More Changes Are Being Made to State and Local Pensions Than You Think

A recent press story highlighted proposed pension cuts in San Diego and San Jose, California as pioneering efforts to rein in pension costs (New York Times 6-6-12).  These cuts were deemed newsworthy because they reduced future benefits for current participants, an action which at the beginning of the financial crisis was thought to have been impossible under most state laws.  In fact, the San Diego and San Jose actions are consistent with developments in a number of other states where sponsors have recognized that they need the freedom to adjust future benefits to solve their pension funding problems.  

How benefit promises have actually played out in the public sector in the wake of the financial crisis is an interesting story.  On the one hand, public plan participants were thought to have a higher degree of protection than their private sector counter­parts.  Whereas the Employee Retirement Income Security Act (ERISA) protects private sector benefits earned to date, it does not prohibit changes in future benefits for current workers.  In contrast, in many states the constitution prescribes or the courts have ruled that the public employer is prohibited from modifying the plan.  This prohibition means that employees hired under a public retirement plan have the right to earn benefits as long as their employment continues.  Thus if the employer wants to reduce the future accruals of ben­efits, such a change usually applies only to new hires.

On the other hand, in the wake of the financial crisis, in many instances the “pension wealth” of both current employees and retirees has been reduced.  The most direct way this reduction has occurred for current workers is through increases in required employee contributions.  Such increases were possible because, while constitutions and state laws preclude benefit changes, they usually place no restrictions on how much the state can ask the employee to pay.  Thus the employee continues to accrue the expected benefit, but the net contribution from the employer has been reduced.

The diminution of employer-provided benefits has not been limited to active workers.  In some states, retirees have seen the reduction or suspension of their cost-of-living-adjustments (COLAs).  In four states – Colorado, Minnesota, New Jersey, and South Dakota – the suspension has been challenged in court and the court upheld the change.  The judges tend to argue that the COLA is separate from the core promised benefits, that retirees knew that the COLA was subject to change, and that the COLA suspension was necessary to prevent the long-term fiscal deterioration of the pension plan.  In three states – Maine, Rhode Island, and Washington – suspensions have been put in place, and challenges are in court.

If one perceives the COLA as an integral part of the benefit, then the suspension would violate the ERISA provisions, which protect all benefits earned to date.  Of course, almost no private sector defined benefit plans have COLAs, so a direct comparison is not possible.

Finally, both New Jersey and Rhode Island have cut benefits across the board for current employees.  These cuts are currently being challenged in court.

The key point is that plan sponsors need to be able to cut future benefits for current employees.  State constitutions and case law make this difficult.  Nevertheless, a number of states have ploughed ahead and made changes, hoping the courts will uphold them based on the fiscal necessity to control benefit costs.  So more reining in of benefits is going on than observers generally perceive.