Public Retirement Systems and the Pandemic: Part I – a Coming Wave of COLA Litigation?

May 29, 2020Alerts

Public retirement systems in the United States are among the entities that may be particularly affected by the COVID-19 pandemic and the resulting economic downturn that has upended so many businesses and governments.

These systems, which are traditionally defined benefit plans, provide for the secure retirement of millions of public employer retirees and their families. The largest such systems, like California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS), hold hundreds of billions of dollars in assets and are among the largest institutional investors in the country. There are also hundreds of small plans for a single municipality or county’s retirees.

All public pension plans have the same basic operations model: C + I = B + E.

C – contributions from participating public employers and active employees
I – investment returns on the plan’s existing funds
B – benefits paid out to retirees and other beneficiaries
E – expenses for running the plan

Roughly speaking, plans must receive enough contributions (C) and create sufficient investment returns (I) to pay out benefits due today and in the future for their members (B) and cover administrative expenses (E).

The pandemic is harming both the stream of contributions and investment returns. First are threats to the employer contributions from plans’ employers, which are states, local governments and school districts. The pandemic is severely affecting the budgets of state and local governments across the country. Sources of revenue like sales and use taxes are drying up, while property tax revenues are projected to decline with many business and homeowners unable to timely pay their bills. Governments are predicting massive budget shortfalls for this fiscal year and next fiscal year (many of which begin on July 1, 2020).

Similar to the 2008 financial crisis, state and local governments facing these shortfalls will scrutinize their budgets to identify where they can make cuts. One of the largest costs for many state and local governments are the contributions they make on their employees’ behalf to public retirement systems. State legislatures and municipal governments are already debating reductions to pension plan contributions. Governments may also furlough existing employees, which will further decrease contributions.

Second, the retirement systems are also facing a substantial loss in investment returns. The Dow Jones, NASDAQ, and S&P 500 all reached record highs in mid-February 2020. Since then, there have been at least two Monday trading sessions that were so bad that they were labeled “Black Monday” plus a “Black Thursday” session. The Dow posted its one worst quarter in history. Oil prices crashed to the point that at one point they were even negative. Public retirement systems target a 7-to-7.5 percent return on investments each fiscal year – a target that will be a challenge in light of these massive economic losses and a concern that there will be multiple months of restricted economic activity to come.

With both sources of funding reeling, retirement systems will face increased pressure to cut the benefits they pay to beneficiaries. It is important to note that systems as a rule do not set the terms of the system. That is controlled by the system’s plan sponsor or settlor, which is the governmental body that set up the trust and is often a legislative body like a state legislature or city council. The plan sponsor has the power to change the terms of the retirement plan and can change it with or without the support of the retirement system. Indeed, sometimes retirement systems oppose support the changes implemented by the plan sponsor.

FAQs on COLA Litigation

In the wake of the 2008 economic downturn, plan sponsors increasingly adjusted cost-of-living-adjustments (COLA) paid by retirement systems for active retirees. Reducing COLAs has the effect of saving plan dollars immediately, not far in the future as do changes for future retirees or new employees. Reducing COLAs after 2008 led to widespread litigation. Another round of COLA reductions is likely to lead to further litigation.

Below we provide answers to some questions retirement systems are likely to face based on the lessons learned from the previous round of COLA litigation. This alert is intended to provide only general information and does not address every potential concern. Indeed, every COLA litigation is unique and often grounded in the state law of whichever jurisdiction is at issue. Given the complexity of this legal landscape, retirement systems should consult with legal counsel about the facts and circumstances of their specific situations.

What is the central claim being raised in COLA litigation?

The main claim raised in COLA litigation has typically been a Contract Clause claim under the U.S. and state constitution. The Contract Clause was a little-known provision of the U.S. Constitution for more than 200 years but has become the critical fight in nearly all COLA litigation.

Some states constitutions have a separate provision related specifically to public pensions. Those states include Alaska, Arizona, Hawaii, Illinois, New Mexico, New York and Texas.

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 COLA was constitutional. Most often, the court finds that the challengers failed the first prong of the Contract Clause test because the retirees did not have a contractual right to an unchangeable COLA for life. Examples of these states include Colorado, Maine, Minnesota, New Jersey, New Mexico and South Dakota. Courts in several states (notably Oregon and Montana) have adopted the three-part test but still found that the COLA change violated the Contract Clause because the retirees had a contractual right to the COLA rate in place at retirement.

What happens in states where courts have not adopted the three-part U.S. Trust test?

Certain states have maintained what is known as the “California Rule,” which states that the government cannot reduce a pension benefit in any meaningful way once a public employee has a vested right. Some of those states hold that employees vest into their retirement rights upon commencement of employment, decades before they may retire. States that continue to follow the California Rule have almost uniformly invalidated COLA reductions for current retirees. These states include Alaska, Arizona, California, Hawaii and Illinois.

What happens in states with a pension clause in the state constitution?

Some of those states have strictly applied the California Rule and invalidated COLA reductions. Those states include Alaska, Arizona, Hawaii and Illinois. On the other hand, New Mexico has a pension clause but upheld a COLA reduction, finding it was not part of the core pension benefit protected by the state constitution. Texas has a pension clause but upheld some reduction in pension benefits, although it has not had a COLA reduction case yet.

What COLA litigation may arise as a result of COVID-19?

More retirement systems may seek to reduce COLA for current retirees. In addition, more systems may propose COLA suspensions (and not just reductions) and implement those suspensions for multiple years or for an indefinite period of time until a plan reaches a certain funding status. Long-term or indefinite suspensions of COLAs, as opposed to reductions or short-term suspensions, are more likely to lead to renewed litigation and more scrutiny by reviewing courts. Permanent suspensions may cause courts to look past the first prong of the U.S. Trust and consider the second and third prongs.

What other lessons emerged from prior COLA litigation?

Process and perception matter. Governments and their respective retirement systems have had the most success in securing adjustments to COLA when they have engaged in a transparent process prior to reducing the benefits. A common theme in many of the decisions where courts upheld changes is a belief on the part of judges that the changes were fair and involved shared sacrifice by all the stakeholders in a public retirement system (current workers, public employers, retirees, and, to a lesser degree, the taxpayers). Courts appear to be persuaded to uphold legislation when they see a lengthy deliberative process by the systems and public employers before changes were made. This is the case even when the Contract Clause analysis does not reach the third prong where this “reasonable and necessary” analysis would occur. Rather, courts will often find there is no contract right based on whether they appear to believe the changes are fair. This can appear results-oriented but means that practitioners must be mindful that the ultimate judicial evaluation of the legislation will rise and fall on whether the process months and years earlier appears reasonable. Put another way, waiting until the state and system are sued to determine legal strategy for how to defend COLA changes is probably too late.

The second lesson to come from this litigation is the anomalous position of the federal Contract Clause. This clause should mean the same thing in all 50 states because it is part of the federal constitution. However, until recently, the threshold question of which test applied to pension challenges under the federal Contract Clause would turn on what state you were in and whether that state had adopted the California Rule. That the same federal provision meant different things and involved a different legal test depending on one’s state is nonsensical, and has gradually changed as states adhering to the California Rule have come to limit the California Rule to their state constitution only. This curious anomaly stems from the nature of the forums since the bulk of COLA litigation has been in the state courts. The closest the U.S. Supreme Court has ever come to providing guidance is that retired Justice David Souter sat on a panel of the First Circuit that upheld Maine’s COLA reduction, though he did not write the panel’s opinion.