t, mean that when the terms of a government job become less generous because of market or fiscal pressures, it’s salaries and other benefits that must take the hit; governments have little ability to adjust pensions for existing employees, since they must offer comparable new advantages to soften the blow. Not all employees would prefer this arrangement; plausibly, some might prefer less of a decrease in salary in exchange for some decrease in the generosity of their future pension earnings. (Surely it depends how poor they are now, and how long they expect to live. Those with shorter life expectancies—men, the less-educated, the poor, minorities, and those in bad health—suffer the most from policies that protect pensions at the expense of current salaries.) While some of this extra pain will fall on public employees, some will fall on taxpayers, and some of the pain of taxpayers may result in trimming various state government services (e.g., police, fire, garbage collection, DMV, schools). The California rule thus makes reductions in government compensation either more painful for employees or more expensive to taxpayers than they would be if pension terms could adjust together with salaries and other benefits.

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This is the static effect of the California rule, but it’s also worthwhile to consider some possible incentive effects of this rule going forward. Even when the terms of a job become more advantageous, governments may hesitate before offering more generous pension rules, since that generosity will become a liability in hard times. Thus, whether the job market becomes better or worse for public employees, the California rule could hinder employers from offering wage/benefit packages that employees prefer. A private employer faced with this regime might just offer stingy pension benefits from the start, since benefits, once granted, are protected from reduction.

But of course we’re not talking about private employers. The California rule applies only to public employees, and it’s known that public-sector compensation packages are more heavily weighted toward pension benefits than are their private-sector counterparts. So the analysis is incomplete unless we bring in the public-choice considerations that make public employers act differently than private employers. The heavy weighting of public employee compensation toward pensions is probably because of a countervailing force: governments, free from the ERISA regulations that govern private employers, find it easier to promise generous pensions and then underfund them, leaving future generations to pick up the bill. Underfunded public employee pensions are thus a form of deficit spending.

If public pension policy is largely driven by an agency problem among public employers, the California rule may have a very different effect than I noted above. Rather than depressing pensions because, once granted, they’re harder to withdraw, the California rule could actually increase pensions. Perhaps the fact that pensions are protected actually makes it easier for governments to credibly promise generous pensions to their employees, knowing that (outside of a cataclysmic event like municipal bankruptcy) later generations won’t be able to undo the terms. The California rule might thus exacerbate the deficit-spending-like bias toward generous pensions that would already exist.

There may be certain theoretic advantages to having a pension-heavy regime, though they run into problems in practice.

  • First, underfunded employer-provided pensions are obviously cheaper than fully funded ones. Public employees would prefer getting these sorts of generous pensions through their workplace than getting a greater cash salary instead and buying a pension on the market, since private pensions would have to be adequately funded. Of course, all this is provided the pensions are ultimately funded through future taxes. Modern-day municipal bankruptcies, though, show that such funding won’t always be forthcoming. Moreover, even if this sort of deficit pension funding is a win-win proposition for public employers and employees, it may no longer be optimal once the larger society (i.e., taxpayers) are added to the mix.
  • Second, this sort of deficit spending may be macroeconomically useful in recessionary times, from a Keynesian perspective. On the other hand, borrowing money from future taxpayers by underfunding current pensions is less transparent than traditional borrowing. And the time when the bills will come due and taxes will have to be raised—once these employees retire—won’t generally be correlated with expansions (which is when Keynesian theory advises that tax hikes are optimal).
  • Third, if, as behavioral economists argue, people don’t save for their retirement as much as they’d like, introducing a bias in favor of more generous pensions may be welfare-improving even if the salary/pension mix is different than the mix that employers and employees would negotiate on their own. Even if this is true, though, providing more generous pension benefits won’t be optimal for all types of workers. The primary losers will be those who value future benefits the least—as noted above, that means those with lower life expectancies, for instance men, the less-educated, the poor, minorities, and those in bad health. The losers will also include those who plan optimally and don’t need the extra nudge.

The inability to adjust pensions for existing employees may also lead to a bias in favor of replacing existing employees with new ones or encouraging existing employees to leave, though that tendency will probably be mitigated by whatever employment protections public employees have by statute or collective bargaining agreement.

In tomorrow’s post, I’ll discuss possible fixes.