Wednesday, March 21, 2018

Richard Epstein: Pension Abuse In California


One of the main themes in the blockbuster case of Janus v. AFSCME—currently before the United States Supreme Court—is the risk of having unions sit on both sides of the table in public-sector contract negotiations. 

Nowhere is that risk more pronounced than in California, where the perverse and pervasive effects of union political influence are on display in Cal Fire Local 2881 v. California Public Employees’ Retirement System, now before the California Supreme Court. Between 2009 and 2013, California law allowed state and local employees with over five years of service to purchase with their own funds up to five years of “fictional years of retirement service credits”—commonly called “airtime”—that they could then add to their years of actual service in order to increase the value of their pensions at retirement.


This novel airtime benefit was supposed to be cost-neutral to public employers, but it never was: each unit of airtime represented a huge windfall to the lucky state employees and a drain on the public treasury. The Public Employees’ Pension Reform Act of 2013 (PEPRA) sought to end the practice moving forward, without taking away airtime rights that had already been purchased by public employees. The union’s position is that the right to purchase future airtime rights was vested in all current employees on passage of the statute, so that PEPRA violates the state constitution’s contracts clause by preventing employees hired before 2013 from making purchases after 2013. The California Court of Appeal rebuffed that union effort by holding that the union did not meet its “elevated” burden of showing that the legislature had indeed intended to create these vested rights going forward. The California Supreme Court should follow suit.

The gauzy structure of the airtime transactions offers proof that this program should never have been implemented at all. It is of course legitimate for individual workers to want to secure additional pension protection. Yet there is an easy way to do that. Instead of putting that cash into airtime, employees could just invest it in a personal retirement plan. The transaction does not involve any government agency but is done with a financial institution, so that there is no risk of excessive compensation stemming from a mispricing of this complex benefit. The individual employee can decide on the appropriate riskiness of the retirement fund by choosing the right mix of stock, bonds, and cash.

This would involve using defined contribution plans, which should be par for the course in all employment arrangements. By cashing the employee’s interest at the outset, the risk of assigning wrong values to any acquired asset is eliminated. In addition, these defined contribution plans are portable, so that an employee who shifts jobs can take his plan with him, thereby increasing mobility in the labor market. Unfortunately, most public-sector retirement plans, like California’s, are currently defined benefit plans, in which the employee’s compensation is determined typically by looking at a combination of salary history and length of service. In these plans, the employer takes the risk of any short-fall in setting aside reserves for covering the future obligation. But in the event that these reserves produce some excess because of, say, excellent stock market performance, the employer can take those extra funds out of the plan, so long as the assets that remain are capable of funding the program.

The California formula for defined benefit plans is a dream for public employees, wholly apart from the added airtime rights at issue in Cal. Fire Local. The basic state formula in California allows an employee, for example, to retire at age 50 with 30 years of service credit and to receive three percent of his final salary for each year of service. For example, an employee who retires at an annual salary of $100,000 is entitled to receive three percent multiplied by 30 years, multiplied by $100,000, for an annual pension fund of $90,000 each year for life, starting at the date of retirement. The enormous burden of the pension plan far exceeds the money set aside to fund these rights in the first place.

The problem became more acute when, in 1999, Governor Gray Davis signed SB 400 that in key places simply substituted in the number “3” for the number “2.5” in the above formula, which effectively allowed for a substantial increase in pension size, without any serious public debate as to its financial implications. SB 400 had other changes, all of which increased pension fund obligations. Thus, it was simply assumed that rising gains in the stock market would allow for rate of return of 8.25 percent on investment over the long haul. But 1999 was a boom year. Then the dot-com bubble burst in 2000. Owing to the unduly optimistic projections, Davis’s plan ended up being off by many billions of dollars, as the stock market endured years of sluggish returns while bond yields remained low. In 2016, Davis said he regretted signing the legislation.

The airtime program only aggravated an already acute situation. Airtime was touted as costing taxpayers nothing because the price was supposedly set equal to the amount of both the employer and employee contributions. But in order to make defined benefit plans appear solvent, their governing boards routinely overstate their anticipated rate of return on future investments. In the end taxpayers, as the Hoover Institution’s John Cogan has powerfully shown, have to pick up the tab. Airtime is no exception to this rule.

In its effort to overturn PEPRA, the union is relying on a long line of California cases that have held that “an employee’s promised benefit vests at the commencement of service.” That position has no analogue whatsoever in private defined-benefit pension plans. Those plans typically vest only after a certain number of years of service, which under federal pension law must be five years or less, but only for the money already contributed into the plan. The California rule immediately vests, which is a bonanza for workers because it insulates them from economic volatility.

On the union view, legislative reform of the pension process can take away any given right from existing employees only by giving them some equally valuable right in return, which necessarily prevents any pension reduction from present employees to bring the system back into financial balance. The entire burden of pension reform therefore must fall on the shoulders of future employees. Yet by the time that those reforms kick in, the financial damage will already have been done. The vested-rights doctrine thus requires state and local governments to raid all other services before touching benefits—a rule which can produce massive dislocations in the provision of education, health care, libraries, parks, police, fire, and much more.

The California Supreme Court should accept the lower court’s view that these rights are not vested because the legislature did not deem them to be vested. Indeed, one hopes that the California Supreme Court will not only make that decision but also recognize that the entire doctrine of vested pension rights rests on rickety constitutional foundations.

The correct starting point for the analysis is that that a public office is a public trust. When the legislature authorizes its administrative officers to enter into particular transactions, these officers act as fiduciaries for the public who must ensure that the transaction benefits the state. When state agencies deal at arm’s length with outsiders, they should adopt the “business judgment” rule, whereby the transaction stands so long as government officials act reasonably and in good faith. But the pension question is different, given the enormous union presence in the legislature. At this point, the level of scrutiny of given transactions has to be raised to ensure that the state and its citizens receive full and fair value from any transaction. In 1987, I wrote in The Cato Journal that the constitutional constraint on government should be captured in the following “givings” clause: “Nor shall public property be given for private use, without just compensation.” That proposition is violated whenever the vested-rights doctrine guarantees that the public gives up more than it gets, given the ever-present risk of union domination.

Indeed, at this point, it is not enough for the California Supreme Court to sustain PEPRA. Instead, it should go one step further and seek to unwind the earlier airtime transaction as a blatant raid on the public treasury. The court should also revisit earlier decisions that vest contract rights to future payments from the time of initial employment. No one would tolerate that abuse for the advantage of corporations. They shouldn’t tolerate it to give government employees, union or non-union, first dibs on public resources. Too many innocent people suffer from that unwarranted privilege.


Professor Richard A. Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, is the Laurence A. Tisch Professor of Law, New York University Law School, and a senior lecturer at the University of Chicago.  This article was first published by the Hoover Institute's Defining Ideas.

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