Eureka

What Will Happen To The “California Rule?

by Shirley Svorny
Thursday, July 23, 2020
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istock

The year 2020 will be recorded in California history books as the year a pandemic arrived in America’s most populous state, but the impact of a California Supreme Court ruling likely will have a more lasting impact on state and local budgets and the economy.

Later this year, the court is expected to address recent lower court rulings related to its 1955 decision in Allen v. City of Long Beach that has, for decades, protected public sector pension benefits. The “California Rule” has become a serious problem at all levels of government because the existing defined benefit plans are seriously underfunded. Shortly before leaving office in December 2018, Gov. Jerry Brown predicted “fiscal oblivion” if reforms were not made to permit cutbacks to public-sector pensions.

A similar problem faced the private sector, but private companies shuttered their defined benefit retirement plans, shifting employees to 401(k) plans or other similar defined contribution plans.

But In the public sector, no such reforms took place.

Because of the constraints imposed by the court in the California Rule, pension benefits reflect the rules in place when a worker was hired. For example, if, at the time an employee was hired, pension benefits were set, upon retirement at age sixty-five, at 2.5 percent of a worker’s highest income multiplied by years of service, a current employee’s benefits increase under that formula as additional years of service are accumulated. Under the California Rule, benefits may not be modified as was common in the private sector.

This year’s expected California Supreme Court ruling will determine the flexibility afforded to state and local governments in realigning their budgets post-COVID-19. If the court does not change the California Rule, growing obligations to pension beneficiaries will continue to crowd out state and local government spending on everything else—including education, highways, prisons, courts, public safety, infrastructure maintenance, and public health. For example, in Los Angeles, without consideration of the impact of the COVID-19-related recession on tax revenues and pension fund assets, the city’s annual required contribution to its pension funds is anticipated to rise from 20 percent of all general fund expenditures in 2020 to 25 percent by the 2024–25 fiscal year.

The extent of cuts in services will depend on whether state and local governments can convince voters to embrace higher taxes, always a heavy lift. Even an increase in taxes is not a silver bullet, as higher taxes will encourage businesses (employers) and wealthy retirees to leave the state. Given California’s existing relatively high state tax burden, additional taxes to fund pensions will compound the situation that has led some geographically mobile businesses to move their headquarters out of state.

If, instead, California’s highest court rules to loosen the California Rule, the state would still not be out of the woods. Public sector unions will not sit idly by—they’ll pressure politicians to keep all or some portion of the benefits in place. Unions make campaign contributions and they have a reputation for getting out the vote. For this reason, the court ruling is unlikely to resolve the liability entirely out of the pockets of public employees.

As these benefits are essentially a transfer to older Californians from younger groups who will pay for the unfunded liabilities through higher taxes or lower public services, millennials have an incentive to unite to oppose the unions’ efforts to preserve existing benefits. Millennials could use social media—better than any other age group—to pressure state and local politicians to modify pension benefits, perhaps advocating for a shift from defined benefit to defined contribution plans.

Given the situation, it’s troubling that there has been almost no public discussion about how to scale back government services as the pension liabilities grow as a share of public-sector budgets. As long as voters are not focusing on the inevitable cuts to public services, term-limited politicians have no incentive to raise the issue; they can avoid hard discussions with constituents about what components of public spending should be prioritized and which should be cut.

For example, in this year’s March primary, not one of the candidates for the Los Angeles City Council mentioned the city’s sizeable unfunded pension liabilities on their respective web pages (this year, the council’s seven even-numbered seats were contested). A voter who looked to the candidates’ web pages for information on important issues would be forced to conclude that homelessness and affordable housing were the city’s only serious problems.

California’s post-COVID-19 effort to realign its spending is likely to bow to pressures from organized, vocal groups. In addition to the California Teachers Association, expect the California Medical Association and the California Hospital Association to lobby heavily. They’ll likely press legislators to spare drastic cuts in education and health care spending. If they’re successful, cuts in other essential services would be even more draconian.

California’s history suggests the interests of individuals who are poor will not be given a high priority. Despite California’s reputation for being progressive, the state has consistently underfunded programs that support the poor.

For example, California’s Medi-Cal physician payments are too low to attract a sufficient number of physicians to serve the Medi-Cal population. A 2018 study of children with special health care needs—200,000 of whom are served by California Children’s Services (a state program for minors with certain disease or health problems)—found that their parents experienced significant delays in securing critical medical equipment and supplies. Low program payments led to a dearth of outside vendors willing to provide equipment.

Moreover, California’s class-size reduction effort, initiated in the late-1990s for grades K-3, came at the expense of residents of low-income communities. Experienced teachers moved to newly created jobs in higher income areas, leaving the inner city with temporary and rush-to-credential inexperienced teachers. Similarly, in 2004, the state mandated nurse-to-patient ratios which increased the demand for nurses, leading to the shift of nurses with experience away from inner-city hospitals.

California politicians have shown an affinity for programs that promise future benefits in the form of pensions to their political constituencies—public-sector employees—but have failed to put away funds to support those promised payments when they become due. They secure the votes of public-sector workers with promises of pensions, but these promises cannot be met without seriously impacting funding for the provision of fundamental state and local government services. They put the interests of poor communities and individuals with medical conditions that need help last.

Now, with the added fiscal impact of COVID-19, hard decisions confront both legislators and their constituents. With little public discussion of the options—and unless millennials organize to push back against intergenerational flows such as those inherent in the states’ public pension system—traditional special interests are likely to dominate the decision-making process.

In an uncertain time, this much seems evident: California voters must pay attention if there is to be any hope of limiting special-interest influence over spending cuts and to avoid disproportionate negative consequences for individuals who are poor.

Shirley Svorny is Professor of Economics Emeritus at California State University, Northridge, and an Adjunct Scholar at the Cato Institute. An expert on the regulation of health care professionals, she’s written about local policies for economic development and the consequences of state medical malpractice insurance caps.