Recently, both Dallas and Houston sought and received legislative relief for their troubled pension funds.
David Godofsky, partner in Alston & Bird’s Employee Benefits & Executive Compensation Group, who is based in Washington, D.C., explains that in both cases the cities were allowed to reduce certain future pension benefits and increase employee contributions.
For example, in Houston, the legislative relief reduced the future cost of living adjustments (COLAs) to pensions. There were different COLAs for different groups of retirees, but those with best were getting 3% per year, not compounded, but based on the original balance at retirement. The COLA is now based on investment returns of the pension fund. According to Godofsky, if a fund has a five-year average return of 5% or less, there is no COLA. If the average return is between 5% and 9%, the COLA is half of the rate of return over 5%, which caps out at 2%. “This is a pretty big reduction if you consider the loss of the compounding effect,” he says.
Also in Houston, they’re requiring active employees to contribute more, using a complicated structure of what certain retirees are contributing. In Dallas, they are asking active employees to contribute more, and future benefits for people who retire have been reduced.
These kinds of reforms would be illegal in some states, Godofsky notes. The rules are different in various states; many have detailed pension protections in state constitutions, and say specifically that pension benefits will be protected. These states include Alaska, Arizona, Connecticut, Delaware, Hawaii, Illinois, Kentucky, Louisiana, Massachusetts, Michigan, New Mexico, New York and Texas.
He explains that these protections vary from state to state. In some states, once you hire an employee, you cannot change the pension benefit adversely even for those pensions not yet accrued. In some states, there might be protections for benefits earned but not for those yet to be reaped, and in others, there are protections for benefits earned and for those employees eligible to retire. Texas has limited protections; they only apply to certain municipal plans and some cities are exempt.NEXT: Contract clauses can limit what municipal pensions can do
According to Godofsky, all states have contract clauses in their constitutions similar to that in the U.S. Constitution. It says something like, “Legislation cannot impair provisions of contracts.” Some courts say that contract laws apply to public pensions—Florida, Arkansas and California are examples.
He says in each of these states, the state Supreme Court has prescribed protections somewhat differently. In Florida, there is no pension protection clause, but the statute says pensions are in the nature of contractual provisions. The Florida Supreme Court held that the protection only extends to benefits already earned or accrued, not to those to be accumulated in the future.
In Illinois, municipalities generally cannot change pensions at all in any adverse way, but they can use traditional contract rules. For example, Godofsky says, employees could agree to lower pensions. “That doesn’t usually happen, but unions do negotiate changes in pensions, so unions are allowed to negotiate with employers to reduce pension benefits,” he notes.
Cities need to look at the specifics of pension reform legislation in each state.
“A lot of states’ and municipalities’ budgets are under pressure because underfunded pension obligations in the past have built up and they don’t have money now to shore up pensions. They are having to pay pension benefits out of current revenue. As pension funding gets built up, they have to divert money to pay for police, schools, medical care and pensions for people who no longer work for government,” Godofsky says.
He adds that states and municipalities can only do so much to increase taxes. Voters revolt and businesses leave, so they end up collecting less in taxes. In some cases, they are only willing to increase taxes at a limited level.NEXT: So what can municipalities do?
In terms of alternatives, Godofsky notes that first of all, there are plenty of states in which municipalities can do whatever.
But, focusing on states with limitations, it is possible to make changes if there is a union involved. Getting buy-ins from unions is very helpful.
In some states, another option is to go the contractual route. For example, according to Godofsky, the employer may say, “We are going to require large contributions to the pension fund unless you individually agree to accept this new pension formula.” He says the more traditional route has been to grandfather people who have been around and change pension benefits for new employees or employees with fewer years of service, but a lot of municipalities have so many retirees now, they need to address funding from current workers.
Godofsky adds that there has been some movement to increase retirement ages. There are some municipalities in which employees can retire at a young age—after 20 years of service, for example. “There is a lot of push now to increase retirement ages. That was a factor for the Texas cities; many municipalities have a retirement age of 50 or 55, in Houston, it was 50. Those are being pushed up generally,” he says.
“Generally speaking, more buy-in from unions and employees can introduce choice, and municipalities will be more likely to survive challenges in jurisdictions in which they are limited on what they are allowed to do,” Godofsky concludes.