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Untouchable Pensions May Be Tested in California

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New York Times  March 16, 2012

Published: March 16, 2012

When the city manager of troubled Stockton, Calif., had to tell city council members why it was on track to become the biggest American city yet to go bankrupt, it took hours to get through the list.
There was the free health care for retirees, the unpaid parking tickets, the revenue bonds without enough revenue to pay them. On it went, a grim drumbeat of practically every fiscal malady imaginable, except an obvious one: municipal pensions. Stockton is spending some $30 million a year to pay for them, but it has less than 70 cents set aside for every dollar of benefits its workers expect.
Some public pension experts think they know why pensions were not on the city manager’s list. They see the hidden hand of California’s giant state pension system, known as Calpers, which administers hundreds of billions of dollars in retirement obligations for municipalities across the state.
Calpers does not want cities like Stockton going back on their promises, and it argues that the state Constitution bars any reduction in pensions — and not just for people who have already retired. State law also forbids cuts in the pensions that today’s public workers expect to earn in the future, Calpers says, even in cases of severe fiscal distress. Workers at companies have no comparable protection.
Stockton is in the midst of a mediation process with its creditors that will determine by the end of June whether it will file for Chapter 9 bankruptcy, which would allow the city to negotiate reductions in its debt in court.
For Calpers, the prospect of a California city in Federal Bankruptcy Court portends a potential test of the constitutional mandate that federal law trumps state laws — in particular, the state laws that protect public workers’ pensions in California. Such a challenge could blow a hole in what experts consider the most airtight pension protections anywhere.
“Obviously, what Calpers wants is that it doesn’t come up in the process, which I think is ridiculous,” said David A. Skeel Jr., a law professor at the University of Pennsylvania who writes frequently on bankruptcy. “My view is that even the California Constitution is subsidiary to federal bankruptcy law.”
As the United States population ages and more and more public workers qualify for retirement, the cost of their pensions is growing fast, turning into a major drag on many local governments’ finances. The pension contributions that cities must make every year are rising, but their revenue, which often depends on property taxes, is not keeping up. Taxed-out residents, many of whom have lost their own pensions in the private sector, are unwilling to pay more. In tax-averse California in particular, where every tax increase must be put to a vote, officials are running out of options and some are considering bankruptcy.
Bankruptcy in America is a collective process, where creditors of a distressed company or municipality come together under court oversight and negotiate a plan to share the losses equitably, for the sake of the greater good. Some creditors may stand more toward the front of the line and others at the back, but there isn’t generally one big creditor that gets paid in full without having to get in line at all.
Yet that’s what Calpers appears to be doing.
“They will probably say it’s a statutory right and it can’t be changed by a bankruptcy court,” said James E. Spiotto, a Chapter 9 specialist with the firm of Chapman & Cutler. “I think it’s still subject to some question.”
A spokeswoman for Stockton’s city manager, Connie Cochran, said she could not discuss the city’s dealings with Calpers, citing the confidential mediation process.
When a company with a pension plan goes bankrupt in Chapter 11, it typically stops making most of its required pension contributions, just as it can stop paying many other bills. Some companies, like Northwest Airlines, even declare bankruptcy the day before a pension contribution is due, to save the cash.
Chapter 11 also permits companies to shed their pension obligations completely, if they can convince the bankruptcy judge that’s the only way they can restructure. The federal government, which insures traditional company pensions, then takes over the defunct plan and pays retirees their benefits, up to statutory limits.
There is no such backstop for state or municipal pensions. But cities, until recently, have managed to avoid bankruptcy, so there is almost no precedent for how public pensions will fare in Chapter 9.
Now that is starting to change.
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Prichard, Ala., tried to file for Chapter 9 bankruptcy in 2009, after its pension fund ran out of money, but its case was thrown out by the judge, who cited a rule that Alabama cities must have bonds outstanding to qualify for Chapter 9. Prichard had no bonds at the time, just a big debt to its retirees. The city went for nearly two years without paying them their pensions, then reached an out-of-court settlement that gave them about one-third, on average, of what they had earned.
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Jim Wilson/The New York Times
The city manager, Bob Dies, in foreground, is focusing on cutting retiree health benefits.
Central Falls, R.I., declared bankruptcy in 2011, after its pension fund for police officers and firefighters nearly ran out of money. The state withheld aid, and passed a law forbidding any effort to revive the pension plan by issuing bonds. Central Falls had little choice but to negotiate sharp cuts with the retirees.
In California, the only precedent is in the city of Vallejo, which declared bankruptcy in 2008. Unlike Prichard and Central Falls, which had their own pension plans, Vallejo is part of a state-run system. It kept making all of its contributions to Calpers throughout its three-year bankruptcy.
“We never shortchanged Calpers,” said Robert V. Stout, Vallejo’s finance director at the time.
Mr. Stout said he had expected to renegotiate the city’s retirement plans in bankruptcy, since everything else was on the table. At the time, Vallejo was in a fiscal tailspin with the mortgage debacle, which hit cities in California unusually hard.
But Calpers drew a line in the sand, warning Mr. Stout and his lawyers that in California, public pensions can be increased but never decreased, not just for retirees, but also for workers at midcareer.
What if the city is bankrupt and cannot afford it?
“They made it quite clear that they take that law very seriously,” Mr. Stout said. Calpers also warned that if the bankruptcy judge ruled that the state pension laws stopped at the federal courthouse door, Calpers would appeal, and make Vallejo pay its legal bills.
“We interpreted that as, ‘If we try, they’ll fight us through the courts forever,’ ” Mr. Stout said. He and Vallejo’s lawyers decided the city couldn’t afford it.
The city ended up cutting services sharply, gutting its retiree health plan, adding a 1 percent sales tax and cutting payments on its bonds. But its police officers and firefighters still qualify for full retirement at 50, and other city workers at 55.
Since Vallejo made no effort to cut pensions in bankruptcy, the legal issues remain untested, said Mr. Spiotto, the Chapter 9 lawyer.
“It’s something that’s in the process of being worked out, not only in California, but in every state,” he said. “It’s a global issue.”
A Calpers spokeswoman responded to questions by providing a 20-page position paper on the laws that protect public pensions in California. The report did not mention bankruptcy but acknowledged that some California cities were struggling.
“It will be vitally important for all interested parties to heed the legal rules protecting the vested rights of Calpers’s members,” the paper said. Challenges “may lead only to additional litigation and administrative costs.”
Critics in academic and legal circles say they believe Calpers wants to keep municipalities in its system because it needs to keep their contributions flowing in without interruption to cover the payouts it makes each month to retirees. Gov. Jerry Brown called that situation “a Ponzi scheme” last December, when he proposed a plan to lower public pension costs gradually, by offering smaller pensions to the workers that cities will hire in the future. The governor’s plan was strongly opposed by public employees’ unions, which have a strong voice in Calpers, and his fellow Democrats in the state Legislature have let it languish.
After Vallejo’s bankruptcy, Calpers’s board passed another rule that any municipality wanting to withdraw from its system would have to first pay off its shortfall, calculated in a way that makes the payment two to three times as big as in the past.
Stockton’s city manager, Robert Deis, is focusing on cutting retiree health benefits instead of pensions, because he said the retiree health plan was completely unfunded — as opposed to its pension being 70 percent funded — and the cost was growing at a faster rate.
Changing the pensions would also be complicated by the fact that some of Stockton’s retirees get both pensions and Social Security, and others get only their city pensions.
Still, the city’s annual contributions to Calpers for pensions, currently $30 million, are greater than its retiree health costs, $9 million this year. Even before the collapse of 2008, Stockton was struggling with its pension contributions. In 2007, it issued bonds to raise the cash it needed to send to Calpers. But then Calpers’s investments took a pounding in 2008, leaving Stockton with a new pension shortfall to cover — plus about $7 million of principal and interest to pay on the bonds every year.
Bankruptcy lawyers said that if such issues were not addressed in Stockton, they were likely to come up elsewhere soon.
“There are a bunch of cities in bad shape, and pensions are part of the problem,” said Mr. Skeel. “If you have a string of Chapter 9’s, I don’t think every one of them is going to say, ‘This enormous obligation can’t be touched.’ I think one of them is going to take the plunge.”

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