In Part IV of ‘Overcoming Economic Downturns and Fiscal Distress’, James Spiotto Discusses the Need to Successfully Address Legacy Costs, So That Funding of Essential Services and Needed Infrastructure Improvement Become the Solution

  • Part III of this series focused on economic development as a tool in riding the wave of economic cycles and structural fiscal issues.
  • In this installment, we look at legacy costs, most notably public pensions, funding problems, pension reform, and litigation.
  • This article serves as an excellent primer on the history and current state of public pension systems, the competing trade-offs of reform, and
  • How increased revenues from economic development and economic stimulus can help address underfunded pension systems.

by James Spiotto

Overview of How the State and Local Government Public Pension Underfunding Problem Developed

State and Local Government Pension Funds Status

There are approximately 4,000 public sector retirement systems for state and local governments in the United States, with $3.8 trillion in assets, 14.4 million current employees, 9 million retirees, and annual aggregate benefit distributions of $228.5 billion. The estimated amount of pension underfunding for states and local governments is estimated to exceed $1 trillion. This unfunded liability for pensions of over $1 trillion can be compared to the estimated total for FY2016 of $3.3 trillion in total revenue for all state and local governments.

Public Pension Benefits from Gratuities to Contractual Obligations

Most states and local governments prior to World War II treated public pension benefits for public workers as a gratuity to be funded on a “pay as you go” basis, with no obligation to pay benefits if the government decides not to. At that time, there were a few states that recognized, by statute or constitutional provisions, public pension benefits as contractual obligations (e.g., New York in 1940). After World War II, there was growing pressure from public workers and their union representatives to have greater assurance of payment than “pay as you go if you want to” gratuity. Most states enacted statutes or constitutional provisions or had state court decisions that interpreted public pension benefit payments as a contractual obligation.

Changes in Demographics of Public Workers over the Last 60 Years Added to the Pension Underfunding Problem – the Dynamic of Longer Lifespans and Lower Retirement Ages

In the 1950s and 1960s, it was not uncommon to have the retirement age be over 63, or even as high as 70, for public workers. In fact, public workers fought against lowering the retirement age from 70 to 63 in a number of states. The
average life of a retiree after retirement was six to eight years. Also, the average lifespan of a U.S. citizen increased from 69 years in 1960 to 78 years in 2012. At the same time, demands for early retirement as low as 55 years of age or after 20 years of service were enacted first for public safety officers, and then for others. All of these changes increased the total amount of pension benefits to be paid, and increased demands for more funding by states and local governments. In 2015, 14.8% of the U.S. population was over 65 and that percentage is expected to grow to 20.9% by 2050.

Economic Downturns and the Need to Balance the Budgets Contributed to Deferred Pension Funding and Increasing Benefits to Make Up for Delayed Funding

Since World War II, we have had 11 economic downturns, each of which has placed budgetary strain on state
and local governments. In order to fund essential services and attempt to balance budgets, there has been the deferral of that which is not perceived to be a payment due now, namely the deferred or reduced funding of pension obligations. In order to placate public workers, deferrals were sometimes softened by increases in benefits. Both deferrals and increased benefits were not tied to the ability to pay and afford them, exacerbating the problems that were occurring organically through demographic shifts.

Many State and Local Governments Have No Current Pension Fund Problem, or Have Resolved It

It should be noted that the vast majority of states and local governments have or will successfully address public pension issues without prolonged disputes or litigation. However, enough state and local governments have significant enough funding shortfalls, that failure to act can lead to a financial crisis for these governments, and grave economic consequences, which threaten the welfare of citizens and provision of government services at an acceptable rate.

The Aging Population and Possible Future Economic Downturn Are Reasons to Be Vigilant No Matter the Current Conditions of Pension Funds

Those over 65 years of age in the United States constitute an increasing percent of the population, namely 14.8% as of 2015, which is expected to grow to 20.9% by 2050. Likewise, the working years of 18-64 of age are expected to be reduced as a percent of population, from 62.2% in 2015 to 57.6% in 2050. These demographic shifts result in about 40 million more people over 65 as potential retirees.

While the USA percentage of population over 65 in 2050 (20.9%) is lower than many other developed countries, such as Europe at 26%, China at 24% and Japan at 33%, it is still a concern. There have been 11 economic downturns since 1949, about one every 7 to 10 years, so we now are facing the probability of an economic downturn in the next few years; the last downturn was the Great Recession of 2008. Economic downturns result in losses on pension fund investments and less revenues available to state and local governments to address issues and meet needs.

Efforts to Address Pension Underfunding Problem with Involuntary Pension Reforms, Resulting in Pension Reform Litigation

Recent Pension Reform and Litigation

Between 2010 and 2015, over 45 states have addressed pension reform. To date, since 2011, there have been over 20 major state or federal state court decisions dealing with pension reforms by state and local governments. Eighty percent (80%) (16 out of 20) of those decisions affirmed the pension reform, which covered reductions of benefits, including cost of living adjustments (“COLA”), or increases of employee contributions, as necessary. Many times, decisions to uphold reform efforts cite the higher public purpose of assuring funds for essential governmental services and infrastructure.

Of the four states that did not approve pension reform, two states, Oregon and Montana, cited the failure of the proponents of reform to prove a balancing of equities, in favor of reform, between the public harm caused caused by unaffordable pension obligations, especially crowding out of funding of needed government services, compared to the harm to employees and retirees, so that the needed reform for a higher public purpose outweighs the harm to employees and retirees. Another state, Arizona, included state court judges in the reform, which violated another of that state’s constitutional provisions about improper influence over judicial officers during service. The recent Illinois Supreme Court rulings appear to stand singularly against pension reform for a higher public purpose or as a reasonable effort to save an insolvent pension system.

Examples of Recent Pension Reforms and Pension Reform Litigation

California: California’s Pension Reform of 2012 estimated savings of between $42 billion – $55 billion for CalPERs and $27.7 billion for CALSTRs. The Public Employee Pension Reform Act of 2012 (“PEPRA”) is now being attacked in Marin County and Alameda County litigation regarding PEPRA’s prohibition on pension spiking, a practice in which maangers give employees raises just prior to retirement, thereby boosting all future pension benefits.
The Cal Fire (Alameda County) and Marin County appeals to the California Supreme Court raise the issue of reversal or modification of the Californian Rule that created an obstacle to prospective modification of pension benefits. The appellate court in effect questioned the California Rule, and favored a reasonable pension benefit, capable of reasonable adjustments, to a rule that prohibited changes in pension benefits for any reason, even if they were not reasonably affordable.

Rhode Island:  Rhode Island’s Pension Reform and Interim Suspension of COLA created hybrid pension plans for non-public safety employees and increased the minimum retirement age. The dispute over this reform was originally settled, but then the police union rejected the proposed settlement. Ultimately, there was a settlement of the litigation, and the reforms were implemented with some settlement adjustments.

COLA Litigation: COLA litigation has resulted in eliminating or reducing COLA in Maine, Minnesota, New Jersey, Rhode Island, South Dakota, Colorado and others. The Arizona Supreme Court case of February, 2014 was an aberration because judges were included in the reform, and, traditionally, judges’ salaries and benefits cannot be
affected while they are sitting, as a manner of maintaining judicial independence. However, there was a pension reform for Arizona public safety officers, lead by the firefighters and police representatives, that was approved by the legislature and supported by a favorable vote by the electorate. The reform was structured as a constitutional amendment regarding pension reform for public safety workers statewide based on a consensual agreement, inter alia, to change existing pension benefit enhancement to COLA reduction reforms similar to that already done in other states. The Illinois Supreme Court has ruled that efforts to reduce COLA benefits for current employees violate the Illinois Constitutional Pension Clause.

Successful Illinois Pension Reform: Illinois Pension Legislation of 2010 for new employees as of January 1, 2011 was not seriously challenged and is effective. This created tier II for new employees with reduced pension benefits.

Recent COLA Rulings: Recently, there were two cases in federal court supporting pension reform in Lexington, Kentucky and Chattanooga, Tennessee which included COLA reform. See Tom Puckett, Roger M. Vance et al., Plaintiffs-Appellants vs. Lexington-Fayette Urban County Government et. al.; Commonwealth of Kentucky, Defendants-Appellees, Case No. 156097, United States Court of Appeals for the Sixth Circuit, August 15, 2016 (“Lexington Case”); John H. Frazier, Reuben K. Salter, William Melhorn, Jr., James Gaston, Plaintiffs-Appellants v. City of Chattanooga, Tennessee; Chattanooga Fire and Police Pension Fund, Defendants-Appellees, United States Court of Appeals for the Sixth Circuit, Case No. 15-6405, November 3, 2016 (“Chattanooga Case”).

Illinois Pension Reform Declared Unconstitutional: Illinois pension reform legislation in 2013, providing a claimed $160 billion in savings over a 30-year period, was struck down by the Illinois Supreme Court as unconstitutional in the case of In re Pension Reform Litigation (Ill. Supreme Court, May 8, 2015, hereinafter “Illinois State Pension Reform Case”). The supreme court held the reform legislation was unconstitutional under the pension protection clause of the Illinois Constitution Art. XIII § 51 (hereinafter “Pension Protection Clause”) whereby, according to the Illinois court, benefits accrue to the public worker once an individual begins work and becomes a member of a public retirement system, and those contractual provisions cannot be impaired or diminished even in the face of an important public purpose argument. The court held that there could be no exercise of police power to disregard the express provision of the Pension Protection Clause, and the failure of the legislature to act consistent with the Pension Protection Clause in the face of the well-known need for funding of the unfunded pension obligations undermines the police power argument. The court appears to be taking the unique position that, because the legislature did not act as the court deemed prudent, the government and people must suffer the consequences, even though the harm suffered by citizens could be avoided (and under U.S. Supreme Court precedent would be avoided).

Chicago Pension Reform Denied: City of Chicago Labor Pension Reform litigation involving public laborers and workers (Ill. Supreme Court, March 24, 2016, hereinafter “City of Chicago Pension Reform Case”) resulted in the Illinois Supreme Court ruling that the reforms were unconstitutional as a violation of Pension Protection Clause for
the reasons set forth in the Illinois State Pension Reform case. The court further found that the alleged consideration for the modification was already required funding and not sufficient to justify the change in benefits. Further, the Illinois Supreme Court ruled that Section 22-403 of the Illinois Pension Code in effect prior to 1970, which provided
that the State of Illinois and City of Chicago were not obligated to fund more than the statutory required payment that the City had consistently funded, was superseded by the Pension Protection Clause. The Supreme Court, at the same time, recognized that both the timing and amount of funding of the pension obligation was a legislative power of the city that the court could not then order or interfere with. It was up to the city to decide the time and amount of funding.

San Jose and San Diego Attempts: San Jose, San Diego and other cities have sought pension reform. San Jose’s pension reform litigation recognized that pensions could not be adjusted but, despite a 70% referendum, the court struck down portions of legislation as violating vested rights of workers. However, the court also recognized the City of San Jose’s right and power to reduce salaries prospectively and to fire or lay off employees. The mayor of San Jose (new since 2015) negotiated a settlement with the labor unions that restored some of the pension benefits that had been cut in Measure F, which was passed in 2012 and approved by 70% of the voters. On November 8, 2016, approximately 60% of the voters approved the settlement which ended the litigation.

Austerity vs. Reform: Some cities since 2007 have resorted to layoffs, furloughs, workforce reductions, and deferred preventive maintenance and infrastructure to deal with issues related to insufficient funds to pay expenses, including costs of labor and pension benefits.

Arizona Public Safety Workers Constitutional Amendment: The public safety officers along with local government and others recognized that the financial health of Public Safety Personnel Retirement System (”PSPRS”) had significantly deteriorated over the last 12 years. Pension benefit increases had been received in full over last 20 years while there had been continued decline in PSPRS funding. (The Plan’s funding ratio declined from 142% in 2000 to 67% in 2010, to 48% in 2015). The historic trend in valued returns was far below assumed returns, having been 5% or less since 2002, while the rate of return for valuation purposes was 8%, recently reduced to 7.5%. Annual pension costs had significantly increased to a level that pension debt threatened the continued delivery of public services and budgets for many local governments. As noted above, in 2014 the Arizona Supreme Court struck down efforts at pension reform. Recognizing the financial distress caused by ever increasing pension costs, as well as unfunded liabilities, the public safety workers, state legislators and local government employers built a consensus for the need for constructive reform. The growing pressure on state and local government budgets, and the limited sources of revenues, led some public safety officers to realize that local governments were going to reduce safety officers, fire trucks and police cars public pension reform could not be enacted. In order to save current jobs, they then supported and sponsored the reform effort.

The reform replaces uncertain inequitable and unsustainable COLA payments with COLA payments based on the consumer price index for the Phoenix region, with a cap of 2% maximum. Further, COLA will be prefunded and actuarially accounted for as part of normal cash determination. This was accomplished through a constitutional amendment (Proposition 124) supported by public safety officers, representatives, state elected officials, and local governments. The constitutional amendment passed a vote of the electorate in May, 2016. In addition, an entirely new retirement plan was developed for new employees. Further, the legislation, S.B. 1428, enacted significant governance reform. It is anticipated that these pension reforms will save between 20% and 43% in normal cost of retirement for each new hire. The reform will reduce future accrual of PSPRS pension liabilities by at least 36%, reduce taxpayer exposure to future market risk by more than 50%, and reduce volatility in employer contribution rates by more than 50%.

Involuntary Modifications of Public Pensions Outside of Chapter 9 Bankruptcy Is Difficult

Outside of a bankruptcy court order, the use of unilateral changes of pension obligations (non-consensual) are practically and politically difficult, but may provide the best results:

Most state court judges are elected by those affected, either directly or indirectly. This is a local rather than federal matter. Most pension plans are subject to state constitutional or statutory provisions that may raise legal issues as to any adverse change of pension benefits. Pension benefit reduction is obviously unpopular
and causes “morale” issues.

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 the pension will be frustrated. Less is truly more if less is assured. Timely modification may save the state or local government, and the pension system.

Pension adjustment mandated by financial distress. 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. 502 (1942) (“Ashbury Park”) and U.S.
Trust v. New Jersey, 431 U.S. 1, (1977) (“U.S. Trust”).

The Economic 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. This will provide, through appropriate funding or adjustment of
pension obligations (tax increases or benefit cuts), benefit levels that can be afforded without eroding infrastructure and essential governmental services.

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. An intermediate step that provides the benefits of a neutral, independent determination of fact issues, and a mechanism for funding affordable benefits is not only desired but necessary. Otherwise, the ultimate harsh results of bankruptcy will be far worse for all.

Not every municipality can file for Chapter 9. Chapter 9 Municipal Debt Adjustment is available in some states as a means for a municipality to adjust its pension obligations. If the state does not authorize its municipalities to file Chapter 9, like Illinois presently, then municipal bankruptcy is not available. Less than half the states
authorize their municipalities to be able to file Chapter 9.

A major obstacle to pension reform is the reality that the net result of reform for unaffordable pension benefits is that someone either has to contribute more (employer or employee) or someone (public workers or retirees) will receive less. An unaffordable pension obligation is a zero sum situation for all; there is no remedy that does not involve an increase in contributions or decrease in benefits. The government can only pay the limited funds it has and nothing more, especially if the government is at its legal or practical tax limits. This is sometimes a lose-lose situation.

While public pension reforms may be a necessary action by some state and local governments to address unaffordable and unsustainable obligations, part of the answer should be the benefits of reinvesting in the state and local governments. As noted in Part III of this series, economic development and infrastructure improvements create a high tide of additional revenues that can lift all boats, including legacy costs. It should not be forgotten that economic development and growth builds on itself. Creating one new job does not end with that job. One new job created by economic development efforts actually means a multiple of jobs through the job multiplier. Creating one new job means a need for additional goods and services to support that one new job, referred to as indirect jobs.

The new employee for one new job is paid and now has money to buy additional goods and services that require additional workers to supply these personal goods and services, referred to as indirect jobs. Depending on the nature of the job, the job multiplier could result in 2 to 6 or even more jobs being created. Further funding of needed infrastructure improvements adds new dollars to the GDP of the state or municipality as construction supplies, workers, and related services are purchased and stimulate the economy. Some studies claim there is more than $3.20 in economic impact over 20 years for each good hard dollar spent on infrastructure construction. The resulting economic tide from reinvesting in state and local governments through economic stimulus programs and needed improvements can reduce if not eliminate the challenges of legacy costs.

The next article in this series will discuss the factors supporting increased business development and reinvestment in state and local governments that create the economic high tide with a specific example of a proposal in Chicago for economic development that could lead to 20,000 new manufacturing jobs.

James E. Spiotto, Co-Publisher © James E. Spiotto. All rights reserved. The views expressed herein are solely those of the author and do not reflect the position, opinion or views of Chapman and Cutler LLP or Chapman Strategic Advisors LLC. 

Up next…Business Development and Balance Budgets for State and Local Government and the Upside Chicago Proposal to create 10-18 industrial parks in the Chicago Area, creating 20,000 New Manufacturing Jobs

Click here to read the introduction to this series, “How State and Local Governments Can Overcome Economic Downturns and Fiscal Distress”

Click here to read Part I: The Gathering Storm

Click here to read Part II: Alternatives Available to the State of Illinois and its Municipalities

Click here to read Part III: Solving Financial Distress with Economic Development