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The Financial Context of the Imminent California Supreme Court Decision on the “California Rule”

Any day now, the California Supreme Court will rule on what may be one of the most significant cases affecting pension reform in California history. The case, CalFire Local 2881 vs. CalPERS, challenges one of the provisions of PEPRA (Public Employee Pension Reform Act) Governor Brown’s 2013 pension reform legislation. The plaintiffs argue that PEPRA’s abolition of purchases of “air-time,” where employees who are about to retire can make a payment in exchange for more years of service applied to their pensions, is illegal. They cite the “California Rule,” an interpretation of California contract law that requires any reduction in pension benefits to be offset by providing some new benefit of equal value.

The stakes couldn’t be higher. Even though pension benefit formulas have been changed for new employees, and are now somewhat more financially sustainable, the California Rule prevents any significant pension reform for existing employees, even for work not yet performed. Changing pension benefit formulas for new employees, while helpful, are not enough. If the California Supreme Court overturns the California Rule, it will not affect the pension benefits that existing employees have earned to-date, but will allow changes going forward. For example, if a public employee has worked 15 years, and earns 3 percent per year towards their pension, if they retired tomorrow their pension would be 15 (years) times 3 percent = 45 percent times their final salary. This would not change. But if they worked another 15 years, and their pension benefit was reduced going forward, they might only earn 2 percent per year for the second half of their career.

The impact of such a change would be dramatic, since less than 20 percent of California’s public sector workforce was hired after the PEPRA reforms took effect for new employees. Reforming the rate of pension benefit accrual for future work for 80 percent of California’s workforce would have a decisive impact on the financial sustainability of the pension systems.

There are many possible ways to further reform California’s public employee pensions, and they cannot come too soon. California’s public sector employers will contribute an estimated $31 billion to the pension systems this year. Extrapolating from officially announced pension rate hikes from CalPERS, California’s largest pension system, by 2024 those payments are projected to increase to $59 billion. According to the State Controller’s office, the unfunded liability for California’s state and local public employee pension systems totaled over $250 billion in 2016. That number could be grossly understated, because one of the biggest variables affecting the amount by which a pension system is unfunded is how much a pension fund’s invested assets will earn. If pension fund earnings don’t meet projections, annual contributions have to rise to make up the difference.

Pension systems have made well publicized reductions to the amount they claim they will earn, touting these reductions as proof of their commitment to cautious, prudent management of their funds. But as reported recently by Andrew Biggs, writing for Forbes, these pension funds have quietly lowered their inflation assumption at the same time, meaning they are still claiming their investments will achieve nearly the same real rate of return. As anyone saving for retirement – or funding a pension – knows without any doubt, the real rate of return is all that matters.

California’s pension systems currently rely on a real rates of return, i.e., the nominal return less the rate of inflation, of approximately 4.5 percent. They have not substantially altered that target, despite the hoopla surrounding the reduction they made in their nominal rate of return projections. The aggressive increases the pension systems are requiring to the contribution rate are a reflection more of their crackdown on the terms of the “catch up” payments employers must make to reduce the unfunded liability than on a genuine reduction to their expected real rate of return. But can pension systems continue to earn real rates of return in excess of 4 percent per year?

For over ten years, pension systems have been the beneficiaries of the longest sustained bull market in U.S. stocks in history. From its nadir in 7,063 in February 2009, to its high of 26,743 in September 2018, the Dow Jones Industrial Average more than tripled. The compounded annual increase was 15.9 percent, while at the same time the rate of inflation averaged 1.8 percent. But trough to peak is a misleading trend. The last peak for the Dow was September 2007, when it had risen to 13,895. This more appropriate peak to peak evaluation has the Dow increasing by 90 percent over 11 years, for an annual average rate of return of 6.1 percent; adjusted for inflation, the return was 4.3 percent. Since September 2018, of course, the Dow has given up 11 percent, and who knows where it’s headed.

Because the Dow Jones Industrial Average generates returns that are nearly always in synch with the other major indexes, these results matter. In the coming years, will inflation adjusted returns on equity investments remain around 4 percent? More important, why is it that after the longest bull run in stock market history, California’s pension systems are underfunded by several hundred billion dollars? Healthy, well managed pension systems should be overfunded at a time like this.

This is the context in which California’s Supreme Court Justices will make a huge decision. The boom in investment returns could well be over, with the pension funds now facing several years of doldrums. The PEPRA reforms weren’t enough to restore financial sustainability in an economic downturn. The required pension contribution rates are already set to double, and California’s cities and counties are unlikely to all be able to handle the stress of pouring additional billions into pension systems. During the last era of pension fund surpluses, pension benefits were increased retroactively. It seems hardly unfair that contract law might also permit them to be reduced, but only from now on.

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Will the California Supreme Court Reform the “California Rule?” – Latest Update

Most pension experts believe that without additional reform, pension payments are destined to put an unsustainable burden on California’s state and local governments. Even if pension fund investments meet their performance objectives over the next several years, California’s major pension funds have already announced that payments required from participating agencies are going to roughly double in the next six years. This is a best-case scenario, and it is already more than many cities and counties are going to be able to afford.

California’s first major statewide attempt to reform pensions was the PEPRA (Public Employee Pension Reform Act) legislation, which took effect on January 1st, 2013. This legislation reduced pension benefit formulas and increased required employee contributions, but for the most part only affected employees hired after January 1st, 2013.

The reason PEPRA didn’t significantly affect current employees was due to the so-called “California Rule,” a legal argument that interprets state and federal constitutional law to, in effect, prohibit changes to pension benefits for employees already working. The legal precedent for what is now called the California Rule was set in 1955, when the California Supreme Court ruled on a challenge to a 1951 city charter amendment in Allen v. City of of Long Beach. The operative language in that ruling was the following: “changes in a pension plan which result in disadvantage to employees should be accompanied by comparable new advantages.

To learn more about the origin of the California Rule, how it has set a legal precedent not only in California but in dozens of other states, two authoritative sources are “Overprotecting Public Employee Pensions: The Contract Clause and the California Rule,” written by Alexander Volokh in 2014 for the Reason Foundation, and “Statutes as Contracts? The ‘California Rule’ and Its Impact on Public Pension Reform,” written by Amy B. Monahan, a professor at the University of Minnesota Law School, published in the Iowa Law Review in 2012.

Pension benefits, most simply stated, are based on a formula: Years worked times a “multiplier,” times final salary. Thus for each year a public employee works, the eventual pension they will earn upon retirement gets bigger. Starting back in 1999, California’s public sector employee unions successfully negotiated to increase their multiplier, which greatly increased the value of their pensions. In the case of the California Highway Patrol, for example, the multiplier went from 2% to 3%. But in nearly all cases, these increases to the multiplier didn’t simply apply to years of employment going forward. Instead, they were applied retroactively. For example, in a typical hypothetical case, an employee who had been employed for 29 years and was to retire one year hence would not get a pension equivalent to [ 29 x 2% + 1 x 3% ] x final salary. Instead, now they would get a pension equivalent to 30 x 3% x final salary.

Needless to say this significantly changed the size of the future pension liability. For years the impact of this change was smoothed over using creative accounting. But now it has come back to haunt California’s cities and counties.

Amazingly, the California rule doesn’t just prevent retroactive reductions to the pension benefit formula. Reducing formulas retroactively might seem to be reasonable, since formulas were increased retroactively. But the California rule, as it is interpreted by attorneys representing public employee unions, also prevents reductions to pension benefit accruals from now on. And on that question, in the case CalFire vs CalPERS, the California Supreme Court has an opportunity this year to make history.

Ironically, the active cases currently pending at the California Supreme Court were initiated by the unions themselves. In particular, they have challenged the PEPRA reform that prohibits what is known as “pension spiking,” where at the end of a public employee’s career they take steps to increase their pension. Spiking can take the form of increasing final pension eligible salary – which can be accomplished in various ways including a final year promotion or transfer that results in a much higher final salary. Another form of spiking is to increase the total number of pension eligible years worked, and the most common way to accomplish this is through the purchase of what is called “air time.”

Based on fuzzy math, the pension systems have offered retiring employees the opportunity to pay a lump sum into the pension system in exchange for more “service credits.” Someone with, say, ten years of service, upon retirement could pay (often the payment that would be financed, requiring no actual payment) to acquire five additional years of service credits. This would increase the amount of their pension by 50%, since their pension would now be based on fifteen years x 3% x final salary, instead of 10 years x 3% x final salary. To say this is a prized perk would be an understatement. How it became standard operating procedure, much less how the payments made were calculated to somehow justify such a major increase to pension benefits, is inexplicable. But when PEPRA included in its reform package an end to spiking, even for veteran employees, the unions went to court.

The spiking case that has wound its way to the California Supreme Court with the most disruptive potential started in Alameda County, then was appealed to California’s First Appellate Court District Three. The original parties to the lawsuit were the plaintiffs, Cal Fire Local 2881, vs CalPERS (Appellate Court case). On December 30, 2016, the appellate court ruled that PEPRA’s ban on pension spiking via purchases of airtime would stand. The union then appealed to the California Supreme Court.

An excellent compilation of the ongoing chronology of the California Supreme Court case Cal Fire Local 2881 v. CalPERS (CA Supreme Court case) can be found on the website of the law firm Messing, Adam and Jasmine. It will show that by February 2017 the unions filed a petition for review by the California Supreme Court, and that the court granted review in April 2017. In November 2017, Governor Brown got involved in the case, citing a compelling state interest in the outcome. Apparently not trusting his attorney general nor CalPERS to adequately defend PEPRA, the Governor’s office joined the case as an “intervener” in opposition to Cal Fire Local 2881. For nearly a year, both petitioners and respondents to the case have been filing briefs.

This case, which informed observers believe could be ruled on by the end of 2018, is not just about airtime. Because whether or not purchasing airtime is protected by the California Rule requires clarification of the California Rule. The ruling could be narrow, simply affirming or rejecting the ability of public employees to purchase airtime. Or the ruling could be quite broad, asserting that the California Rule does not entitle public employees to irreducible pension benefits, of any kind, to apply for work not yet performed.

One of many reviews of the legal issues confronting the California Supreme Court in this case is found in the amicus brief prepared by the California Business Roundtable in support of the respondents. A summary of the points raised in the California Business Roundtable’s amicus brief is available on the website of the Retirement Security Initiative, an advocacy organization focused on protecting and ensuring the fairness and sustainability of public sector retirement plans. An excerpt from that summary:

“The Roundtable brief asserts the California Rule has numerous legal flaws:

(1) It violates the bedrock principle that statutes create contractual rights only when the Legislature clearly intended to do so.

(2) It violates black-letter contract law by creating contractual rights that violate the reasonable expectations of the parties.

(3) It violates longstanding constitutional law by assuming that every contractual impairment automatically violates the California and Federal Contract Clauses.

(4) It lacks persuasive or precedential value. The Rule was initially adopted without anything resembling a full consideration of the relevant issues.

(5) It has been almost uniformly rejected by federal and state courts—including by several courts that previously accepted it.

(6) It has had—and will continue to have—devastating economic consequences on California’s public employers.”

Pension reform, and pension reformers, have often been characterized as “right-wing puppets of billionaires” by the people and organizations that disagree. The fact that one of the most liberal governors in the nation, Jerry Brown, actively intervened in this case in support of the respondent and in opposition to the unions, should put that characterization to rest.

If the California Supreme Court does dramatically clarify the California Rule, enabling pension benefit formulas to be altered for future work, it will only adjust the legal parameters in the fight over pensions in favor of reformers. After such a ruling there would still be a need for follow on legislation or ballot initiatives to actually make those changes.

What California’s elected officials and union leadership, for the most part, are belatedly realizing, is that without more pension reform, the entire institution of defined benefit pensions is imperiled. Hopefully California’s Supreme Court will soon make it easier for them all to make hard choices, to prevent such a dire outcome.

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Edward Ring co-founded the California Policy Center in 2010 and served as its president through 2016. He is a prolific writer on the topics of political reform and sustainable economic development.

REFERENCES

California Government Pension Contributions Required to Double by 2024 – Best Case
– California Policy Center

California Public Employees’ Pension Reform Act (PEPRA): Summary And Comment
– Employee Benefits Law Group

Allen v. City of of Long Beach
– Stanford University Law Library

Overprotecting Public Employee Pensions: The Contract Clause and the California Rule
– Alexander Volokh, Reason Foundation

Statutes as Contracts? The ‘California Rule’ and Its Impact on Public Pension Reform
– Amy Monahan, Iowa Law Review

Did CalPERS Use Accounting “Gimmicks” to Enable Financially Unsustainable Pensions?
– California Policy Center

Cal Fire Local 2881, vs CalPERS (Appellate Court case)
– JUSTIA US Law Archive

Cal Fire Local 2881 v. CalPERS, California Supreme Court, Case No. S239958 – Case Review
– Messing, Adams and Jasmine

Intervener and Respondent State of California’s Answer Brief on the Merits
– Amicus Brief, Governor’s Office, State of California

Amicus Brief of the California Business Roundtable in Support of Respondents
– Amicus Brief, California Business Roundtable (CBR)

RSI Supports California Business Roundtable Amicus Brief
– Summary of CBR Amicus Brief by Retirement Security Initiative

Resources for California’s Pension Reformers
– California Policy Center

 

 

 

In New Year, court could usher in dramatic reform on California’s pension front

Government Unions Need Property Tax Increases to Fund Unsustainable Pensions

Let’s be honest.  When politicians and pundits discuss the state budget, very little is about the impact on homeowners. Notwithstanding the fact that a person’s home is their most important asset, this lack of perspective is understandable. When people think about political issues impacting their status as homeowners, they are far more likely to focus on local taxation – fees for utilities, parcel taxes, local bond debt, etc.

But state finances in California can – and do – have a profound impact on one’s status as a homeowner and, unfortunately, it is rarely in a good way. First, homeowners should be aware that there is no bright line between local governments and the state. State laws on school finance, redevelopment, law enforcement, natural resources and transportation have a huge impact the budgets of cities, counties and special districts.

Take schools, for example. Because of California Supreme Court rulings in the 1970’s, local school districts have lost a great deal of local control over their budgets. (Contrary to urban legend, loss of local control had very little to do with Prop 13). Much of K-12 funding now comes from the state. And the amount of that funding has a lot to do with whether a local school district is “rich” or “poor.”

The complexity of the relationship between state and local governments leads some to tune out issues about the budget believing that it is not relevant to their lives. That would be a big mistake. Homeowners should be aware that this year’s proposed budget reflects a significant five percent increase over last year. Not only has state spending increased every year except one during the recession, that spending has gone up 30% in five years. California now has a $113 billion general fund budget and that doesn’t even include special funds and money from the federal government.

One of the driving forces behind higher state spending is an effort by Governor Brown and others to corral the massive obligations to the state’s pension funds and government retiree healthcare. Brown should be applauded for his efforts to reduce debt but some of us can’t help but feel he is trying to remove sand from a beach with a pair of tweezers.  California’s accumulated debt in all forms is staggering.  In a recent piece in the Wall Street Journal, Steven Malanga of the Manhattan Institute noted how unfunded pension costs, not just in California but nationwide, are gobbling up all of the new revenue coming in to state and local governments from the economic recovery and higher taxes.

And some of those tax hikes in other parts of country are huge. But here in California, we already have the highest income tax rate, the highest state sales tax rate and the highest gas tax in America.  In short, the tax and spend lobby is running out of options. So who is the last remaining target?  You guessed it:  Homeowners.

And the only thing standing in their way is Proposition 13.  While other states have some limited protections for homeowners, none are as effective as California’s landmark Proposition 13.

Homeowners need to be on guard.  All those proposals to lower the 2/3 vote on local parcel taxes and bonds repaid only by property owners are just the beginning.  As the demands to make good on California’s hundreds of billions worth of debt become clear, those who are blessed with home ownership need to pay attention, not only to local politics, but to the state budget as well.

Jon Coupal is president of the Howard Jarvis Taxpayers Association — California’s largest grass-roots taxpayer organization dedicated to the protection of Proposition 13 and the advancement of taxpayers’ rights.

California Supreme Court Supports Rights of Charter Cities Over State Legislature

California Supreme Court Declares that the State’s 121 Charter Cities Have a Constitutional Right to Circumvent the Union-Controlled State Legislature and Establish Their Own Policies Concerning Government-Mandated Construction Wage Rates for Taxpayer-Funded Construction

Yesterday morning (July 2, 2012), the California Supreme Court ruled 5-2 in State Building and Construction Trades Council v. City of Vista that the state’s charter cities have the constitutional right to establish their own policies concerning what their contractors are required to pay their trade employees working on construction projects paid for in whole or in part by the charter city. See the decision here.

There has been a recent flurry of cities trying to enact charters to gain some freedom from costly state mandates, especially freedom from the state’s inaccurate and inflated prevailing wage rates that apply to construction contracts of $1000 or more. In the City of El Cajon (in San Diego County), 58% of voters approved that city’s proposed charter on June 5, 2012. That charter includes an exemption from state prevailing wage.

Meanwhile, voters in the City of Auburn defeated a proposed charter with a similar prevailing wage exemption on June 5, 2012 after three union entities spent almost $80,000 to defeat a small local grassroots movement for a charter. Unions spent $56.40 per vote against the proposed charter to keep state control over the city’s contracting rules.

Article XI, Section 3 of the California Constitution describes how a general law city can organize under a charter. The California Supreme Court ruled on July 2, 2012 that the constitutional rights for a charter city extend to governing authority over contracting rules for purely municipal construction projects. In the case of the City of Vista, it established its own policy on prevailing wage in 2007 with the intention of saving millions of dollars on the seismic retrofit of an existing fire station and the construction of two new fire stations, a new civic center, a new sports park, and a new stagehouse for the city’s Moonlight Amphitheatre.

Charter cities are trying to circumvent the state’s prevailing wage laws because pay rates determined under these laws are often obviously much higher than actual regional market rates. In addition, the definitions of public works under these laws apply to projects that no reasonable Californian would consider to be government work.

Instead of surveying contractors or workers or looking at statistics from the California Economic Development Department, the California Department of Industrial Relations uses a system of calculating rates in which all of the employer payments indicated in the applicable union collective bargaining agreement for a construction trade in the union’s geographic region are added up to produce the wage rate for that region.

The state rates even incorporate employer payments to union-affiliated trusts that are not related to employee compensation; in fact, these trusts are sometimes used for union political purposes. Classified by the California Department of Industrial Relations in the mysterious “Other” column of prevailing wage determinations, this component was added to law through a bill signed by Governor Gray Davis just before he was recalled in 2003.

See the state-mandated construction wage rates for taxpayer-funded projects here.

In addition, the state defines a public works project to mean a construction project that gets any sort of public financial benefit. That means the state identifies many privately-owned and privately-built projects as public works projects. Hotels and retail developments become public works projects equivalent to courthouses and city halls.

Few Californians understand the complicated, convoluted, and often ambiguous structure of the state’s laws and regulations concerning government-mandated construction wage rates. For a simple explanation of the state’s prevailing wage laws and the prevailing wage laws of the state’s charter cities, see this guidebook: Are Charter Cities Taking Advantage of Prevailing Wage Exemptions?

To see how state prevailing wage laws could be reformed to produce more accurate rates and more reasonable definitions of public works, see these two comprehensive reform bills introduced by Assemblywoman Shannon Grove (R-Bakersfield) but defeated in January 2012 on party-line votes in the Assembly Labor and Employment Committee: Assembly Bill 987 (reform definition of public works) and Assembly Bill 988 (reform calculation of prevailing wages).

OUTLOOK: In the November 2012 election, voters in the cities of Costa Mesa, Escondido, and Grover Beach will consider enacting charters that allow these cities to establish their own policies concerning government-mandated construction wage rates for purely municipal construction. I predict that dozens of cities will seek this authority from their citizens in 2014.

Here is a compilation of the substantial press coverage about this important court decision:

News Coverage So Far: City of Vista Wins California Supreme Court Ruling – Charter Cities Can Set Their Own Policies Concerning Prevailing Wage


APPENDIX: Union Perspectives on Charter Cities Establishing Their Own Policies Concerning Government-Mandated Construction Wage Rates

1.      Official Statement After Unions Lose in California Supreme Court

“The fight against prevailing wage is part of a larger effort by the super-rich ruling class to fatten their own wallets by forcing everyone else to sacrifice…We will continue to fight at every turn.” – July 2, 2012 statement of the State Building and Construction Trades Council of California in response to the California Supreme Court decision

Source: an article in the Newport Beach /Costa Mesa Daily Pilot, an article in the North County Times, and in an article in the San Francisco Chronicle.

2.      Dialogue at the California Appeals Court oral arguments on November 14, 2008 (one year after devastating fires in San Diego County):

Judge (to the Union Lawyer): “How do you balance (your) argument against a municipality that might say ‘prevailing wages, that concept is going to, in effect, prevent us from building the fire station that we need?’”

Union Lawyer: “The same argument could be made about a lot of laws that cost money.  The way I balance it is to say that when the people as a whole deal through the legislature with a problem that does have real extra-municipal dimension, the interests of an individual locality have to yield.”

Another Judge (to the Union Lawyer): “The response that troubles me a little bit: ‘Well, if they can’t afford to build the fire station, and they have fire problems, that’s their tough luck,’ even though they’re using municipal funds. They’re not using state funds; the state isn’t granting its largess to solve the problem. So the charter makes no difference; the city simply is stuck.”

Union Lawyer: “When you say stuck, they have to follow the exact same rules that every other government entity follows in California to construct things…It’s true the city could say ‘we might be able to get lower bids on our project if we don’t include prevailing wage specifications, and we’d like to do that,’ but where the legislature has dealt with an issue that has extra-municipal concerns, the judgment of the entire legislature has to trump, because there are substantial externalities involved.”

Source: Wildfires: Construction Unions Put Self-Interest above Public Interest in Court Case Against City of Vista’s Right as a Charter City to Set Its Own Prevailing Wage Policies

3.      From a Commentary by Bob Balgenorth (President of the State Building and Construction Trades Council of California) published on July 26, 2007:

The State Building Trades intends to establish with its lawsuit that ignoring the State’s prevailing wage law is not just bad policy – it is also illegal.

Source: “Charter Cities Must Comply with Prevailing-Wage Law,” Capitol Weekly, July 26, 2007. (It took five years for this lawsuit to reach the final and decisive outcome of failure.)

Kevin Dayton is the President and CEO of Labor Issues Solutions, LLC and is the author of frequent postings about generally unreported California state and local policy issues at www.laborissuessolutions.com.