How Will State Courts Rule on Pension Reforms? Pension Law Map Gives Guidance

The New Jersey Supreme Court recently upheld payment reductions to the state’s pension fund. A month before, the Illinois Supreme Court rejected the state’s pension reform efforts. Both states have among the worst pension funding levels in the country, and Illinois is sinking faster than New Jersey. So what explains the different court rulings?

The answer in part is the states offer their public pensions different levels of protection. This interactive map at Governing.com identifies the legal basis of pension protections in each state. State pension law limits the realm of reform options. Legislators are largely unfettered when it comes to making changes for future workers. However, pension reforms directed at current employees and retirees face substantial barriers.

In states that view public pensions as contracts, adjusting pensions for current workers and retirees is an uphill battle. The United States Constitution forbids states from making laws impairing contractual obligations, and many state constitutions have a similar prohibition. This makes altering pension benefits for current employees tough, though not impossible.

Determining whether modifications to contractually protected pensions are constitutional requires a three step inquiry:

1. Is there a contractual relationship?
2. Has the contractual relationship been substantially impaired?
3. Was the change reasonable and necessary to serve an important public purpose?

The third inquiry is only needed if the first two inquiries are answered in the affirmative.

The answer to each question varies by state. Some states have held a contract is formed during the first day on the job while others have held a contract is formed only after the employee starts collecting retirement benefits. Concerning the second and third inquiries, pension law scholar Amy B. Monahan asserts, “[I]t is relatively easy to establish impairment of [a pension] contract, while it is quite difficult to establish that the impairment is reasonable and necessary to achieve an important public purpose. As a result, a contractual approach to public pension protection often significantly limits a state’s pension reform options.”

Turning to the New Jersey and Illinois cases, both states protect pensions under contract theory. The 2011 New Jersey pension law contained language declaring pension fund members have a “contractual right” to pension funding from the state, and the state’s failure to provide funding “shall be deemed an impairment of the contractual right.” However, the New Jersey Supreme Court held the law could not create a contractual right to pension payments because the state constitution’s debt limitation clause requires voter approval of large, long-term financial obligations. The pension law exceeded the debt limitation clause’s boundaries but was not voter approved. Therefore, no contract was formed meaning New Jersey is not required to make the pension fund payments as the law originally required.

The Wall Street Journal claims the court ruling may give reformers leverage in future negotiations under the premise that the state would fund pensions on the condition that benefits are reduced. It seems equally likely that reform efforts could be hindered by the decision. The decision reduces the state’s credibility, and pension negotiations require tremendous bipartisan political goodwill that may be in short supply following the court ruling. This much is certain: New Jersey’s long-term financial troubles will be exacerbated by the state’s failure to properly fund its pensions.

On the other hand, the Illinois Constitution states public pensions are contracts. Hence, the Illinois Supreme Court had no difficulty finding a contractual relationship existed, so employees who commence work for the state can never have their benefits reduced, even in dire financial circumstances. The court held, “[A]ccepting the State’s position that reducing retirement benefits is justified by economic circumstances would require that we allow the legislature to do the very thing the pension protection clause was designed to prevent it from doing.”

Illinois pension benefits can only be reduced through a constitutional amendment, and Illinois Governor Bruce Rauner has proposed seeking an amendment that would make pension reforms viable. Without reform, Illinois will be forced to slash services or raise taxes to pay for pension benefits.

States that treat pensions as a property interest have a better chance at reforming pensions. Private property rights are secured by the United States Constitution and state constitutions. Property rights apply to what one already has, not prospective gains. Thus, states can modify future benefits but not previously accrued benefits.

Although litigation is likely to accompany a benefit change, the state has a much lower burden to meet under the property interest view of pensions than the contract view. Altering future benefits under the property approach requires:

1. No individual be deprived of a fundamental right.
2. The state not act in a manner so “arbitrary and outrageous” that the conduct “shocks the conscience.”

Connecticut is a state that considers pensions a property interest. A federal court in the state ruled that vested firefighters were not exempt from negotiated benefit changes, including a benefit accrual reduction from 2.5 percent to 2 percent. The court held the firefighters “do not have a fundamental right to their vested pension benefits… .” Additionally, the benefit change was not “arbitrary, outrageous, or conscious-shocking” because the modification was reached through negotiation.

Texas and Indiana treat state pensions as gratuities, and the gratuity approach would seem to provide pensions protection more like a property interest than a contract. Minnesota affords public pensions protection under the doctrine of promissory estoppel meaning although public pensions are not themselves contracts, public pensions are enforced as contracts.

Regardless of how a state classifies its pensions, retired workers will almost certainly be exempt from benefit changes. If the pension is considered a contract, service during employment fulfilled the employee’s end of the contract. This obligates the state to honor its end of the bargain. Similarly, retirees have already earned their benefits under the property interest approach. States have the ability to change retiree benefits with their “police powers,” but the change would have to pass a very high level of legal scrutiny.

Accordingly, states that treat pensions as a property interest have a better chance at bringing pension benefits to a sustainable level than states where pensions are considered contracts. Pension reformers in states that protect pensions as contracts should attempt to reclassify public pensions as a property interest, or at the very least, reduce the contractual protections to earned benefits only. Amending a state constitution is a colossal political effort and will require support from all segments of society. Nevertheless, pension fund solvency is an issue that affects all of a state’s residents. Citizens of New Jersey and Illinois may be forced to take this drastic action to rein in their states’ pension debts.