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Wednesday, May 14, 2014
COLA Cuts in State/Local Pensions by Alicia H. Munnell, Jean-Pierre Aubry and Mark Caferelli
“…Between 2010 and 2013, 17 states (with a total of 30 plans) enacted legislation that reduced, suspended, or eliminated COLAs for current workers and often for current retirees. Cutting COLAs is an extremely attractive option to plan sponsors, because it is virtually the only way to make large reductions in a plan’s unfunded liability.
“Reducing benefits for new hires or even future benefits for current employees – if legally possible – lowers future pension costs but has no effect on the existing liability. The existing liability represents benefits already earned, including promised COLAs. To the extent that the cost of future COLA payments is embedded in the liability estimate, cutting COLAs reduces the unfunded liability.
“All the COLA changes represent a cut in benefits, but the magnitude of the cuts varies. They essentially fall into three groups: 1) virtually eliminating the COLA for the foreseeable future; 2) reducing guaranteed fixed amounts; and 3) reducing caps for CPI-linked COLAs…
“The vast majority of states that changed their COLA had a fixed guarantee of 2.5-3.5 percent compounded annually, regardless of what was happening to inflation. These states include Colorado, Florida, Illinois, Minnesota, Montana, New Mexico, Ohio, and South Dakota. In the current low-inflation environment, such guaranteed adjustments more than compensate for increasing prices and therefore produce increasing real benefits after retirement.
“Three states (Colorado, Ohio, and South Dakota) abandoned the guarantee and linked future COLAs to changes in the CPI, with both Colorado and South Dakota including provisions that link the COLA to funded status as well. Two states (Minnesota, and Montana) reduced the guarantee and linked future increases to the funded status of the plan.
“Illinois and New Mexico simply reduced the amount of the guarantee. Florida suspended the COLA for several years, but plans to reinstate a 3-percent guaranteed increase in 2016…
“Four states that cut their COLA – Colorado, Illinois, Maine, and Ohio – have plans where workers are not covered by Social Security... Illinois, where participants in SURS and TRS are not covered by Social Security, reduced the COLA for those hired before 2010 from a guaranteed 3 percent to 3 percent of the lesser of: 1) their current benefit; or 2) $1,000 multiplied by years of service.5 Those who retire during or after July 2014 will receive COLAs only every other year…
“If inflation remains low (less than 2 percent), most public employees in the four states will not be seriously hurt by the changes in the COLA. Even at low inflation rates, however, those with higher benefits in Illinois and Maine will be affected, as these states have targeted their COLAs to retirees with benefits below $30,000 and $20,000, respectively. If inflation rises to 3 or 4 percent, participants in all four states at all benefit levels will see the real value of their entire retirement income erode…
“Most states protect pensions under a contracts-based approach. The federal Constitution’s Contract Clause and similar provisions in state constitutions prohibit a state from passing any law that impairs existing public or private contracts.7
“A handful of states that protect pensions under the contract theory have state constitutional provisions that expressly prevent the state from amending the plan in any way that would produce benefits lower than participants expected at the time of employment. Illinois and New York have such a provision...
“…How state and local defined benefit promises have actually played out in the public sector in the wake of the financial crisis is an interesting story. Public plan participants were thought to have a higher degree of protection than their private sector counterparts. Whereas ERISA protects benefits earned to date, participants may end up with less than expected if their employer closes down the plan for reasons of economy or bankruptcy and the benefit formula is applied to today’s earnings rather than to the higher earnings at retirement.
“In contrast, in many states the constitution prescribes, or the courts have ruled, that the public employer is prohibited from modifying the plan. This prohibition means that employees hired under a public retirement plan have the right to earn benefits as long as their employment continues. Thus, if the employer wants to reduce the future accruals of benefits, such a change usually applies only to new hires.
“On the other hand, in the wake of the financial crisis, in many instances the ‘pension wealth’ of both current employees and retirees has been reduced through reductions in the COLA. Courts apparently do not view COLAs as a core benefit protected under the laws of the state…
“The key point is that defined benefit promises in the public sector are not as secure as one would have thought before the financial crisis. It was the belief that they were guaranteed that led economists to argue that the liabilities should be discounted by the riskless rate for valuation purposes. But when the stock market collapsed, benefit promises were in many cases reduced.”
5 For example, for a retiree with 30 years of service and a benefit of $40,000, the COLA will be the lesser of: 1) 3 percent of $40,000 or $1,200; or 2) 3 percent of $30,000 (30 years of service x $1,000) or $900. The alternative formulation serves as a cap.
7 To determine whether a state action is unconstitutional under the Contract Clause, the courts undertake a three-part test. First, they determine whether a contract exists. This part of the test involves determining when the contract is formed and what the contract protects. Second, the courts determine whether the state action constitutes a substantial impairment. If the impairment is substantial, then the court must determine whether the action is justified by an important public purpose and if the action taken in the public interest is reasonable and necessary. This approach sets a high bar for changing future benefits.