COLA Freezes: Pension Reform's Third Rail

Here are 7 things to consider before cutting retirees' cost-of-living allowances.
by | June 7, 2012

Last week, financially distressed Providence, R.I., announced a sweeping reform of its pension plan including a freeze on retirees' cost-of-living allowances (COLAs). The city's mayor says this action will avert bankruptcy. The COLA freeze is patterned after state workers' pension reforms enacted last year. The Providence plan would also limit future pensions to 1.5 times statewide average household income, capping payouts at $82,000.

Last month, Chicago's labor-friendly mayor Rahm Emanuel urged Illinois legislators to suspend COLAs statewide for 10 years, lest the city's quality of life will plummet. Meanwhile, a New Jersey judge ruled that pension COLAs can be suspended if financial conditions require such a remedy. The New Jersey court decision falls on the heels of similar COLA freezes in Colorado, Minnesota and South Dakota, which were upheld in several courts.

The reason public officials are targeting the COLA benefit is that it's one of the most costly enhancements in a pension plan: The actuarial cost includes the lifetime compounding of retirees' annual benefits increases. In states like Rhode Island where COLA benefits were completely out of control at levels that exceeded the CPI (sometimes giving 5 percent or more, perpetually compounding annual increases regardless of actual inflation), the "COLA" benefit is clearly unsustainable and requires reforms.

In Baltimore, Md.; San Jose, Calif.; and a number of other municipalities, a similarly idiotic "COLA" surrogate or supplement was installed, giving retirees a pension increase or "13th paycheck" in years that markets outperformed the average. That policy guarantees that the pension fund will never achieve its expected return. The good years are skimmed off while the taxpayers have to cough up for market losses. Even worse, these schemes siphon off more from the plan when markets become more volatile as they have since 1997.

These arrangements clearly require reforms. It's inevitable that retirees will suffer a reduction of these benefits whenever the employer can prove that the benefit is unsustainable and unaffordable, that other measures were taken or at least considered to address the funding deficits, and that the selected solution was reasonably expected to be the least invasive measure that achieves fiscal sustainability. Judges are more sympathetic to revisions of these "extras" that do not alter the basic pension plan benefit, and seem inclined to accept arguments that failure to suspend the COLAs and fix ill-founded supplemental benefits will actually jeopardize the basic benefit plan. (In this context, the basic benefit is what courts may deem the "reasonable benefit," a special term in such proceedings, as I will explain shortly.)

In this context, the three federal court threshold conditions are essential to any rational discussion and defense of COLA freezes and impairment of contracts. (1) The change must be proven to be necessary. This requires fiscal analysis, usually a multi-year financial forecast of the employer's fiscal capacity as well as the pension plan's projected assets, liabilities, costs, contributions, investment returns and funding ratios. (2) The change must represent the minimum change required to sufficiently remedy the problem, which requires that other remedies must be considered and complementary measures implemented where feasible. (3) Finally, the remaining or replacement benefit must be a "reasonable benefit." Federal courts have been remarkably consistent in referring to these criteria.

In federal court, these three conditions require a facts-and-circumstances hearing and determination, and are entirely situational: there is no formulaic solution set or a presumptive safe harbor. For example, if it is possible to shore up a pension plan with increased contributions from employees who can usually work another year before retirement, there would be no justification for freezing COLA benefits for retirees who have no way to make up for the loss of their promised benefits. Likewise, if the employer's immediate and longer-term financial condition and its regionally competitive taxing authority are sufficient to absorb higher costs of the plan at taxpayers' expense, there won't be many judges who will uphold a COLA freeze. But if there are truly no other solutions to the problem that can be designed without imposing a fair-share sacrifice on retirees, then the COLA benefit will become fair game in most states and more generally in federal court. In states where the pension benefit is constitutionally protected by settled case law or explicit constitutional provisions (see the Amy Monahan research that I've cited in previous columns), a COLA freeze may be untenable, but elsewhere it is likely to become part of the proposals that employers will advance and defend in court.

Public officials proposing a COLA freeze as part of the pension-reform plan should consider the following precepts, which I have not published before and which reflect my evolving thoughts on this subject:

1. Formally evaluate the (un)sustainability of benefits. To defend a COLA freeze that clearly violates a contractual obligation and a moral obligation to retirees, public employers must first demonstrate that the pension plan is distressed to the level that its costs of funding cannot be reasonably paid by the employer. The employer must also demonstrate that its projected financial condition is incapable of absorbing the mounting pension costs. Typically this requires a pension funding ratio well below the national average, rapidly escalating employer contribution requirements, and a stagnant budgetary projection for the next five years. In court, an independent report from an objective financial analyst and an independent actuary will be required. Union lawyers will certainly retain an expert to try to identify hidden reserves, potential tax increases, discretionary programs that could be cut, capital outlay that could be delayed, and a variety of actuarial gimmicks.

2. OPEB benefits should be capped in tandem. Many employers give retirees a lifetime of medical insurance benefits with no ceiling on cost increases. With medical inflation running three times the CPI inflation rate, it's foolhardy to attack the COLA benefit without also addressing the OPEB especially if the latter is legally modifiable. OPEB benefits usually enjoy less legal protection than pensions, so the path of least resistance in managing total long-term costs is likely to include a cap on OPEB payouts. Often these changes can be negotiated through collective bargaining if the labor agreement is the legal foundation of the benefit, as was the case in San Diego. If a plan-wide hard freeze is not viable, a fixed stipend limit for those now working might be combined with a CPI escalation limit for today's retirees. These measures will dramatically reduce actuarial liabilities and annual required contributions. The problem for many employers, of course, is that they haven't funded their OPEB plan, and are simply making annual payments to the retirees. For these employers who keep kicking the OPEB can, the short-term budget savings from an OPEB cap will be less than the actuarial savings from a funded pension fund which cuts out the COLA.

3. Pain-sharing. A balanced approach to pension reform should take into account benefits reductions for incumbent employees, as well as reform of the COLA benefit. This should include higher employee contributions and reductions of prospective benefits accruals where legally allowed. It's generally not equitable to penalize retirees only, and one should expect counsel for retirees to challenge an employer's or plan's assertion that it has exhausted all other remedies if the COLA freeze is the central feature of the plan restructuring. Equity requires that other prospective reductions in future service accruals by active employees should precede a COLA cut. The Providence plan's cap on future pension benefits would be a good example of pain-sharing, as would the Baltimore pension reform plan to raise age and service requirements for public safety workers with less than 15 years of tenure. If employee contributions are not increased and the employer makes no additional efforts of its own, this issue is sure to arise in judicial review. A COLA freeze should be undertaken as a last resort and presented in court as unavoidable in light of legal restrictions on other modifications of participants' vested rights. Of course, as Willie Sutton famously said about robbing banks, "that's where the money is."

4. Minimize pain for low-income and elderly retirees. I would encourage employers to consider freezing the COLA only on retiree pensions that exceed a low-income level, if that is financially feasible. For example, a COLA benefit linked to the CPI could be retained for the first $30,000 of pension income (essentially the maximum Social Security pension level), and then the COLA could be suspended for pensions in excess of that level. Along this line, retirees with pensions exceeding statewide average household income could be excluded from COLA eligibility altogether during periods of plan-funding deficiency. Similarly COLAs could be suspended or eliminated for service (not disability) retirees under age 70, which encourages longer working careers and reduces the compounded actuarial cost considerably. These "progressive" structures will appeal to labor-friendly politicians as less punitive to those least able to lose the inflation protection. Pension hawks would suggest that COLAs should also be prohibited for those who received retroactive pension benefits increases during their careers — which contributed to the underfunding problem in the first place.

5. Restore the COLA automatically but partially when funding levels exceed distressed levels. As I've explained elsewhere, there is an urban legend in the public pension community that an 80 percent pension funding ratio is adequate — which is nonsense at most points in the business cycle, as I've written in my column on Pension Puffery. But for purposes of COLA restoration, we need to set a standard somewhere, and 80 percent is probably a reasonable static level for this specific purpose. Unfortunately, this standard virtually guarantees that a plan that achieves 80 percent funding near the peak of a business cycle — and reinstates its COLA — will inevitably be required to impose another COLA freeze in the next recession when the funding ratio once again falls below the threshold. That will just stir up the retirees even more. In light of the longer-term inflation risks I cite below (in #7) a strong case can be made that the COLA freeze should remain in force for the higher-pension retirees, at least in the modified form suggested in #4 above, until the plan eliminates its unfunded liabilities or the employer experiences a material reduction in required contributions to levels it can afford to maintain indefinitely.

6. Require employers to amortize properly. If retirees are required to sacrifice their inflation protection, then employers should also bear a fair share of getting the plan back to proper funding levels. A balanced funding plan should require pension plans that freeze COLAs to amortize unfunded liabilities over periods no longer than the average remaining service lives of employees and the average remaining life expectancy of the retirees. Otherwise the retirees are subsidizing the employer.

7. Inflation-guard the pension portfolio. Looking out into the next decade, I assign even odds to a scenario in which Western democracies including the USA are unable to control their income-maintenance and entitlement programs while maintaining both fiscal discipline and economic growth, which would ultimately result in domestic inflation as a result of currency erosion. Pension managers and public employers must begin planning eventually for the possibility that inflation in the 2020s will rise to levels similar to the 1970s, if not worse. That would put more pressure on COLA benefits at the same time that pension plan funding ratios plummet from investment losses on paper assets. With the entire Baby Boom generation then retired, pressure will mount to increase COLA benefits at the expense of those born after 1964. The public pension community and public officials face a daunting task of communicating that today's COLA caps are absolutely the most that retired Boomers will see in their retired years. Those who retire at earlier ages than their private-sector peers should not expect ever-increasing protection from inflation at the expense of the general public and their younger successors in the public service. (My concluding comments in the paragraph below may provide some insights on the appropriate policy metrics and standards.) Meanwhile, investment managers and pension investment committees need to develop an inflation-resistant investment strategy to preserve purchasing power parity if this scenario begins to prevail.

Ad hoc COLAs. Finally, it should be noted that some public employers continue to deny reality and award COLA benefits on an ad hoc yet recurring basis without any actuarial foundation or a sustainable long-term policy framework. These arrangements are usually doomed to fail. Where retirees learn that televised public sit-ins at council and commission meetings will win them a pension increase, the Pavlovian process of selective reinforcement virtually guarantees a repeat performance in a few years, regardless of the plan's funding condition. Unless the employer establishes a clear policy that it will award ad hoc COLAs only in years when the plan is funded above 120 percent (to account for the next recession's inevitable decline in the pension funding ratio below 100 percent), and that these supplements can be reversed if plan funding falls below 90 percent, an ad hoc COLA policy is doomed to ratchet up costs and drive the plan into worsening funding levels over time. If '70s-style inflation rates ever return, the same metrics would be valid should retirees start crying for COLA increases.

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