How the “California Rule” Holds Back Pension Reform

These days, local governments announcing bankruptcy seems like routine in California. Since the onset of the 2008 financial crisis, many state and local governments have seen their pension funds take huge losses. Yet, many of the underlying problems that have made pension shortfalls difficult to address go back many years — more than half a century, in fact.

One major reason public pensions have been so difficult to reform is their having a special legal status above other kinds of employee compensation. A new Federalist Society paper by Emory University law professor (and CEI alumnus) Alexander Volokh explains how this strange situation came to be and offers some ideas for reform.

One of the most important developments in public pension policy occurred in 1955. That’s when the California Supreme Court created what became known as the “California rule” regarding the legal status of public pensions. The case, Allen v. City of Long Beach, concerned a challenge to a 1951 city charter amendment that increased the employee pension contribution and changed the formula for determining payouts.

The amendment was struck down. Volokh explains:

The Court held that the amendment unconstitutionally impaired the contract rights of the employees who were adversely affected. in doing so, it stated a test that would be often repeated in public employee pension cases:

An employee’s vested contractual pension rights may be modified prior to retirement for the purpose of keeping a pension system flexible to permit adjustments in accord with changing conditions and at the same time maintain the integrity of the system. such modifications must be reasonable . . . . To be sustained as reasonable, alterations of employees’ pension rights must bear some material relation to the theory of a pension system and its successful operation, and changes in a pension plan which result in disadvantage to employees should be accompanied by comparable new advantages.

In this case, there were no comparable new advantages, nor was there any evidence that the changes were related to the integrity of the pension system.

In short, pension systems could not be subject to any changes short of their facing a crisis that threatened their survival.

This rule remains in effect: as the California Supreme Court has since summarized, “By entering public service an employee obtains a vested contractual right to earn a pension on terms substantially equivalent to those then offered by the employer.” in other words, one has “the primary right to receive any vested pension benefits upon retirement, as well as the collateral right to earn future pension benefits through continued service, on terms substantially equivalent to those then offered.”

As Volokh points out, the California rule has been adopted by 12 states that account of over a quarter of the U.S. population — Alaska, Colorado, Idaho, Kansas, Massachusetts, Nebraska, Nevada, Oklahoma, Oregon, Pennsylvania, Vermont, and Washington. That makes it difficult to reform underfunded pensions in large swathes of the country.

But not only is the California Rule bad policy, Volokh argues, it is also legally bizarre.

As state and local governments seek to resolve their unfunded public pension problems, the California rule, by freezing public-employee pension benefits in place, deprives governments of the flexibility to alter some of the future conditions of public employment.

If the government really promised its employees that its pension rules would be at least as generous for the duration of their employment, such a promise should be enforced — governments can’t take property without paying just compensation, even in the face of a fiscal crisis; why should they be able to do so with contract rights? But there is no such explicit promise. And guaranteeing particular pension rules is a strange thing to suppose governments have implicitly promised, given that they don’t promise other, more important prospective benefits: one’s tenure in one’s job, one’s future salary, or any other aspects of compensation.

To address the challenges the California Rule poses, Volokh offers five policy options.

  1. Flexible definition of benefits. This could be expressly stated in statutes regarding public employee pensions.
  2. Short-term contracts. To give governments greater flexibility.
  3. State constitutional amendments. To abolish the California rule outright.
  4. Changing state case law. This is an especially difficult option, as it would take several years to implement. Specifically, Volokh suggests “to alter the California rule by a pattern of anti-California-rule appointments to the state supreme court.”
  5. Privatization. Outsourcing some government services would make contractors, not the state or local government, responsible for employees’ retirement plans.