The Constitutional Protection of Public-Employee Pensions

In a previous post, I discussed how public employee pensions are protected by the Contract Clause of the federal constitution (“No State shall . . . pass any . . . Law impairing the Obligation of Contracts.”) and similar clauses in state constitutions. I noted that California-and a handful of other states following California’s example-had its own special Contract Clause doctrine. This post discusses the California rule in greater detail, because this rule is both influential and a bad idea. For even more detail, see my paper on the subject.

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Most states are free to alter public employee pensions, as long as they do so on a purely prospective basis. For instance, a state can reduce cost-of-living adjustments (COLAs), say from 3% to 2%, as long as the amount accrued so far is still subject to the old COLA. But the rule is otherwise in California: California courts have held that “upon acceptance of public employment [one] acquire[s] a vested right to a pension based on the system then in effect.”

In California, when a public employee begins work, he not only acquires a right to the pension accumulated so far-presumably zero on the first day, and increasing as he works longer-but also the right to continue to earn a pension on terms that are at least as generous as the ones then in effect, for as long as he works. And if pension rules become more generous in the future, then those more generous terms are the ones that are protected. Any changes to these rules must be reasonable, meaning that they “must bear some material relation to the theory of a pension system and its successful operation,” and any disadvantages to the employees “should be accompanied by comparable new advantages.” This is the “California rule.”

The California rule was created in 1955, when the California Supreme Court considered a challenge to a 1951 city charter amendment in Allen v. City of Long Beach. The amendment raised the amount of employees’ retirement contributions from 2% to 10%. It changed the pension from a fluctuating amount (based on the salary attached to the retiree’s previous position at the moment pension payments are made) to a fixed amount (based on the retiree’s salary around the time of his retirement). And it required extra contributions from employees who had returned from military service.

The Court held that the amendment unconstitutionally impaired the contract rights of the employees who were adversely affected, even though the changes were purely prospective. In doing so, it stated a test that would be often repeated in public employee pension cases:

An employee’s vested contractual pension rights may be modified prior to retirement for the purpose of keeping a pension system flexible to permit adjustments in accord with changing conditions and at the same time maintain the integrity of the system. Such modifications must be reasonable . . . . 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.

In Allen itself, there were no comparable new advantages, nor was there any evidence that the changes were related to the integrity of the pension system.

The same logic applies to other prospective changes, like cost-of-living adjustments to pension benefits to be earned from future service. In Pasadena Police Officers Ass’n v. City of Pasadena (1983), the California Court of Appeal considered a challenge to a 1981 charter amendment placing a 2% cap on the rate of increase of police and firefighters’ cost of living allowance. An unlimited COLA had been introduced for all retirees (past and future) in 1969; employees who had retired since 1969 were exempted from the 1981 cap, but those who had retired before 1969 weren’t. Active employees could choose an option that, in essence, amounted to making the cap prospective only.

As to active employees, the court had little trouble finding, based on Allen, that the cap was unconstitutional because it reduced the pension that would be earned under the previous rules-both what had already been earned and what would be earned later-and was not accompanied by any comparable new advantages.

As to the pre-1969 retirees, it’s true that they worked their entire career with no expectation of a COLA, which was only introduced in 1969. “Thus, they had no vested contractual right, based on the contract in effect during their employment, to continuation of the COLA benefit.” But the retirees formed a new contract with the state in 1969 when they elected to switch to pensions with COLAs; and the 1981 amendments impaired this new contract.

And what goes for increases in contribution rates and limitations in cost-of-living adjustments naturally goes just as well for the outright elimination of the pension system. In Legislature v. Eu (1991), the California Supreme Court considered a challenge to Proposition 140, “The Political Reform Act of 1990,” a California constitutional amendment adopted by initiative. The amendment, among other things, ended the accrual of pension or retirement benefits for any state legislators serving after its effective date. There was no problem as to new legislators taking office after the amendment. But as to incumbent legislators, the pension restrictions were unconstitutional: there were no “comparable new advantages,” since the pension system was entirely terminated.

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Does it make sense to protect the rate of future pension accrual as a contract? If there were an explicit contractual term regarding pensions, the question would be easy; but usually there’s nothing but a statute defining pension rules.

The basic idea that a pension statute creates a contract with employees is sound: pensions are deferred compensation, and government employees take their jobs in reliance on the full compensation package, from current salary to fringe benefits to pensions. But what’s covered by this contract? Certainly whatever has been earned so far should be protected; this includes past salary and benefits, including whatever part of the pension has already been accrued. As to the more extensive rights protected by the California rule-the “collateral right to earn future pension benefits through continued service, on terms substantially equivalent to those offered” when one was hired-it seems that this, too, should be protected in California now. Given that it’s been the law since 1955, public employees have sensibly relied on the rule in accepting employment. So it’s reasonable to consider that the future rate of pension accrual has implicitly become part of public employees’ contracts.

Nonetheless, the California rule isn’t sensible. Consider what isn’t protected. Salaries aren’t constitutionally protected, even if a salary reduction will have an indirect effect on the amount of one’s pension. Cost-of-living increases to salaries can be revoked for the future, but cost-of-living increases to pensions can’t. Tenure in office isn’t constitutionally protected either, though states can adopt civil service laws if they like. Only pension rules have a special status. But it seems strange to privilege pensions over everything else in this way.

When pensions are given special protection that’s unavailable for other job characteristics, the mix of wages and pensions is distorted relative to what it would otherwise be (given collective bargaining, tax policy, employee time and risk preferences, and other factors). If market or fiscal pressures mean government compensation must become less generous, it’s salaries and other benefits that must take the hit, even if some employees would prefer to take some of the blow in terms of decreased pension benefits. Those with shorter life expectancies-men, the less-educated, the poor, minorities, and those in bad health-suffer the most from policies that protect pensions at the expense of current salaries. Some of the pain will also fall on taxpayers, and some of that pain may result in trimming state government services (e.g., police, fire, garbage collection, DMV, schools). The California rule thus makes reductions in government compensation either more painful for employees or more expensive to taxpayers than they would be if pension terms could adjust together with salaries and other benefits.

Also, consider some possible incentive effects of the California rule. Even without the California rule, public employers offer more generous pension benefits than the private sector, perhaps because underfunded public employee pensions are a form of deficit spending. The California rule might exacerbate these tendencies, since it allows public employers to more credibly commit to having generous pensions paid by future generations.

The inability to adjust pensions for existing employees may also lead to a bias in favor of replacing existing employees with new ones or encouraging existing employees to leave.

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How can the rule be fixed? Merely reciting the need to shore up pensions or invoking a “fiscal emergency” doesn’t help: if the fiscal emergency was largely caused by governments’ past unwillingness to fully fund the pension, then the underfunding is the government’s own fault. This is even true when the crisis is created by a tax-limiting voter initiative like Proposition 13. In any event, the California rule would still require compensating the harmed employees with comparable benefits, so the ability to modify pensions seems to be of little help in resolving a fiscal crisis. Here are some possible fixes:

• Shifting toward defined-contribution plans. A defined contribution plan is just an investment account that earns whatever it earns based on contributions. With these plans, the whole issue becomes moot. Defined-contribution plans are also always fully funded, so disguised deficit spending or unsustainable promises become more difficult. But since defined-contribution plans are riskier for the employee than defined-benefit plans, the employer may have to pay for the shift to defined-contribution plans through higher wages or more generous benefits.
• A flexible definition of benefits. One possibility would be to expressly reserve flexibility in the statutory definition of pension benefits, for instance by providing that employee contributions would be determined based on ongoing actuarial advice.
• Short-term contracts. Perhaps providing benefits via short-term contracts (rather than by statute) could preserve government flexibility to modify pensions prospectively. If pension terms are enshrined in memoranda of understanding-perhaps the result of collective bargaining with public-employee unions-that expire at a certain time, it seems hard to argue that the employees have acquired any vested rights to anything beyond the term provided. But this theory may be on shaky ground in the case of pensions; California courts might hold that terms must be preserved not for the length of an individual contract, but for the entire length of government service.
• State constitutional amendment. The California rule could abolish by state constitutional amendment. (Such an amendment has already been proposed and may soon be on the ballot in California.) But this might itself be a law impairing the obligation of contracts, so it might be valid only for future employees.
• Changing state case law. A long-term possibility would be to alter the California rule by appointments to the state supreme court.
• Privatization. Another possibility-which alleviates the problem but doesn’t solve it structurally-is to pursue privatization and outsourcing. Firing state employees is constitutional, and providing pensions and retirement plans for the contractors’ employees will be left to the private employers. Those private pensions, if offered, will have to be ERISA-compliant, which alleviates problems of underfunding; and in any event, the state won’t be on the hook for anything beyond the current contract price.

These are all possibilities for treating pension benefits just like other aspects of compensation: as something earned over time and not guaranteed for the future. In addition to being more rational as a public-employee compensation policy, abandoning the California rule would also give governmental units in California, and wherever else the rule has been adopted, flexibility to deal with changing circumstances.

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