State And Local Government Pensions: In What Circumstances Can Governments Reduce Pension Benefits?

Some states and localities allow no reductions in pensions after an employee's date of hire, and others permit complete flexibility. In between are the majority of jurisdictions, which allow pension reductions in limited circumstances. The rules allowing reductions continue to be tested and to produce new precedent. In the "laboratory" of federalism, state and local cases and rules like those described here are the "experiments" that, over time and through study and comparison, should evolve to increase the fairness and predictability of laws governing public pension plan reductions. The legal protections for pension benefits of public sector employees and private sector employees have one common denominator: complexity. The source and the effect of the complexity are different for pubic sector pensions, however. While private sector pension laws regulate cut-backs in pension plan benefits in great detail, public sector pension protections are less detailed and, in many states and localities, less predictable in application. A state or local government's ability to reduce pensions may be more restricted or less restricted than in the private sector. This article provides an overview of issues relevant to determining under what circumstances, and to what extent, a state or local government pension benefit formula may be reduced. Given the complexity and importance of this topic for the pension plan participants, for the sponsoring governments, and for taxpayers, the relevant law will continue to be tested and to evolve. It is hoped that this article may serve as a starting point for further detailed analysis in any specific situation, and as a guide to the types of issues that deserve careful examination when a state or local government adopts or attempts to change the terms of a pension plan it sponsors for its employees.

Why There Is a Lack of Uniformity in Governmental Pension Protections

The legal protections and constraints that apply to pension plans of state and local governments are not as uniform as those that apply to private sector pensions, for several reasons. First, the pension provisions of the Internal Revenue Code (IRC) have only limited applicability to governmental pensions. In particular, the anti-cutback rules of IRC Section 411(d)(6) are inapplicable, and the only vesting requirements under federal law are the limited rules that were in effect under the IRC before September 1, 1974. The Employee Retirement Income Security Act of 1974 (ERISA) does not apply, and the Pension Benefit Guaranty Corporation (PBGC) has no jurisdiction over governmental pensions. A primary source of national law for state and local pensions is the contract clause of the US Constitution, which provides that "[n]o state shall enter into any...Law impairing the Obligation of Contracts."1 The case law demonstrates, however, that application of the contract clause of the US Constitution to state and local pension obligations varies greatly. To further complicate and differentiate the laws relevant to different jurisdictions, state constitutions include varying protections for public pensions. A majority of state constitutions include contract clauses similar to the US Constitution, and eight state constitutions have provisions that address pension protections participants in state and local pension plans. In addition, several state constitutions address other aspects of governmental pension security, such as funding of the pension system, protection of the pension assets, and management of the pension system. (For a helpful comparison of state constitutional provisions, see NEA Issue Brief on Pension Protections in State Constitutions, June 2004.) As a result of all of these varying laws, state and local pension plan participants do not all enjoy the same level of protection from benefit reductions. The remainder of this article examines the primary factors that determine the outcome of a legal claim that a state or local pension benefit may not be reduced.

When Does a Public Pension Benefit Become a "Vested" Right?

To comply with the vesting requirements of IRC Section 411, a governmental pension plan must fully vest benefits upon a participant's attainment of normal retirement age and upon a partial or complete termination of the plan, but in either case only to the extent the plan has sufficient assets to fund benefits.2 These requirements provide significantly weaker vesting protection to governmental pension plan participants than the rules applicable to private sector pension plans. Unlike private sector plans, the IRC does not require governmental pension plans to meet minimum funding standards or to vest an employee's benefit after a specified number of years of service. To fill this gap in applicable tax laws, state and local pension plan participants must look to other legal sources. State-Level Developments BENEFITS LAW JOURNAL 67 VOL. 20, NO. 4, WINTER 2007 State laws provide for vesting at varying times in a pension plan participant's career, from full vesting in the future application of a benefit formula to no vesting.

The Strictest Approach: Contract Rights Guarantee Future Application of Benefit Formula in Effect upon Hire or First Contribution to the Plan

Under a minority of state constitutions, statutes, and court rulings, an employee's right to a pension benefit formula vests upon hire, and the vested right includes the ability to accrue pension benefits into the future according to the pension formula in effect when the employee first becomes a member of the retirement system. The state constitutions of Alaska, Illinois, New York, and Arizona have been interpreted to require this result.3 In New Hampshire, the pension formula becomes a protected right when the individual becomes a permanent state employee.4 Georgia cases give employees a vested right to continue under the pension formula in effect when the employee commences contributions to the pension plan and performs services covered by the pension plan.5

The right to future accrual of a pension, for a lifetime of employment, is the most generous pension vesting right possible for employees and the most daunting fiscal commitment for pension plan sponsors. When vesting is interpreted to guarantee an unchanged benefit formula from the start of covered employment through retirement, a legislature's decision to establish or improve a public pension plan creates a liability that may extend 60 or more years into the future. The financial consequences of such benefits may last far beyond the period for which approving legislative body can be held accountable, and beyond the time to which actuarial projections reliably extend. Under these laws, a pension formula may be reduced only for employees hired after the reduction is adopted.

A Second Approach: Contract Rights Permit Reasonable Modifications to Pensions Before Retirement or Before Satisfaction of Benefit Eligibility Requirements

The California Rule: No Changes to Pension Contract Permitted After Retirement

Court decisions in California and several other states have allowed some flexibility in the pension "contract." California courts have allowed changes to pension benefits for those who have not retired, subject to the requirement that "such modification must be reasonable." To be "reasonable," according to California courts, the pension changes "must bear some material relation to the theory State-Level Developments BENEFITS LAW JOURNAL 68 VOL. 20, NO. 4, WINTER 2007 of a pension system and its successful operation," and changes "which result in a disadvantage to employees should be accompanied by comparable new advantages" to "the particular employee whose own vested pension rights are involved."6 Comparing the California rule to...