Constitutional showdown

If the purpose of a constitution is to establish a framework for a sustainable system of governance, including fiscal management, then state constitutions with provisions guaranteeing pension benefits fall short.

The impulse to protect pensions is understandable, but constitutional pension protection provisions impede sound fiscal management and should be removed.

Seven states have guarantees of public employee pension benefits in their constitutions, according to the Center for Retirement Research at Boston College. Some of them provide guarantees for past and future accruals, some for past accruals only.

But the reality is that such guarantees do not provide security, or promote prudent oversight or sound fiscal management. Instead, in too many cases, the guarantee has encouraged manipulation of pension financing.

The actuarial valuation of liabilities often has been understated by those overseeing the funds by use of high discount rates instead of more appropriate low rates, based on the premise that the obligations are riskless because of the constitutional guarantees. That undervaluation of pension liabilities encouraged politicians to shortchange pension contributions while at the same time increasing pension benefits to unaffordable levels.

The public employee unions accepted the reduced funding, seeing the constitutional guarantee as the ultimate security of the promised benefits.

But the guarantee has provided no security for Detroit's pension plan participants. The Dec. 3 ruling of U.S. Bankruptcy Judge Steven W. Rhodes enables the city of Detroit to seek protection under Chapter 9 of the U.S. bankruptcy code and reduce public pension benefits despite the supposed protection under the Michigan Constitution.

The court's ruling will not be binding in other cases. It “just affects the parties before it, and has no further "precedential' value,” Harvey Leiderman, San Francisco-based partner in the law firm Reed Smith LLP, said in an e-mailed response to questions. “This "ruling' is likely to be appealed to a higher federal court.” It “won't become "precedent' (and) binding on other courts until (a) higher federal court of appeals or the Supreme Court rules.”

Meanwhile, Illinois' state retirement systems are on an unsustainable course, despite pension guarantees in the state's constitution, and despite reforms adopted early in December that have yet to play out in terms of legal challenges or optimistic actuarial projections. In 1995, Illinois adopted a major reform to raise funding of the state systems to near 90% in 50 years, or by 2045. That earlier reform effort shattered as the Legislature ignored targets, worsening the funding ratio and leading to this year's new reforms.

The New York State Common Retirement Fund is an exception. The state has a constitutional guarantee and it is also one of the best funded public systems.

On the other hand, one of the best funded public plans, the Wisconsin Retirement System, has no such constitutional guarantee.

To save defined benefit plans at failing and weak systems, the trustees must provide leadership to encourage policymakers to strengthen oversight and funding, and to keep benefits affordable. Where the internal governance of the system is weak, legislators need to toughen it.

In addition, legislators should seek to scrap the constitutional guarantees. They provide no enforcement mechanism or counterbalance to the temptation to cut contributions or boost benefits the guarantees provide.

The constitutional guarantee was seen as a means to provide additional support beyond whatever funding a system would have. That's because public plans, unlike private-sector plans, have no underlying insurance program, such as the Pension Benefit Guaranty Corp., to pay benefits in the event a plan runs out of assets.

But legislatures that manipulated the systems by shortchanging funding could always fall back on the idea that the power to tax provided the ultimate backup. Yet even taxes reach a limit. If they get too high they threaten the fiscal and economic wellbeing of the state, including budgetary spending necessities and priorities.

Constitutional guarantees are too rigid, taking no account of changing economic conditions, such as in Detroit or cities in California that are facing legal challenges over their fiscal obligations.

The guarantees provide no mechanism to ensure payment of actuarial required contributions, or to ensure benefit affordability. The guarantees provide no real recourse for taxpayers against irresponsible legislatures that fail to properly fund public retirement systems. The issue is too remote for most voters to recognize until too late, and they can hardly throw out the whole legislature when they do recognize it.

In fact, many public plans offer pension benefit raises and annual cost-of-living raises, even as the funding level of the plans deteriorates. The constitutional provisions also generally provide no limit on amounts guaranteed.

The constitutional guarantees fail to take account of conflicts of interests. Legislators have a conflict of interest because in public employee collective bargaining negotiations, they can benefit (in future political campaigns from the financial contributions of unions and the votes of union members) if they support benefit increases.

In addition, the constitutional guarantee of public employee pensions provides a benefit for one group, public employees, at the expense of others, the taxpayers. Constitutions are supposed to protect all people equally, not provide a special benefit for one group at the expense of others.

The pension benefit guarantees should be removed from the state constitutions, or amended to provide checks and balances and a framework for sustainable fiscal management.

This article originally appeared in the December 23, 2013 print issue as, "Constitutional showdown".