The Costs of COLAs.
As public plans seek ways to improve funding, some look to adjust retiree COLAs
Retirees participating in New Jersey's public pensions better not expect a cost-of-living adjustment (COLA) anytime soon.
The pension-reform bill signed in late June by New Jersey Governor Chris Christie effectively eliminates the COLA until a public plan in the state gets to at least 80% funding -- which will take a while, since the new law aims to increase the funded ratio of combined state and local systems from the current 62% to more than 88% over the next 30 years. That same month, courts in Colorado and Minnesota ruled that legislatures in those states had the right to reduce COLAs for current retirees.
For plans that urgently need to improve the unfunded liability, "a COLA is one of the few things that impacts benefits very quickly," says Joe Newton, a Dallas-based Senior Consultant at Gabriel, Roeder, Smith & Co. "It can have the most velocity of change. If you change the multiplier, that is not going to have a big impact on the unfunded liability."
Many states like New Jersey have changed the COLA in the context of a broad package of pension reforms. Increasing contributions affects new hires and sometimes existing hires, while raising the retirement age has the greatest significance for existing employees, and changing the COLA affects retirees. "It is a kind of share-the-pain approach to improving the funding level," says Cathie Eitelberg, Washington-based National Director for the Public Sector Market at consultant The Segal Co.
Understanding the Boundaries
Both the Colorado and Minnesota suits claimed that the plans' retirees had a contractual right to COLAs, which would make them protected, says Amy Monahan, a University of Minnesota Law School Associate Professor. However, in general, "The presumption is that, when a legislature passes a law, it does not create a contract by doing so," she says. "State laws generally are viewed as statements of current legislative policy. A later legislature can amend that."
So, courts look at the statutory language for evidence of intent to form a contract. "Colorado's decision says that there is nothing in the statutory language that says this is a contractual right," Monahan says. The Colorado Supreme Court previously has held that public pension benefits are contractually protected, she adds, but the COLA decision made a distinction between the base pension benefit as protected and the COLA. Minnesota's decision looks somewhat similar to Colorado's, she says, determining that nothing in the statutory language requires the finding of a contract, and making the distinction between the base benefit and the COLA.
Retirees may not appreciate the legal distinction. Cutting COLAs hurts the oldest participants most, as their purchasing power increasingly suffers, says Dean Baker, Co-Director of the Washington-based think tank the Center for Economic and Policy Research. "It is like saying, 'OK, you will have a good pension for the first five or 10 years after you retire, but if you live into your 80s and 90s, it is really not going to help you a lot,'" he says. "Part of the point of a defined benefit pension is that you are guaranteeing people a standard of living."
While these state-court rulings do not set binding precedents in other states, they likely will have a practical impact, Monahan predicts. "State legislatures considering taking action might feel a little more comfortable with it," she says. "These types of cases help states understand where the boundaries might be." Of course, a state's laws and previous court rulings play a big role. "In some states, there are rulings that it does not make sense to distinguish between the base benefit and the COLA," she says. "In some states, there are rulings that say you cannot change COLAs for future service."
However, a state always has the sovereign power to act in the best interests of its citizens, Monahan says. "Both courts essentially said that what they did to COLAs was reasonable and necessary. That part of the ruling will be the most influential in other states," she says. "Both decisions say, even if it is considered contractual, you could still make these changes." Colorado and Minnesota each made the COLA changes as part of comprehensive efforts to improve public-pension funding and took steps also affecting new hires and current employees. "This was not just going after current retirees," she says.
The Corporate COLA Comes, and Goes
Private-sector plans already learned the lesson of COLA costs. COLAs built into a plan "are extremely rare, in the low single digits," among corporate plans, says Ari Jacobs, Retirement Solutions Leader at consultant Aon Hewitt. Ad hoc COLAs that adjust benefits on a one-time basis are a little more common, he says, but still in the single digits.
Automatic COLAs always have been relatively rare in private-sector plans, says John Ehrhardt, a New York-based Principal at consultant Milliman, Inc. Some employers "were doing it on an ad hoc basis, when inflation was a lot higher in the '80s and the beginning of the '90s," he says. "Those folks' plans were overfunded, and there was no way to use a surplus effectively: They could not take a credit for it, so, from a cash point of view, they could provide benefit increases."
Private employers have rules that ultimately discouraged most from adding guaranteed COLAs or ad hoc COLAs given on a regular basis. "The IRS says that, if you are doing it every year or on a regular cycle, it is part of accrued benefits," Ehrhardt explains. "Once it is part of the accrued benefit, it is illegal to cut back by plan amendment."
Plus, as inflation declined, protecting retirees' purchasing power became a less-urgent priority. By the time the dot.com bubble burst around 2000, Ehrhardt says, more plans became underfunded, and most that had offered ad hoc adjustments stopped. "If anybody had a COLA, that is when they took it away, and only prospectively," he says. Benefits already accrued would have to include the COLA, while future benefits accrued would not.
Inflation adjustments have not made a comeback with private plans since then, particularly given the current focus on minimizing pension expenses, and with expected lifetimes longer, that increases the value of the COLA, Ehrhardt says. "A COLA increases pension expense and cash costs," he says. "A 3% COLA in a retirement plan might increase the value of the benefit by 20% to 25%."
Making a COLA Affordable
Public plans can make COLAs work, as evidenced in a study released in June by the National Institute on Retirement Security (NIRS), "Lessons from Well-Funded Public Pensions: An Analysis of Six Plans that Weathered the Financial Storm." All six of the state-level plans studied -- in Delaware, Idaho, Illinois, New York, North Carolina, and Texas -- have some type of COLA provision.
"COLAs are still extremely important to retirees in terms of getting inflation protection. People are living longer, and if you retire at 65, you may be in retirement for 20 or 30 years. If there is no inflation protection, your purchasing power is really going to decline over time," says Ilana Boivie, the NIRS Director of Programs, who co-authored the study, "but COLAs also cost money, so they do need to be granted responsibly."
Asked the key to sponsors handling COLAs responsibly, Boivie says, "There is a constant balance between what retirees need to maintain their standard of living, and the affordability of the system. The key thing to keep in mind with COLAs is to account for the costs right away, and pay for them as quickly as possible."
While many COLA modifications affect new hires, as the cases in Colorado and Minnesota show, some public plans also are making alterations that affect retirees. "If you are talking about changes to new hires, they have a lot of options," Newton says of controlling COLA costs. "Changes to retirees come down to a state-by-state issue, so they may not have many options there."
More than 60% of large public plans have a guaranteed COLA, either at a fixed rate or based on the CPI (Consumer Price Index), Newton says. About 20% of large plans go the ad hoc route, while another 10% to 20% give "contingent" COLAs if the plan achieves a specified result.
For plans with ad hoc COLAs, the recent cost-cutting "happened automatically, because the money was not there," Newton says. Other plans have turned toward contingent COLAs. New Jersey's pension reform eliminated automatic annual payment increases for all current and future retirees, and established that reaching a "Target Fund Ratio" will define boards' future ability to change plan design.
"A COLA can be ratcheted down by putting a lower cap on the COLA, or tying it to another result that will trigger it, such as the level of investment return in a given year or the funding level," Segal's Eitelberg says. "If a plan is funded at 80%, they may not grant a COLA, but if they get to 90%, they may grant a 2% COLA, and if they get to 100%, it might be 3%."
Plans also can limit costs by capping the COLA, either based on a participant's retirement benefit or on the COLA percentage. "You can control the base it is applied to and the percentage applied to the base," Eitelberg says. For example, a plan could say that it will apply the inflation adjustment up to $20,000 in a retiree's annual benefits, or that it will cap the COLA at the amount of its current average benefit. "It is almost a means-testing approach," she says.
A percentage-based cap can establish a maximum based on the CPI. Say that a retirement system caps the CPI-based COLA at 2%. If the CPI runs at 3% one year, retirees get 2%. If the CPI totals 1% the next year, retirees get 1%. "It is pretty common if they have a CPI-related benefit to have a cap," Newton says. "A dollar-cost cap is not as common."
Eitelberg has not seen much outright dropping of a public plan's COLA, but she has seen plans put it on hold. "We have seen it structured in a way that, when it is tied to funding, there may not be payment of a COLA for a long time," she says. "We have not seen a lot of entities eliminate it entirely, but we have seen them structure it in ways that effectively suspend it until funding improves."
Moves like that go over much better when plan officials keep participants informed and even involved in the process, Eitelberg says. For plans eyeing pension reform, she suggests creating a task force that has representatives from the plan, employers, participants, and retirees. When that happens, she says, "that process, more times than not, results in agreement around reduction in costs and increases in contributions, with the understanding that the long-term goal is to sustain the plan over time. The discussion is around being able to get the plan to sustainability and concern that, if no action is taken, the plan may not survive."
A lot of the changes public plans have made impact new hires, Eitelberg says, so the process has less tension. Yet, even decisions affecting current members, such as extending the retirement age and increasing contributions, fare better when a plan communicates a lot during the process. "We have seen it to be extremely successful to participants' understanding," she says. "Having said that, we also have seen lawsuits. It is always possible that plans are going to have litigation."