How Flexible Is the California Rule? A Tale of Four Cases


How Flexible Is the California Rule? A Tale of Four Cases

California appellate court upholds statute limiting pension spiking, but it may be reversed on appeal

California is notorious for having a constitutional doctrine that is highly protective—some would say overprotective—of public-employee pensions. The “California Rule,” which has spread to several other states (see this May 2016 post), has stood as an obstacle to public-employee pension reform for over half a century. (See my July 2014 policy study on the California rule.)

Seeking at least some relief from rising pension costs, the California Legislature passed a statute in 2013 limiting the practice of “pension spiking,” by which government bodies allow public employees to artificially inflate their ending compensation in order to increase those employees’ pensions. And this statute was recently upheld in an August 2016 ruling by a California appellate court in Marin Ass’n of Public Employees v. Marin County Employees’ Retirement Ass’n. If the California Supreme Court upholds this decision, it could ease the state’s pension woes to a certain extent. But the Court of Appeal’s reasoning is questionable and rests on a strained reading of past California cases. It wouldn’t be surprising if the Supreme Court eventually reversed this decision.

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To understand the Marin County case, it helps to know the background of the California Rule and a few related cases.

The California Rule was created in 1955 in Allen v. City of Long Beach, and is based on the Contract Clauses of both the federal and California constitutions. The Contract Clauses limit the government’s ability to impair the obligations of contracts—and public-employee pensions are considered contractual in California. The government may modify the contract in reasonable ways—but, as the California Supreme Court held in Allen v. City of Long Beach: “To be sustained as reasonable, alterations of employees’ pension rights must bear some material relation to the theory of a pension system and its successful operation, and changes in a pension plan which result in disadvantage to employees should be accompanied by comparable new advantages.”

The distinctive feature of the California Rule, though, is what the Court said was part of the contract: not just the entitlement to the pension accumulated based on work done so far, but also the entitlement to keep accumulating a pension in the future according to the rules already in place. Thus, the Court in Allen v. City of Long Beach struck down a Long Beach city charter amendment raising employee retirement contribution amounts, even though these changes were purely prospective.

While the California Rule has often been applied very strictly to bar prospective changes to pension rules, it hasn’t been totally inflexible. To see this, consider Lyon v. Flournoy, decided by a California appellate court in 1969.

Lyon concerned the state legislators’ retirement system. Charles W. Lyon was a state assemblyman (who served as Assembly Speaker from 1943 to 1946) and state senator. (Among other achievements, he defeated science fiction writer Robert Heinlein in 1938.) His political career ended in 1954 (when he was convicted on bribery-related charges), and he started collecting his pension in 1955. He died in 1960 and his widow kept collecting surviving-spouse payments.

When the Legislators’ Retirement Law was passed in 1947, the rule was what I’ll call “dynamic indexing”: the pension would be based on the salary of legislators in effect at the time the pension was paid, not any salary that the retiree earned while he was working. The idea was that sitting legislators’ salaries would surely increase over time, which would provide enough assurance to retired legislators that their pensions would keep pace with inflation.

In 1947, the legislature was part-time and legislators’ salaries were constitutionally fixed at $1,200 per year; salaries were increased by constitutional amendment to $3,600 in 1949 and $6,000 in 1955, but after that, the voters rejected several proposed salary-increasing amendments over the next decade.

Since the legislature couldn’t increase pensions by increasing legislative salaries, it instead helped retirees by establishing cost-of-living allowances (COLAs) in 1963.

In 1966, the voters ratified a comprehensive constitutional amendment which, among other things, made the legislature full-time and increased legislative salaries to $16,000 a year. But the constitutional amendment also provided that previous retirees’ pensions would continue to be calculated based on the old $6,000 legislative salary rather than keeping pace with the new, increased salaries.

Lyon’s widow (arguing for herself and other widows and surviving retired legislators) argued that legislative pensions should continue to be calculated based on current legislative salaries—that is, based on the massively increased salaries starting at $16,000. The appellate court disagreed, even though it accepted the contention that “changes detrimental to the individual must be offset by comparable new advantages.” Here, the court said, even though the fluctuation provision of indexing pensions to salaries of current officeholders was eliminated, another fluctuation provision was put in its place: COLAs. So “one fluctuation device has been substituted for another.”

But wait a minute: Surely, in light of the massive increase in sitting legislators’ salaries, the switch to COLAs can be called “detrimental” to the retiree. How, then, can the switch to COLAs be characterized as a comparable new advantage? The court’s answer was that, in the perspective of 1963—when voters had repeatedly rebuffed legislative salary increases at the polls—the dynamic-indexing provision was, as a realistic matter, “dormant.” The 1963 COLA provision was thus a significant improvement; and the 1966 constitutional revision freezing the reference salary for previous retirees at $6,000 merely ratified the dormancy.

The Lyon court’s reasoning was a triumph of functionalism over formalism: As a practical matter, following the original current-salary indexing would give retirees a windfall unrelated to their expectations, unnecessary to maintain their standard of living (which was already guaranteed by COLAs), and out of proportion to their previous retirement contributions.

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So Lyon suggests the California Rule might not be totally inflexible—though it was only an appellate decision. In 1978, the California Supreme Court decided Betts v. Board of Administration, which some took as casting doubt on Lyon. The petitioner was Bert A. Betts, who had been state Treasurer from 1959 to 1967. While in office, he had participated in the Legislators’ Retirement Fund, which—as in Lyon’s case—implemented dynamic indexing. In 1974, after Betts left office but before he retired and applied for benefits, the legislature changed the fluctuating formula to a fixed formula based on the retiree’s own highest salary. The California Supreme Court repeated the old rule that “changes in a pension plan which result in disadvantages to employees should be accompanied by comparable new advantages,” noted that the change from fluctuating to fixed was a disadvantage, and invalidated the change.

But what about the 1963 COLAs—the same as the ones described in Lyon? Didn’t those provide an offsetting advantage? No: Betts continued to work for a few years after 1963, during which time he was entitled to both sources of fluctuation. He was entitled to dynamic indexing, and he was also entitled to COLAs. Was this too generous? Perhaps, but that was actually California law from 1963 until Betts left office in 1967, so it technically was what the state intended. The 1974 elimination of dynamic indexing was thus unambiguously a detriment to Betts, and one not accompanied by comparable new advantages.

The Supreme Court recognized that Lyon had come out the other way, but didn’t repudiate that appellate decision’s reasoning: rather, the Betts Court stressed that Lyon’s situation was “an unusual fact situation which was historically unique,” based on the voters’ longtime refusal to raise legislative salaries. The Lyon court’s concern with avoiding the unjustified windfall that would have resulted if Lyon had benefited from the unexpected post-1966 massive increase in legislative salaries just didn’t apply here. (Moreover, Betts benefited from the simultaneous presence of both fluctuations while in office, whereas Lyon’s situation was distinguishable because the gradual replacement of one (dormant at the time) fluctuation with another (actual) fluctuation all happened after Lyon retired.)

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On the one hand, Betts seemed to take a stricter view than Lyon, so one might think Lyon might no longer be good law. On the other hand, Betts took care to distinguish Lyon rather than questioning its reasoning, so maybe Lyon was still good law after all. The latter seems like the better view, and indeed the California Supreme Court explicitly ratified the Lyon reasoning in 1983, in Allen v. Board of Administration. (Don’t confuse 1983’s Allen v. Board with 1955’s Allen v. City of Long Beach!)

Don A. Allen was a legislator who served during the crucial 1963–65 terms and retired before 1967—while both dynamic indexing and COLAs were in effect, but before legislative salaries were massively increased and decoupled from previous retirees’ pensions.

The Supreme Court quoted the familiar language that disadvantages “must be accompanied by comparable new advantages,” but nonetheless held that Allen wasn’t entitled to a pension based on the new, increased legislative salaries. As Lyon explained, and as Betts continued to recognize, the legislative case was unique. While dynamic indexing was technically the law, that system “was not operating as originally designed,” and “the prospective advantage” of this provision “remained theoretical” and “dormant” because of voters’ refusal to increase salaries. The introduction of COLAs fulfilled the true objective of the indexing provision, which was to maintain purchasing power; adhering to the technicalities would merely result in an unjustified “windfall” consistent with neither their expectations nor their modest retirement contributions. (And this was true even though Allen and his co-litigants, unlike Lyon, had retired after the introduction of COLAs.)

The decision in Betts, the Allen v. Board Court explained, didn’t change anything: Betts was entitled to his double benefit of dynamic indexing and COLAs because (unlike the pre-1967 retired legislators) he had in fact worked under that system for a few years. And, more generally, there were no factors in Betts “militating against the reasonableness of that expectation such as were present in Lyon and are present here.” In other words, the strict Betts rule continues to be the case, but when exceptional factors are present, as in Lyon and Allen v. Board, the Court is willing to look past form to substance.

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All of which gets us to the Court of Appeal’s recent decision in Marin Ass’n of Public Employees. This case was about “pension spiking” among Marin County employees—a practice that “has long drawn public ire and legislative chagrin,” by which an employee’s compensation is increased (or various non-salary items are included in final compensation figures) immediately before retirement, in order to inflate pension amounts that are tied to final compensation.

In 2013, California enacted the Public Employees’ Pension Reform Act, whose declared purpose was to “exclude from the definition of compensation earnable any compensation determined by the [county retirement] board to have been paid to enhance a member’s retirement benefit.” The newly excluded items included one-time, atypical payments, as well as various cash payments in lieu of fringe benefits. Marin County, which had severe pension difficulties, was one of the first counties to implement the Act.

After dealing with various nonconstitutional issues, the court came to the Contract Clause argument. First, the court wrote: “There is no absolute requirement that elimination or reduction of an anticipated retirement benefit ‘must’ be counterbalanced by a ‘comparable new benefit.'” This argument proceeded in several steps. First, the court focused on the word “must.” Consult the “comparable new benefit” language in the cases discussed so far, and you’ll see that Allen v. City of Long Beach and Betts say “should,” while the appellate court in Lyon and the Supreme Court in Allen v. Board say “must.” Legal usage often distinguishes between the mandatory “must” and the hortatory “should,” and the court concluded that, since “should” is the Supreme Court’s preferred expression, it’s unlikely that the use of “must” in Allen v. Board signaled a fundamental change in doctrine. Moreover, the Court in Allen v. Board actually upheld the pension reform.

This is true, as far as it goes: there is no inflexible requirement of comparable new advantages. But it should be clear from the foregoing discussion of Lyon and Allen v. Board that the result there was based on a highly unusual historical circumstance, which isn’t present here. The Marin County employees actually spent time working under a system in which pension spiking was allowed—not just allowed, but common, and well-known (as the court itself conceded, in describing the practice as a widespread and much-reviled abuse). The plaintiffs argued that employees expect to be able to spike; that the increased pension payments resulting from pension spiking are taken into account actuarially in employees’ retirement contributions; and that the prospect of spiking induces employees to accept lower salaries than they otherwise would. Whether or not all these claims are fully accurate, it’s certainly not true that the increased pension payments resulting from spiking are unexpected.

The court went on to hold that in any event, there is a new benefit provided by the Pension Reform Act. Because the Act reduces pension payments, it also reduces employees’ retirement contributions every pay period: “Put simply, the new benefit is an increase in the employee’s net monthly compensation. Put even more simply, it is more cash in hand every month.”

Perhaps: but an employee who is now close to retirement would only benefit from having more cash in hand every month for a short period, and that benefit would be far from commensurate with the reduced pension benefit.

Aside from these arguments, the court focused on the fact that the change was moderate and reasonable, that it was prospective only, and that it was made necessary by the state’s pension crisis. But moderate and reasonable changes have been struck down in previous cases. At pp. 29–30 of its opinion, the court cites half a dozen cases to support the proposition that “reductions in promised benefits,” “changes in the number of years service required,” and “a reasonable increase in the employee’s contributions” can count as “acceptable changes.” But every one of these cases is plainly distinguishable. In some of the cases, comparable advantages were actually present; in some of the cases, the pension reduction was merely derivative of a change in the retirement age, and California courts have never held that there’s a constitutional right to length of tenure; in one of the cases, upward or downward flexibility was built into the employee contributions by the requirement that contributions would be “computed on the basis of actuarial advice”; and one of the cases was from 1938, before the California Rule was invented!

As to the fact that the change was prospective, Allen v. City of Long Beach itself struck down a purely prospective change. Moreover, previous cases have refused to make exceptions on the basis of a fiscal emergency, since the fiscal emergency is the government’s own fault (“a contract may not be impaired because of a crisis created by the state’s voluntary conduct,” a couple of cases have said); and the emergency can be remedied without reducing current employees’ expected pensions, for instance by increasing taxes.

The Court of Appeal’s decision in Marin Ass’n of Public Employees, then, is 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.

Alexander “Sasha” Volokh is an associate professor of law at Emory Law School. An archive of his previous articles is available here.

Leonard Gilroy is Senior Managing Director of the Pension Integrity Project at Reason Foundation, a nonprofit think tank advancing free minds and free markets. The Pension Integrity Project assists policymakers and other stakeholders in designing, analyzing and implementing public sector pension reforms.