As Public
Pension Plans Seek Ways to Improve Funding, Some Look to Adjust Retiree COLAs
(Judy Ward / PlanSponsor)
http://www.plansponsor.com/MagazineArticle.aspx?id=6442482100
September, 2011
Retirees
participating in New Jersey’s
public pensions better not expect a cost-of-living adjustment (COLA) anytime
soon.
The
pension-reform bill signed in late June by New Jersey Governor Chris Christie
effectively eliminates the COLA until a public plan in the state gets to at
least 80% funding—which will take a while, since the new law aims to increase
the funded ratio of combined state and local systems from the current 62% to
more than 88% over the next 30 years. That same month, courts in Colorado and Minnesota
ruled that legislatures in those states had the right to reduce COLAs for
current retirees.
For plans
that urgently need to improve the unfunded liability, “a COLA is one of the few
things that impacts benefits very quickly,” says Joe Newton, a Dallas-based
Senior Consultant at Gabriel, Roeder, Smith & Co. “It can have the most
velocity of change. If you change the multiplier, that
is not going to have a big impact on the unfunded liability.”
Many states like
New Jersey
have changed the COLA in the context of a broad package of pension reforms.
Increasing contributions affects new hires and sometimes existing hires, while raising the retirement age has the greatest significance for
existing employees, and changing the COLA affects retirees. “It is a kind of
share-the-pain approach to improving the funding level,” says Cathie Eitelberg, Washington-based National Director for the
Public Sector Market at consultant The Segal Co.
Understanding the Boundaries
Both the Colorado and Minnesota
suits claimed that the plans’ retirees had a contractual right to COLAs, which
would make them protected, says Amy Monahan, a University of Minnesota Law
School Associate Professor. However, in general,
“The presumption is that, when a legislature passes a law, it does not create a
contract by doing so,” she says. “State laws generally are viewed as statements
of current legislative policy. A later legislature can amend that.”
So, courts
look at the statutory language for evidence of intent to form a contract.
“Colorado’s decision says that there is nothing in the statutory language that
says this is a contractual right,” Monahan says. The Colorado Supreme Court previously has held
that public pension benefits are contractually protected, she adds, but the
COLA decision made a distinction between the base pension benefit as protected
and the COLA. Minnesota’s decision looks somewhat similar to Colorado’s, she
says, determining that nothing in the statutory language requires the finding
of a contract, and making the distinction between the base benefit and the
COLA.
Retirees may
not appreciate the legal distinction. Cutting COLAs hurts the oldest
participants most, as their purchasing power increasingly suffers, says Dean
Baker, Co-Director of the Washington-based think tank the Center for Economic
and Policy Research. “It is like saying, ‘OK, you will have a good pension for
the first five or 10 years after you retire, but if you live into your 80s and
90s, it is really not going to help you a lot,’” he says. “Part of the point of
a defined benefit pension is that you are guaranteeing people a standard of
living.”
While these
state-court rulings do not set binding precedents in other states, they likely
will have a practical impact, Monahan predicts. “State legislatures considering
taking action might feel a little more comfortable with it,” she says. “These
types of cases help states understand where the boundaries might be.” Of
course, a state’s laws and previous court rulings play a big role. “In some
states, there are rulings that it does not make sense to distinguish between
the base benefit and the COLA,” she says. “In some states, there are rulings
that say you cannot change COLAs for future service.”
However, a
state always has the sovereign power to act in the best interests of its
citizens, Monahan says. “Both courts essentially said that what they did to
COLAs was reasonable and necessary. That part of the ruling will be the most
influential in other states,” she says. “Both decisions say,
even if it is considered contractual, you could still make these changes.”
Colorado and Minnesota each made the COLA changes as part
of comprehensive efforts to improve public-pension funding and took steps also
affecting new hires and current employees. “This was not just going after
current retirees,” she says.
The Corporate COLA Comes, and Goes
Private-sector
plans already learned the lesson of COLA costs. COLAs built into a plan “are
extremely rare, in the low single digits,” among corporate plans, says Ari Jacobs, Retirement Solutions Leader at consultant Aon Hewitt. Ad hoc COLAs that adjust benefits on a one-time
basis are a little more common, he says, but still in the single digits.
Automatic
COLAs always have been relatively rare in private-sector plans, says John Ehrhardt, a New York-based Principal at consultant Milliman, Inc. Some employers “were doing it on an ad hoc
basis, when inflation was a lot higher in the ’80s and the beginning of the
’90s,” he says. “Those folks’ plans were overfunded,
and there was no way to use a surplus effectively: They could not take a credit
for it, so, from a cash point of view, they could provide benefit increases.”
Private
employers have rules that ultimately discouraged most from adding guaranteed
COLAs or ad hoc COLAs given on a regular basis. “The IRS says that, if you are
doing it every year or on a regular cycle, it is part of accrued benefits,” Ehrhardt explains. “Once it is part of the accrued benefit,
it is illegal to cut back by plan amendment.”
Plus, as
inflation declined, protecting retirees’ purchasing power became a less-urgent
priority. By the time the dot.com bubble burst around 2000, Ehrhardt
says, more plans became underfunded, and most that
had offered ad hoc adjustments stopped. “If anybody had a COLA, that is when
they took it away, and only prospectively,” he says. Benefits already accrued
would have to include the COLA, while future benefits accrued would not.
Inflation adjustments have not made a comeback with private plans since then,
particularly given the current focus on minimizing pension expenses, and with
expected lifetimes longer, that increases the value of
the COLA, Ehrhardt says. “A COLA increases pension
expense and cash costs,” he says. “A 3% COLA in a retirement plan might
increase the value of the benefit by 20% to 25%.”
Making a COLA Affordable
Public plans
can make COLAs work, as evidenced in a study released in June by the National
Institute on Retirement Security (NIRS), “Lessons from Well-Funded Public Pensions:
An Analysis of Six Plans that Weathered the Financial Storm.” All six of the
state-level plans studied—in Delaware, Idaho, Illinois, New York, North Carolina,
and Texas—have
some type of COLA provision.
“COLAs are
still extremely important to retirees in terms of getting inflation protection.
People are living longer, and if you retire at 65, you may be in retirement for
20 or 30 years. If there is no inflation protection, your purchasing power is
really going to decline over time,” says Ilana Boivie, the NIRS Director of Programs, who co-authored the
study, “but COLAs also cost money, so they do need to be granted responsibly.”
Asked the
key to sponsors handling COLAs responsibly, Boivie
says, “There is a constant balance between what retirees need to maintain their
standard of living, and the affordability of the system. The key thing to keep
in mind with COLAs is to account for the costs right away, and pay for them as
quickly as possible.”
While many
COLA modifications affect new hires, as the cases in Colorado
and Minnesota
show, some public plans also are making alterations that affect retirees. “If
you are talking about changes to new hires, they have a lot of options,” Newton says of
controlling COLA costs. “Changes to retirees come down to a state-by-state
issue, so they may not have many options there.”
More than
60% of large public plans have a guaranteed COLA, either at a fixed rate or
based on the CPI (Consumer Price Index), Newton
says. About 20% of large plans go the ad hoc route, while another 10% to 20%
give “contingent” COLAs if the plan achieves a specified result.
For plans
with ad hoc COLAs, the recent cost-cutting “happened automatically, because the
money was not there,” Newton
says. Other plans have turned toward contingent COLAs. New Jersey’s pension
reform eliminated automatic annual payment increases for all current and future
retirees, and established that reaching a “Target Fund Ratio” will define
boards’ future ability to change plan design.
“A COLA can
be ratcheted down by putting a lower cap on the COLA, or tying it to another
result that will trigger it, such as the level of investment return in a given
year or the funding level,” Segal’s Eitelberg says.
“If a plan is funded at 80%, they may not grant a COLA, but if they get to 90%,
they may grant a 2% COLA, and if they get to 100%, it might be 3%.”
Plans also
can limit costs by capping the COLA, either based on a participant’s retirement
benefit or on the COLA percentage. “You can control the base it is applied to
and the percentage applied to the base,” Eitelberg
says. For example, a plan could say that it will apply the inflation adjustment
up to $20,000 in a retiree’s annual benefits, or that it will cap the COLA at
the amount of its current average benefit. “It is almost a means-testing
approach,” she says.
A
percentage-based cap can establish a maximum based on the CPI. Say that a
retirement system caps the CPI-based COLA at 2%. If the CPI runs at 3% one
year, retirees get 2%. If the CPI totals 1% the next year, retirees get 1%. “It
is pretty common if they have a CPI-related benefit to have a cap,” Newton says. “A
dollar-cost cap is not as common.”
Eitelberg has not seen much outright dropping of a
public plan’s COLA, but she has seen plans put it on hold. “We have seen it
structured in a way that, when it is tied to funding, there may not be payment
of a COLA for a long time,” she says. “We have not seen a lot of entities
eliminate it entirely, but we have seen them structure it in ways that
effectively suspend it until funding improves.”
Moves like
that go over much better when plan officials keep participants informed and
even involved in the process, Eitelberg says. For
plans eyeing pension reform, she suggests creating a task force that has
representatives from the plan, employers, participants, and retirees. When that
happens, she says, “that process, more times than not, results in agreement
around reduction in costs and increases in contributions, with the
understanding that the long-term goal is to sustain the plan over time. The
discussion is around being able to get the plan to sustainability and concern
that, if no action is taken, the plan may not survive.”
A lot of the
changes public plans have made impact new hires, Eitelberg
says, so the process has less tension. Yet, even decisions affecting current
members, such as extending the retirement age and increasing contributions,
fare better when a plan communicates a lot during the process. “We have seen it
to be extremely successful to participants’ understanding,” she says. “Having said that, we also have seen lawsuits. It is always
possible that plans are going to have litigation.”
Judy Ward
editors@plansponsor.com