Pension reform vs. the ‘California Rule’

Chad Aldeman

Cities and states faced with rising pension costs have begun to search for the most effective way to balance retirement promises made to workers with the need for fiscal sustainability and employer flexibility. Most prominently, a federal judge ruled last month that the city of Detroit could declare bankruptcy, opening the door for it to cancel or revise contracts such as those for retiree pensions. In Illinois, another state with a constitutional protection for government-worker pensions, the governor recently signed legislation that would raise the retirement age for mid-career workers and reduce cost-of-living adjustments for all workers who have not yet retired. Unions there immediately challenged the constitutionality of the legislation.

Another battle is playing out in California. In June 2012, San Jose mayor Chuck Reed convinced a seventy-to-thirty majority of his city’s voters to endorse changes to pension and retiree health care plans for city workers. The municipal unions filed a lawsuit the next day, and in late December 2013 a judge ruled that the pension changes violated the state constitution. Under what’s known as the “California Rule,” the Golden State’s constitution protects the right of workers, from their first day on the job, to accrue future benefits. (A dozen other states also use the California Rule as the legal protection for government pensions.) In other words, if a teacher is hired on January 1, 2014, her pension-benefit formula can never go down for the rest of her working career and into retirement, even if, for example, she lives until the year 2074.

While the California Rule protects pension benefits in perpetuity, it doesn’t protect the employee’s salary, health care, or the job itself. It’s easier to fire someone than to change her pension formula.

This results in a set of twisted ironies. First, it’s alright for employers to lower employee salaries but not to raise their retirement contributions. This doesn’t make any sense. If I ask you to take a 1 percent pay cut or require you to pay 1 percent more into your retirement plan, these two actions should have the same financial impact—yet the law treats them differently. Second, employers can change the components of benefit formulas but not the formula itself. Pensions are based on a formula where the benefit equals some multiplier (in California, it’s 2 percent) times salary (in California, it’s the highest twelve months of salary for workers who have at least twenty-five years of experience) times years of service. Employers can change an employee’s salary, and they can fire the employee (thereby ending their years of service). These things would obviously reduce an employee’s pension benefit, but the California Rule only protects the benefit formula, not the actual benefit.

Mayor Reed is among a coalition of California municipal leaders now leading a bigger fight. He’s sponsoring a ballot initiative that would change the state constitution and allow state and city governments to make proactive changes to retiree benefits. The initiative would protect any benefits that an employee has already accrued but would no longer guarantee employees the right to accrue the same level of benefits forever into the future. The attorney general recently gave the initiative a title and a short, one-hundred-word description. The first two sentences summarize that it

Eliminates constitutional protections for vested pension and retiree healthcare benefits for current public employees, including teachers, nurses, and peace officers, for future work performed. Permits government employers to reduce employee benefits and increase employee contributions for future work if retirement plans are substantially underfunded or government employer declares fiscal emergency.

Reed and his backers must now decide whether that language adequately captures the proposal and if it’s worth proceeding to a statewide vote. The initiative requires the signature of 8 percent of all registered California voters—that’s 807,615 people—in order to be on the ballot this coming November.

Ultimately, nonsensical pension protections such as these must come to an end. They’ve forced state and local governments to pay out ever-higher proportions of compensation in the form of retirement benefits instead of salaries. Such protections also act as an intergenerational wealth transfer from younger to older workers. Because they lock in benefits for existing workers, the only way for state and local governments to address funding problems is to target new workers. Nearly every state has created less generous plans for new workers, plans that will require them to pay more money up front, remain in their jobs longer before “vesting” into the system and qualifying for even a minimum benefit, and work longer before they retire with full benefits. This situation can’t last forever. We should protect the benefits that individuals have already accrued, especially those of present retirees and those nearing retirement, but we shouldn’t tie the hands of state and local governments decades into the future.

Chad Aldeman is an associate partner at Bellwether Education Partners, which recently launched Teacherpensions.org.

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