San Jose, California. (Photo credit: Wikipedia)
By Ronald Rotunda
If something is too good to be true, it probably is. That old saw applies to the generous pension that states and cities routinely promise. Federal law protects pensions from private companies by requiring that they be actuarially sound: the retirement plan must collect and retain sufficient funds to pay future obligations. If private companies ran their pensions the way most states do, their officers would risk civil and criminal penalties for fraud.
Nationally, state plans covering public employees of cities, police, etc. are underfunded by $1.4 trillion, or 14 followed by 11 zeros. To correct that underfunding, you have to take the entire gross domestic product of Norway, add it to Belgium, and throw in Austria, and give all that to the states.
Raising taxes will not work because there is just too much money to raise. Moreover, many residents wonder why they have to pay high taxes to fund state pensions that are much more generous than they could ever receive. Some states replace nearly 90% of an employee’s annual salary, with yearly increases greater than the cost of living. Some employees can retire at full pension at age 55 or earlier, and they contribute far less than a private employee’s must pay.
When states try to reform their system they meet legal hurdles. First, is the state pension a contractually binding “contract” that the state cannot “impair” without violating the Constitution? Not all pensions confer vested rights. The Supreme Court has held, for example, that Social Security offers only a hope backed by a statute that Congress can change retroactively. Politicians talk about a “lock box,” and the solemn “promise,” but the Court says no.
Many state courts conclude that pensions of public employees are contracts and that the state cannot impair them, retroactively. Some state courts hold that a state can change pension rights prospectively. For example, in 2013 the Florida Supreme Court reversed the lower courts and held that it was constitutional for the legislature to require a 3% employee contribution as of a certain date and eliminate cost-of-living adjustments for services performed after that date. These were prospective changes.
That’s common sense. Any private employer can offer you a new contract, with a different salary going forward. A pension is simply a deferred salary. However, some courts do not allow the state to reduce pensions, even prospectively. It should be no surprise that California is in this camp, leading a dozen other states.
These state courts hold that state retirement statutes create contracts as of the first day of employment, so that the state cannot reduce pension benefits (or increase workers’ contributions) for any of its current employees, even if the changes are entirely prospective. Future salaries can change, either up or down, but pensions are different: on the day the employee starts work, his pension is a guaranteed property right. The only way the state can modify its plan (say by requiring the employees to pay 4% instead of 2%), is to limit these changes to new employees hired after the change. That makes reform as difficult as kissing a porcupine.
If you worked a year, and the state says, “instead of paying you the agreed-upon rate of $75,000, we will pay you $100,000 retroactively,” the state is giving you a gift. However, in 1999, California Gov. Gray Davis raised retirement benefits retroactively and the state courts decided that those retroactive increases are constitutionally protected contracts, even though the California Constitution specifically prohibits retroactive increases in compensation for work already done. One of the lawyers for a union successfully defending retroactive pensions argued before the state court that the court should remember, “It’s your pensions, it’s our pensions.” This lawyer (a former state judge) later told a reporter, “If you haven't got the facts or the law, you pound the table.” Reform is impossible when judges rule that the state constitution protects retroactive increases in pensions.
There is another alternative – cities and other state subdivisions can go bankrupt. Bankruptcy judges can change (or impair) contracts. They do it all the time. They can give a haircut to the bondholders; pension holders (whether they are looking forward to retirement 20 years hence or are enjoying retirement now) are simply unsecured bondholders.
In San Jose, California’s third largest city, the people approved by a 70% majority a plan that the Democratic Mayor drafted to reduce pension benefit by requiring existing workers to increase their pension contribution. Another California city, San Bernardino has responded to the pension burden by seeking bankruptcy protection. Its biggest creditor is the California pension fund. Critics claim that using bankruptcy to solve the problem is like using a blunderbuss or meat axe rather than a sniper’s rifle or a scalpel. However, state courts like California give the cities no other choice.
Mr. Rotunda is the Doy & Dee Henley Chair and Distinguished Professor of Jurisprudence, Chapman University, Fowler School of Law.
