Statutes as Contracts? The 'California Rule' and Its Impact on Public Pension Reform

Author:Amy B. Monahan
Position:Associate Professor and Vance K. Opperman Research Fellow, University of Minnesota Law School
Pages:1029-1083
SUMMARY

State and local retirement plans are underfunded by trillions of dollars, at a time when many states are facing decreased revenues and increased social needs. As a result, many states are actively considering how best to address the problem of state and local pension plan underfunding given their limited resources. In many states, however, courts have held that the statutes establishing state... (see full summary)

 
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1029
Statutes as Contracts? The “California
Rule” and Its Impact on Public Pension
Reform
Amy B. Monahan
ABSTRACT: State and local retirement plans are underfunded by trillions
of dollars, at a time when many states are facing decreased revenues and
increased social needs. As a result, many states are actively considering how
best to address the problem of state and local pension plan underfunding
given their limited resources. In many states, however, courts have held that
the statutes establishing state retirement systems created contracts between the
state and employees that prohibit the state from making any detrimental
changes to the benefits provided to current employees within such systems,
even on a prospective basis. This Article examines the development of such a
rule in the California courts, a rule that has been widely influential in this
area of law, as evidenced by the fact that courts in twelve other states have
followed the California Supreme Court’s holdings. This Article demonstrates
that by holding that benefits not yet earned are contractually protected,
without explaining the basis for finding that such a contract exists,
California courts have improperly infringed on legislative power and have
fashioned a rule that is inconsistent with both contract and economic theory.
I
NTRODUCTION .................................................................................... 1031
I. BACKGROUND ...................................................................................... 1034
A. PUBLIC EMPLOYEE PENSION PLANS ................................................. 1034
B. STATUTES AS CONTRACTS ............................................................... 1037
1. In General ............................................................................. 1037
2. Supreme Court Cases Holding That State Law Creates a
Contract ................................................................................ 1038
C. UNCONSTITUTIONAL IMPAIRMENT OF CONTRACTS .......................... 1040
1. In General ............................................................................ 1040
Associate Professor and Vance K. Opperman Research Fellow, Un iversity of Minnesota
Law School. I am grateful to Steve Befort, Kristin Hickman, Richard Hynes, and the participants
in the “Government Unions in the United States” conference held at North western Law School
for their helpful comments on earlier drafts of this Article, and to Lynn Mueller for excellent
research assistance.
1030 IOWA LAW REVIEW [Vol. 97:1029
2. As Applied to Prospective Changes ..................................... 1042
D. PENSIONS AS DEFERRED COMPENSATION .......................................... 1043
E. FEDERAL COURTS ON PUBLIC EMPLOYEE PENSION STATUTES AS
CONTRACTS ................................................................................... 1045
F. RIGHTS TO FEDERALLY CREATED PUBLIC RETIREMENT BENEFITS ..... 1045
G. SUMMARY OF THE FEDERAL APPROACH ........................................... 1046
II. THE CALIFORNIA RULE ........................................................................ 1046
A. CALIFORNIAS GENERAL APPROACH TO STATUTES AS CONTRACTS .... 1047
B. PUBLIC EMPLOYMENT AND COMPENSATION RIGHTS IN CALIFORNIA 1050
C. THE EVOLUTION OF CALIFORNIAS PUBLIC PENSION JURISPRUDENCE 1051
1. Early Cases ............................................................................ 1051
2. The Long Beach Cases ......................................................... 1056
a. Reasonable Modifications Under Kern .............................. 1058
b. The Introduction of the “Comparable New Advantages”
Requirement in Allen v. City of Long Beach .................. 1059
D. THE EVOLUTION OF THE ALLEN STANDARD ..................................... 1061
1. Material Relation to the Theory of a Pension System ....... 1061
2. Comparable New Advantages .............................................. 1062
3. Reasonable Modifications .................................................... 1064
4. A Break from Allen in Lyon v. Fluornoy? ............................... 1064
5. Future Accruals .................................................................... 1066
E. THE INTERSECTION OF THE CALIFORNIA RULE AND TRADITIONAL
CONTRACT CLAUSE ANALYSIS ......................................................... 1069
F. ADOPTION OF THE CALIFORNIA RULE BY OTHER STATES .................. 1071
1. States That Adopted the California Rule and Later
Modified It ............................................................................ 1071
2. Critiques of the California Rule .......................................... 1074
III. UNPACKING THE LEGAL AND PRACTICAL IMPLICATIONS OF THE
CALIFORNIA RULE ................................................................................ 1075
A. THE FLAWED LEGAL THEORY ......................................................... 1076
B. THE ECONOMIC INEFFICIENCIES AND INEFFECTIVENESS OF THE
CALIFORNIA RULE .......................................................................... 1079
C. THE REAL (HISTORICAL) PROBLEM—LONG VESTING PERIODS ......... 1079
D. THE FIX? ....................................................................................... 1082
CONCLUSION ....................................................................................... 1083
2012] STATUTES AS CONTRACTS? 1031
INTRODUCTION
Despite balanced-budget requirements,1 nearly every state in this
country carries significant off-balance-sheet debt in the form of
underfunded public employee pension liabilities.2 The aggregate amount of
this debt is estimated to be $3 trillion, with some estimates as high as $5
trillion.3 While liabilities vary significantly from state to state, several states
have unfunded liabilities of hundreds of billions of dollars.4 The amount of
money necessary to fully fund state and local employees’ pension benefits is
staggering, particularly at a time when the general economy is struggling
and state revenues are down.5 To put it in perspective, if one assumes an
unfunded liability of $3 trillion, every household in the United States would
need to contribute $27,000 to achieve full funding.6 Thus, in order to fully
fund state pension plans over the next thirty years, financial economists
estimate that contributions to such plans would need to increase by a factor
of 2.5, an amount equal to 14.2% of state revenues.7 And in some states an
even greater percentage of state revenue would be necessary.8
Against this background, it is not surprising that many states are
exploring options that will decrease their retirement plans’ unfunded
1. For an overview of state balanced-budget requirements, see NATL CONFERENCE OF
STATE LEGISLATURES, NCSL FISCAL BRIEF: STATE BALANCED BUDGET PROVISIONS (2010),
available at http://www.ncsl.org/documents/fiscal/StateBalancedBudgetProvisions2010.pdf.
2. For an overview of states’ unfunded pension liability, see ALICIA H. MUNNELL ET AL.,
CTR. FOR RET. RESEARCH AT BOS. COLL., THE FUNDING OF STATE AND LOCAL PENSIONS IN 2010
(2011), available at http://crr.bc.edu/images/stories/slp_17_508.pdf.
3. Robert Novy-Marx & Joshua Rauh, The Crisis in Local Government Pensions in the United
States, in GROWING OLD: PAYING FOR RETIREMENT AND INSTITUTIONAL MONEY MANAGEMENT
AFTER THE FINANCIAL CRISIS 47, 48 (Yasuyuki Fuchita et al. eds., 2011).
4. See BRYAN LEONARD, STATE BUDGET SOLUTIONS, JUST HOW BIG ARE PUBLIC PENSION
LIABILITIES? (2011), available at http://www.statebudgetsolutions.org/doclib/20110304_
StatePensionLiabilityMarch4.pdf (summarizing the results of several diff erent estimates of
public pension liabilities, which put California’s unfunded liability anywhere from roughly $60
billion to $398 billion); see also HOWARD BORNSTEIN ET AL., STANFO RD INST. FOR ECON. POLICY
RESEARCH, GOING FOR BROKE: REFORMING CALIFORNIAS PUBLIC EMPLOYEE PENSION SYSTEMS
(2010), available at http://siepr.stanford.edu/system/files/shared/G oingforBroke_pb.pdf
(estimating California’s unfunded pension liabilities at half a trillion dollars).
5. See, e.g., LUCY DADAY AN & DONALD J. BOYD, NELSON A. ROCKEFELLER INST. OF GOVT,
NO. 83, TAX REVENUES FINISHED 2010 STRONG; GROWTH CONTINUES IN EARLY 2011 3–5 (2011),
available at http://www.rockinst.org/pdf/government_finance/state_revenue_report/2011-04-
19-SRR_83%20rev.pdf (finding that while state revenues were increasing in 2010, the majority
of states had revenue levels in 2010 that were equal to or lower than revenues in 2007).
6. Novy-Marx & Rauh, supra note 3, at 72.
7. Robert Novy-Marx & Joshua D. Rauh, The Revenue Demands of Public Employee Pension
Promises 1 (Simon School Working Paper No. FR 11-21, June 2011), available at http://www.
kellogg.northwestern.edu/faculty/rauh/research/RDPEPP.pdf.
8. See id. at 40 tbl.5 (estimating that California, for example, would need to contri bute
17.7% of tax revenue to public employee pension funds over the next thirty years to fully fund
the state’s plans).

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