“…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.
For the full
report, Click Here.
For a complete analysis, read COLA: a Guarantee for Illinois Judges (What about Public Employees?), Click Here.
For a complete analysis, read COLA: a Guarantee for Illinois Judges (What about Public Employees?), Click Here.
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