New Municipal Bankruptcy Ruling Highlights the Need for Pension Reform

Recently, U.S. Bankruptcy Judge Christopher Klein ruled that the city of Stockton, California could reduce the amount it was obligated to pay in pension costs and could even leave the state’s retirement system (CalPERS). The significance of this decision is difficult to overstate. Pensions were long thought to be absolutely sacrosanct and unable to be cut, even in bankruptcy, especially since pension obligations are specifically protected under state law. Judge Klein’s ruling has highlighted the fact that political promises must bend to the reality of numbers.

The impetus for this ruling was another creditor of the city of Stockton that, under the city’s plan, was to be paid pennies on the dollar for an investment, while CalPERS was set to receive no cuts. This kind of precedent could have devastating effects throughout the municipal bond market since it would allow other types of creditors to take all the payment reductions during bankruptcy while preserving pension funds. In his ruling, Judge Klein noted that even though pensions enjoy some protected status under California state law, these rules do not necessarily apply when a city is under federal bankruptcy protection. This ruling should be a wake up call for cities like Chicago that are awash in red ink due to skyrocketing pension costs and feel that pensions would be safe because of state constitutional provisions guaranteeing them.

As we have written before, municipal bankruptcies due to pension costs can be avoided if officials act now. The traditional defined-benefit model, which guarantees employees a certain payment indefinitely into the future, regardless of funding or market performance, is simply unsustainable. By switching to a defined-contribution 401(k) style pension system for all new hires (like the vast majority of private sector employees), government employees would share the risk of investment with the state and would also be legally able to make sure the state sufficiently funded their pension. Oklahoma was the most recent state to make the switch, but Michigan, Alaska and Utah already have similar plans for their state employees.

Switching from a defined-benefit pension system to a defined-contribution model for new hires would allow states and municipalities to cap unfunded pension liabilities and work to pay them off over time while being able to stop new liabilities from piling up. This is by far the best way to protect current employees and retirees. The pension crisis in America is not a partisan issue, but rather a numbers issue.

Judge Klein has delayed ruling on a plan that the city of Stockton offered to escape federal bankruptcy until later this month, but the new ruling will certainly impact their proposal. By ruling that pensions can be cut during bankruptcy, the city must treat all investors fairly and work to come to a deal with CalPERS and other creditors. The lesson municipalities should take from this, especially those facing their own pension crisis that might end up in bankruptcy, is that the best way to protect current and retired employees’ pensions is to transition to a defined-contribution plan for new hires.

For more information on America’s pension crisis, see the ALEC report Keeping the Promise: State Solutions for Government Pension Reform.