Promises To Keep – The Nature Of A Public Agency’s Benefits Commitment To Its Employees

This updated article addresses several important legal issues that arise when a California public agency attempts to reduce the level of benefits that it provides to its employees.

State and local governments throughout the United States, especially in California, are feeling the squeeze. Because of lower federal and state subsidies, reduced local revenues and increased expenses, public agencies of all types are feeling greater financial stress today than at any other time in recent memory.

One of the major expenditures for every employer is the compensation and benefits that it provides to its employees. Governmental employers are now being forced to look at every available means, including the reduction of employer-paid benefits, as a way to “stop the bleeding.”

Impairment Of Contract

Although seldom discussed, it is well settled in California that the terms and conditions of public employment applicable to retirement and certain other benefit rights cannot be destroyed without impairing a contractual obligation of the employer. This principle rests upon the “contract clause” of the United States Constitution, which prohibits any state from passing a law “impairing the obligation of contracts.” Under the contract clause, the seminal case law in this area provides that a “state can no more impair, by legislation, the obligation of its own contracts, than it can impair the obligation of the contracts of individuals.”

Under California law, an impairment of contract may occur if a governmental employer modifies its benefits program to take away some or all of the benefits to which active employees or retirees are currently entitled or to which active employees will be entitled upon retirement. California case law has identified three questions that must be answered in order to determine whether a governmental employer’s reduction or elimination of benefits coverage would run afoul of the contract clause:

1. What is the contract?
2. Is the modification consistent with the express or implied terms of the contract?
3. Even if the modification is inconsistent with the contract, is it still permitted under a recognized exception?

What Is The Contract?

In the retirement plan context, the California courts have announced the following general rules for establishing the terms of a public employee’s benefits contract:

1. The contract provisions in effect at the time a person becomes a public employee are binding on the state with respect to that employee.
2. If an employee’s rights are augmented during his or her subsequent tenure, the employee’s contractual expectations are measured not only by those benefits that were in effect when the employee commenced employment, but also by any additional benefits conferred during his or her employment.
3. A person’s pension rights become even more rigidly fixed upon retirement.

Under these general rules, an employee or retiree would have “vested” rights in the most valuable level of retirement benefits provided by his or her governmental employer at any time during the individual’s employment, with special emphasis on his or her retirement date. In general, the terms “vested” and “contractually vested” in this context refer to a right that a governmental entity cannot reduce or eliminate without impairing an obligation of contract.

However, the same courts have crafted a number of ill-defined exceptions to the general rules, which greatly complicate the analysis. They are:

1. An employee does not obtain, prior to retirement, any absolute right to fixed or specific benefits, but only to a “substantial and reasonable pension.”
2. An employee’s vested contractual 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.
3. A public pension system is subject to the implied qualification that the governing body may make reasonable modifications and changes before the pension becomes payable and until that time the employee does not have a right to any fixed or definite benefits. Such modifications must be reasonable, and it is for the courts to determine upon the facts of each case what constitutes a permissible change.
4. 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 must be accompanied by comparable new advantages.
5. The comparative analysis of disadvantages and compensating advantages must focus on the particular employee whose own vested pension rights are involved, and the offsetting improvement must also relate to the benefit that has been diminished.

This analysis, first applied in California public agency employment situations solely to salary and retirement benefits, has since been applied to various other elements of compensation, including disability retirement benefits, medical coverage and other welfare benefits.

Many governmental employers provide some level of retiree medical coverage. Faced with potentially astronomical cost increases for such coverage, California public agencies are becoming more concerned about their ability to modify such coverage in order to control costs. There is very little guidance in California on whether and how agencies can modify their retiree medical commitments. On the one hand, the California Attorney General has issued an opinion, which has since been cited with approval in one case by the California Court of Appeal, that applied the courts’ general rules in the retirement plan context to the issue of discontinuance of retiree medical coverage. The opinion states that “the elements of compensation for a public office become contractually vested upon acceptance of employment,” and that “such contractual interests include not only those in effect upon commencement of employment, but also those conferred during the employee’s tenure.” For this reason, the Attorney General concluded that health and life insurance benefits provided to certain public officials pursuant to an official declaration of policy could not be discontinued.

On the other hand, in an unpublished Court of Appeal case that was decided in June 2003, the defendant school district had provided to certain retirees the same medical coverage that it provided to its active employees (without cost to either the actives or the retirees). Later, however, the district required retirees to contribute towards their health coverage and made a slight reduction in their coverage under the plan’s PPO option. A group of retirees filed suit to prevent the district from reducing the retirees’ health benefits or from charging the retirees anything to enroll in the PPO plan (regardless of how much the active employees had to pay) since no retiree contribution requirement had been imposed previously. In essence, the retirees urged the court to apply the general rules cited above to prohibit the district from making any changes that would reduce their benefits or increase their cost beyond the most favorable level that had been provided during their years of employment.

The appellate court refused to impose on the district such a categorical requirement. Rather, the court analyzed the retirees’ claims based on the long-term conduct of the parties to determine whether an implied-in-fact contract existed that would prevent the district from reducing retirees’ benefits or increasing their costs. The court concluded that the various documents and writings that were adopted during the history of the relationship, including board policies, collective bargaining agreements, memoranda of understanding, and letters to individual retirees, were central to a determination of the precise terms of the contract that existed between the district and the retirees regarding continuing medical coverage. In doing so, it addressed the retirees’ arguments that the district’s obligations should be based on the most generous benefits offered during an employee’s career with the entity.

Unfortunately for public agencies, unpublished opinions cannot officially be cited in future legal proceedings. Thus, although a subsequent court may find a court’s analysis in an unpublished opinion to be persuasive, such opinions themselves have no precedential value.

Is The Proposed Change In Benefits Consistent With The Contract?

Whether a proposed change in benefits is consistent with the contract will depend upon whether entitlement to the particular benefit was earned and became part of the employee’s contract. To preserve its ability to make changes in benefits or to amend or terminate the program at any time, the governmental entity should clearly reserve this right in the relevant documents and oral communications. With a conspicuous and communicated reservation of rights provision, the governmental entity should be able to preclude reasonable reliance by its employees on the continued existence or nature of the program.

On this subject, the California Supreme Court has held that a reduction in employee contribution rates that was made according to procedures delineated in a public sector pension plan did not require offsetting comparable advantages because the plan was not modified when the changes made were contemplated in the plan’s original provisions. For example, a California public agency should be able to amend the terms of a benefits program in any lawful way that it wishes in the future, as long as the intent to reserve the authority to make discretionary changes is clear in both the communications regarding the program and in its formal provisions.

Similarly, where benefits are being provided to bargaining unit employees pursuant to a memorandum of understanding or other collective bargaining agreement, it should be legally defensible to change such benefits through a contract renegotiation. One 1998 California Court Of Appeals case held that collectively bargained annual leave and longevity pay benefits could be bargained away. Unfortunately, that same court did not decide whether retiree medical benefits could be reduced in the same manner. A public agency may have problems if, at the same time, it attempts to reduce the benefits of non collectively bargained employees who are receiving the same level of benefits as the bargaining unit employees.

Is The Proposed Change Permitted Under A Recognized Exception?

Courts have recognized certain circumstances in which the constitutional protection against impairment of contracts would not prevent a reduction or elimination of benefits. Although an employee has vested contractual rights to a benefit, these rights may be modified prior to retirement in certain circumstances. For example, a public employee who terminated employment prior to retirement age received a smaller refund of CalPERS employee contributions when the legislature amended the statute to provide that interest on such refunds would be calculated only through the June 30 preceding the date of refund rather than through the date of actual withdrawal. The court concluded that the original interest calculation provision did not amount to a vested contractual right and that the legislature could therefore revise it without impairing a contractual obligation.

Rights may be modified after retirement as well, although cases indicate that post retirement changes are more rigidly confined than those that precede retirement. The principle that rights become more fixed at retirement arose in pension cases because pension payments are in effect deferred compensation. Therefore, once an employee has already fulfilled the terms of his or her contract, the compensation to which the employee is entitled may not be changed subsequently to his or her detriment.

In addition, language in a few cases indicates that a change in benefits that is inconsistent with the contract nevertheless may be acceptable in the event of financial necessity or insolvency of the plan sponsor or the plan itself. For example, in one case, the court recognized that maintaining the actuarial soundness of a county’s health plan was one factor that justified the county’s adoption of a plan that did not require equal county contributions for active employees and retirees. However, other cases have rejected changes based on cost justification where such changes were inconsistent with the contract. Just because a proposed change would save the employer money is not a sufficient justification by itself.

What To Do?

Before a California public agency changes its benefit programs, it must first understand the nature and extent of its current obligations. Do its obligations to provide health, retirement, retiree health benefits arise under statute, such as a city charter, or pursuant to a memorandum of understanding? Every governmental employer also should conduct a detailed audit of its benefits programs to determine what representations or promises have been made regarding the nature and continuation of such benefits. A detailed review and analysis is essential because defining the precise terms of otherwise amorphous contracts is extremely difficult.

At a minimum, we suggest that the following steps be taken:

1. The terms of any documentary references to an entity’s benefits program(s) should be reviewed and analyzed;
2. A further investigation of any oral representations that might have been made on the subject should be conducted;
3. Supervisory personnel should receive training regarding what they should and should not say to employees and retirees regarding their benefits; and
4. A clear and conspicuous reservation of rights provision should be added to all plan documents and promotional materials and communicated to all employees and retirees.

These steps should allow public agency management to define as precisely as possible the terms of its contract with its employees and retirees. Depending on the agency’s goals, it may also be used to assure that no contractual vesting rights are created in the future.

In the final analysis, whether a governmental employer can reduce or eliminate its benefits programs depends upon a detailed analysis of the promises that it has made, both factually and legally, and the general rules and exceptions that the courts have crafted.

Of course, before a governmental employer takes any action to change the status quo in this matter, it should also consider the other potential non-legal implications of reducing or eliminating its employee or retiree benefits. Such other adverse consequences may include negative publicity and lowered employee morale, both of which should be fully analyzed and recognized as significant concerns.