Public Retirement Systems and the Pandemic: Part II – the Litigation Risk of Benefit Modifications

June 1, 2020Alerts

The ongoing COVID-19 pandemic has presented public retirement systems with a serious financial challenge. In response ― beyond reducing current retirees’ COLA, which we covered in Part I — plan settlors may seek to reduce costs by making changes to other benefits provided to current retirees and future benefits to be provided to active employees.

For an introduction to retirement systems and their funding, consult Public Retirement Systems and the Pandemic: Part I – a Coming Wave of COLA Litigation?

Plan sponsors have reduced and modified a large and diverse group of benefit components in the last decade. This alert distills those reductions to the main categories and identifies the primary themes from litigation in states across the country.

As with COLA litigation, this alert is intended to provide only general information and does not address every potential concern. Indeed, each benefit litigation is unique and often grounded in the state law of the jurisdiction at issue, as well as the unique language of the existing pension benefit and the proposed changes to it. Given the complex legal landscape, retirement systems should consult with legal counsel about the facts and circumstances of their specific situations.

What benefits have been modified, resulting in litigation?

We preface this list by saying there are undoubtedly additional benefits that have been modified but have not led to litigation (or reported litigation). Below are modifications of benefits that have led to litigation:

  • Decrease the ability of current retirees to work after retirement for public employers
  • Decrease or eliminate health care premium subsidies for current retirees
  • Revise the definition of earnable compensation for future service credit earned by active employees
  • Lower the formula multiplier for future service credit
  • Revise service credit accrual formula retroactively for active employees
  • Increase age/service credit requirements for retirements for active employees
  • Change the retirement benefit from a variable formula to a fixed formula or vice versa
  • Freeze retirement accounts in current system for active employees and move all future accrual to new, less rich system
  • Increase employee contributions for actives
  • Change service credit purchase terms
  • Change terms of tax shelter plan

What is the central claim being raised in benefits litigation?

As with COLA litigation, the main claim raised in benefits litigation has been a Contract Clause claim under the U.S. and state constitutions. A little-known provision of the U.S. Constitution for over 200 years, the Contract Clause has become the critical fight in nearly all pension benefit litigation.

In addition, some states have separate provisions in their state constitutions related specifically to public pensions. These states include Alaska, Arizona, Hawaii, Illinois, New Mexico, New York and Texas.

A final nuance unique to pension benefit litigation is that, in certain instances, claims have been made pursuant to a collective bargaining agreement in place between a public employer and its unionized employees. The claims under the CBA have sometimes been contractual and sometimes been Contract Clause claims.

What is the key consideration involving Contract Clause claims?

The first and oftentimes dispositive consideration is whether the court adopts the three-part Contract Clause test outlined by the U.S. Supreme Court in 1977 in U.S. Trust Co. of New York v. New Jersey.  That test inquires:

  • Is there a contract?
  • If so, was the contract substantially impaired?
  • If so, was the impairment reasonable and necessary to serve a legitimate public purpose?

Courts that have adopted the three-part test have often, though not always, gone on to find that the adjustment to the pension benefits was constitutional. Most of the time, the court finds that the challengers failed the first prong of the Contract Clause test because the plaintiffs (be they employees or retirees) did not have a contract right to the benefit.

How does the Contract Clause analysis in pension benefits litigation differ from COLA litigation?

Contract Clause analysis includes additional considerations beyond those of COLA litigation. First, courts will analyze whether the modified benefit is a core part of the pension benefit or an ancillary one and thus not protected. For example, most courts have held that retiree health care benefits (such as subsidized premiums) are not a core pension benefit and thus can be changed, even in states still following the California Rule or with pension protection clauses in their state constitutions.

The state’s definition of vesting is an additional factor. Some systems’ statutory schemes include a provision stating when an active employee vests into benefits. Other states have developed common law about when employees vest into benefits. Whether an employee has a vested right to the affected benefit will also determine if a court finds there is any contract right to the benefit. States that find active employees do not vest into retirement benefits until they reach retirement (if at all) permit considerable changes to the terms of the benefits prior to the point of vesting. By contrast, states that find active employees vest in their retirement benefits at the start of their employment or shortly after beginning employment (such as California, Arizona and Illinois) are more likely to find changes in benefits violate the Contract Clause.  However, if the benefit at issue is found not to be a core pension benefit — for example, retiree health care in California — then the change will be upheld.

What benefit changes for current retirees have been upheld?

Two stand out. First, there has been considerable litigation around decreasing health care benefits for current retirees and many of these changes have withstood scrutiny. In Colorado, this was litigated three decades before the adoption of the three-part test and found not to be a pension benefit. Even California has upheld changes to retiree health care benefits. However, some states (Hawaii, Alaska and Kentucky) have struck down changes and found them part of the core pension benefit, relying on state statutes or pension protection clauses in the respective state’s constitution. Illinois has had a mixed judicial record and the cases there have turned on the terms of collective bargaining agreements.

Secondly, plan settlors have successfully modified the rules governing retirees’ ability to return to work for a public employer after retirement (while still collecting a retirement benefit). States that have litigated this issue have determined this is not a core pension benefit and thus is not protected by the Contract Clause.

Several benefit modifications involve changing future accrual of benefits for current employees. How have courts analyzed these changes?

Courts have upheld many of these changes, reasoning that the Contract Clause does not protect the future accrual of benefits, but only benefits that have already been earned. This dovetails with the legal principle that, generally, a legislature cannot bind future legislatures. Thus, changes like lowering the formula multiplier for future service or moving employees into a new, less rich system for future service are often upheld. On the other hand, increasing the age/service credit requirements for active employees who are vested (as defined by that system) or revising service credit accrual retroactively have not been upheld, as courts have found these changes affected previously earned pension benefits and thus cannot be changed retroactively. This has been described as “moving the goalposts,” and has often been struck down. One exception has been that some systems have changed the calculation of final salary (often called highest average salary) for active employees who are not currently eligible for retirement and those changes have survived challenge.

As always, there are exceptions to these trends. Arizona, a state with a pension protection clause and common law that employees vest into their pension benefits upon commencement of employment, has barred prospective changes to a lower multiplier for future service. 

What future benefits litigation is on the horizon?

This area of law has been challenging in that, unlike COLA litigation, plans have made a wide range of changes to benefits, resulting in litigation that has been far more varied than COLA litigation which tends to affect a single benefit (COLA) for a certain cohort (retirees).  In addition, anecdotal information suggests systems are making changes every year that could be litigated, but aren’t. Thus, predicting what changes are litigated requires predicting which changes in which jurisdictions are most likely to lead to litigation.

What benefits changes may be litigated? Systems will look for more near-term savings as a dollar saved this fiscal year is worth far more than a dollar (or even many dollars) saved in a generation.  Systems will examine changes that save them money in the present, such as health care benefits for retirees. Similarly, systems will consider raising contributions for current employees or employers because they increase the system’s bottom line this year. Those near-term benefit reductions are more likely to be litigated than reduced benefits, which workers may not realize for decades.

States with pension protection clauses in their constitutions, a commitment to the California Rule or decisions finding early vesting by current employees are most likely to see new litigation, as litigants may feel they have a better chance to successfully challenge the benefit reductions. In addition, there are still many states that have had no pension litigation in the last 10 to 20 years and would also appear likely to see future litigation as parties believe they have more of a blank slate for securing favorable decisions.