In this blog I and multiple commenters have broached the subject of the suspect constitutionality of PSPRS' replacement of the old permanent
benefit increase (PBI) formula with the new cost of living allowance (COLA).
This change was put in place by the passage
of
Proposition
124, the Public Retirement Benefits Amendment, in May 2016.
It amended the Arizona Constitution via
referendum to allow a change in a public pension benefit.
This referendum was passed by Arizona voters
by a 70-30% margin.
However, changing a public pension benefit is considered an unconstitutional
act in Arizona based on Article 29 of the state constitution, which states “Public
retirement system benefits shall not be diminished or impaired . . . “ This was the legal justification for Kenneth
Fields' and Philip Hall’s successful challenges to the change in the PBI
formulation under the Elected Officials’ Retirement Plan (EORP). The EORP PBI is a retirement benefit, and it
could not be “diminished or impaired” unilaterally by the Arizona legislature
under SB 1609.
In order to avoid the same legal problems caused by SB 1609,
which was only approved by the legislature, Proposition 124 added the following
(italicized) language to Article 29 after a vote by the state’s citizens:
Public retirement system benefits shall not be diminished or
impaired, except that certain adjustments
to the public safety personnel retirement system may be made as provided in
senate bill 1428, as enacted by the fifty-second legislature, second regular
session.
This ostensibly allowed the state to “constitutionally” change a public
pension benefit, eliminate the PBI formulation for all PSPRS members, and move to a strict
COLA for existing retirees and all defined benefit tiers. Proposition 124 did not affect EORP members,
and the Arizona Supreme Court ("the Court") quickly dealt with the PBI issue in one short
paragraph in its decision in Hall. The change was unconstitutional under Article
29, just as it was in Fields, and it
did not matter if a member was retired or active.
This is where it gets interesting for PSPRS members. Outside of Article 29, another argument
that was used by plaintiffs in their cases against SB 1609 was that it violated
the Contract Clauses of both the Arizona and United States Constitutions. Since Hall only dealt with EORP, which was
not affected by Proposition 124, there was no reason to decide if changing the
PBI via referendum violated the Contract Clauses. The Supreme Court even avoided the
consideration of the Contract Clause in its original decision saying:
The dissent also maintains that the Bill’s changes to the
Plan may be upheld under the Contract Clauses of the United States and Arizona
Constitutions. U.S. Const. art. 1, § 10; Ariz. Const. art. 2, § 25. See infra ¶ 107. As we have explained,
however, the Bill’s unilateral and retroactive changes to the vested terms of
the Plan violate Yeazell and the Gift
Clause. See supra at ¶¶ 19–23.
Consequently, analyzing whether the Bill would pass review under the Contract Clauses
were it not for Yeazell and the Gift
Clause is unnecessary and violates the principle of judicial restraint. See Superintendent, Mass. Corr. Inst. v. Hill,
472 U.S. 445, 453 (1985) (stating that judicial restraint requires “avoid[ing]
unnecessary resolution of constitutional issues”).
The Supreme Court was using other guidelines in its decision
and was not going to go there when it came to the Contract Clauses. It even refused to do so in a Motion for
Reconsideration filed after its decision.
Before we discuss this further, a little refresher on what
exactly was changed by Proposition 124 might be helpful.
The old PBI, which was often incorrectly called a “COLA”, was not based on
any measure of inflation. It worked by
taking half of any annual investment earnings over 9% and putting it in a Fund
for Future Benefit Increases (“the Fund”).
The money was sequestered and could only be used to pay PBI's. From the Fund, PBI’s of up to 4% of the average normal retirement could
be paid to retirees. For many years, the
Fund had an excess, so PBI’s became a regular and expected annual raise for
retirees. The problem with the PBI
formula was that it worked in only one direction.
Whenever PSPRS earned over 9%, money was moved to the Fund, but if PSPRS
lost money, nothing went back to PSPRS’ investment pool to help mitigate losses. If PSPRS lost 10% one year, then earned 10%
the next year, 0.50% of the second year’s earnings would still be bled off into
the Fund, even though averaged only 0.25% for the two years. The rough years of the 2000’s
showed the ugliness of this system.
While PSPRS became more underfunded every year and employer contribution
rates increased, PSPRS was still forced to take much-needed investment earnings
and use them to pay PBI’s.
To further illustrate this, we can use the current fiscal year
(FY) as an example. Let's say PSPRS ends the current FY with a 13% annual return. Under the old PBI system, half of the amount
over 9% annual return was required to be transferred to the Fund. With $9 billion in investments, this would be
$180 million taken from PSPRS’ investment pool to be used for PBI’s. This would be despite the fact that PSPRS is
less than half funded and many employers are already straining their budgets to
make their annual contributions.
If we look at the FY 2016 PSPRS annual report, there were
11,863 retirees or survivors, and the average normal retirement was $4,632 per
month. A 4% monthly increase would on
the average normal pension would be $185.28.
The cost of this PBI per year would be $26.375 million, leaving over
$150 million for PBI’s in future years.
Any future FY’s that achieved returns greater than 9% would continue to add to
the Fund, and PBI’s of up to 4% would be paid as long as there was money in the
Fund. This PBI, as the name says, is permanent, not just for that year of excess earnings, so it would have to be paid to all retirees who received it until they or their surviving spouses died. Remember too that as long as there is money remaining in the Fund, more PBI's could be awarded in future years, compounding the unfunded benefit increases. Also, as the average normal
retirement benefit increased over the years, whether through wage inflation of those still working or via PBI's, future PBI’s would increase as
well. This allowed monthly retirement
benefits to steadily increase over the years, especially for those with
less-than-average benefits, as their PBI’s were a higher percentage of their
monthly benefits as compared to those retirees with average or above-average
monthly benefits.
The new COLA system that was put in place with the passage
of Proposition 124 is much simpler. It
allows for the payment of an annual COLA that is the lower of 2% or a local consumer price index for the Phoenix
area. The COLA is also paid on an
individual’s own retirement, not the average normal benefit, so a retiree
cannot see his retirement grow any faster than 2% per year. If inflation is higher than 2%, retirees will
see a loss in earning power that year.
If it less than 2%, they will only get a COLA that matches that annual
inflation rate. If inflation is 1% one
year and 5% the next year, the retiree will see his benefit increase by 1% the
first year and 2% the next year. The
other 3% of inflation will have to be absorbed by the retiree. The COLA’s will be paid for in the employer
contribution rates in FY 2018, which started July 1, 2017. The first COLA will not be paid to PSPRS
retirees until FY 2019, sometime after July 1, 2018.
So we can see that there is a dramatic difference between
the old PBI and new COLA systems. I
would be the last person to defend the old PBI system. It was a system designed by selfish,
shortsighted, and foolish people who thought that PSPRS would never earn less
than 9% a year and that high inflation would be a permanent condition in the
economy. They never took in to consideration the compounding effect of this benefit, which anyone with any common sense could have seen would eventually harm the pension. While not as bad as the PBI
system, the new COLA system has its own cabal of selfish, shortsighted, and
stupid proponents. The only difference is
that these people think that low inflation and low market returns will be the
new normal. The disgraceful
sellouts in the state-level fire and police unions have designed and/or
supported a system that will rob retirees of purchasing power in order to bring
PSPRS back to financial solvency. Of
course, this is not the subject of this post.
Those who want to read more about what has happened in the reform
efforts can look back at older posts.
Returning to our original topic, I do not know if the
plaintiffs in Parker v. PSPRS will
challenge the constitutionality of Proposition 124. They would seem to have a good case under the
Contract Clauses of the Arizona and United States Constitutions. Here is what Article I, Section 10 of the
United States Constitution says:
No State shall
enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and
Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver
Coin a Tender in Payment of Debts; pass
any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of
Contracts, or grant any Title of Nobility.
I have place in boldface the relevant part about
contracts. Article II, Section 25 of the
Arizona Constitution has nearly identical language and says, “No bill of
attainder, ex-post-facto law, or law impairing the obligation of a contract,
shall ever be enacted.”
The United States Constitution makes it very clear that no
state can void a contract through passage of a law. The Arizona Constitution specifically
prohibits the Arizona Legislature from doing so. Yet this is exactly what the Arizona
Legislature did by passing SB 1428 and referring a constitutional amendment to
the ballot. I am not a constitutional
scholar but what the Arizona Legislature did would seem to violate the letter
and spirit of the Contract Clauses. They
passed an unconstitutional law then referred it to the voters in order to make
it “constitutional” under Article 29, but this still violated the Contract
Clauses.
Under this same guise, couldn't the Arizona Legislature have changed our pension in any way they wanted? All
it would take is for them to pass a law and send it to the voters
for approval as a constitutional amendment to Article 29 of the Arizona Constitution. Proposition 124 set the precedent for any abrogation of pension promises as
long as the voters approve an amendment to Article 29, but the pension is still a contract between
employees and the state pension system. Can
it be this simple to change this contract? Article 29 of the Arizona Constitution is meant to give additional protection to the pension contract between public employees and their government employers, but does its public pension-centric focus allow for amendments that can actually override the Contract Clauses? This seems to be what the Arizona Legislature and state public safety union leaderdship believe.
If we look deeper into the Hall decision, the Supreme
Court time and time again refers to the plaintiffs as being in a contractual
relationship with the State:
Yeazell thus protects the specific terms of a public pension
contract from unilateral retroactive alteration. Even the dissent in Yeazell
recognized this as the Court’s holding. See id. at 118, 402 P.2d at 547 (Udall,
J., dissenting) (stating that the majority’s holding was based on the
“erroneous premise that there was created upon employment an absolute binding
‘contract’ to a specific pension,” which meant that the majority was holding
that “the legislature, by subsequent enactment, can modify the original pension
terms only if the employee consents”).
The Bill’s changes to the Class Members’ pension contracts
are consequently invalid under Yeazell. When the Class Members were elected or
appointed as judges, they entered a contractual relationship with the State
regarding the public retirement system of which they became members. Their
retirement benefits were a valuable part of the consideration the State offered
upon which the Class Members relied when accepting employment. See Fields, 234
Ariz. at 220 ¶ 27, 320 P.3d at 1166 (“As in Yeazell, Fields has a right in the
existing formula by which his benefits are calculated as of the time he began
employment and any beneficial modifications made during the course of his
employment.”). Under their contracts, the Class Members received retirement
benefits as terms of their contracts for which they agreed to share the cost
with their employers. Thus, an increase in the Class Members’ proportionate
share of the contribution rate above 7% and the change in the statutory formula
granting permanent benefit increases without the Class Members’ consent are
breaches of that contract and infringe upon the Class Members’ contractual
relationship with the State. See Thurston, 179 Ariz. at 52, 876 P.2d at 548 (“Where the modification is detrimental to the employee, it may not be applied absent the employee’s express acceptance of the modification because it interferes with the employee’s contractual rights.”). By including in its scope Class Members who were Plan members at the time of enactment, the Bill retroactively, unilaterally, and substantially changed the contract terms that the parties previously agreed to. This violates Yeazell.
As can be seen by all the portions I have put in boldface, the sanctity of the contractual relationship between EORP members and the State was considered the crux of the matter by the Court. This was based on the precedent set in the
Yeazell v. Copins case, which dates all the way back to 1956. The Court could easily dismiss the State's arguments for changing EORP's PBI system to a strict COLA by pointing to Article 29, as the post-retirement benefit increase mechanism was very clearly a retirement benefit that cannot be "diminished or impaired." However, when it came to the increase in employee contribution rates, the Court used the pension contract-centric
Yeazell to overturn the State's actions in SB 1609. The Court reminds us that employees make a decision on whether to accept employment with an Arizona government entity based on the conditions existing at that time. EORP members are not like Tier 3 PSPRS members who will enter PSPRS knowing that they will not have a fixed contribution rate and must split normal contributions 50/50 with employers during their entire careers. Tier 3 employees should be aware of this risk when they are offered employment. If they are not comfortable with this situation, they can either go into a separate defined contribution plan or decline to work for the state agency.
But what about the dire financial state of EORP and PSPRS? There are certain conditions under which a contract can be changed retroactively. Here the issue is brought up in the Hall decision:
EORP and the dissent both argue that this is not the end of the analysis. They note that Yeazell commented that if a governmental entity shows that its pension plan is actuarially unsound, “the law governing mutual mistakes of fact” applies. See 98 Ariz. at 116, 402 P.2d at 546. They interpret this comment to mean that if EORP and the State could show that the parties to the Plan made a mistake about the Plan’s financial viability, the Bill’s retroactive changes would be permissible modifications of the Plan under Yeazell. But EORP and the dissent over-read Yeazell’s comment. Although this Court indeed said that the law of mistakes of fact applied to a pension plan if it was actuarially unsound, we expressly and carefully declined to address the consequences of such an application: “We do not, however, mean to imply what rights or remedies might be available to either party in a situation where it is established that a retirement plan is actuarially unsound. This is a matter beyond the issues of the present litigation.”
However, the Court quickly rejected the State's arguments in the following paragraphs:
This Court’s reticence was appropriate. While the defense of mutual mistake of fact applies in any contract dispute, EORP and the State are unable to prove that defense as a matter of law. That defense requires that the party seeking to void a contract prove that (1) the parties made a mistake about a basic assumption on which they made the contract, (2) the mistake had a material effect on the exchange of performances, and (3) the party seeking avoidance does not bear the risk of the mistake. Restatement (Second) of Contracts § 152(1) (1981); see also Renner v. Kehl, 150 Ariz. 94, 97, 722 P.2d 262, 265 (1986) (applying § 152 in resolving claim of mutual mistake of fact). EORP and the State cannot prove two of these elements.
First, EORP and the State cannot show that the parties made a mistake about a basic assumption of the Plan. They claim (and the dissent accepts, see infra ¶¶ 73, 104) that the mistake was the parties’ shared assumption that the Plan was actuarially sound, meaning that the parties mistakenly believed that the Plan’s investment returns would be sufficient to maintain the Plan’s actuarial soundness without changing the benefit increases formula or the employee contribution rate. But disappointment about anticipated investment returns does not qualify as a mistake. See Restatement (Second) of Contracts § 152 cmt. b (noting that “market conditions and the financial situation of the parties are ordinarily not such assumptions,” and “mistakes as to market conditions or financial ability do not justify avoidance under the rules governing mistake”). Moreover, the Plan’s actuarial soundness is within the Legislature’s control. The Legislature is responsible for setting the amounts of the employer contributions and court filing fees, see A.R.S. § 38–810(B)–(D), and the Legislature may not “reduce the amount of the contributions to the fund if thereby the soundness of the fund is jeopardized,” Yeazell, 98 Ariz. at 116, 402 P.2d at 546. If the Plan is underfunded because of inadequate investment returns, the State may increase employer contributions and filing fees.
Second, even if unanticipated reductions in investment returns could qualify as a mistake, EORP and the State cannot show that the State did not bear the risk that this mistake might occur. The Legislature designed the Plan so that the State accepted the risk of variable investment returns. When investment returns are high, the State’s funding obligation through employer contributions is reduced or eliminated, as happened from 1998 to 2001. But when investment returns are low, the State’s funding obligation is necessarily increased. In either situation, however, the Class Members’ contribution rate remains fixed. Thus, the Class Members are not permitted to obtain any cost savings from higher investment returns, but they likewise are not required to pay more because of lower investment returns. The reward and risk of investment returns falls on the State. This is simply the nature of defined benefit plans. See Hughes Aircraft Co. v. Jacobson, 525 U.S. 432, 439 (1999) (stating that in a defined benefit plan “the employer typically bears the entire investment risk” and “must cover any underfunding as the result of a shortfall that may occur from the plan’s investments”). Because the State bears the risk of the claimed mistake, the State cannot rely on the defense of mutual mistake of fact to justify changes to the Plan.
Again, I have highlighted the numerous portions where the Court repeatedly argues that the poor financial performance of the pension's investments is not a justification for unilaterally changing, to the employees' detriment, the conditions of the pension contract in place at the time of hire. I would argue that the sheer stupidity of the PBI formula, which was destined to lead to where we are now, was a mistake and enough to make its elimination or replacement constitutional. This does not even take into consideration the immorality of the PBI formula as a form of inter-generational theft.
So, we can see that the Court did everything possible to lay the groundwork for a constitutional challenge to Proposition 124 by declaring the contribution rates at the time of hire a contract that cannot be changed simply because of the disappointing financial performance of the pension. The Arizona Legislature did not subject EORP members to the same changes affecting PSPRS members. This was probably due to the small size of EORP's membership, 1,591 total active and retired members as of the end of FY 2016, versus 30,569 active and retired members in PSPRS. For some perspective, the Phoenix Police Department alone had 2,486 active members at the end of FY 2016. I also suspect that the State and EOR did not want to tangle again with retired Judge Kenneth Fields, a committed fighter who would have surely challenged any changes to the PBI formula for EORP members. Without EORP members being subject to Proposition 124, there was no reason for the Court to even consider the Contract Clause of the Arizona Constitution. The Court found all it needed to make its decision in
Yeazell and did not want to look any deeper or broader into the Arizona Constitution, and based on what they did put in the
Hall decision, it seems to me that the Contract Clause would have only bolstered the decision in favor of the plaintiffs.
So what happens if Arizona voters approve an amendment to the State's Constitution that violates another part of the Constitution, as it seems like was done here? I was hoping that there would be something in the Arizona Constitution that addressed this situation, but I found nothing in
Article IV, Section 1 of the Arizona Constitution, which deals with the initiative/referendum process. I did not read the entire Constitution, but my guess is that that is why we have an Arizona Supreme Court to decide difficult issues such as this. Only they could decide which part of the state's Constitution has has precedence over the other, and even their decision might not be final, as this could be an issue that goes all the way up to the United States Supreme Court.
I think that will eventually occur in some pension lawsuit somewhere in the United States. As more and more states find themselves in the position of Illinois with pension burdens so onerous that they cannot pay for other necessary government functions, some state will, via the initiative or referendum process, attempt to greatly reduce the pension benefits of state employees and/or retirees. I suppose Parker v. PSPRS could be as good a test case as any. However, I have no insight into what Thomas Parker and his fellow plaintiffs and lawyers have in mind when they go before Judge Jo Lynn Gentry. The excess contribution issue is already settled with only the final rate of interest to be decided, but could they ask Judge Gentry to consider the constitutionality of the replacement of the old PBI system with the new COLA? What of L. Lee Rappleyea, the PSPRS retiree who sued PSPRS over the constitutionality of SB 1609? Her case was never actually litigated because the decision in Fields was applied to her case. Now she and her fellow plaintiffs are losers without ever having had their day in court. Could she refile her case, claiming that Proposition 124 is violating her rights under the Contract Clause? Or could someone else take up this fight? I don't know. Searching the Maricopa County Superior Court website, I find no new cases filed against PSPRS in 2016 or 2017, but I suppose a case could be filed in any court in the state.
If Proposition 124 were found to be unconstitutional, it would upset the whole apple cart of pension reform, and it would only take one PSPRS retiree or one active Tier 1 member to do this. This would be a disaster for PSPRS, which if I had to predict, would lead to the final PSPRS reform: the complete elimination of any defined benefit pension plan for Arizona's future public safety personnel. After all, this is what happened to EORP, which is now exclusively a defined contribution pension. A successful repeal of Proposition 124 would show that any type of retroactive pension reform, with the possible exception of bankruptcy, is impossible. It will just be simpler to go with a defined contribution plan that has predictable costs and benefits.
The next court date in Parker is for a status conference on July 12, 2017. It will be interesting to see what happens and if a court date for oral arguments is eventually set for some time in the future.
