Public Pensions May Rethink Vacation Payouts After Court Ruling

Cities and states that let retiring public employees boost their pension benefits with payouts for unused vacation days may rethink that practice after a ruling late last week.

The Arizona Supreme Court said a one-time payout for unused vacation days doesn’t form part of an employee’s compensation when calculating pension benefits. Though the decision was specific to the city of Phoenix’s pension plan, attorneys and pension consultants say it could have broader implications as municipalities across the country struggle to maintain plans that are underfunded.

“This is a big victory for municipalities going forward,” said Eric M. Fraser, a partner at Osborn Maledon PA, who represented the city of Phoenix in the dispute. “First of all, the practice of pension spiking is significant, and ending pension spiking will save substantial taxpayer money.”

Past Practices

For decades the city of Phoenix allowed eligible employees to profit financially from forgoing vacations by cashing out for a lump sum payment up to two and one-half years of accrued leave. The city then counted the payouts as compensation, thereby allowing plan members to increase or “spike” their pension benefits, the Arizona Supreme Court explained in its decision.

When the city changed that long-standing practice in 2014 to reduce rising pension costs, individual plan members and the unions representing plan members sued, arguing the city had unlawfully redefined and limited the plan’s definition of “compensation.”

The Arizona Supreme Court said the government’s past practice doesn’t give unions a contractual right independent of the plan to include one-time payouts for accrued vacation leave in their compensation calculations for pension benefits.

The court said the terms that bind the unions, the employees, and the plan are the plan terms themselves, not the unilateral decisions of the government, even if they were in place for many years, Fraser said.

“That’s the way this case, I think, will be very important in the pension plan context,” he said.

The American Federation of State, County and Municipal Employees AFL-CIO Local 2384 didn’t respond to a request for comment. Attorneys for the union and plan members also didn’t respond to a request for comment or questions about whether the unions plan to appeal.

The city of Phoenix made these changes to the plan based on the recommendations of its Pension Reform Task Force, which was formed by the mayor and city council in 2011, Fraser said.

“We are not aware of other municipalities in the state counting retirement payouts for unused vacation as pensionable pay,” he said. “The city of Phoenix is unique, however, in that the City Charter establishes an independent retirement system for city employees specifically. Other municipalities typically do not have their own pension systems and instead participate in the state’s retirement plans.”

However, some consultants expect to see more lawsuits over how vacation is counted pop up as a result of this ruling.

“I won’t be surprised if we see more challenges towards this or more people paying attention to it,” said Elliot Dinkin president and CEO of Cowden Associates Inc., a Pittsburgh-based consulting and actuarial firm that specializes in compensation, employee benefits, and retirement plans.

“I think it’s enough of a big deal that it will definitely warrant some attention, and Arizona is not alone. There are other municipal pension plans that have similar provisions,” Dinkin said.

Pension Protection

Public pension plans are a key component of the fiscal health of state and local governments, holding just over $4 trillion in assets for 20 million active and retired public sector employees in 2018, according to a 2019 analysis from the Center for Retirement Research at Boston College.

In May, the center was projecting that most state and local pension plans would end fiscal year 2020 with negative annual investment returns, reduced asset values, lower funded ratios, and higher actuarial costs if markets remained at their current levels until June.

Not counting vacation payouts as compensation is not out of step with best practices, and the drive to limit pension spiking is relatively common, said Jean-Pierre Aubry, director of state and local research at the Center for Retirement Research at Boston College.

But in terms of pension finances, it’s not a huge amount, Aubry said. “It’s not like that’s what’s breaking the back of pension finances,” he said.

State and local pension plans are governed by state laws— unlike pension plans in the private sector, which are governed by the Employee Retirement Income Security Act.

Arizona is one of several states that have a pension protection clause in the Constitution, said Anna-Marie Tabor, an attorney and director of the Pension Action Center at the University of Massachusetts Boston.

“What that means is the state legislature in general can’t unilaterally change the rights that the participants have under the plan. So that matters because so many of these plans are underfunded and systems are grappling with what to do about this,” she said.

The plan documents govern how the plan counts unused vacation and that varies state by state and county by county, Dinkin said.

“The plan document definition of ‘compensation’ for use for pension purposes is typically defined in the document, and if it’s not all inclusive, somebody can take an interpretation either way,” he said.

—With assistance from Warren Rojas

The case is State, Cty., & Mun. Emps. Local 2384 v. City of Phoenix, Ariz., No. CV-19-0143-PR, decision 7/10/20