How California Public Agencies Can Reform Pension Benefits

Category: Published Articles
Date: Nov 6, 2019 04:48 PM

This article appeared on Law360.

In 2011, in a report that led to the enactment of the California Public Employee Pension Reform Act (“PEPRA”), the Little Hoover Commission gave a dire warning: 

California’s pension plans are dangerously underfunded, the result of overly generous benefit promises, wishful thinking and an unwillingness to plan prudently. 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.

This warning came after the Great Recession reduced the value of the CalPERS fund by 24 percent in a single fiscal year to approximately $180 billion, leaving CalPERS 61 percent funded.

Today, after nearly a decade of market growth and increased pension contributions by both employees and employers, the situation is not fundamentally different. Despite the CalPERS fund more than doubling in size to over $370 billion, CalPERS is still only about 70 percent funded. With fears of another recession looming, public agencies need to take steps sooner rather than later to plan ahead and consider how CalPERS’s unfunded liabilities will affect them.

Although CalPERS has already taken steps to reduce its unfunded liability, much of the burden fell on employers. For example, CalPERS changed actuarial policies to shorten the period in which employers pay their unfunded liability, trading higher up-front costs for long-term savings. CalPERS has also lowered its assumed rate of investment returns – used to “discount” contributions towards future benefits – from 7.5 percent to 7 percent, meaning that agencies will have to pay higher contributions to pay for a given benefit. However, CalPERS’s own financial investment advisor has estimated that expected returns are closer to 6 percent, and if investment returns do not meet the 7 percent target, CalPERS is likely to increase contribution rates even further to make up for the shortfall.  In the event of a recession, the need for additional rate hikes will only increase.

Between already-accrued pension benefits and CalPERS’s efforts to reduce unfunded liabilities, pension costs represent an increasing share of the annual budgets for many public agencies, crowding out discretionary spending and reducing the funds available for public services.

Restrictions on Ability to Control Rates

Managing these increasing costs is a difficult task, due to several legal restrictions on agencies available options, including constitutional principles, statutory provisions, and the realities of labor negotiations.

Constitutional restrictions

Under California law, once a public agency makes an official declaration of policy, by express or implied contractual terms, to provide a pension or other post-employment benefits for its employees, an employee becomes “vested” in those future benefits. California courts have generally held that contractual pension rights are vested as of each employee’s first day of employment after the public agency adopts the policy; this is known as the “California Rule.”

Once a benefit is determined to be a vested, it is protected by the Contracts Clauses of the United States and California Constitutions. This prohibits a public agency from revoking or adversely modifying that benefit, as that would constitute an unconstitutional impairment of a contractual obligation.

However, this does not mean that agencies are completely precluded from modifying future benefits for current employees or even for existing retirees. A thorough vesting analysis performed with the help of legal counsel may reveal several avenues for agencies to reform pension benefits.

1)      Was there a valid and binding contractual promise to provide post-employment benefits?

For example, if a retirement benefit adopted by a city council resolution does not comply with procedural requirements under the city charter, or if a benefit adopted by collective bargaining is void because of a conflict with federal tax law, those promises might be unenforceable.[i]

2)      What where the terms of that contractual promise?

If an employer’s current policy or practice is more generous than the benefit that was actually promised, the employer may be able to revert to the benefit level that was promised.[ii] And if the terms of the alleged promise are not explicitly stated, California courts have held that employees and retirees have a heavy burden in demonstrating an implied vested right to a continued benefit.

3)      Does the contractual promise permit the employer to make modifications to the benefit during or after employment?

For example, a specific benefit set forth in a negotiated memorandum of understanding may only be binding for the term of the agreement, unless it was already vested prior to inclusion in the MOU or unless the MOU contained an express or implied term indicating the parties intended the benefit to extend beyond the life of the agreement. Or if retirees were promised the same health benefits as those negotiated for current employees, the employer may well have room to negotiate lower benefits for both groups.

If a particular post-employment benefit has in fact vested, the employer may only reduce or eliminate that right in very narrow circumstances. For current retirees, a vested benefit may only be impaired upon agreement between the retiree and the public agency. For current employees, it can be impaired if the parties agree, or if the employer makes “reasonable” modifications for the purpose of maintaining the integrity of the pension system, which must be determined on a case-by-case basis.

Statutory restrictions

CalPERS pension benefits for all participating agencies are governed by the Public Employees’ Retirement Law (“PERL”) and by PEPRA.  Before PEPRA, one tool many employers made use of was to negotiate lower benefits for future hires, while preserving benefits for existing employees and thus avoiding any impact on vested rights. However, in most cases this is no longer possible under PEPRA. PEPRA itself did impose a lower tier of benefits for “new members” (generally, those who first became CalPERS members in or after 2013). But the law also requires that all “classic members”, including lateral hires from other agencies, must receive the same benefits as if they had been hired in December 2012. Thus, in most agencies, reducing future benefits is no longer an option.

There is one limited exception: For safety members, PEPRA provides three available benefits formulas. The default formula is whichever of the three is closest to, but no more generous than, the formula provided to classic members. But PEPRA explicitly allows agencies to negotiate a lower tier of benefits for future safety hires.

Labor relations

A third restriction on agencies’ ability to reduce pension costs is the obligation to notify and bargain with employee organizations under the Meyers-Milias-Brown Act (“MMBA”) and other similar labor relations statutes. For obvious reasons, public employees and employee organizations are often very hesitant about changes that could potentially reduce their own future benefits or increase pension contributions and thus reduce their take-home pay.

But fundamentally, both employers and employees have an interest in resolving the pension crisis, and no one benefits by avoiding the necessary reforms. If agencies do not take steps to manage pension liabilities, the problem will only compound over time, increasing the risk of pay cuts, layoffs, or even bankruptcy. By taking a transparent and collaborative approach to labor negotiations, agencies and employees can work together to protect the public pension system.

Possible solutions

With all of these restrictions, trying to reduce increasing pension costs may seem like an impossible task. Luckily, with a good understanding of the law, a creative approach, and strong leadership agencies still have options available.

Cost sharing – Have employees shoulder more of the burden

Some provisions of PEPRA have helped reduce ongoing pension costs for employers by requiring employers to help fund their own future benefits. The law eliminated employer-paid member contributions (“EPMC”) for “new” members, and required that new members pay at least 50 percent of the actuarial normal cost of their own pension benefits. For Classic members, agencies can still make the same reform by reducing or eliminating EPMC, in order to have employees bear the full cost of their own contributions.

In addition to eliminating EPMC, agencies can ask – or in some cases require – employees to help share the cost of the employer’s contribution.  Under Government Code section 20516.5, after negotiating in good faith and completing any applicable impasse proceedings, agencies can require employees to contribute up to 50 percent of the normal cost, so long as doing so is no more than a specified percentage of pay. Because new members already contribute at least 50 percent of the normal cost, this only applies to classic members. And because of the percentage limits, this option is also irrelevant for many non-safety classic members. The highest rate that non-sworn employees can be forced to pay is 8 percent of pay. For agencies that adopted one of the enhanced non-safety formulas for classic members (2.5% @ 55, 2.7% @ 55 or 3% @ 60), employees are already paying an 8 percent member rate. Government Code Section 20516.5 is most applicable to Classic safety employees, because the statutory maximums are higher (12 percent for peace officers and firefighters and 11 percent for other safety members, or 50 percent of normal cost, whichever is lower).

In addition, for both classic and new members, Government Code section 20516 allows employers and employees to agree to have employees pay an even larger share of pension contributions. When negotiating cost sharing, it is important that agencies carefully calculate the cost of anything given in return. For example, employee groups may ask for a wage increase that matches the amount of the cost share, e.g. a 2% pay raise in exchange for contributing an additional 2% of pay towards pension. This is not a cost neutral exchange. Because the salary increase will also result in other costs, such as increased CalPERS contributions and overtime costs, this exchange would actually result in an increased net cost to the agency. For an exchange to be cost neutral, the negotiated cost share amount will need to account for both the direct cost of a salary increase (or anything else given in return) and any additional “roll up” costs.

Reducing reportable compensation

Another option is to negotiate changes to employees’ compensation and benefits to reduce the amount that is reportable to CalPERS (or “PERSable”). As an example: a pay raise would increase PERSable compensation and therefore also increase future pension liability and ongoing pension contributions; instead, an agency could provide increased health benefits or paid time off. 

Employers can also renegotiate specialty pays so that they do purposely not satisfy the requirements of the CalPERS regulations governing reportable “special compensation,” making the pay non-reportable. For example, when a compensation item combines the requirements of two or more recognized special pays (such as longevity or performance bonuses), the result is a non-reportable “hybrid” pay.

In addition, CalPERS has indicated that when an agency makes a general salary increase to a group of employees (such as a bargaining unit covered by an MOU), any lump sum payments made in the same fiscal year are not PERSable. For new members, one-time payments are not reportable under any circumstances. For new members, uniform allowances and bonuses are also non-reportable. For this reason, agencies with a high proportion of new members should consider focusing compensation increases towards these types of pay.

Retiree medical benefits reform

Many agencies can potentially achieve significant savings by restructuring health benefit costs for current and future retirees, such as by moving retirees to more affordable plans or reducing the agency’s contributions. But agencies should be aware of legal limitations: for employers that provide healthcare benefits through CalPERS, statutory provisions in the Public Employees' Medical & Hospital Care Act (PEMHCA) set strict minimums for employer contributions. Employers should also analyze whether employees and retirees have vested rights that would impose constitutional protections on retirement benefits in their current form. Public agencies considering this option should consult with trusted legal counsel.

The article can be found here.

[i] San Diego City Firefighters, Local 145 v. Board of Admin. of the San Diego City Employees’ Retirement Sys. (2012) 206 Cal.App.4th 594 [141 Cal.Rptr.3d 860].

[ii] Retired Employees Assn. of Orange County, Inc. v. County of Orange (9th Cir. 2014) 742 F.3d 1137, 1142.

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