How Have Obligations Related to Pension Benefits Changed Over Time, and What Options Exist When They are Unaffordable?




Pensions have undergone transition over time from a gratuity (to be paid if you want) to a contractual obligation (that is enforceable). 

States take different approaches in analyzing the pension rights of public employees and whether those rights can be modified. Prior to the second half of the 1900’s, pension payments were considered to be in the nature of a gratuity that could be reduced at will. Pension obligations were viewed as “pay as you go” since they were to be paid if there were funds and if the state or local government so desired. Currently, states take different approaches in dealing with the impairment of pension benefits.

State Constitution Specifically Prohibits Impairment of Public Employee Pensions General Constitutional Prohibition
Against Impairment of Contracts (Applicability to Pensions Depends on Whether the Courts View Pensions as Contractual Obligations; Also, States that Do Not Have Their Own Contract Clause Oftentimes Rely on the Contract Clause of the U.S. Constitution):
State Statute or Case Law Prohibiting Impairment of Public Employee Pensions
Alaska, Arizona, Hawaii, Illinois, Michigan, Louisiana, New York Arkansas, Georgia, Nebraska, New Jersey, Oklahoma, Rhode Island, Tennessee, West Virginia Alabama, California, Colorado, Connecticut, Delaware, District of Columbia, Florida, Idaho, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maine, Maryland, Massachusetts, Minnesota, Mississippi, Missouri, Montana, Nebraska, Nevada, North Carolina, North Dakota, Ohio, Oregon, Pennsylvania, South Carolina, South Dakota, Utah, Vermont, Virginia, Washington, Wisconsin, Wyoming
States underwent development of constitutional, statutory and case law provisions on pension obligations being contractual obligations that could be enforced in most cases. How different states have different approaches:
  • Contractual rights. Generally, state constitutional or statutory provisions provide that pension benefits are contractual rights. Six states have raised the issue of pension rights, stating they are a property right as opposed to a contractual right (Wisconsin, Ohio, Maine, Connecticut, New Mexico and Wyoming).
  • Impairment. A non-impairment law is not intended to stretch pensions beyond their elastic limits. *****Brief elaboration of this point?*****
  • Developed case law that permitted modification of pensions. As circumstances change and available funds are stressed, pensions can and need to be changed, but within certain parameters:
    • Right to modify must be clear in legislation, employment agreements and union contract (Rhode Island).
    • Adverse conditions which could lead to the failure of pension plan, and the purpose of the legislation justifies amendment (Vermont).
    • To balance within reform adverse consequences of actuarially necessary changes to strengthen or improve the pension plan (Colorado, West Virginia).
    • Reasonable modifications that bear material relationship to theory of the pension system and its successful operation (Massachusetts).
    • Certain legislation by its nature cannot bind successive legislatures and can be changed (Georgia).
    • Contractual pension rights may be altered if changes are related to maintaining a healthy pension system as a whole. Changes that disadvantage members must be accompanied by comparable new advantages (California).
    • Caps on cost of living increases or changes in percentages used for increases that cut benefits were upheld in order to maintain the viability of the pension program (Minnesota, South Dakota, New Jersey and Colorado).
  • What can be adjusted. Non-impairment laws are not all-encompassing. Some provisions of reform are non protected under non-impairment laws. Even though such changes may indirectly affect pension benefits received by a particular or particular set of public employees, many state and local governments can and in some cases have made the following changes to their pension systems:
    • Benefits that accrue in the future.
    • Reduction in mandatory retirement age.
    • Reduction in hours or salary.
    • Loss of benefits for non-compliance with the plan.
    • Dismissal of public employees.
  • The argument for pension adjustments in times of insolvency. Pension obligations can, in very extreme circumstances, be “discharged” where necessary to serve an important public purpose:
    • If the state and local government cannot fund pension obligations and essential government services. If there are not sufficient tax revenues to pay for essential government services and pay pension obligations, then pension obligation must be adjusted for the common good. This scenario is dependent upon the government in question being in a state of inability (insolvency) to pay, not simply an unwillingness to pay.
    • Pension obligations cannot be enforced if to do so would frustrate the essential purpose of the governmental body and sacrifice the required services it must provide.
    • The U.S. Supreme Court has supported the ability of the state to set up a municipal receivership or other quasi-judicial mechanism to discharge obligations that cannot be paid given dire financial conditions and a need to continue essential governmental services for the financial survival of the governmental body.
    • Bridgeport, Connecticut in the 1990s had reduced revenues and, in order to balance its budget as required by state law, it reduced services and increased taxes only to find individual and corporate taxpayers left, further reducing revenues (The Death Spiral).
    • U.S. Supreme Court has recognized the need for contractual impairment to protect health, safety, and welfare of local citizens. In the case of Faitoute Iron & Steel Co. v. City of Asbury Park, 316 U.S. 502 (1942), the New Jersey Municipal Finance Act provided that a state agency could place a bankrupt local government into receivership. Under the law, similar to a Plan of Adjustment for a Chapter 9 municipal bankruptcy action, the interested parties could devise a plan that would be binding on non-consenting creditors if a state court decided that the municipality could not otherwise pay its creditors and the plan was in the best interest of all creditors as a whole. Id. at 504. After certain bondholders dissented, the court determined that the plan helped the city meet its obligations more effectively. Id. “The necessity compelled by unexpected financial conditions to modify an original arrangement for discharging a city’s debt is implied in every such obligation for the very reason that thereby the obligation is discharged, not impaired.” Id. at 511. The court then found that the plan protected creditors and was not in violation of the Contract Clause. Id. at 513. See also U.S. Trust v. New Jersey, 431 U.S. 1, 25-28 (1997).
    • This precedent has been used to justify pension reform. The Supreme Court of Puerto Rico has ruled (citing the U.S. Trust v. New Jersey case) that the protection of pension obligations is not absolute, but may be modified if reasonable and necessary to advance an important public interest, namely a financial crisis that threatens the actuarial solvency of the pension system. Hernandez v. Commonwealth, 2013 WL 3586616. (S. Ct. Puerto Rico, June 24, 2013).
Municipal insolvency and Chapter 9 impairment of pension obligations…

Involuntary modifications of public pensions outside of Chapter 9 bankruptcy is difficult. Outside of a Bankruptcy Court Order, changes of pension obligations by the government (unilateral reductions) are practically and politically unlikely, but may provide the best results. Most state court judges are elected by those affected, either directly or indirectly; they are closer to the problem and the stakeholders, and pension obligations are a local rather than federal matter. Most pension plans are subject to state constitutional or statutory provisions that may not permit changes without compromise. Pension benefit reduction is obviously unpopular and causes “morale” issues, but these can be partially alleviated if public employees feel that their labor representatives gave them a voice in the decision.

If the state or local government fails financially, the pension system is sure to follow. But “Necessity knows no laws.” Change may be mandated by the reality of the situation – if the state or local government fails financially then it has less funds to keep public employees hired and to pay for pensions. Thus, the pension system will fail, pensioners will receive less. The purpose of pension to provide stability in retirement will be frustrated. In a situation where there are no ‘good’ answers and left to choose between reduction in pension benefits or government insolvency, less is often truly more, especially if less is assured. Timely modification may save both the state or local government and the pension system.

There is precedent to “discharge” pension obligations where the governmental body’s survival mandates such action so that essential government services can continue to be provided. See Faitoute Iron & Steel Co. v. City of Ashbury Park, 316 U.S. 511-513 and U.S Trust v. New Jersey, 431 U.S. 1, 25-28.

Survival of the state or local government is key to long-term survival of pensions. The inability of a state or municipality to fund essential governmental services at an acceptable level can be fatal to its survival à la Detroit:

  • Pay what is sustainable and affordable. What is needed is a mechanism that provides an independent and neutral determination of what is affordable and sustainable so the debate of unwillingness or inability can be transcended to what can be paid and what cannot with appropriate mandated increased funding or adjustment to what can be afforded as pension benefits without eroding infrastructure and essential governmental services at an acceptable level.
  • Bankruptcy may lead to more drastic reductions. Bankruptcy is not only rare but is accompanied by a stigma that affects all creditor relations of the government and has far reaching negative consequences. Intermediate step that provides the benefits of a neutral, independent determination of fact issues and a mechanism for funding the affordable benefit is not only desired but necessary. Otherwise, the ultimate harsh result will be far worse to all.
  • Not every municipality can file for Chapter 9. Chapter 9 Municipal Debt Adjustment is available in some states as a means to a municipality to adjust its pension obligations. If the state does not authorize its municipalities to file Chapter 9 then municipal bankruptcy is not available.
  • Difference between Chapter 9 and Chapter 11. Unlike a Corporate Chapter 11 proceeding only a municipality (if authorized by its State) can file for Chapter 9 (creditors have no right to initiate a Chapter 9). There is a low threshold for rejecting of labor contracts in a Chapter 9 (“unduly burdensome in proposing a plan”) (unlike Section 1113 of the Bankruptcy Code for Corporations-multi-step procedure of disclosure, a proposal and negotiations first). There are no priorities for unpaid wages, benefits or accrued vacation or retirement benefits (Chapter 11 provides a priority over unsecured creditors of up to $12,475 per employee for prepetition wages, benefits accrued vacations and healthcare benefits).
  • If municipalities cannot use Chapter 9, what can be done? Absent the use of recourse to Chapter 9 the ability of state courts to address underfunding is uncertain and probably unsatisfactory without the right of the state to adjust labor agreements especially pensions for a higher public purpose – its survival and the health, safety and welfare of its citizens. For a more detailed discussion, see Spiotto,“How Municipalities in Financial Distress Should Deal with Unfunded Pension Obligations and Appropriate Funding of Essential Services,” Willamette Law Review, Volume 50 No. 4 p. 515 (Summer 2014) and “Financially Distressed Cities and Bankrupt Cities: Should Unfunded Pension Obligations Impair Funding of Essential Services?”. Pension plans and provisions for employee benefits should be written to permit modification, especially in the case of dire necessity or hardship to the governmental body. Absent that provision permitting modification, there may be difficulty in obtaining Court relief except for impairment permitted for a higher public purpose. Further, state constitutional provisions may prohibit any reduction to the extent of earned benefits.
Recent Chapter 9 court decisions are unanimous on ability of a municipality in Chapter 9 to modify pension obligation…

Vallejo – Exited Chapter 9 without tackling pension costs. The city’s annual contribution to CalPERs more than $14 million in 2013.

Stockton – Proposed plan leaves pensions untouched and proposes to continue making required payments to CalPERs.

Previously, 2013 the bankruptcy court judge had suggested Stockton would have difficulty confirming a plan without confronting pension obligations and suggested in dicta that pensions were contractual obligations that could be impaired in a Chapter 9.

On October 1, 2014, the bankruptcy court ruled that the obligations owed to CalPERs was not secured by a statutory lien (as claimed by CalPERs) but rather is as unsecured claim that can be adjusted just like other executory contract claims. (Transcript of Proceedings, October 1, 2014, In re City of Stockton, No. 12-32118-C-9 (Bankr. E.D. Ca.)) and February 2015 Bankruptcy Court Ruling that obligations to CalPERs could be impaired even though the final confirmed plan of adjustment did not so provide for any impairment.

San Bernardino – In holding that San Bernardino was eligible to be a debtor under Chapter 9 and rejecting the objection of CalPERs to the filing, the court noted: “The city cannot pay its obligations with money it does not have…. Impairment of Contracts seems inevitable….” In re City of San Bernardino California, 499 BR 776 (Bankr. C.D. Ca. 2013) (Decision on appeal).

Detroit – In rejecting a constitutional challenge to Chapter 9, the court held that pension benefits can be adjusted in Chapter 9 like any other debt obligation regardless of any state constitutional provisions. Further, while pension benefits can be cut, the plan must be fair and equitable. In re City of Detroit, 504 B.R. 191 (Bankr. E.D. Mich. 2013). (Decision on appeal).

But what do state and local governments do if they cannot file Chapter 9?
  • Use of U.S. Supreme Court precedent in U.S. Trust and Asbury Park cases to permit adjustment of pension obligations for a higher public purpose – the survival of the government.

Puerto Rico – Puerto Rican Supreme Court decision is not a Chapter 9 case. This court upheld legislation reforming the Commonwealth’s pension system in a challenge based on a constitutional provision that no laws impairing the obligations of contract shall be enacted. The court held the reforms were necessary to deal with the financial crisis that threatened the actuarial solvency of the system and that contractual protections were not absolute but must be harmonized with the public interest.

San Jose – In another non-bankruptcy case, the state court in San Jose Public Officers’ Association v. City of San Jose, No. 1-12-CV-225926 (Superior Ct. of Ca., Santa Clara County December 20, 2013), took an approach different from the Puerto Rican Supreme Court. Specifically, the court found invalid provisions due to fiscal and service emergency such as:

  • Provided for increased pensions contributions for current employees to cover unfunded actuarially accrued liabilities.
  • An alternative retirement plan for employees who wish to avoid increased contribution rates.
  • Suspension of all or part of COLA payments due to all retirees.

However, the court rejected a number of other claims, and found the reform of pensions was valid as to,inter alia, the ability of the municipality to reduced salaries of the city workers due to financial distress (poison pill provision), also objections based upon equitable and promissory estoppel and a change in the definition of “disabled worker” to not able to work at all.

  • All these provisions had been approved in a referendum by about 70% of the voters.
  • While referring to a budget and economic crises that had precipitated the enactment of the modifications, the court focused on the violation of vested rights and did not discuss the impact the ruling would have on the ever-increasing unfunded pension liability or higher public purpose.
  • The court did not hold that the vested rights doctrine did not mean that pension provisions could never be changed.
  • According to the court, the modification of pensions must not frustrate the reasonable expectations of the parties to the contract of employment but a municipality in financial distress could lower salaries.
Outside Chapter 9 what involuntary modification can be made in financial distress situation?
  • To rescue failing plans. If the pension plan is to fail or is actuarially unsound, courts have allowed change to provide a better outcome than uncontrolled collapse.
  • To change unworkable legislation. Pension plan base upon legislation (state or local) which does not work can and should be changed and courts have recognized the need and ability for such a change.
  • To balance rights and interests. Some courts have attempted to balance the interest and benefits in authorizing change to pension plans.
  • These principles in practice:
    • Changes to prevent pension plan from failing. Even states that find that their relevant contracts clauses prevent an impairment of pension rights, typically hold that adverse conditions which could lead to the failure of the pension plan and thus the purpose of the legislation itself, justify amendments to the plan.
    • Balancing advantages versus disadvantages of proposed modifications. Accordingly, in Colorado, a pension plan can be changed so long as any adverse modification is balanced by a corresponding change of a beneficial nature, a change that is actuarially necessary, or a change that strengthens or improves the pension plan. McInerney v. Public Employees’ Ret. Ass’n, 976 P.2d 348, 352 (Colo. App. 1999).
    • Reasonable modification of pension in furtherance of the theory of the pension system. In Massachusetts, modifications to a state retirement scheme can be permitted so long as such modifications are reasonable and bear some material relationship to the theory of a pension system and its successful operation. Madden v. Contributory Retirement Appeal Board, 729 N.E.2d 1095 (Mass. 2000).
    • Modification of pension must be related to higher public purpose. The courts of Vermont have found that, even if a party’s contract rights have been impaired, the contract clause is only violated where the impairment is not reasonable and necessary to achieve an important public purpose. Accordingly, an ordinance requiring greater contributions by employees along with increased benefits was not an impermissible impairment. Burlington Fire Fighters’ Ass’n v. City of Burlington, 543 A.2d 686 (Vt. 1988).
    • Does significant impairment reasonably relate to a justifiable public good. West Virginia has also adopted a balancing test holding that, where a substantial impairment has been shown and a legitimate public purpose for the impairment is demonstrated, a court must determine whether the adjustment of the rights and responsibilities of the contracting parties is based upon reasonable conditions and is of a character appropriate to the public purpose justifying the legislation adopted.State ex rel. West Virginia Regional Jail & Correctional Facility Auth. v. West Virginia Inv. Mgmt. Bd., 508 S.E.2d 130 (W.Va. 1998). See “Financially Distressed Cities and Bankrupt Cities: Should Unfunded Pension Obligations Impair Funding of Essential Services?”.

by James E. Spiotto, Co-Publisher © James E. Spiotto. All rights reserved (2015).