California Court Ruling Allows Pension Changes

On August 17, 2016 the First Appellate District Court ruled on the lawsuit brought by the Marin Association of Public Employees against the Marin County Employees’ Retirement Association (MCERA) and State of California. The case was brought after MCERA eliminated pay items considered pensionable following the States enactment of the California Public Employees’ Pension Reform Act of 2013.

The Act mostly just enacted lower benefit formulas for employees hired after 2013. For existing employees, the Act did little of substance other than attempting to eliminate pension spiking, which is the practice of increasing an employee’s retirement allowance by increasing final compensation and including various non-salary items such as unused vacation pay, pay for uniform allowances, pay for equipment or vehicle use, and adding service credit for unused sick time, vacation time or leave time.

The Marin County Employees Association sued claiming they were entitled to those benefits because they were a “vested right” based on the legal theory that once a pension benefit is enhanced it can never be taken away, something commonly referred to as the “California Rule”.

The California Rule has been used for years to prevent the state, cities and counties from modifying pension formulas for existing employees.

The conclusion of the Appellate Court was that the only constitutional protection provided to employees was for a “reasonable” pension and that until the employee retires, their pension benefits are subject to change to keep the plan flexible and that this flexibility is necessary to permit adjustments in accord with changing conditions and at the same time maintain the integrity of the system and carry out its beneficent policy.

BACKGROUND

Each county plan is administered by a retirement board, which is required to determine whether items of remuneration paid to employees qualify as ‘compensation’ and therefore must be included as part of a retiring employee’s ‘final compensation’ for purposes of calculating the amount of a pension.

In the aftermath of the severe economic downturn of 2008–2009, public attention across the nation began to focus on the alarming state of unfunded public pension liabilities. Pension funds for state and local government workers throughout the country are underfunded by approximately a trillion dollars according to their actuaries and by as much as $3 trillion or more if more conservative investment assumptions are used. The Federal government also has $3.5 trillion in unfunded pension liabilities.

The Growing Pension Crisis

The Court in their ruling stated the depth of the pension crisis in California quoting the results of the  Stanford Institute for Economic Policy Research which calculated the total unfunded liability for all pension systems in California.

The Institute determined the California Public Employees’ Retirement System, the California State Teachers’ Retirement System, and the University of California Retirement System, and County systems throughout California had $281 billion in unfunded liabilities assuming a 7.5% rate of investment return. This amounts to $22,000 worth of unfunded liabilities per California household. They also calculated the liability using the same rate of return CalPERS uses if an agency wants to leave their system, which is a 3.7% rate of investment return. This increased the total unfunded liability to $946 billion or $75,000 per household.

It is also important to note that as staggering and unaffordable as these numbers are they do not include the past 2 years of lower than assumed investment earnings. In addition, this debt is interest bearing because it is money that is not in the system earning investment returns. And since there is no money available to pay down the debt (if required to be paid right away it would bankrupt most municipalities) it will be paid back over the next 20 to 30 years at 7.5% interest which will double or triple the actual cost to taxpayers and move hundreds of billions of dollars from taxpayer services to pension costs.

The Little Hoover Commission Report Cited

The court in their ruling also cited the 2011 Little Hoover Commission report which advised the Governor and the Legislature that California’s pension plans are dangerously underfunded, the result of overly generous benefit promises, wishful thinking and an unwillingness to plan prudently and stated unless aggressive reforms are implemented now, the problem will get far worse, forcing counties and cities to severely reduce services and lay off employees to meet pension obligations.

The Commission urged a number of structural changes that realign pension costs and expectations of employees, employers and taxpayers.  The situation was described as “dire,” “unmanageable,” a “crisis” that “will take a generation to untangle,” and “a harsh reality” that could no longer be ignored.

According to the Commission the money coming into the pension funds is nowhere near enough to keep up with the money that will need to go out and stated that the state must “exercise its authority—and establish the legal authority—to reset overly generous and unsustainable pension formulas for both current and future workers.”

To provide immediate savings of the scope needed the Commission stated “state and local governments must have the flexibility to alter future, unearned retirement benefits for current workers.”

One feature of the system that drew the Commission’s critical attention was “pension spiking,” which the Commission defined as the practice of increasing an employee’s retirement allowance by increasing final compensation or including various non-salary items (such as unused vacation pay) in the final compensation figure used in the employee’s retirement benefit calculations, and which has not been considered in prefunding of the benefits. The commission found the practice had become “widespread throughout local government,” and had generated “public outrage that cannot continue to be ignored and pensions must be based only on actual base salary, not padded with other pay for clothing, equipment or vehicle use, or enhanced by adding service credit for unused sick time vacation time or other leave time.

THE LAWSUIT

Reaction to MCERA’s change in policy was almost immediate.  On January 18, 2013, less than three weeks after the Pension Reform Act took effect, five recognized employee organizations and four individuals commenced a legal action against their retirement association MCERA.  Plaintiffs alleged that on December 18, 2012: The MCERA board voted to implement AB 197 effective January 1, 2013 and announced a new policy for the calculation of retirement benefits.

Under the new policy, MCERA would begin excluding standby pay, administrative response pay, callback pay, cash payments for waiving health insurance, and other pay items from the calculation of members’ final compensation for all compensation earned after January 1, 2013.

Plaintiffs prayed for declaratory and injunctive relief that AB 197 and MCERA’s “actions are unconstitutional impairments of vested rights and therefore unenforceable.”

The State of California was granted leave to intervene, as expressly directed by the governor, in order that it could defend the constitutionality of AB 197.

THE PLANTIFFS ARGUEMENTS

The crux of this appeal is whether MCERA may eliminate benefits previously treated as compensation earnable from the calculation of the pension formula for what plaintiff’s term “legacy members”—employees who were hired prior to January 1, 2013.

The second ground for reversal advanced by plaintiffs is that MCERA did not follow the correct procedural requirements of AB 197 for excluding payments made to ‘enhance a member’s retirement benefit.

The court ruled that Section 31542 of the County Employee Retirement Law (CERL) is clearly intended to serve as the mechanism for calculating the pension of an employee about to retire and there is nothing to indicate the statute was intended to govern the situation here—a shift in policy by the retirement board in compliance with a new command from the Legislature, clearly intended to be applied in the future to plaintiffs’ so-called employees when they put in for retirement.

Plaintiffs’ essential position is clearly set out in their opening brief: Public employees earn a vested right to their pension benefits immediately upon acceptance of employment and such benefits cannot be reduced without a comparable advantage being provided.

A corollary of this approach was the employee’s argument that they are entitled to any increase in benefits conferred during their employment, beyond the pension benefit in place when they began and since they are performing work under the improved pension system, the terms of that system become an integral part of their compensation, and therefore immediately become vested in the improved benefit.

Plaintiffs candidly admitted in practice, this means that for existing employees, any changes must generally be neutral with regard to the overall benefit provided and cannot represent a net decrease in the pension benefit.  Less ambiguously, they assert neither MCERA nor the Legislature can now curtail those benefits.

Plaintiffs insist that if their position was not vindicated on this appeal, California will have returned to the view that public employee pensions are mere ‘gratuities’ to be granted or taken away at the whim of the employer.

But the Appellate Court provided a review of principles governing public employee pensions that showed that much of plaintiffs’ reasoning is not controversial, but their ultimate conclusion cannot be sustained. 

 THE APPELLATE COURTS RESPONSE

Some General Law of Pensions States are prohibited by the United States Constitution from passing a law “impairing the obligation of contracts.”  (U.S. Const., art. I, § 10.)  Article I, section 9 of the California Constitution states a parallel proscription: “A law impairing the obligation of contracts may not be passed.”   Public employment gives rise to certain obligations which are protected by the contract clause of the Constitution, including the right to the payment of salary which has been earned. The court ruled that “Earned” in this context obviously means in exchange for services ALREADY performed. In accordance with this view, a pension is treated as a form of deferred salary that the employee earns prior to it being paid following retirement.

The court concluded that an employee does NOT earn the right to a full pension until he has completed the prescribed period of service and although vested prior to the time when the obligation to pay matures, pension rights are not immutable.  For example, the government entity providing the pension may make reasonable modifications and changes in the pension system.  This flexibility is necessary to permit adjustments in accord with changing conditions and at the same time maintain the integrity of the system and carry out its beneficent policy.

REVIEW OF PREVIOUS SUPREME COURT RULINGS

The Supreme Court stated in the Kern v City of Long Beach case (supra, 29 Cal.2d 848, 854.) “the rule permitting modification of pensions is a necessary one since pension systems must be kept flexible to permit adjustments in accord with changing conditions and at the same time maintain the integrity of the system and carry out its beneficent policy.” Thus the Appellate Court ruled it appears that an employee may acquire a vested contractual right to a pension, but that this right is not rigidly fixed by the specific terms of the legislation in effect during any particular period in which he serves.  The statutory language is subject to the implied qualification that the governing body may make modifications and changes in the system and that the employee does not have a right to any fixed or definite benefits, but only to a ‘substantial’ or ‘reasonable’ pension.  There is no inconsistency therefore in holding that he has a vested right to a pension, but that the amount, terms and conditions of the benefits may be altered.”

The Appellate Court also cited Casserly v. City of Oakland (1936) 6 Cal.2d 64 as one of the authorities for the proposition that “it has also been held that a pension could be reduced prior to retirement from two-thirds to one-half of the employee’s salary, and modifications have been approved in some cases when made after the happening of the contingencies upon which the payments were to commence.”

The “Must” versus “Should” Debate

With respect to active employees in the Allen v Board of Administration case the Supreme Court held that any modification of vested pension rights must be reasonable, must bear a material relation to the theory and successful operation of a pension system, and, when resulting in disadvantage to employees, must be accompanied by comparable new advantages.

However, the First District Appellate Court stated they did not believe the word “must” was intended to be given the literal and inflexible meaning attributed to it by plaintiffs.   The Supreme Court in the 1983 Allen opinion cited three decisions as support for the quoted proposition.  The two Supreme Court decisions cited employed the word “should” be accompanied by comparable new advantages; Abbott v. City of Los Angeles, supra 50 Cal.2d 438, 449. It is only a 1969 Court of Appeal decision, which cites the same two Supreme Court decisions that use “must.”

The Appellate Court stated “only the least authoritative of the three sources cited supports the word ‘must,’ while the two Supreme Court decisions employ ‘should.’  Second, barely a month later, the Supreme Court—speaking though the same justice—filed another decision which used the ‘should’ formulation from the 1955 Allen decision as quoted in Abbott.”

The Court went on to say “there is nothing in the opinion linking the reduction to provision of some new compensating benefit.  If the court intended ‘must’ to have a literal meaning, the retirees would have won.  They lost.  In light of the foregoing, the Appellate Court could not conclude that Allen v. Board of Administration in 1983 was meant to introduce an inflexible hardening of the traditional formula for public employee pension modification.”

A New Benefit WAS Provided

The court also determined there was a new benefit provided because MCERA’s change in policy resulted in each of those employees’ paychecks no longer being reduced by deductions to cover those sums in funding the employee’s retirement.  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.

APPELLATE COURT’S CLARIFICATION OF THE “CONTRACTS CLAUSE” OR “CALIFORNIA RULE”

Plaintiffs’ initial premise, and the centerpiece of their oral argument, is that the moment each individual plaintiff commenced working for a public agency in Marin County, that person acceded to a “vested right” to a pension.  To a large extent, that premise is correct.  As already established by Miller, the “right” to a pension “vests” when the first portion of wages or salary already earned is deferred by being withheld for a future pension.  But to call a pension right “vested” is to state a truism.  As one Court of Appeal sensibly noted, “ALL pension rights are vested” in the sense they cannot be destroyed. However, until retirement, an employee’s entitlement to a pension is subject to change short of actual destruction. 

That same Court of Appeal characterized that entitlement as only “a limited vested right” and not every change in a retirement law constitutes an impairment of the obligations of contracts.  Nor does every impairment run afoul of the contract clause.  The United States Supreme Court has observed, although the Contract Clause appears literally to proscribe any impairment, the prohibition is not an absolute one and is not to be read with literal exactness like a mathematical formula.  Thus, a finding that there has been a technical impairment is merely a preliminary step in resolving the more difficult question, whether that impairment is permitted under the Constitution.

Courts Must Determine What is a Reasonable Change

Modifications to pension benefits the court stated must be reasonable, and it is for the courts to determine upon the facts of each case what constitutes a permissible change.  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.

Past court rulings have found that “Reasonable” modifications for future benefits eared can encompass reductions in promised benefits.  These include:

  1. A change of retirement age
  2. A reduction of maximum possible pension
  3. The repeal of cost of living adjustments
  4. A reduction of the pension cap
  5. Changes in the number of years of service required to qualify for a pension
  6. A reasonable increase in the employee’s contributions
  7. A reasonable change in what is considered pensionable compensation

The Court’s ruling stated “thus, short of actual abolition, a radical reduction of benefits, or a fiscally justifiable increase in employee contributions is allowed before the pension becomes payable and that until that time the employee does not have a right to any fixed or definite benefits but only to a substantial or reasonable pension.”

THE COURT’S CONCLUSIONS

The Appellate Court stated that it is without dispute that (1) up to January 1, 2013, there was a contract between MCERA and certain public employees concerning how those employees would be compensated, and (2) that after January 1, 2013, under compulsion of the Pension Reform Act, the agreement was unilaterally altered by MCERA to reduce the scope of compensation that had been accounted as “compensation earnable.”  The issue here is whether the amendment of section 31461—of CERL, the only part of AB 197 challenged by plaintiffs and addressed here—qualifies as an “unreasonable” change, a “substantial” impairment, and thus a violation of the state and federal constitutions. We conclude the dual answer is NO:  MCERA’s implementation of the amended version of section 31461 does not qualify as a substantial impairment of plaintiffs’ contracts of employment with its right to a “reasonable” and “substantial” pension.  Thus there is no violation of the state and federal constitutions.

The Ventura Decision and Changing Pensionable Compensation Post PEPRA

The Supreme Court’s Ventura Decision in 1997 added items to what was considered pensionable pay for counties makes clear that before the Pension Reform Act that compensation paid in cash and which was not overtime was required to be included as compensation earnable.  And while it is true that the retirement boards have some discretion to interpret and apply CERL—this discretion is limited by the contours of the statute and the constitution, including the Contracts Clause.

However, the Appellate Court stated that the “Supreme Court’s discussion of compensation earnable in Ventura County would appear to have little, if any, relevance to the scope and meaning of the subsequently amended language of section 31461 we are considering here.  The utility of Ventura County is also weakened because none of the words ‘constitution,’ ‘contract,’ or ‘impair’ were used in the opinion, so it is no authority for an unchanging constitutional dimension to a statute as substantially amended as was section 31461.  The permanence plaintiffs attribute to MCERA’s exercise of discretion in allowing certain payments to be included in compensation earnable is troubling because it seems to deny MCERA the discretion to change that decision.”

They also stated that “Plaintiffs’ insistence on retaining their claimed ‘vested rights’ measured by the former version of section 31461 and Ventura County has hindered their appreciation of how that right is only to a ‘reasonable’ pension, that the public employee does not have a right to any fixed or definite benefits that may be fixed by the specific terms of the legislation during any particular period.”

“The qualification is a necessary one since pension systems must be kept flexible to permit adjustments in accord with changing conditions and at the same time maintain the integrity of the system. Restricting their unyielding focus to only their “vested rights” has led plaintiffs to pay insufficient attention to the ever-present possibility of legislative involvement, one of the essential attributes of sovereign power that is always to be consulted.”

The Appellate Court thus ruled that an employee does not have a right to any fixed or definite benefits, which can mean that any one or more of the various benefits may be wholly eliminated prior to the time they become payable, so long as the employee retains the right to a substantial pension. 

They went on to say that “plaintiffs have failed to make out a clear case, free from all reasonable ambiguity and reasonable doubt, that they are the victims of a constitutional violation. Put another way, after January 1, 2013, payment of any of the items specified in section 31461, subdivision (b), could not be deemed salary already earned pursuant to a contract that enjoyed constitutional protection.” 

Pension Changes Must Be Prospective

The Appellate Court emphasized the limited nature of their holding stating “the Legislature’s change to the definition of compensation earnable was expressly made purely prospective by the Pension Reform Act and MCERA’s responsive implementation was also explicitly made prospective only and nothing altered the status of compensation or payments accrued prior to January 1, 2013.”

THE BOTTOM LINE

The Appellate Court ruled that as long as they are prospective and reasonable and do not destroy the pension system, the pension changes that can be considered and implemented by governmental agencies may include:

Increasing the minimum retirement age,

Increasing the number of years of service required to qualify for a pension,

Reducing the pension cap as a percentage of salary,

Eliminating retiree cost of living adjustments (COLA),

increasing employee contributions,

Lowering the maximum pension dollar amount; and

Changing what is considered pensionable pay.

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About the author:  Ken Churchill is the author of numerous studies on the pension crisis in California and is also the Director of New Sonoma, a pension reform group.

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