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San Diego and San Jose Voters Approve Sweeping Public Sector Pension Reforms

SAN FRANCISCO — As state and local governments grapple with the costs of their employees’ retirements, elections this month in two big California cities may signal a sea change in the pension reform debate.

On June 5, more than two-thirds of voters in both San Diego, the state’s second-largest city, and San Jose, its third largest, approved sweeping reforms to curtail government employee pensions.

Experts say the elections are important because it shows strong public support in two major cities for changes that many municipalities may need to pursue amid an ongoing weak economy.

“I have a feeling just because of the wave of anger, outcry throughout the nation on public pension benefits, that this will probably start serving as a model,” San Diego chief operating officer Jay Goldstone said about the city’s vote for a 401(k)-style plan for new employees. “Voter approval was 66 to 67%. That sends a very loud message.”

Because employee wages and benefits typically take up the largest piece of general fund budgets, cutting pension benefits can give local governments significant savings, but not necessarily right away.

“We have been watching pension reform across the nation,” said John Hallacy, head of municipal research at Bank of America Merrill Lynch. “I think it is great that they both [San Diego and San Jose] are taking action to ameliorate a difficult funding situation.”

Voters in each city approved different reforms, but both measures reduce costs, primarily through culling benefits for new hires, with some cost-cutting tied to current employees’ pension plans.

The fact that voters approved the changes by overwhelming margins is important, according to Howard Cure, head of municipal bond research at Evercore Wealth Management.

“Voters are more willing to make changes to the system than elected officials,” Cure said, noting that many elected officials get help from the unions they negotiate with to get into office. “If you start leaving it up to the voters, you can have a lot of these programs revised.”

San Jose Mayor Chuck Reed and San Diego Mayor Jerry Sanders both pushed for the reform even though voters eventually made the decision. In San Diego, a group that included the mayor gathered 116,000 signatures to get the initiative on the ballot, while in San Jose, Reed proposed the changes to the City Council, which put its measure to voters.

San Diego’s reform measure appears more radical since it would switch new employees to a 401(k)-style plan — a defined contribution plan compared to the current defined benefit plan. For current employees, the parts of their salaries that are tied to pension contribution rates will be frozen for five years.

However, police officers will remain in the old plan with an 80% salary cap that will be calculated using the three consecutive highest years rather than just the three highest years. This change is meant to help prevent pension “spiking.”

“What is even more important is that the city will start creating certainty, and we know the bond market loves certainty,” Goldstone said. He said the new plan would eliminate long-term risk as the city’s responsibility stops with its one-time annual contribution to each employee’s plan.

According to financial analysis of the impact of San Diego’s Proposition B by the city’s budget analyst and the mayor’s office, it will save the city $950 million over a 30-year period.

Those savings will take some time. Goldstone said the effective closing of the defined benefit plan would force the city to contribute more in the near term, possibly around $50 million in the first three years, before the savings materialize.

Some of the cost would be offset by the frozen pension portion of some workers’ salaries.

San Jose’s Measure B seems to take a tougher stand on current employees. To stay in their existing plan, they would have to contribute significantly more. New hires would pay 50% of pension costs, compared to roughly one-quarter paid by current employees.

The measure also raised the age of retirement for new hires in the city’s defined benefit plan to 60 for public safety employees and 65 for all others. In addition, it caps the actuarial rate at 2% of a worker’s salary annually, with a 65% maximum benefit. Benefits would also be based on the highest average salary over a three-year period.

Current workers in San Jose have the first choice of contributing 4% more of their salary to help pay off the pension plan’s unfunded liabilities starting in June 2013. Those contributions could jump another 4% per year until they cover half of the unfunded liability cost or reach a cap of 16%.

Employees who don’t want to face those higher contributions could opt out of the existing pension. They would keep the benefits earned to date, but going forward would switch to a new plan with benefits that grow at a lower rate and higher retirement ages. As with new employees, benefits would also be based on the highest average salary over a three-year period, rather than the highest single year.

On Tuesday, the San Jose City Council enacted a new second-tier pension plan for new civilian employees.

In a statement Wednesday following the release of a grand jury report on local pensions, Reed encouraged other cities in Santa Clara County to enact pension reforms.

“It’s clear that while most of the attention has focused on San Jose and our fiscal challenges, we are not alone in this,” Reed said. “Our neighboring cities have seen dramatic increases in cost and unfunded liabilities, and together we are short nearly $7 billion.”

Those neighbors and other governments around the state and nation may be waiting to the see the outcome of the legal challenges mounted by unions.

Unions in both cities filed lawsuits before and after the election to try and block the pension changes.

San Jose employee unions contend the changes violate the state constitution and impair legally protected, vested retirement benefits.

The San Jose Police Officers’ Association said in its lawsuit that Measure B violates the California constitution in numerous ways, such as by violating contracts, taking private property without just compensation or due process and curbing free speech.

“Hundreds of current police officers … will suffer severe and irreparable harm upon implementation of Measure B,” the suit filed last week said.

Reed said in response to the lawsuits that Measure B was “carefully crafted” to follow state law and that the city’s charter gives it the authority to implement the changes.

San Jose has also asked a federal court to rule on its measure in an effort to head off a long legal battle.

In San Diego, a judge Wednesday heard a union challenge that had been delayed until after the election. The suit argues that the city had an obligation to meet and confer with unions before putting the initiative on the ballot since the mayor is an author of the proposition and lead negotiator with the unions.

The city has rejected the argument, saying Sanders is a private citizen and the city didn’t have an obligation to meet and confer.

San Diego is also moving to try to speed up the legal process. City attorney Jan Goldsmith filed papers with the state court of appeals on Tuesday, asking it to hear any claims filed against the city since they will eventually end up there anyway.

Whether more large local governments will put the issue to voters like San Jose and San Diego did remains unknown, but the issue has gained serious traction.

The California League of Cities said in a report earlier this year that 152 cities have adopted new pension tiers and 205 have asked employees to pay more toward pension costs.

But changes may be needed on a state level to help reduce pension costs for current employees, a need that may grow as the baby boomer generation moves further into retirement.

Last year, voters in San Francisco and Modesto approved pension reform measures, albeit ones less stringent than those taken on by San Jose and San Diego.

Gov. Jerry Brown has proposed pension changes for state and local government employees, but he has yet to make much headway in the union-friendly Legislature dominated by Democrats.

California’s independent Little Hoover Commission issued a report last year that urged the Legislature to give local governments the authority to freeze pension benefits for current employees. So far, nothing has been done.

With little movement on the state level, the job may go to voters.

“I think more and more, cities and public agencies are going to realize that is what they are going to have to do,” Goldstone said.

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