Pension Reforms Have Their Day In Court

Many U.S. states and cities have approved measures to help fix poorly funded public pensions. Now courts will decide if they are legal or not.

Most efforts would affect the benefits of new hires. But some changes -- such as one approved in San Jose, California, this month -- would apply to plans of current government workers.

Public-sector unions are suing to block them, arguing that it is illegal to change the pension benefits for current workers. There is no nice, simple rule that governs such changes. Legal protections for public pensions are developed under each state’s laws and vary significantly.

In some states, such as Illinois and New York, a specific constitutional provision protects public-employee pensions from reduction. In other states, such as Ohio, courts have held that the government is free to change the benefits at any time before retirement.

California has played an important role in the development of law on public pensions. Historically, both federal and state courts considered pension benefits provided to government employees to be mere “gratuities” that could be amended or withdrawn at any time. In the early 20th century, however, several state courts began to characterize public pensions not as gifts, but as a form of deferred compensation. Just as employees are entitled to a salary promised by an employer for work they have performed, so too are they entitled to the pension benefits they have earned.

Contractual Benefits

California courts went well beyond this level of protection. Under what has come to be known as the California rule, pension benefits are treated as contractual in nature, and can’t be reduced once an employee has begun working for the state. Not only are earned benefits protected, but employees also have a collateral right to earn future pension benefits at an undiminished rate for as long as they remain employed.

Given this high level of protection, it wasn’t surprising that representatives of city workers filed suit challenging the changes almost immediately after the initiative in San Jose passed. The case will almost surely proceed to the California Supreme Court. Under the California rule, the changes indeed appear to be legally impermissible.

But the state’s courts owe it to the residents of California to revisit their prior decisions regarding public-pension benefits. Courts typically don’t part from longstanding precedent, but there is good reason for them to do so here.

Generally speaking, when legislatures or city councils adopt statutes or ordinances, these laws aren’t considered to have created contracts. Instead, legislative enactments are considered to be current policy positions that can be amended by future legislatures. The U.S. Supreme Court has held that for a statute to create a contract, the legislature’s intent to form such a contract must be unmistakable. After all, if a court were to bind a future legislature without having a clear indication of the legislature’s intent to bind itself, significant separation-of-powers issues are raised.

Nevertheless, in developing their rule on public-pension benefits, California courts have never even tried to justify their position based on the legislature’s intent to create a contract. Although a contract can be implied from the offer and from acceptance of employment with certain pension benefits, such a contract would cover only benefits that had already been earned for service performed. The implied contract would protect pension benefits to be earned in the future only if there was evidence of such a promise on the part of the state. But California courts have found a legal right to future pension accruals without ever providing evidence supporting the creation of that right.

Unmistakable Intent

San Jose’s city charter provides that “Subject to other provisions of this article, the Council may at any time, or from time to time, amend or otherwise change any retirement plan or plans or adopt or establish a new or different plan or plans for all or any officers or employees.” If the first step in a legal analysis is to determine whether a statute or ordinance creates a contract, and we are looking for unmistakable intent, there is a good argument here that the city didn’t intend to create a contract or make a promise on which employees could reasonably rely.

Even if the court doesn’t find the charter language to authorize the change, San Jose (or any other municipality or state) has the authority to make pension changes under its sovereign power if such change is reasonable and necessary to serve an important public purpose.

This looks like a simple test on its face. It is in fact quite hard for a government to meet, because the government must establish that the change was the “least drastic” way to achieve its policy goal.

The trade-offs are difficult. Is it less drastic to fire some city workers, or to reduce future pension accruals? Is it less drastic to raise taxes than it is to cut the pension benefits?

There are no clear-cut rules. It comes down to the court’s judgment. That is why predicting the outcomes of these cases is difficult.

California courts once led the country in moving away from the absurd gratuity approach to public pensions. My hope is that the state’s courts will once again prove to be leaders in this area of law, and take this opportunity to fix the flaws in the California rule by announcing a clear, legally supported standard. This isn’t an argument for simply approving the changes in San Jose. It is a plea for the California courts to return to first principles and establish the legal basis, if any, for creating a right to future pension benefits.

(Amy Monahan is an associate professor of law at the University of Minnesota. The opinions expressed are her own.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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