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Can State and Local Pension Promises Be Altered?

The perception is that public employees have much greater protections with respect to their defined-benefit plans than their private-sector counterparts. While the Employee Retirement Income Security Act of 1974 — the governing law in the private sector — protects benefits earned to date, state laws or constitutions prevent public-plan sponsors from reducing future benefits for current employees. Thus, if the employer wants to reduce the future accrual of benefits, such a change can apply only to new hires.

But in a recent blog post, I described how actions taken by plan sponsors have shown that public-sector benefit promises are less secure than one would have thought before the financial crisis.

Plan sponsors have reduced the pension wealth of current employees by increasing required employee contributions so that while the employee continues to accrue the expected benefit, the net contribution from the employer has been reduced. In the case of retirees, sponsors have reduced or suspended cost-of-living adjustments. And these changes have been upheld in a number of courts.

Thus, to the extent that protections exist, they must apply only to “core” benefits. Most states protect core benefits under the U.S. Constitution’s Contract Clause or similar provisions in state constitutions. To determine whether a state action is unconstitutional under the Contract Clause, the courts apply a three-part test. First, they determine whether a contract exists. This process determines when the contract was formed and what it protects. Second, the courts determine whether the state action constitutes a substantial impairment to the contract. If the impairment is deemed substantial, then the court must determine whether the action is justified by an important public pur­pose and if the action taken in the public interest is reasonable and necessary.

The strength of the protections depends on where the protections are located. Constitutional provisions are harder to overcome than statutes or case law. Only three states — Alaska, Illinois and New York — have explicit constitutional provisions that protect future as well as past benefits for current employees. In these states, changing benefits for existing employees is virtually impossible without amending the state constitution. Other states where benefits are protected have statutes that expressly adopt the contract clause theory or judicial decisions that have ruled the relationship to be contractual. Interestingly, for 13 states, the protections apply only once benefits are vested, and eight states protect benefits only once the employee is eligible for retirement.

Two states that protect benefits under the contract clause — New Jersey and Rhode Island — have passed legislation that explicitly reduces core benefits for current employees. These cuts have been challenged, and the cases are currently in the courts. The outcome of these challenges will provide some information on how much freedom states actually have to change future benefits for current employees. The answer may well hinge on whether the court accepts the argument that there is an important public purpose for such changes.

A failure to permit such changes would have serious consequences. First, limiting pension reductions to new workers reduces pension costs only slowly over time. Second, exempting current workers from cuts creates a two-tiered compensa­tion system under which workers doing similar jobs would receive different amounts based solely on when they were hired. Finally, allowing public employees to enjoy greater protections than their private-sector counter­parts is perceived by many as unfair.

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About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.