California Supreme Court Upholds Pension Reform Twice, But the “California Rule” Persists

The Contract Clause of the U.S. Constitution is fairly accommodating to state legislatures that try to alter the obligations of contracts, including the contractually vested rights associated with state and local public employee pension benefits. But states generally have their own constitutional contract clauses—and state supreme courts are the supreme arbiters of what their own constitutions require. Some states go even further and have extra constitutional provisions specifically protecting public employee pensions; but regardless of the precise wording, state supreme courts that are disposed to grant public employee pensions constitutional protection have plenty of ways to do so.

California, for instance, along with some other states, like Arizona and Illinois, has long been known for its strict “California rule,” which provides some of the strongest legal protections for public employee pensions in the nation. Like most other states, California interprets the terms of public employee compensation, as laid out in public employment statutes, as contracts. Then—unlike many other states—it interprets those contracts as though they not only protect the benefits already earned but also guarantee at least as generous terms for the entire duration of one’s employment.

Thus, if an employee started working for the state when the employee pension contribution rate was 5 percent, a hypothetical statute raising that contribution rate to 10 percent several years later would count as an impairment of the state’s contractual obligation. Likewise, if the annual cost-of-living increase for retirees was 5 percent when the employee was hired and a later statute lowered it to 3 percent.

Under the California rule, if a later statute makes the terms of employment more attractive, then that new arrangement becomes the new standard, which is protected against deterioration for the employee’s entire working life with the state (and for the duration of retirement as well). Once such deterioration is shown, California courts have routinely demanded that the state provide compensating advantages to affected employees before upholding the pension reform; a mere fiscal crisis isn’t enough. (There were exceptions, as described in a previous article, but that was the general rule.)

Then, in 2016, a strange thing happened. A California appellate court examined the practice of “pension spiking.”

Public employee pensions are typically based on one’s final compensation—what one earned in the years just before retirement. What if you inflated that final compensation by taking various one-time cash payments, like additional overtime hours, or the cash value of unused leave or of various fringe benefits? That’s referred to as pension “spiking,” a practice long reviled as an abuse of the pension system.

In 2012, the California legislature passed a statute limiting this practice—the Public Employees’ Pension Reform Act (PEPRA), reform legislation championed by former Gov. Jerry Brown. But the Marin Association of Public Employees challenged the statute as a violation of the state’s Contract Clause.

So far, business as usual. The strange thing was that the California appellate court upheld the statute, even though in passing this law the legislature had changed longstanding rules to reduce public employee pensions from what they otherwise would have been, while (at least for some employees) providing little to no compensating advantage.

I wrote at the time that this decision—Marin Ass’n of Public Employees v. Marin County Employees’ Retirement Ass’n—rested on “a strained reading of past California cases” and was “in substantial tension with the California Supreme Court’s doctrine on the Contract Clause and the California Rule. Anything can happen on appeal, but it wouldn’t be surprising to see this decision reversed by the Supreme Court.”

The California Supreme Court granted review in late 2016—and then we waited for a long time, perhaps because another case challenging the same section of the statute, Alameda County Deputy Sheriff’s Ass’n v. Alameda County Employees’ Retirement Ass’n, brought by public employees in Alameda and other counties, was then also making its way through the court system.

In January 2018, the appellate court hearing Alameda County declined to follow the Marin County case (the two cases were from different appellate divisions, so the Alameda court wasn’t bound by the Marin decision) and held that the statute may have violated the constitution (but sent the case back to the trial court for further factual development). The California Supreme Court granted review of Alameda County in March 2018, and then we waited some more.

And then, in 2019, another strange thing happened.

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In March 2019, in an unrelated case, the California Supreme Court decided Cal Fire Local 2881 v. California Public Employees’ Retirement System, and upheld a different section of the same pension reform statute.

That section involved a different practice: the purchase of additional retirement service credit. Consider a state agency employee who retires at age 55, with a final average compensation of $100,000, after working for the state for 30 years. That employee’s pension will be, roughly speaking, $100,000 x 0.02 (pension multiplier) x 30 years of service = $60,000.

The number of years worked is often referred to by pension systems as either “credited service” or “service credit.” Under certain conditions, public employees in California could buy additional service credits, paying the pension system an amount of money to inflate their service credit by an additional 1 to 5 years. In theory, if all of the pension system’s actuarial assumptions are correct, service credit purchases are supposed to be cost-neutral to the state, because the employee’s payment is set to equal the present value of the future benefits. But in practice, experience has deviated significantly from most actuarial assumptions for the California Public Employees’ Retirement System (CalPERS), California State Teachers’ Retirement System (CalSTRS), and many other public pension systems, generating billions in unfunded liabilities and prompting system trustees to make significant adjustments in assumptions, such as CalPERS’ multiyear stepdown in its assumed rate of return on assets to 7.0 percent.

As a result, an employee’s payment toward service credit in the past can often turn out to be less than the present value of future benefits, sometimes far less—especially if the employee’s compensation went up after they bought the additional service credit. Hence, the opportunity to purchase additional service credit could be a lucrative investment for a public employee.

California’s PEPRA statute abolished this practice effective in 2013, even for existing employees. Employees who had already purchased additional service credits could keep what they’d bought, but nobody was going to be buying any more. People who had read a lot of California pension cases and were familiar with the California rule could be forgiven for suspecting that this statute would be struck down: employees who began work with those pension rules would be contractually entitled to a continuation of those rules (or other rules at least as generous), and the government wouldn’t be able to abolish those rules without offering compensating advantages. If this is true for cost-of-living adjustments or employee contribution rates, why not for the right to buy additional service credit? True, the Marin County case had followed a different line of thinking, but that was just one of two conflicting appellate decisions.

But surprisingly, the California Supreme Court (which has three Republican and four Democratic appointees) unanimously upheld this pension rules change. The opinion, written by Chief Justice Tani Cantil-Saukaye (a Gov. Arnold Schwarzenegger appointee), reads very differently than previous California pension opinions.

The first indicator of an unexpected ruling comes in the first title heading of the discussion: “Constitutional protection of the terms and conditions of public employment has historically been the exception, not the rule.” Given that courts in most states now recognize that public employment statutes define implicit contracts that are protected by the Contract Clause—and given the persistence of such strong protections in California—that title heading seems incongruous.

It turns out that this isn’t a sign of some great reversal: the court immediately concedes that some statutes clearly show a legislative intent to create contractual rights and that other contractual rights arise implicitly—in the case of pensions because pensions are a form of deferred compensation. In this case, there’s no clear legislative intent to create contractual rights, so the interesting question will be whether the opportunity to purchase additional service credit is just another type of pension right that’s implicitly protected as a contract because it’s deferred compensation.

And here, the California Supreme Court gets to its important holding: the opportunity to purchase additional service credit is not a form of deferred compensation like ordinary pension benefits. It states:

“Pension benefits, the classic example of deferred compensation, flow directly from a public employee’s service, and their magnitude is roughly proportional to the time of that service. Just as each month of public service earns an employee a month’s cash compensation, it also earns him or her a slightly greater benefit upon retirement. In this way, pension benefits are, literally, earned by an employee’s work.”

This explains the difference between ordinary pension benefits and additional service credit, which isn’t related to the length of service. It’s a benefit that employees can buy, but not a benefit that they could earn through work; in fact, it’s more similar to the opportunity that employees have to buy life and long-term disability insurance or create flexible spending accounts—all valuable benefits of employment, but not ones that are particularly pension-like. (It’s true that they needed to work five years before being able to buy credit, but those five years are an eligibility requirement for pension vesting generally.)

Thus, the opportunity to buy additional service credit wasn’t really a pension-like benefit, even though—this is the surprising bit—it was bundled together with the pension system. Because it was neither compensation nor deferred compensation, there was no cause to imply a contract; and so, the default rule that terms and conditions of public employment are gratuities kicked in.

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After the California Supreme Court’s decision in Cal Fire, it suddenly became more plausible to argue that pension spiking—although employees expected it as part of their pension rules—wasn’t truly pension-like because some aspects of the extra compensation that inflated the final compensation weren’t earned during that period, and because other aspects were just monetary substitutes for various perks of the job that weren’t pension-like.

Some interested parties filed supplemental briefs with the California Supreme Court in Alameda County, arguing that Cal Fire strengthened their argument that abolishing pension spiking was constitutional. The oral argument happened by videoconference in May 2020. Several justices asked questions that were critical of the state’s position. For instance, Justice Godwin Liu asked whether public employees wouldn’t have reasonably believed that pension spiking was legal and that they would be able to exercise that option before they retired.

Then, in July 2020, the California Supreme Court released its opinion. In an opinion again written by Chief Justice Cantil-Saukaye, the court unanimously upheld the statute. After reading the tea leaves in Cal Fire, we shouldn’t call that result strange. But the court didn’t resolve this case, as it had resolved Cal Fire, by holding that the Contract Clause wasn’t even implicated. Instead, it held that the public employees did have a contractual right, but that it was validly abrogated.

The state Supreme Court probably had no choice but to do so: in 1997, in Ventura County Deputy Sheriffs’ Ass’n v. Board of Retirement, it had defined “compensation earnable,” one of the key statutory terms, expansively, holding that it included all cash compensation, including the value of in-kind benefits. Given this background, it seems difficult to say that pension spiking (like purchasing additional service credit in Cal Fire) isn’t really part of compensation—and everyone agrees that actual compensation is really entitled to constitutional protection as a contractual right. So a full Contract Clause analysis seems inescapable here.

After disposing of various non-constitutional issues, the California Supreme Court addressed the part concerning the Contract Clause. First, the court recognized that several subsections of the statute modified the pension system by excluding various aspects of compensation that would have been allowable under Ventura County. Second, the court noted that the statute wasn’t automatically constitutional merely because it applies prospectively. In the first place, the California rule has long ignored the prospective-retrospective distinction; and in the second place, pension spiking is necessarily something that happens just before retirement but is anticipated by employees from the start of their career, so what would it even mean to apply the rule “prospectively” in this context (unless that just means the rule is limited to new hires)?

Now the question arises: does this violate the California rule?

Here, the state Supreme Court says no. Under the California rule, first, we need “to determine whether the modification imposes disadvantages on affected employees”: clearly it does. Next, we need to determine “whether the disadvantages are accompanied by comparable new advantages”: clearly, they are not. Then we get to the two interesting steps of the analysis. We need to decide “whether the legislative body’s purpose in making the changes was sufficient, for constitutional purposes, to justify an impairment of pension rights.” And if so, we need to decide whether it’s acceptable, in light of these legitimate purposes, to proceed without providing comparable advantages to the affected employees.

Let’s focus on these last two prongs of the analysis.

First, was the legislature’s purpose constitutionally permissible? Not every purpose will do. Over half a century ago, the California Supreme Court wrote that “modifications of pension plans are permissible only if they relate to the operation of the plan and are intended to improve its functioning or adjust to changing conditions,” and “alterations of employees’ pension rights must bear some material relation to the theory of a pension system and its successful operation.”

General fiscal problems usually aren’t sufficient; in fact, since the California rule was formulated, most pension modifications have been held to be improperly motivated. But in this case, the court found that the motivation was acceptable. The basic theory built into the California public employee pension system is that pensions are based on your final compensation, which is based on the average daily compensation of employees who are like you—and not based on how long you personally worked. So taking the cash value of your own overtime or your own unused leave, or taking various “one-time or ad hoc payments”—which is the essence of pension spiking—would count as a distortion of the true measure of compensation, incompatible with the general theory of the pension system. Those payments are “not paid in return for the delivery of services but for another purpose entirely—to boost the employee’s post-employment pension benefits. This is clear pension abuse . . . .”

So here, the exclusions of various payments from final compensation “unquestionably bear a material relation to the theory of a pension system and its successful operation.”

And now, the final prong of the analysis: was the legislature constitutionally required to offset these disadvantages with comparable advantages?

The classic rule is that disadvantages should be accompanied by comparable advantages; and while “should” is less mandatory than “must,” it still means that as a default, it really ought to be done. This seems to be an issue of first impression—previous pension cases haven’t even gotten that far, since various challenged pension reforms have usually either chosen to give comparable advantages or failed at a previous step of the analysis. Here, the court says that the legislature should “offset any financial disadvantages unless to do so would undermine, or would otherwise be inconsistent with, the constitutionally permissible purpose underlying the modification.” And, in this case, that provision is satisfied. Because the legislature was closing loopholes and preventing abuse, whatever advantages the pension spikers were getting were illegitimate advantages that shouldn’t have existed in the first place. The legislature should always be able to close loopholes and prevent abuse without having to compensate those who were counting on exploiting the loopholes and abusing the system.

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Put it all together and what do you get? Is the California rule dead? Not at all; in fact, both Cal Fire and Alameda County strongly reasserted the California rule.

These two cases don’t overrule any major California rule decisions. If a legislature seeks to curtail pension benefits (e.g., by lowering the multiplier used to calculate pension benefits or cutting cost of living increases) merely because there’s a fiscal crisis or because it believes that a past legislature made promises that, in retrospect, seem too generous, that will still be held an illegitimate motivation, and so the reform will be struck down unless it provides comparable advantages. That both cases were decided unanimously, by the state Supreme Court with a majority of Democratic appointees, should probably tip us off that no radical change was intended.

But these two cases from 2019 and 2020 do provide some welcome clarity around the edges of the California rule.

Cal Fire tells us that not every statutory benefit of public employment is a contractual benefit that is protected by the Contract Clause. Only actual compensation and deferred compensation (in the form of pensions) are implicitly protected by the Contract Clause. And, importantly, even if a benefit looks like it’s bound up with the pension system (like additional service credits), we still have to see whether the benefit is sufficiently pension-like.

This focus on what’s “pension-like” is also a theme of Alameda County: even if a benefit is bound up with the pension system and enjoys constitutional protection as a contractual benefit (like pension spiking), it can still be abolished without compensation if, taking into account the proper operation of a pension system, the benefit can be characterized as abusive.

Those seem to be limited reformist holdings that legislators and judicial appointees of both parties can get behind.