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COLA clashes in spotlight as public plans, participants tussle

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Through legislation and regulation, public pension plans are reforming their cost-of-living-adjustment rules, which often ignites legal clashes with employees and retirees.

The reason isn't surprising.

“"Reform' has become a euphemism for benefits reduction,” said Keith Brainard, the Georgetown, Texas-based research director for the National Association of State Retirement Administrators, noting that “reform” encompasses COLA reductions among several public pension cost-reduction policies.

Disputes over the meaning of state constitutions' protection of pension rights highlight the conflict between legislators trying to trim pension costs and improve pension system health vs. retirees and employees fighting to preserve what they say are contracts protecting their retirement.

Among recent developments:

• The Illinois Supreme Court in March ruled as unconstitutional a pension reform law affecting the $5.68 billion Municipal Employees' Annuity & Benefit Fund of Chicago and the $1.36 billion Laborers' and Retirement Board Employees' Annuity & Benefit Fund of Chicago. The former has a funding ratio of 40.9%, as of Dec. 31, while the latter has a funding ratio of 64.3%.

The law, which took effect in 2015, reduced the COLA formulas affecting participants in the two plans and raised employee and employer contributions. The court ruled the law violated the state constitution's pension protection clause that says benefits “shall not be diminished or impaired.” In May 2015, the state Supreme Court cited the same reasoning in declaring unconstitutional a state pension reform law, which reduced COLAs, capped pensionable salaries and raised retirement ages.

• The New Jersey State Supreme Court, also in March, heard oral arguments in a challenge by union members and others that a 2011 law suspending COLAs for participants covered by the $68.1 billion New Jersey Pension Fund, Trenton, violated the state constitution.

COLAs, the plaintiffs asserted, are a “non-forfeitable right.” In court documents, attorneys for Gov. Chris Christie said that although public pensions have state constitutional protection, COLAs lack such protection.

If the state Supreme Court supports the plaintiffs, Gov. Christie said the New Jersey Pension Fund would immediately have to recognize another $17.5 billion in unfunded pension liabilities. Moody's Investor's Service, New York, has predicted a pro-plaintiff ruling would raise the pension system's unfunded liability — on a statutory accounting basis — to $53 billion from $40 billion. That would drop the 2014 statutory funding ratio to 44%, from 51%; and

• Arizona Gov. Douglas A. Ducey in February signed into law changes to the cost-of-living adjustments for participants in the $8 billion Arizona Public Safety Personnel Retirement System, Phoenix, whose funding ratio is approximately 50%.

This law creates three tiers of participants, and it calls for a referendum to repeal the permanent benefit increase formula for members of the first two tiers and create a new COLA formula.

The new law was a response to a 2014 ruling by the Arizona State Supreme Court that said a previous COLA reduction law was unconstitutional because it diminished benefits. That high court ruling restored the permanent benefit-increase formula.

The Arizona case illustrates how legislators are fighting for COLA reductions even if they are initially rebuffed by the courts. Still, state supreme courts in Colorado, New Mexico, Washington, and Wisconsin are among the state courts that have upheld COLA reform laws in recent years, according to Moody's Investors Service.

Sharing the pain

COLA reductions enable legislators to “spread the burden” among all benefits recipients rather than just shift the pension cost-cutting to new employees through other actions, said Jean-Pierre Aubry, associate director, state and local research, at the Center for Retirement Research, Boston College.

“Our sense is that those COLA adjustments were going from overly generous to realigning them with economic sanity,” he said. “Up to this point, this tool has been sensible. COLAs are being aligned with actual inflation.”

However, legislators who reduce COLAs below keeping pace with inflation “are cutting into peoples' standard of living,” Mr. Aubry said. “Governments are more willing to test the (state) laws when it comes to COLAs.”

Analysts point out that many COLA reform laws took effect during the years immediately after the 2008-2009 economic crisis, when plunging investments, high unemployment and shrinking tax revenues squeezed state coffers. However, COLAs often had been put in place in the 1980s, when inflation was higher.

“COLAs are expensive benefits and will continue to be examined by legislatures as they reform pension plans,” said Luke Martel, director of retirement research for the National Conference of State Legislatures. Reducing COLAs, raising retirement ages, requiring higher service requirements and imposing higher contributions by employees are the primary tools legislators are using to enact pension reform, he said.

Between 2009 and mid-2015, a NASRA survey found that 29 states had enacted laws to reduce public pension plans' COLAs. Fifteen states changed the COLAs affecting current retirees; eight states made adjustments to benefits of current employees and new hires; and six states changed the COLA system for new hires. Some were upheld by states courts; others were overturned.

“Cost savings is definitely the primary driver,” said Mr. Brainard, noting that COLAs can have a profound effect on overall pension costs. “As a rule of thumb, a pension plan with an automatic 3% annual COLA will add 25% to the plan's cost.”

COLA reform involves a succotash of strategies, thanks to different COLA formulas among the states, different roles that state constitutions play in governing pensions and various legal challenges challenging COLA reform.

For example, the NASRA study points out that some state pension plans have automatic COLAs, while others have ad hoc COLAs that require a governing body to approve a benefit increase.

Many public plans peg COLA to inflation, measured by the Consumer Price Index, but even then there is variation. Formulas can be designed to reflect a percentage of the CPI or place a cap on the COLA increase regardless of how high the CPI grows.

Component of plan health

Credit rating agencies view COLA changes as a component of state pension plan health, and the strength of a pension plan can influence a state's overall credit rating.

“We will take account of a COLA that is out of line with existing economic conditions,” said Douglas Offerman, senior director at Fitch Ratings Inc., New York. “If the state has the ability to lower unfunded pension liabilities, that (COLA reduction) is a tool. The larger point is whether the state has the ability to make a change.”

Mr. Offerman and others who analyze public pension plans say a COLA reduction for retirees is a strong component of pension reform.

“COLA reform has an immediate impact on accrued liability,” said Thomas Aaron, a Chicago-based vice president and senior analyst for Moody's Investor's Service. COLAs “can be mathematically significant.”

However, COLAs are only part of the firm's analysis of a public pension plan, and “pensions are far from the only thing” in a credit rating. In most cases, COLA reform laws represent “a response to rising balance sheet obligations or rising cost in the (state) budget,” Mr. Aaron said.

Robert Steyer writes for Pensions & Investments, a sister publication of Business Insurance.