The Anticipated Demise of the Vested-Rights Doctrine

By Jeff Chang

California’s cities are in crisis mode.

With pension costs outpacing revenue growth and severely underfunded retirement systems (the California Public Employee Retirement System is only 68 percent funded), local governments are grappling with tough questions surrounding their public employee retirement benefits.

Decades of unfavorable case law protecting such benefits have handcuffed cities to financially unsustainable pension liabilities, with no way out in sight.

This could all soon change. Four cases on appeal to the California Supreme Court may alter the way California cities think about, and plan for, their public employee retirement benefits.

Shifting from past rulings, the state High Court could allow public agencies to modify retirement benefits for active employees by weakening the vested rights doctrine. This doctrine, the fundamental policy protecting California’s public employee benefits, is case law that’s been shaped over the last 70 years.

The California Supreme Court has recognized in dozens of cases that public employees have a vested contractual right to pension benefits from the start of their employment, and held that such a right “may not be destroyed, once vested, without impairing a contractual obligation” of the public entity.

In an off-the-cuff statement earlier this year, Gov. Jerry Brown said he had a “hunch” courts would modify the vested rights doctrine, what he’s dubbed the “California rule,” so “when the next recession comes around the governors will have the option of considering pension cutbacks for the first time.”

For cities in search of broad sustainable solutions providing both short- and long-term financial relief, which they may not see until the 2013 Public Employees’ Pension Reform Act materializes, a state Supreme Court decision could deliver some freedom to make financially needed changes.

Change will not come quickly — or even without a fight. But local governments can start evaluating what a weakening of the vested rights doctrine could mean for future retirement benefit plans.

What if the Vested-Rights Doctrine Gets Weakened?

Let’s assume the Court weakens the vested rights doctrine.

If this happens, agencies may be permitted to modify, freeze or even terminate a defined-benefit plan (like CalPERS) without having to substitute it with something comparable. This paradigm shift would present a fresh-start opportunity for cities to rethink the way they’ve been doing things for generations and allow local governments to design a fiscally responsible benefits system based on long-term affordability.

Under current laws, benefits can only be increased or maintained, contributions are determined by CalPERS and county retirement systems, cities have little to no control over what they pay for benefits and taxpayers are on the hook for the payment of lifetime benefits.

With a change to the vested-rights doctrine, cities could choose to provide benefit levels that they can afford, reduce benefits if the costs become too high and require employees to share the investment risk associated with their retirements.

Agencies would also have other choices to make:

Stay in CalPERS or not. Agencies may want to opt out of the largely one-size-fits-all CalPERS system to gain more local control over retirement benefits. This will likely be a contentious decision. CalPERS is influential and any widespread move away from it could be a huge leap from both a labor and cultural perspective.

Legislative changes may ultimately need to happen to give communities the leeway to make a shift from a multi-employer, defined-benefit plan to an agency-maintained, defined-contribution plan.

Under CalPERS and county defined-benefit systems:

Benefits are determined by legislation and statutes
Benefits are subject to projections and cost allocations of actuaries and/or an administrative board
Required contribution levels are dictated to public agencies
Agencies have little or no control over the terms of the plan (eligibility, exclusions, vesting, etc.)
Agencies are subject to the system’s rules on making changes or getting out

Keep some form of a defined-benefit plan or not. With a stand-alone plan, an agency could gain control over benefit costs by being able to change its rates and contributions. This could be a chance for agencies for step away from past practices to embrace new contribution levels and benefit rules.

Move to a defined contribution plan or not. Under an agency-maintained, defined-contribution plan, public agencies could:

Negotiate and design benefits based on budget, competitiveness and worker demographics
Decide how much the agency can afford and will pay into the retirement benefit program
Take on the administration and investment of the retirement benefits plan
Still require that public employees contribute toward their retirement
Shift, partially or completely, the market risks found in defined benefit plans to employees

Such a shift would mean a lot more work, but also a lot more control. If an agency currently manages a defined-contribution plan (such as a 401(a) or 403(b) plan) then it is already well-versed in setting up and managing such benefit plans.

While these changes will rely on the state’s High Court and Legislature, it’s important to note that retirement benefit changes will take time, careful thought, research and analysis at the municipal level.

With this in mind, here are some of the next steps your organization can take to open up discussions about making long-term, sustainable and worthwhile changes to your retirement benefit systems: