WASHINGTON — As state and local governments grapple with pension reform, they may have more flexibility to reduce benefits for current public employees than conventional wisdom suggests, according to a new report from the Center for Retirement Research at Boston College.
Forty-three states have made significant changes to improve the financial condition of their retirement plans and reduce costs in the wake of the financial crisis. Moody’s Investor Service announced in July that states and localities face more than $2 trillion in unfunded pension liabilities. As a result, many states have considered closing existing pension plans to new hires and adjusting employee and employer contribution levels.
But one option that has generally been off the table is reducing future benefits for current workers because states face legal constraints on their ability to make such changes, the report said.
“These constraints not only tie the hands of pension reformers, but also accord public employees greater protections than their private-sector counterparts.” wrote Alicia Munnell and Laura Quinby, authors of the 10-page report. “Changing the status quo will likely require both legislative action and legal argument.”
The legal approaches to protect public pensions vary by state. Most protect pensions under a contract-based approach. The U.S. Constitution’s contract clause and similar provisions in state constitutions prohibit passing any laws that impair existing public or private contracts.
To determine whether a state action is unconstitutional under the contract clause, the courts apply a three-part test, which requires the determination of whether a contract exists, whether state action would substantially impair the contract, and, if so, whether the action would be justified by an important public purpose or would be reasonable and necessary if taken in the public interest.
However, recent court decisions suggest it is necessary to separate core benefits from the cost-of-living adjustment and that, in some cases, changes to COLAs may be permitted. In four court cases — Colorado, Minnesota, New Jersey and South Dakota — courts upheld changes to COLAs after they were challenged.
Munnell said she is “surprised” at the court actions because she has always looked to the Employee Retirement Income Security Act of 1974 (ERISA), which governs private pensions and protects accrued benefits but allows employees to change the terms going forward. The report also found that the burdens of pension reform are falling more heavily on new workers rather than current workers.
“If you just start hacking away at benefits for new employees and don’t think about making an adjustment on the wage side, your compensation package is going to go way down and you won’t get good workers,” Munnell said. “Being able to share the burden between current and future employees, so that you aren’t putting it all on future, will make it easier states and localities to hire quality workers.”
The report recommends states establish ERISA-type public pension standards because the protection accorded to benefits is less embedded in state constitutions and more open to interpretation than commonly perceived and it will cover future employees.