Public pension benefits & the law

 

fedgazette: It seems to be widely accepted that public pension benefits are guaranteed and untouchable. Is that generally the case, or is it more complex than that?

MARTIN: The general view of state courts to modifications of public pension benefits has shifted over time from a broadly accepted “gratuity theory,” where any legislated change was permissible, to a much more restrictive view on legislative attempts to modify public pension plans. Minnesota courts held a gratuity view of public pensions for a long period, thanks to cases going back to 1915 (Gibbs v. Minneapolis Fire) and 1940 (Johnson v. State Employees Retirement Association). That view changed in Minnesota in 1973 with Sylvestre v. State, which involved judicial pensions, and the court explicitly dropped the gratuity theory in Christensen v. MERF in 1983. While the Minnesota courts have imposed considerable constraints on pension modifications, public pensions are not necessarily guaranteed or untouchable in the view of the Legislature, which reduced benefits for retirees and active members in 2010.

MONAHAN: I agree it’s complex. While many states have strong legal protections for public pension benefits, it is legally possible, under certain circumstances, to amend those benefits. The difficulty is determining what changes are legally permissible, and in what circumstances. In most states, there is a lot of uncertainty surrounding these issues.

fedgazette: So pension benefits have gone from a fairly weak “gratuity theory” to having much stronger legal protections. How and why did this occur, exactly? Were there a lot of abuses regarding benefit reductions that led to these legal cases?

MONAHAN: The cause of the legal shift is complex. It’s easy to see why a legal theory that let the government amend or eliminate pension benefits at any time and under any circumstances would be extremely unpopular. And there certainly were cases where the government took advantage of this legal power and eliminated benefits.

But unpopularity alone is generally not enough to bring about legal change, and one of the interesting things about the law in this area is how courts reacted to, and overruled, the gratuity theory. In some states, newly enacted state constitutions contained prohibitions on the state giving “gifts,” which gave courts an easy solution—pensions couldn’t be considered gratuities because the state constitution prohibited state-paid gratuities. In other states, courts implied the creation of a contract in order to provide legal protection to public pensions. Some courts implied that they were dismissing the gratuity approach for policy reasons. For example, in 1983 the Supreme Court of Minnesota noted in Christensen v. MERF that while the gratuity theory may have been justified in the past because pensions were insignificant in amount, times had changed, and pensions were entitled to more protection than the gratuity theory offered.

MARTIN: I agree that actual or potential policymaker abuse under the gratuity theory led courts to abandon it. However, neither of the two prominent Minnesota cases, Sylvestre and Christensen, fairly would be labeled as court corrections of arbitrary or abusive legislative action.

 

fedgazette: If benefit protections under the gratuities concept was viewed as too soft, how would you characterize protections now, say, in Minnesota or other states you're familiar with?

MARTIN: Under a contract theory (or quasi-contract theory in Minnesota), they range from being fully formed and extensive to being a work in progress. Pennsylvania has perhaps the strongest contract view; every element of a benefit plan is fixed and immune from reduction or adverse modification, and even member contribution rates cannot be raised for the duration of a plan member’s lifetime. Even former legislators there who were convicted of felonies involving their public offices in the 1980s kept their public pensions because a forfeiture law was enacted after they took office.

Minnesota generally has “contract-like” protections, but member contribution rates can be changed, and some benefit reductions can be informally bargained and traded for other benefit increases under some circumstances. Because of the limited number of court decisions applying the quasi-contract theory applicable here, the exact parameters of protection are still developing. A challenge by several Minnesota retirees to recent reductions to post-retirement adjustments by the 2010 Legislature may provide additional clarity.

MONAHAN: As Mr. Martin’s response indicates, there is significant variation among the states with respect to the strength of current legal protections. Some states have incredibly strong legal protections that essentially guarantee an employee a pension that is at least as generous as that which she would have earned under the benefit formula in effect on the day she first began work for the state. In other states, legal protections only become effective once the employee is eligible to retire. And in many states, the existing judicial decisions don’t provide a clear answer regarding what is protected and what isn’t.

fedgazette: You’ve just touched on it, but is there any legal difference—in theory or practice—between earned benefits and “expected” benefits, like future cost-of-living adjustments or formula multipliers that are locked in for future work years? My sense is that future expected benefits seem to have strong protections. What’s the legal case and the nonlegal rationale for this?

MONAHAN: This is a great question, but a difficult one to answer. In the states that protect public pensions under a contract theory, the contract is typically interpreted to protect all relevant terms, including benefits that have already been earned as well as the rate of future benefit accruals. This would include any guaranteed cost-of-living adjustments. This type of protection leads to an odd practical result. The state could fire an employee or reduce the employee’s salary, but could not, for as long as the employee is employed, reduce any aspect of her pension benefit, even on a prospective basis. Employees in the private sector, in contrast, are guaranteed only their pension benefits that have been earned to date.

The broad protections provided to many public sector employees result from the legal framework that some courts have adopted. If courts are going to take the position that a binding contract is created on the day an employee first begins work and remains in effect until the employee terminates employment, they have to protect future benefit accruals as well as benefits already earned. With that said, there really haven’t been a lot of cases challenging the ability of states to change the benefit formula on a prospective basis, and I do think there is legal uncertainty regarding how courts would respond to such challenges.

MARTIN: In Minnesota, the courts have not explicitly distinguished between earned or accrued benefits and expected benefits. In the unilateral contract theory established by Sylvestre, continuing employment is the basis for the contract and benefit protection extends to all benefit plan provisions, including post-retirement adjustments occurring in the future. The Christensen quasi-contract theory turns on employee expectations—the level of reliance on promised benefits—which may or may not extend to future benefits and probably depends on proximity to retirement. 

fedgazette: You’ve also touched on this, but if the benefits at the time of hiring can be deemed irrevocable, why is the cost structure not similarly protected?

MARTIN: That situation is true in Minnesota, but not necessarily true in other states. The difference lies in the legal distinction between a pure contract theory versus Minnesota’s quasi-contract theory, also called promissory estoppel. In Minnesota, the ability of the state to increase member contributions without a benefit increase was upheld under the 1983 decision of AFSCME Council 6 v. Sundquist because employee contributions had been increased numerous times previously, so members could not justifiably rely on unchanging contribution rates.

In the current Minnesota litigation over reduced or suspended post-retirement adjustments, the state is arguing in part that the Christensen protections do not apply because post-retirement adjustments have been changed previously on a number of occasions, and no member reliance is justified.

MONAHAN: That’s a great overview. I would just add that protection of worker contribution levels does vary significantly by state. In some states, the contract is deemed to include the worker contribution level and therefore cannot be changed. In other states, the statute authorizing the public pension benefits specifically states that worker contributions will fluctuate based on the funding needs of the plan. It all comes back to what is considered to be included in the contract.

fedgazette: How have courts historically viewed “sponsor impairment” when it comes to benefit reductions? Does actuarial or fiscal distress play any legal role if a government plan sponsor wants or needs to reduce benefits?

MONAHAN: Sponsor distress can absolutely play a role in the legal ability of states to reduce pension benefits. No matter what a state’s law is regarding public pension benefits, states always retain something called the “police power,” which allows states to take action necessary to preserve public safety, order and welfare.

In states that protect public pensions as contracts, the police power will allow changes provided that the changes are reasonable and necessary to serve an important public purpose. This is actually a very difficult legal standard to satisfy. Take, for example, a state that is in severe fiscal distress and desires to reduce future benefits to alleviate a budget deficit. Helping to solve the state’s fiscal crisis would likely be considered an “important public purpose.” But the United States Supreme Court has stated that for a change to be considered necessary, the state must establish, first, that no less drastic modification could have been implemented to accomplish the state’s goal and, second, that the state could not have achieved its public policy goal without the modification.

It’s unclear under existing rulings when a state’s fiscal crisis would be considered severe enough to warrant the modification of the state’s contracts and, even then, under what circumstances the court will consider benefit reductions to be necessary to achieve fiscal relief. We do not yet know to what extent a state would first have to cut spending and raise tax rates before it would be allowed to reduce contractually protected pension benefits.

MARTIN: Before resorting to police power, in some contract-theory states, courts have suggested that legislatures can change a retirement plan to strengthen it actuarially if the alteration does not break contractual obligations. Pennsylvania, with perhaps the most restrictive version of the contract theory, has suggested actuarial strengthening as a permissible purpose, but I am not aware that it has actually been used there. In Minnesota, there has not been any explicit statement by the courts regarding this matter. In the closest statement—the 1983 AFSCME case—higher member contribution rates were permitted under Minnesota’s quasi-contract theory, but were not intended to strengthen the retirement plan, but to replace decreased employer contribution rates to assist in balancing the state budget.

fedgazette: In light of declining pension funding ratios, some benefit reductions are being proposed, even passed into law. What has been the general position of employee unions to proposed benefit reductions? Protect all benefits at all costs? Compromise for the good of the team?

MARTIN: The 2010 Minnesota Legislature enacted numerous benefit reductions affecting active, deferred and retired members that had been proposed by the five major plan governing boards. With the exception of Education Minnesota, representing teachers, the major public employee unions testified in support of the 2010 changes. 

Education Minnesota objected because the package did not include other proposals permitting early retirement and providing additional funding. AFSCME Council 5, representing state employees, indicated that it supported proposed benefit reductions for members of the Minnesota State Retirement System, which include temporary reductions in annual adjustments for retirees until the plan becomes 90 percent funded and a variety of other permanent changes for current and deferred members. But the council indicated that it would not support other plan modifications, including higher member and employer contributions.

The post-retirement adjustment suspensions and reductions have been challenged in court and will be argued in March. Litigation on the active and deferred member benefit reductions has not yet occurred. The major Minnesota plan administrations also were required to study alternative benefit plans, including defined contribution plans, and report on their advantages and disadvantages to the 2011 Legislature. Prior testimony by the public employee labor unions has been unfavorable to any defined contribution plan replacement coverage. 

MONAHAN: My general sense is that unions have been willing to work with the states regarding pension plan changes. While they are of course hesitant to give up pension benefits that are in many cases legally protected, they are aware of the fiscal realities and are often unenthusiastic about other options. After all, even though pension benefits may be legally protected, in most cases the state is free to lay off or terminate current employees, lower current salaries or reduce nonpension benefits. Difficult choices have to be made, and my sense is that unions have been willing to consider all of the options, including pension plan changes.

fedgazette: If benefits are legally protected, can they also be legally unprotected by changes in state law?

MONAHAN: In most states, it would take a court decision to change the legal protections for public pensions. In other words, the legislature would have to pass a law changing the terms of a public pension plan and affected participants would have to sue. In deciding such a case, a court could clarify, or even depart from, its earlier rulings and in doing so provide a new standard to analyze what changes to public pension plans are permissible. Because most state pension protections are the product of court rulings, it would take a new court ruling to change. As a result, legislatures don’t have any easy options.

We’ve seen some state legislatures go ahead and make changes to existing plans (notably in Minnesota, Colorado and South Dakota) and, predictably, each state has been sued by affected participants. Those cases are still working their way through the courts.

MARTIN: As Professor Monahan observes, since legal protections for public pension benefits are largely a result of judicial ruling, the relaxation of public pension plan member protections cannot be implemented through legislation. If significant pension revisions are necessary, state legislatures can use other strategies, such as establishing revised benefit plans for new employees, making future compensation increases contingent on pension waivers, reconfiguring whole government departments or programs with employment reductions, or even seeking governmental bankruptcy protections.

fedgazette: Because legal protections reside at the state level, does that mean legal challenges—and precedent—will play out differently in each state, or will case law migrate across state borders?

MARTIN: States develop their own common law. Thus, Minnesota differs significantly from Pennsylvania in utilizing a quasi-contract approach to public pensions, while Pennsylvania continues to utilize a pure contract approach.

However, states do not develop their body of common law in a vacuum. Pennsylvania and Minnesota public pension cases are cited both in arguments before the courts of other states and in the decisions rendered in those states. The way that courts typically wrestle with new or changing legal problems is to adapt some existing body of settled law in an area having analytical similarities, whether the settled law is unique to the particular state or is borrowed from another jurisdiction. The process has a certain trial-and-error flavor to it while the adoption process is playing out. 

This is perhaps why the Sylvestre unilateral contract theory in Minnesota has been a dead end, apparently replaced by the Christensen quasi-contract theory. If another state’s court develops a body of decisions that better fit a legal problem analytically and provide more workable resolutions of disputes, practitioners will argue the appropriateness of the new legal theory in other states and, if another state’s court is receptive, the approach will migrate. Authors and commentators like Professor Monahan also serve that migration process by assembling and contrasting the approaches of the various states, analyzing their strengths and weaknesses, filling in theoretical gaps and suggesting logical extensions and expansions.

MONAHAN: I agree with Mr. Martin’s comments. While one state’s decisions are not in any way binding on another state, I think that state courts considering these issues will absolutely be paying attention to decisions in other states, particularly given all of the current uncertainty in this area of the law.

fedgazette: Thank you both very much.