Legal Protections for Pension Benefits and the Implications for Bond Investors


Managing municipal bond portfolios in today’s municipal market requires understanding, analyzing, and monitoring pension risk. Breckinridge’s bond review process includes, among other things, cross-checking clients’ bonds against an internally generated database of distressed pension plans, assessing issuers’ pension exposure prior to purchasing their debt, and surveilling existing holdings.

However, over the past few months, it has also become important for investors to understand the legal protections for public pension benefits. Pension contributions may comprise as much as 25 percent of some cities’ budgets in only a few years,1 and in extreme cases, excessive pension costs could crowd out other budget line items, including debt service payments. In addition, the latest round of pension reforms, which impose benefit reductions on current employees and retirees, face legal challenges in many states. In New Jersey, labor unions have pledged to sue if proposed pension changes become law. In Minnesota, retirees won a preliminary decision in opposition to that state’s new reform law. Until last year, reducing benefits for current employees and retirees was unthinkable to many lawmakers and labor leaders.

This Special Commentary outlines states’ various approaches to pension protections and discusses the implications for the investing community. It builds on Breckinridge’s February 2010 Special Commentary: Public Sector Legacy Costs and the Impact on Municipal Credit Quality. Our review of public pension law reveals that state protections for pension benefits vary and that states providing more limited protections may be in a better position to negotiate pension reforms.

A Survey of Public Pension Laws2

Protections for state and local pension benefits are promulgated through state laws. States typically characterize a public employee’s “right” to receive a pension in one of four ways: as a contract, as a property right, as a reliance-based right or as a gratuity. States that treat benefits as contractual obligations offer the strongest protections for public employees and retirees. Conversely, benefits characterized as gratuities offer employees little protection. In between these extremes are states that protect public employees’ pensions through a property-right theory of law or a reliance-based theory.

Contract Approach

Most states have opted for the contract-based approach. Some states, such as New York and Hawaii, create this contractual protection through the state constitution. Others have created protections through state statutes, collective bargaining agreements or court opinions.

The level of contractual protection varies. For example, New York’s constitution generally prohibits reducing pension benefits for current employees, whether the benefits have been earned or are merely expected to be earned in the future.3 In contrast, Hawaii protects only earned benefits; benefits that are expected but have yet to be earned have little protection.4

Contractual protections provide state and local governments with limited wiggle room when it comes to renegotiating pension contracts. Governments may impair contracts only if the impairment is both “reasonable” and “necessary.” Demonstrating “necessity” is very challenging, as a government can always impose additional taxes or new spending cuts to meet its contractual obligations.5

Property Approach

Another common approach among the states is to treat public pension benefits as property interests. In these states, including Connecticut and New Mexico, the law often protects benefits that have been earned plus those that can legitimately be expected. However, the protection is limited.

Property-rights-based protections provide governments with significant negotiating flexibility. Under the property approach, governments can negotiate reductions to benefits so long as their actions are not “arbitrary” or “outrageous” and the government has provided some notice to the affected persons. The government’s reductions must also comport with the Fifth Amendment’s “takings” clause. Courts in property-interest states have ruled that financial crises provide adequate justification to scale back pension benefits6 and that Fifth Amendment concerns are no bar to reducing benefits.7

Reliance-based Approach

One state, Minnesota, employs a reliance-based standard to protect pension benefits.8 In Minnesota, the general rule is that an employee or retiree is protected against pension reductions if he can show he was harmed by the change and justifiably relied on the state’s benefit promise.

The reliance-based approach likely places Minnesota governments in a strong negotiating position. The reliance standard generally requires an individual to factually demonstrate he relied on the government’s promise. Proof of reliance might be difficult for many employees and retirees. However, Minnesota retirees won a preliminary decision in opposition to the state’s new reform law and the case is now pending in court.

Gratuity Approach

Finally, a few states treat pension benefits as mere government gratuities. The notion of a pension as a gratuity is an antiquated legal concept that has been rejected by most state courts. However, it remains the law with respect to public pensions in Texas and, possibly, Arkansas.

While the gratuity approach technically permits benefit reductions for employees or retirees, gratuity states have nonetheless tended to bargain in good faith with their labor unions. For example, changes that Texas made to its pension system in 2009 applied only to new hires.

Implications for Investors

One conclusion to draw from the general legal outline presented here is that bond investors who are worried about an impending pension crisis ought to favor investments in states that construe pension benefits as property interests, reliance-based interests or gratuities. State law provides these governments greater negotiating flexibility than governments in contract-based states.

However, legal protections in contract-based states vary significantly. The difference between New York’s contractual requirement to keep its pension promises and Hawaii’s is vast. After analyzing pension rules and other credit fundamentals, investors should feel comfortable lending to most high-grade municipal issuers in contract-based states.

Negotiated Agreements are More Likely Than Lawsuits or Defaults

Negotiation remains the likely outcome to most governments’ pension issues. Governments and employees routinely renegotiate agreements covering hours, overtime rules and pension-contribution rates during times of fiscal stress. The next logical step is to renegotiate benefit promises.

Investors should expect these negotiations to be difficult and to take shape over several budget cycles. Labor leaders have little incentive to swiftly bargain away benefits because there is always the possibility that pension fund returns will improve. Moreover, policymakers can tackle unfunded pension obligations in a variety of ways, including tax hikes, fee increases, spending cuts, asset sales, privatization efforts, inter-local cooperation agreements, debt refinancing, and extending the amortization period for the unfunded pension liability. In some cases, municipalities may seek state assumption of pension debts.

During these negotiations, default is likely to be the policy choice-of-last-resort. Both labor and management value access to the capital markets. For labor, default typically induces additional layoffs and larger benefit cuts due to the employer’s diminished access to capital. Default also harms labor’s brethren in the private sector, including trade unions for carpenters, construction workers and others who benefit from bond-financed infrastructure projects. For management, default requires confronting voters who often own their government’s debt and who, polls show, are skeptical of public employee benefit packages. Officials who repudiate municipal bond contracts are also often plainly in violation of state law.9

Default also remains unlikely because municipal debt levels are manageable. Unlike today’s many underwater homeowners, most municipalities are not overleveraged. As a percentage of GDP, outstanding municipal debt remains less than its levels in the early 1990s, and in the second quarter of 2010, municipal debt actually decreased as a percentage of GDP.10 There is little reason to default – whether because of pension liabilities or any other liability – when debt levels remain within historical norms.

Breckinridge continues to evaluate municipal bonds at the credit level and on a bond-by-bond basis. Our credit staff assesses pension liabilities and their legal protection in conjunction with other fundamentals to determine issuers’ overall creditworthiness. We continue to invest only in bonds that meet our stringent credit standards and are constantly analyzing our holdings to preserve value and generate income over time.

DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this paper should be construed or relied upon as legal or financial advice. An investor should consult with an investment professional before making any investment decisions. Factual material is believed to be accurate, taken directly from sources believed to be reliable, such as the U.S. government, official financial reports, academic articles, and official trade organizations. However, none of the information should be relied on without independent verification.

1 See Richard Riordan and Alexander Rubalcava, “How Pensions Can Get out of the Red,” New York Times, September 15, 2010.
2 Author’s note: The research for this special commentary derives from the author’s own research and significantly borrows from the work of Professor Amy Monahan of the University of Minnesota Law School. See her writing footnoted below.
3 N.Y. Const. art. V, sec. 7.
4 Kaho’hanohano v. State, 162 P. 3d 696 (Haw. 2007).
5 The general approach to analyzing whether a state has impaired a contract is as follows: (1) there must be a contract, (2) the contract must be impaired, and (3) the impairment must be substantial. If all three of these indicators are present, then the state must demonstrate that is actions were reasonable and necessary in furtherance of a legitimate public purpose. The three-part rule boils down to this: the government can abrogate a contract if it has an emergency justification and there is no alternative solution to the emergency except abrogation. See United States Trust Co. v. New Jersey, 431 U.S. 1 (1977) and State & Local Government Debt Financing, Volume 3, Chapter 13:11, Page 38 (Edited by David Gelfand, 2009 Ed.).
6 Walker v. City of Waterbury, 601 F. Supp. 2d 420 (2009).
7 Amy Monahan, Public Pension Plan Reform: The Legal Framework, University of Minnesota Law School. Legal Studies Research Paper Series, Research Paper No. 10-13 (March 2010), p. 27. Note that benefit reductions are “takings” without “just compensation” only if the beneficiary has an “entitlement” to the benefits. One way to demonstrate an entitlement to a property interest is to show the beneficiary had a “distinct investment-backed expectation” that he would receive the property. However, pension plan beneficiaries in property interest states can have no such expectation precisely because they have not contracted for the benefit. See Board of Regents v. Roth, 408 U.S. 564, 564 (1972). “Property interests… are defined by existing understandings… that secure certain benefits and that support claims of entitlement to those benefits.”
8 Officially, Minnesota employs a “promissory estoppel” approach to define employees’ interests in the state’s pension funds. For ease of explanation, Breckinridge has substituted the term “reliance” instead of “promissory estoppel,” but the terms are not identical. See Christensen v. Minneapolis Municipal Employees Retirement Board, 331 N.W. 2d 740, 747 (Minn. 1983).
9 For example, many states require local officials to appropriate debt service payments on general obligation bonds through state law. A failure to appropriate payments often gives rise to a writ of mandamus suit by aggrieved bondholders. Harrisburg, Pennsylvania’s creditors filed suit for mandamus when that city nearly defaulted on its bonds in September 2010. If a court had heard the suit, it is very likely the court would have found Harrisburg officials acting contrary to their duties under state law and granted the writ.
10 See Federal Reserve’s Flow of Funds Report, September 17, 2010, Table L. 211 (p. 91).

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