Public-sector pension reforms are subject to legal
constraints. Defined-benefit pensions in government plans are protected by
Article 9, Sec. 24, of the Michigan Constitution, which states, “The
accrued financial benefits of each pension plan and retirement system of the
state and its political subdivisions shall be a contractual obligation thereof
which shall not be diminished or impaired thereby.” While this statement seems relatively clear
in theory, there has been litigation to determine what it means in practice.
In Studier v. Michigan Public School Employees’
Retirement Board, the Michigan Supreme Court confirmed that employees are
entitled to the pensions that they have already earned through participation
under the system’s rules so far, but the court did not hold that employees are
entitled to future participation in that same system.[*],
 Going forward, then, a
government can “freeze” the pension benefits that an employee has earned,
meaning they no longer earn further benefits under their current terms.
This does not mean the state is entirely off the hook,
however. If a gap opens between the benefits earned by those employees before
the freeze and the money set aside and invested to pay for those benefits, the
state cannot renege on providing the earned benefits; employees still have the
legal and constitutional right to expect that their earned benefits will be
paid. The employees’ right to these benefits is ultimately a claim on the Michigan
In reference to public pension plans, the Michigan
Constitution also states, “Financial benefits arising on account of service
rendered in each fiscal year shall be funded during that year. …” The Michigan
Supreme Court recognizes this constitutional injunction to mean that the state
should be “prefunding” these benefits — that is, that pension liabilities
should be saved for during the year they are earned, rather than being paid
only when they come due years later.
This prefunding is usually accomplished by making
annual payments to a pension fund that is invested in order to grow over time
(the investment portfolio is managed by the state Department of Treasury). For example, a single year of service
might be worth an additional $600 per year in pension benefits for an employee
upon retirement. Under a series of assumptions, such as when that employee will
retire, how long he or she will collect pension benefits after retirement, and
how much the state’s pension fund investments should grow, state actuaries
calculate a “normal cost” of retirement to be set aside annually to cover the
$600 benefit to be paid each year to the retired employee as a result of the
employee’s earlier year of service.[†] The
total annual normal payments deposited to the pension fund during the
employee’s preretirement years will generally be less than the total amount of
money paid to the employee during his or her retirement years, since the
earlier normal-cost deposits are assumed to grow through investment returns
during the employee’s working life. This prefunding is supposed to ensure that
the state does not push its pension costs for current service into the future,
and it is thus meant to thwart the temptation for policymakers to provide
ever-increasing benefits paid for long after they’ve left office.[‡]
While the state Supreme Court ruled that retirement
costs are not supposed to be deferred under the Michigan Constitution, the
court also ruled that it does not have the power to prevent the governor and
Legislature from deferring them. On
the whole, while the state constitution clearly requires the state to pay
retirees the pension benefits they have accrued during their working years, the
court does not have the power to mandate that these benefits be prefunded.
When pension benefits are not properly prefunded,
unfunded future liabilities accrue.[§]
Standard pension funding policies encourage the state to make annual payments
to completely eliminate its unfunded liabilities over time. This process
ensures that sufficient pension funds are available when employees retire.
Based on the most recent annual actuarial valuation, school districts were
paying down the defined-benefit plan’s unfunded liability over a 26-year
The Michigan Constitution states that these unfunded
liabilities cannot be paid off, however, using money meant to prefund benefits
being earned in any particular year.
In accounting terms, then, the constitution requires that the normal cost be
paid before any money is used to address unfunded liabilities.
constitution is otherwise silent, however, about paying down unfunded
liabilities.[¶] It does not require that a particular payment
method for unfunded liabilities be followed.
Inevitably, there is more to financing a pension
system than the state constitution discusses. The constitution does provide a
framework, however, within which the Legislature must operate when considering
[*] Common pension fund rules include minimum
service requirements, minimum ages to begin collecting a pension, and rules for
annual payments typically determined by a formula that uses an employee’s
compensation, a percentage multiplier and the number of years he or she
has served in the system.
[†] This hypothetical case is given as a simple
example of how a pension would be prefunded. The state does not perform such
calculations for each individual employee, but rather for the entire system.
a well-funded plan can also have the perverse effect of encouraging
policymakers to increase pension benefits and increase the plan’s long-term
liabilities. For a discussion of this point, see “Political Incentives” in
Richard C. Dreyfuss, “Estimated Savings From Michigan’s 1997 State Employees
Pension Plan Reform,” (Mackinac Center for Public Policy, 2011), 7,
https://www.mackinac.org/ archives/2011/2011-03PensionFINALweb.pdf (accessed Feb.
[§] Note that unfunded liabilities can accrue
even with prefunding when the plan’s investments or demographics do not meet
initial actuarial expectations.
[¶] This silence about unfunded liabilities may
be due to the constitution’s framers’ assumption that the pensions would be
properly prefunded. In that case,
no unfunded liabilities would accrue to begin with.