Can Maryland cap future state pension benefits without violating employees' contract rights?

Plain-English summary

Two members of the Maryland General Assembly asked the Attorney General whether proposed legislation to adopt federal tax code benefit limits for the Maryland State Employees' Retirement and Pension Systems would violate the Contract Clause of the U.S. Constitution. The legislation was needed because the Systems did not then meet the annual benefit accrual limits in Internal Revenue Code §415, and falling out of compliance risked the Internal Revenue Service ruling the Systems' pension plans were not "tax-qualified," which would strip members of favorable tax treatment on their contributions and earnings.

The opinion concluded the legislation would not violate the Contract Clause. Even assuming Maryland pension statutes create a contractual obligation, as Maryland case law had recognized for vested pension rights, that contract implicitly includes the State's reserved power to amend pension terms going forward, and courts had never invalidated a purely prospective pension change under the Contract Clause. Because no member of the Systems had, as of January 1, 1990, accrued a benefit exceeding the IRC §415 limits, the legislation would only cap benefits not yet earned, which the opinion treated as essentially eliminating any impairment question. The opinion went on to conclude that even if a court found the legislation impaired a contract, the impairment would be reasonable, since the IRS's shift away from a longstanding non-enforcement policy was a legal development the General Assembly could not have anticipated, and necessary, since adopting the public-sector IRC §415 limits was the least drastic way to protect the tax-qualified status enjoyed by roughly 160,000 members, compared to the available alternative of the "grandfather" election, which would have required adopting less favorable private-sector limits for newer members.

Currency note

This opinion was issued in 1991 and analyzed then-current versions of Internal Revenue Code §415, §414(h), and §401(a)(16), including specific dollar thresholds in effect for 1991 plan years, applied to the Maryland State Employees' Retirement and Pension Systems as they then existed. Federal tax law benefit limits, dollar thresholds, and IRS enforcement policy change over time, and the systems themselves may have been restructured or recodified since 1991. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify the current Internal Revenue Code §415 limits and the current status of Maryland's retirement systems before relying on any specific rule described here.

Common questions

Would Maryland violate its pension contract with employees by capping future benefit accruals to protect the plans' federal tax status?
According to this 1991 opinion, no. The Attorney General concluded that because the proposed benefit limits under IRC §415 would only apply prospectively, to benefits not yet earned, the legislation would not impair any existing pension contract, and Maryland courts had recognized that the State retains an implicit power to alter pension terms as to future benefits.

Why did Maryland need to change its pension law at all?
The opinion explained that the Systems did not then satisfy the benefit accrual limits Congress added to IRC §415 for public pension plans in 1986, and continued noncompliance risked an IRS determination that the plans were not tax-qualified, which would eliminate valuable tax advantages, such as tax-deferred growth on contributions, for roughly 160,000 members.

Could Maryland have avoided the new limits some other way?
The opinion noted the Systems could have elected a "grandfather" provision protecting benefits already accrued before 1990, but that election would have required adopting the federal government's stricter private-sector benefit limits for anyone who joined the Systems afterward, since no member's accrued benefits actually exceeded the public-sector limits as of 1990, the opinion found the simpler prospective adoption of the public-sector limits was the least drastic way to comply.

Background and statutory framework

The opinion explained that a "tax-qualified" retirement plan gives members tax-deferred treatment of their own and the State's contributions and earnings, plus favorable tax treatment on some distributions, and that under IRC §414(h) the State's "pick up" of employee contributions meant those contributions were not taxed before going into the plan. In the Tax Reform Act of 1986, Congress set specific dollar and percentage limits on annual benefits for public pension plans under IRC §415(b)(1), later modified by the Technical and Miscellaneous Revenue Act of 1988's optional "grandfather provision" in IRC §415(b)(10)(C) for benefits accrued before January 1, 1990. The opinion's Contract Clause analysis, grounded in Article I, §10, cl.1 of the U.S. Constitution, was guided primarily by the federal district court's decision in Maryland State Teachers Ass'n v. Hughes, 594 F. Supp. 1353 (D. Md. 1984), which had rejected a Contract Clause challenge to 1984 Maryland pension reform legislation, and by Maryland case law recognizing that pension statutes create contractual duties toward vested members, including Board of Trustees v. City of Baltimore, 317 Md. 71 (1989), and Quesenberry v. Washington Suburban Sanitary Commission, 311 Md. 417 (1988).

Applying the MSTA framework, the opinion reasoned first that any pension contract implicitly includes the General Assembly's reserved power to alter future benefit terms, then that a purely prospective change (one that does not touch benefits already accrued) essentially forecloses a Contract Clause impairment claim, citing MSTA's observation that no U.S. Supreme Court decision had ever invalidated a non-retroactive pension statute on Contract Clause grounds. Even assuming an impairment, the opinion concluded it would satisfy the two-part reasonableness and necessity test from United States Trust Co. v. New Jersey, 431 U.S. 1 (1977), reasoning that the IRS's shift away from its 1977 non-enforcement policy toward public pension plans (as reflected in a 1989 Federal Register notice) was an unforeseeable legal development that made the proposed legislation reasonable, and that adopting the public-sector IRC §415 limits, rather than the more restrictive private-sector limits triggered by a grandfather election, was the least drastic way to protect the tax-qualified status relied on by the Systems' approximately 160,000 members.

Citations and references

Statutes:

• IRC §415, the federal benefit-accrual limitation provision central to this opinion
• Article I, §10, cl.1 of the Constitution, the source of the federal Contract Clause
• IRC §414(h), governing the State's "pick up" of employee retirement contributions
• IRC §401(a)(16), the tax-qualification standard tied to compliance with benefit limits
• IRC §415(b)(1), setting the maximum employer-provided benefit for public plans
• IRC §415(b)(2)(C), providing for actuarial adjustment of the benefit limit before age 62
• IRC §415(b)(2)(D), providing for actuarial adjustment of the benefit limit after age 65
• IRC §415(b)(2)(F), the provision setting a benefit-limit floor
• IRC §415(b)(2)(F)(i)(II), specifying the $75,000 floor for benefits commencing at or after age 55
• IRC §415(b)(10)(C), the grandfather provision protecting benefits accrued before January 1, 1990
• Tax Reform Act of 1986, the federal law adopting the public-plan benefit limits discussed
• Technical and Miscellaneous Revenue Act of 1988, the federal law adding the grandfather election

Cases:

• Maryland State Teachers Ass'n v. Hughes, 594 F. Supp. 1353 (D. Md. 1984), aff'd No. 84-2213 (4th Cir. 1985), cert. denied 475 U.S. 1140 (1986), federal district court decision rejecting a Contract Clause challenge to 1984 Maryland pension reform legislation, the primary framework used in this opinion
• Board of Trustees v. City of Baltimore, 317 Md. 71, 100, 562 A.2d 720 (1989), Maryland Court of Appeals decision holding pension plans create contractual duties toward persons with vested rights
• Quesenberry v. Washington Suburban Sanitary Commission, 311 Md. 417, 423, 535 A.2d 481 (1988), Maryland Court of Appeals decision cited alongside Board of Trustees on pension contract rights
• United States Trust Co. v. New Jersey, 431 U.S. 1, 17, 19-21 (1977), U.S. Supreme Court decision setting out the reasonableness and necessity standard for justifying a contract impairment
• Baker v. Baltimore, 487 F. Supp. 461, 468 (D. Md. 1980), federal district court decision on the State's reserved power to amend pension contracts

Source

• Landing page: https://oag.maryland.gov/resources-info/Pages/attorney-general%E2%80%99s-opinions.aspx
• Original PDF: https://oag.maryland.gov/resources-info/Documents/pdfs/Opinions/1991/Volume76_1991.pdf (this opinion appears at printed pages 351-357 of the bound annual volume; Maryland's site does not publish a standalone PDF of this opinion)

Original opinion text

Best-effort transcription from a scanned PDF. Minor errors may remain, the linked PDF is authoritative.

RETIREMENT SYSTEMS

Constitutional Law - Contract Clause - Legislation to
Impose Prospective Benefit Limits Would Not Violate
Contract Clause

                          February 15, 1991

The Honorable William H. Amoss
The Honorable Richard N. Dixon
Maryland General Assembly

   You have requested our opinion as to the constitutionality of

legislation that would impose certain prospective benefit limits in order
to enable the Maryland State Employees' Retirement and Pension
Systems (the "Systems") to retain their tax-qualified status under the
Internal Revenue Code ("IRC"). Specifically, you asked us whether
proposed legislation to adopt the limitations on the accrual of annual
benefits set out in IRC §415 would cause the Systems to violate the
Contract Clause of the United States Constitution.1

For the reasons stated below, we conclude that enactment of such

legislation would not violate the Contract Clause.

                                  I

                            Background

"Through the years, Maryland's policy has been to stay as close as

possible to the federal requirements regarding qualified pension plans."
Joint Committee on Pensions, Report of the 1989 Interim 118 (December
1989). A plan that is qualified affords its members the following
advantages:

   1
    Article I, §10, cl.1 of the Constitution provides that "[n]o State shall ...

pass any ... Law impairing the Obligation of Contracts ...."

       °   Members are not taxed on the earnings on
           their contributions while they remain in the
           plan.
       °
           Members are not taxed on either the State's
           contributions or the earnings on those
           contributions while they remain in the plan.

       °    Members or their beneficiaries are entitled
            to special tax treatment on distributions in
            certain circumstances.

       °    In accordance with IRC §414(h) and State
            law, employee contributions are "picked up"
            by the State. This employer pick up means
            that the employees' contributions are not
            taxed before being contributed to the plan.

A non-qualified plan loses all of these advantages for its members.

According to the Joint Committee, "the State's various retirement

and pension plans have been maintained as [tax-qualified], even though
Maryland currently does not meet all the applicable requirements."
Report at 119. One requirement that the Systems do not now meet
involves certain benefit limits in IRC §415, discussed in Part II below.
If the Systems permit the accrual of benefits in excess of these limits, it
risks a finding by the Internal Revenue Service that its plans are not
qualified. IRC §401(a)(16).2

                                 II

            Benefit Limitations Under IRC §415

 IRC §415 seeks to prevent highly compensated employees from

accumulating very large pension benefits. Its overall limitations on
benefits have always applied to public retirement plans; however, recent
legislation has focused more specifically on public plans.

   2
      The Internal Revenue Service has previously not sought to disqualify

noncomplying public plans. That IRS enforcement policy may change, according
to the Joint Committee Report. See Part III D below.

In the Tax Reform Act of 1986, Congress adopted specific limits for
public plans. Under IRC §415(b)(1), the maximum employer provided
benefit may not exceed the lesser of (i) $90,000 (as adjusted for
inflation) or (ii) 100% of the participant's high three year average
compensation.3 The maximum benefit limitation is actuarially reduced
or increased if benefit payments commence before age 62 or after age

65. IRC §415(b)(2)(C) and (D). See also IRC §415(b)(2)(F). In no
    event may the dollar limitation be less than $75,000 if the benefit
    payments commence at or after age 55. However, the $75,000 limit is
    actuarially reduced if benefits are paid prior to age 55. The $75,000
    floor is not adjusted for inflation. IRC §415(b)(2)(F)(i)(II). Finally,
    there is a special limitation for police and firefighters with at least 15
    years of service. The dollar limitation for qualified police and
    firefighters may not be less than $50,000 (indexed for inflation).4

In the Technical and Miscellaneous Revenue Act of 1988, Congress
permitted governmental plans to elect a "grandfather provision." IRC
§415(b)(10)(C). The grandfather provision protects the accrued benefits
of individuals who were members of a governmental plan prior to
January 1, 1990 regardless of whether the IRC §415 limitations are
exceeded. The "cost" of electing to protect the benefits of pre-1990
participants is that governmental plans must opt to apply the less
advantageous private plan limits to those participants who become
members on or after January 1, 1990. The effect of the private plan
limits is to discourage early retirement by lowering the limit and
reducing benefits significantly.5

According to the Systems, as of January 1, 1990, no member had

accrued a benefit that exceeds the IRC §415 limits; hence, no members
of the Systems need protection under the grandfather provision. Thus,
there appears to be no compelling reason to adopt the grandfather

   3
     The dollar limitation in effect for plan years beginning January 1, 1991

is $108,963.
4
In 1991, the limitation may not be less than $60,535.
5
The private sector limits may be summarized as follows: Rather than
determining the maximum employer benefit payable at age 62, in private plans
the dollar limitation of $90,000 (adjusted for inflation) is actuarially adjusted
depending upon whether retirement begins before or after the "Social Security
retirement age." For employees born prior to January 1, 2000, the Social
Security retirement age is 65. The Social Security retirement age will be either
66 (for those born after December 31, 1999 and prior to January 1, 2016) or 67
(for those born after December 31, 2017).
If the benefit begins before the Social Security retirement age, the limit must
be reduced to the actuarial equivalent of the dollar limitation beginning at the
retirement age. Significantly, private plans are not entitled to the special public
plan floor of $75,000 for benefits payable at age 55 and before age 62.

provision and, consequently, the more restrictive private sector limits for
those who become members after January 1, 1990. Therefore,
legislation to specifically incorporate by reference the IRC §415 limits
would operate prospectively only.

                                III

                  Contract Clause Analysis

A. Introduction

Our assessment of the Contract Clause issue is guided primarily by
Maryland State Teachers Ass'n v. Hughes, 594 F. Supp. 1353 (D. Md.
1984), aff'd No. 84-2213 (4th Cir. 1985), cert. denied 475 U.S. 1140
(1986) ("MSTA"), in which the court rejected a Contract Clause
challenge to the 1984 pension reform legislation. Applying the analysis
of that case, we conclude that legislation incorporating IRC §415 benefit
limits into the law governing the several Systems would not impair an
existing contract (assuming one existed). Moreover, even if the
legislation were thought to impair a contract, the impairment is
reasonable and necessary to serve an important public purpose.

B. Nature of Contract

 The first question in analyzing a change to a pension statute is

whether "a contractual obligation was created by [that] statute." MSTA,
594 F. Supp. at 1359. In MSTA, the federal court assumed without
deciding that the legislation providing for the Retirement Systems did
create a contract. 594 F. Supp. at 1362. And the court's assumption is
buttressed by later decisions of the Maryland Court of Appeals. Board
of Trustees v. City of Baltimore, 317 Md. 71, 100, 562 A.2d 720 (1989)
("Under Maryland law, pension plans create contractual duties toward
persons with vested rights under the plans."). See also Quesenberry v.
Washington Suburban Sanitary Commission, 311 Md. 417, 423, 535
A.2d 481 (1988). For purposes of this opinion, we likewise assume that
the statutes to be amended by the proposed legislation create a contract.

But any such contract implicitly contains authorization for it to be

altered by the General Assembly. "Under Maryland law, the State has
reserved the power to amend or alter pension contracts, and that
reserved power '... is part of each pension plan which a legislature
enacts, whether explicitly or not.'" MSTA, 594 F. Supp. at 1362
(quoting Baker v. Baltimore, 487 F. Supp. 461, 468 (D. Md. 1980)).

C. Impairment

Assuming that a contractual obligation was created, the next step in
the analysis is a determination whether the actions by the State impaired
the obligation of the State's contract. MSTA, 594 F. Supp. at 1359. See
United States Trust Co. v. New Jersey, 431 U.S. 1, 17, 19-21, (1977).

 If legislation operates prospectively only, an impairment almost

surely does not exist. In MSTA, the court observed that it could not find
any Supreme Court decision that had "invalidated a non-retroactive state
statute on the basis of the Contract Clause." 594 F. Supp. at 1361. The
proposed legislation would not result in a retroactive impairment of
contract since no member has an accrued benefit exceeding the IRC
§415 limits.

Regarding limits on future benefits, the court pointed out in MSTA
that "the legitimate expectations of [members of the Systems] did not
include an immutable, unalterable pension plan as to future benefits to
be earned pro rata by future employment service." 594 F. Supp. at 1364
(emphasis in original). Legal developments before the MSTA decision

• and, of course, MSTA itself - "should have made anyone interested
  aware that Maryland law would not extend unalterable contractual
  protection against change in pension benefits which were to be earned
  on a pro rata basis by employment service in the future." Id.

  For these reasons, the proposed legislation would not impair the
  purported contract rights of the few members of the Systems who might
  in future be affected by the new limits.

D. Countervailing State Interests

 Even if the legislation were viewed as substantially impairing a

contract, the Contract Clause would not necessarily be violated. An
impairment is justifiable if it is "reasonable and necessary to serve a
legitimate or important public purpose." MSTA, 595 F. Supp. at 1361.
See United States Trust Co., 431 U.S. at 25.

"Reasonableness is to be judged in light of whether the prior state

contractual obligations or counterpart private rights 'had effects that
were unforeseen and unintended by the legislature' when the contract
creating the obligations and rights were created." MSTA, 594 F. Supp.
at 1362 (quoting United States Trust Co., 431 U.S. at 31).

In 1977, the Internal Revenue Service announced a "non-

enforcement" policy with respect to state retirement plans. News
Release I.R. 1869 (August 10, 1977). However, as a result of the 1986
and 1988 legislation discussed in Part II above, the IRS has expressed
an intention to abandon this policy. See 54 Fed. Reg. 21440 (May 18,
1989) (preamble to proposed regulations). The Maryland General
Assembly could not have predicted the date of adoption of these two
federal laws or the reversal in position by the IRS. Now that the Joint
Committee is aware of these developments, its proposal to prospectively
incorporate the IRC §415 limitation on benefits accrued by members in
the Systems is reasonable.

That action can also fairly be said to be "necessary." "Necessity is
to be judged on two levels: 1) whether a less drastic modification could
have been implemented; and 2) whether, even without modification, the
state could have achieved its stated goals." MSTA, 549 F. Supp. at
1362.

 The proposed legislation, prospectively limiting the amount of

benefits a member is permitted to accrue in the future is prompted by an
important public policy goal - to avoid jeopardizing the tax advantages
that the general membership of the Systems (approximately 160,000
members) now enjoys. The State cannot achieve this goal without
legislation taking account of the benefit limits in IRC §415.

  To be sure, the State does have an alternative: the General

Assembly could elect the "grandfather clause" of IRC §415. But this
election requires the adoption of the private sector limits.6 The private
sector limits require an actuarial reduction for benefits received prior to
age 65, and the normal retirement age in the Systems is under age 65.
Thus, adopting the private sector limits would result in additional
actuarial reductions of the retirement benefits of members who retire
prior to the social security retirement age (currently age 65) but after age

62. Under the circumstances, adoption of the public sector IRC §415
    limits is the least drastic method of complying with the federal
    requirements relating to qualified pension plans. The method is
    necessary to serve a legitimate and important public purpose. MSTA,
    594 F. Supp. at 1361.

    6
    See note 5 above.

                                IV
    
                          Conclusion
    

    In summary, it is our opinion that the enactment of proposed
    legislation to impose certain benefit limits required by §415 of the
    Internal Revenue Code would not violate the Contract Clause.

                                     J. Joseph Curran, Jr.
                                     Attorney General
    
                                     Jack Schwartz
                                     Chief Counsel
                                       Opinions and Advice
    
                                     Carla Goldman Katzenberg
                                     Assistant Attorney General