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 taxpayer.
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 amortization period.
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.
The state 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 reforms.
[*] 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.
[‡] Unfortunately, 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, http://www.mackinac.org/ archives/2011/2011-03PensionFINALweb.pdf (accessed Feb. 16, 2012).
[§] 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.