Retiree health benefits, commonly treated by governments as malleable when times are tough, may be harder to slash if a recent California Superior Court ruling holds. And according to one ratings agency, that means the financial implication for at least California cities (if not others outside of California) could weigh on debt burdens even further and hurt a government’s ability to borrow.

The ruling was issued Sept. 13, when a California Superior Court judge struck down efforts by the city of Los Angeles to limit that city’s contributions to retiree health care benefits. The judgment is limited to a small labor group (unions representing city attorneys, engineers and architects) who challenged the cost-saving initiative, which is likely to be appealed. But Moody’s Investors Service calls the implications “significant” because the decision implies that the benefits have legal protections comparable to pensions.

In his analysis issued last week, Moody’s Senior Vice President Eric Hoffman said the ruling will have a negative impact on Los Angeles’ credit rating as well as San Jose as that city is also dealing with similar litigation. “Negative credit impacts could eventually hit many California municipalities looking to trim retiree health care commitments to rein in costs,” he wrote.

Public employees in LA were contesting what’s called the “freeze ordinance,” a 2011 mandate that required employees to contribute 4 percent more of their salaries for other post-employment health benefits (OPEBs) or accept a plan that caps the city's contribution to health care insurance at $1,140 a month throughout retirement. The majority of the city’s employee groups agreed to the increased contributions and monthly caps, saving the city an estimated $80 million in the current fiscal year.  But Judge Luis Lavin agreed with the select unions contesting the ordinance, ruling that the health subsidies are a vested right and the city could not unilaterally change policy without providing relatively equal replacement benefits.

Hoffman notes that the question of whether health care retirement benefits are legally protected in a way similar to pensions “is sure to become an area of increased focus for municipal market participants.” Certainly, said Doug Rose, president of the California State Association of County Retirement Systems, if the ruling stands it will prompt more caution in governments when outlining benefits to new employees.

“In Los Angeles, they found that it was a contract because of the way it was written,” he said. “It stated the premium subsidy [OPEB benefit] ‘will’ be provided. So it was unequivocal.”

Financially, the ruling is not expected to significantly damage Los Angeles's finances as the city is one of the few that prefunds its OPEB liabilities. According to a Pew Charitable Trusts study that looked at the country’s 61 biggest cities, researchers found that in fiscal 2009, Los Angeles had 55 percent of its retiree health care costs funded and just three others were at or above 40 percent (Denver was 51 percent, the District of Columbia was 49 percent and Louisville was at 40 percent). The vast majority of cities were below 5 percent funded. Because OPEB liabilities have generally been viewed as non-binding, most governments have adopted a pay-as-you-go approach. But barring cuts in benefits, such an approach “could create large scale financial problems over the next couple decades if current cost trajectories and funding practices continue,” Hoffman notes.

Rose adds that in the wake of the ruling, cities going forward will likely “be more thoughtful about the promises they’ll make and about whether they can fund them.”

But Josh Franzel, vice president of research for the Center for State & Local Government Excellence, said it is difficult to compare the binding qualities of healthcare benefits with pensions. Pensions are a relatively static benefit determined by a formula and an employee’s salary. Health care coverage is more susceptible to outside forces.

“Especially with retiree health benefits, it’s always changing anyway based on variables – the cost of benefits, the age of retirement, [for example],” Franzel said. “There’s a lot more movement with employer subsidy.”

The legal protections of pensions and OPEB vary state by state. Hoffman notes that in March 2013, in contrast to the Los Angeles decision, an Illinois circuit judge ruled that a constitutional clause protecting pension benefits did not extend to health care. Still, 12 other states have contract law similar to California’s and could be impacted: Alaska, Colorado, Idaho, Kansas, Massachusetts, Nebraska, Nevada, Oklahoma, Oregon, Pennsylvania, Vermont and Washington.

“These states say that, for the courts to find they have a contract, you have to have an offer, an acceptance and both have to give up something in exchange,” Rose said. “When you induce someone to come work for you by giving this promise, that’s essentially a contract.”