1 PENSION TASK FORCE OPTIONS FOR GOVERNMENTS TO OBTAIN RELIEF FROM PENSION LIABILITIES POST FIELDS Marc R. Lieberman Partner Kutak Rock LLP October 3, 2014

Gist of Fields ►In Fields v. Elected Officials’ Retirement Plan, 234 Ariz. 214, 320 P.3d 1160 (2014), the Arizona Supreme Court held that Senate Bill 1609, which sought to limit the payment to retirees of post retirement benefit increases, violated the “Pension Clause” contained in Art. XXIX, Section 1(C) of the Arizona Constitution. 2

What’s the Pension Clause? ►Art. XXIX, §1(C) of the Arizona Constitution has two separate components: The “Contract Clause,” which is the first half of the provision, and the “Pension Clause,” which is the second half of the provision. ►The “Contract Clause” provides: “Membership in a public retirement system is a contractual relationship that is subject to article II, § 25….” 3

What’s Art. II, § 25 (the “Contract Clause”)? ►Art. II, § 25 of the Arizona Constitution prohibits a government’s impairment of contracts (“No… law impairing the obligation of a contract, shall ever be enacted”). Despite the fact that the provision appears absolute, the courts have construed Art. II, § 25 as allowing governments to enact legislation impairing contracts if certain elements are satisfied. 4

The Pension Clause ►The Pension Clause is the second half of Art. XXIX, §1(C) of the Arizona Constitution, which reads in its entirety as follows (Contract Clause is in Blue and the Pension Clause is in red): “Membership in a public retirement system is a contractual relationship that is subject to article II, §25, and public retirement system benefits shall not be diminished or impaired.” 5

Differing Application Of The Contract Clause And Pension Clause ►In Fields, the Court emphasized that the Contract Clause pertains to “the general contract provisions of a public retirement plan, while the Pension Clause applies only to public retirement benefits.” ►As a result of this dichotomy, the Court held that the Pension Clause “confers additional, independent protection for public retirement benefits separate and distinct from the protection afforded by the Contract Clause.” 6

The Pension Clause Prohibits Legislative Impairment Of Any Vested Retirement Benefit ►Fields confirmed earlier decisions (Yeazell, Thurston) holding that members and retirees have a vested right to rely on benefits promised them at the time of their hire. ►Fields held that SB 1609’s attempt to change the formula for calculating post retirement benefit increases, which had the effect of reducing the benefits promised retirees when they were hired, violated the Pension Clause’s prohibition against the diminishment or impairment of retirement benefits. ►As a result, the Court invalidated that portion of SB 1609 (which had the effect of impairing post retirement benefit increases), and never reached the issue of whether SB 1609 violated the Contract Clause (Art. II, § 25). 7

Given Fields, Is There Any Legal Mechanism To Change Pension Rights? As plan funding levels decline due to a variety of factors, governments are desperate to stem increases in employer contributions– given Fields, can anything be done to reduce benefits and thereby reduce employer contributions? There are several options (some far better than others): 8

Consensual Change Since pension rights arise out of contract, and contracts can be modified with the consent of the parties, pension rights can be changed with the consent of all affected employers and employees. This can be accomplished through (i) execution of written consent forms or (ii) legislation sponsored by both employees and employers. Far Fetched? E.g., 2014 Fire Fighter Legislation: Members of the PSPRS are proactively seeking to enact changes to the PSPRS which materially reduce their benefits with the aim of enabling the PSPRS to be sustained (and materially reducing employer contributions). This legislation is being accompanied by proposed changes to Art. XXIX which would authorize the changes as constitutional. Better to be proactive than reactive or worse, bury your head in the sand. 9

Nonconsensual Change ►Repeal of Art. XXIX or parts thereof If plan funding levels continue to decrease and employer contributions continue to escalate, efforts might be made to change the constitution to eliminate the Pension Clause or indeed, close one or more of the State’s public retirement plans, as was recently done with EORP. 10

Proposal A ►Changing Art. XXIX, § 1(C) to retain the prohibition against “diminishment and impairment” but making clear that language is not intended to provide protection in addition to that provided by the Contract Clause: −“Membership in a public retirement system is a contractual relationship that may not be diminished or impaired in violation of subject to Article II, Section 25, and public retirement system benefits shall not be diminished or impaired.” 11

Benefits of Proposal A ►If Proposal A is enacted, the Legislature would be authorized to impair pension benefits if the legislation met the stringent tests for such impairment under the Contract Clause. −To be constitutional, such legislation would have to have a “significant and legitimate public purpose” and be a “reasonable and appropriate measure to achieve the public purpose.” 12

Detriments of Proposal A ►If Proposal A were enacted, the Legislature would be empowered to impair pension benefits in appropriate cases, and correspondingly, the pension benefits of members would no longer be absolutely protected from legislative impairment. −What’s more important, preserving the plans’ fiscal health for future generations or protecting the pension rights of existing members? 13

Application of the Statutory Vesting Provisions ►Many government retirement systems contain provisions specifying that members have no vested right to benefits until such time as they apply for benefits– we call these the Statutory Vesting Provisions. −PSPRS has had Statutory Vesting Provisions in place since 1983, and EORP and CORP have had similar Provisions since ►In cases now pending, courts are determining if members hired after the Statutory Vesting Provisions came into effect are precluded from complaining about legislative impairments to their benefits enacted before the members’ retirement. −The impact of a decision upholding the effectiveness of the Statutory Vesting Provisions is profound: more than 90% of PSPRS active members were hired after 1983, when the PSPRS Statutory Vesting Provision became effective, and more than two-thirds of EORP and CORP members were hired after 2000, when the Statutory Vesting Provisions for EORP and CORP were enacted. 14

Impact of Statutory Vesting Provisions ►If the statutory vesting provisions are enforceable, those portions of SB 1609 applicable to active employees will be effective as against more than 90% of the PSPRS membership, and more than 2/3 of the EORP and CORP membership. 15

Municipal Bankruptcy ►If all else fails, and employer contributions continue to escalate, cities, towns and counties who can no longer pay their contributions to government pension plans might seek to discharge their pension obligations by filing for bankruptcy under Ch. 9 of the Bankruptcy Code. −AZ is one of only 12 states allowing municipalities to file BK without condition. −NO consensus at this time whether a Ch. 9 filing in Arizona would enable an employer to discharge its public employee pension obligations, although recent decisions in the Detroit bankruptcy suggest that state constitutional prohibitions similar to the Contract Clause and Pension Clause would be unenforceable in bankruptcy and that the pension rights of active employees can be discharged in bankruptcy. 16

Pension Obligation Bonds ►Several governments (Illinois, Puerto Rico) have repeatedly resorted to issuing pension obligation bonds to cure their unfunded pension obligations. −Essentially, a participating employer would issue POBs and use the proceeds of the issue to satisfy all or a substantial portion of the employer’s unfunded accrued liability to the pension plan. In turn, the employer would be obligated to pay interest on the bonds, together with principal on maturity, and all interest remitted to the holder of the bonds would be taxable. The strategy only makes sense if the cost of the bonds proves less than anticipated increases in employer contributions. −While governments have had little trouble selling POBs, because they are taxable instruments, their promised yields will be higher, and consequently, will be more expensive to issue, than non-taxable municipal issues. 17

The Sun Will Shine Tomorrow, Annie While it seems as if there is precious little good news about the fiscal health of government retirement systems, there is hope: ►The Arizona systems are reporting healthy investment returns, and the decline in their funding levels is moderating; ►Both employers and employees recognize that post retirement benefit enhancements must be reduced (the single greatest source of unfunded accrued liability) ►Many employee groups are taking proactive measures to cure the deficiencies in their plans 18

QUESTIONS? ►Marc R. Lieberman −Chair, Public Pensions −KUTAK ROCK LLP −8601 N. SCOTTSDALE ROAD, SUITE 300 −SCOTTSDALE, AZ −(480)

Contact ► Scottsdale Office: 8601 North Scottsdale Road, Suite 300 Scottsdale, AZ (480) Marc R. Lieberman Kutak Rock LLP