I’ve got a blog post on the Reason Foundation‘s web site about the “California rule”, which I blogged about here between February 3 and February 7. You can find the whole blog post here. Here’s an excerpt:
Most states are free to alter public employee pensions, as long as they do so on a purely prospective basis. For instance, a state can reduce cost-of-living adjustments (COLAs), say from 3% to 2%, as long as the amount accrued so far is still subject to the old COLA. But the rule is otherwise in California: California courts have held that “upon acceptance of public employment [one] acquire[s] a vested right to a pension based on the system then in effect.”
In California, when a public employee begins work, he not only acquires a right to the pension accumulated so far—presumably zero on the first day, and increasing as he works longer—but also the right to continue to earn a pension on terms that are at least as generous as the ones then in effect, for as long as he works. And if pension rules become more generous in the future, then those more generous terms are the ones that are protected. Any changes to these rules must be reasonable, meaning that they “must bear some material relation to the theory of a pension system and its successful operation,” and any disadvantages to the employees “should be accompanied by comparable new advantages.” This is the “California rule.”
. . .
How can the rule be fixed? Merely reciting the need to shore up pensions or invoking a “fiscal emergency” doesn’t help: if the fiscal emergency was largely caused by governments’ past unwillingness to fully fund the pension, then the underfunding is the government’s own fault. This is even true when the crisis is created by a tax-limiting voter initiative like Proposition 13. In any event, the California rule would still require compensating the harmed employees with comparable benefits, so the ability to modify pensions seems to be of little help in resolving a fiscal crisis. Here are some possible fixes:
- Shifting toward defined-contribution plans. A defined contribution plan is just an investment account that earns whatever it earns based on contributions. With these plans, the whole issue becomes moot. Defined-contribution plans are also always fully funded, so disguised deficit spending or unsustainable promises become more difficult. But 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.
- A flexible definition of benefits. One possibility would be to expressly reserve flexibility in the statutory definition of pension benefits, for instance by providing that employee contributions would be determined based on ongoing actuarial advice.
- Short-term contracts. Perhaps providing benefits via short-term contracts (rather than by statute) could preserve government flexibility to modify pensions 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 rights to anything beyond the term provided. But this theory may be on shaky ground in the case of pensions; California courts might hold that terms must be preserved not for the length of an individual contract, but for the entire length of government service.
- State constitutional amendment. The California rule could abolish by state constitutional amendment. (Such an amendment has already been proposed and may soon be on the ballot in California.) But this might itself be a law impairing the obligation of contracts, so it might be valid only for future employees.
- Changing state case law. A long-term possibility would be to alter the California rule by appointments to the state supreme court.
- 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.
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.