Unfunded Retiree Healthcare: The Elephant in the Room
The following outline is accompanied by a set of slides that were recently presented at the the Stanford Institute for Economic Policy Research in November 2014
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- When Detroit declared bankruptcy, the press highlighted its unfunded pension obligations. But actually its unfunded retiree healthcare liabilities were almost twice as large. This is why we say that retiree healthcare is the elephant in the room –sitting quietly with little notice in the halls of cities and states
- This set of slides will turn the search light on retiree health care benefits in 4 steps:
- Define these benefits and how they are reported by states/cities,
- Outline the huge amounts of unfunded liabilities for these benefits,
- Compare the rules on public pension to those on public retiree healthcare, and
- Evaluate various proposals to curb the growth of unfunded healthcare liabilities.
- Retiree healthcare benefits mainly take the form of government subsidies of insurance premiums to public employees who retire before going on Medicare at age 65. Sometimes these premium subsidies extend to premiums for Part B of Medicare and even Medigap. These subsidies range from 50% to 80% of the retiree’s premiums on a high-end healthcare policy.
- Retiree healthcare benefits constitute the bulk of OPEBs – other post employment benefits. Before 2006, there was virtually no disclosure about OPEBs so they could be increased without political accountability. Since 2006, GASB has required states and cities to report on their OPEBs in the footnotes to their financial statements. But GASB has never required any advance funding of OPEBs, as is required for public pension plans.
- Recently, GASB has announced proposals to standardize the calculation of OPEBs – most importantly, by mandating the use of a discount rate based on AA rated bonds. Under these proposals, OPEBs would be included as liabilities on city and state balance sheets. These proposals, if adopted, could affect bond ratings and focus political debate on this subject.
- Turning to the scope of the problem, we can see a big discrepancy between states. States like NY and NJ each have over $60 billion in unfunded liabilities (and high OPEB per capita). States like South Dakota and Idaho have low unfunded liabilities (and low OPEB per capita). This depends on the number of public employees covered by OPEBs and the extent of their benefits. (The median state in this S&P survey of unfunded OPEB liabilities was $1,219 per capita).
- The problem of unfunded OPEB liabilities is growing in many states due to chronic underfunding. Here we see in the left bar the percentage of state tax revenues actually used to fund OPEBs, versus the higher percentage that should have been contributed based on 6% returns and 30 years of level payments. States are justifying their lower contributions by back-loaded amortization periods and assumptions of higher returns. According to JP Morgan, most states annually contributed 30% to 60% of what was needed to fund its OPEBs.
- Similarly, on the city level, we see a great disparity in levels of OPEB funding across the country. The unfunded OPEB liabilities of New York City were twice the total of the 30 largest cities. And New York City also had the highest unfunded OPEB liability per household, followed by Boston. The figures of New York City include its obligations to teachers for retiree healthcare. By contrast, Denver, Minneapolis and Tampa had very low unfunded OPEBs by dollar amount and household.
- The situation in California is complex. The unfunded OPEBs from State government is almost the same amount as New York State, though California has a lower unfunded OPEB liability per capital. But other governmental units in California have promised healthcare benefits to their retirees. These include counties, cities, school districts, the UC system and the trial courts. Thus, the total OPEB liabilities for California were over $157 billion, of which less than 5% was funded.
- The level of OPEB funding is much lower than the level of pension funding , because there never has been a funding requirement for OPEBs. As a result, OPEBs must generally be funded out of current tax revenues. On the other hand, pension obligations to employees are often protected by statute or state constitution. Since these protections do not generally apply to OPEBs, they are easier to change from a legal viewpoint, though these changes are still often subject to collective bargaining.
- Because OPEBs are generally funded out of current tax revenues, it is useful to compare the growth trends in OPEBs and property taxes. This comparison is made in the chart on page 11. The increase in retiree healthcare costs ( HC ) is absorbing a large portion of the growth in property taxes in 3 of the cities, and actually exceeds the growth in property taxes in Springfield.
- Let’s look at Newton, a Boston suburb with 170,000 people. Newton is spending $21 million per year on retiree healthcare benefits — which equals $747 per household or 7.5% of the average property tax bill. To increase property taxes by $8.4 million, Newton had to pass an override of proposition 2.5. But most of that increase — $8.1 million — is going to pay retiree healthcare benefits as they rise. If that $8.1 million instead had gone into adding teachers, Newton could have hired 79 more teachers.
- So what can be done to constrain the growth of OPEBs? It is very difficult to reduce healthcare benefits going to those already retired. However, some jurisdictions have directly addressed healthcare costs in the future: by increasing future deductibles and copayments, decreasing cost of living adjustments and reducing the scope of subsidized healthcare services — e.g., retirees pay full premiums of dental and eye care.
- In California, the courts have generally been receptive to modest limits in OPEB benefits. The courts have generally taken the position that counties did not promise PERMANENT healthcare benefits as a specific level, and they are not guaranteed by statute or the constitution. But the court rejected the changes proposed by Los Angeles City as an impairment of a vested right — citing precedents from pension law.
- Another approach is to revise the eligibility standards for retirees to qualify for OPEBs. A worker can qualify for OPEBs in Mass, for example, after only 10 years of PART TIME work. Many workers can receive OPEBs even if they retire and go to work for a company with healthcare benefits. When workers reach age 65 and go on Medicare, they could be asked to pay their own Part B premiums.
- The majority of states have cost of living adjustments built into their OPEB plans. Yet 17 states have recently reduced COLAs for retiree healthcare benefits. While most of these COLAs reductions were legally challenged, the courts have generally upheld these reductions on the theory that the COLA portion is not a contractual right.
- Most healthcare plans utilized by retirees with OPEBs are relatively high cost and high quality. Very few of these plans are provided through a state connector offering a menu of healthcare plans. However, an individual can receive federal premium subsidies under Obamacare only by purchasing a policy on a state connector. Thus, if retired public employees were required to obtain their policies through the state connectors, the federal premium subsidies could be used to offset local premium contributions.
- Here is an illustration of the costs and premium subsidies for a gold level plan from the Mass connector. For a family of four with an annual income of $50,000 per year, the government premium subsidy is $945 per month out of a total policy cost of $1,319 per month. Thus, the city or state could be pay NO premium subsidy and the retiree would receive a high quality plan for only $374 per month.
- Conclusions — While unfunded OPEBs have been rising faster than unfunded pensions, the OPEB situation will become highlighted by the new disclosure and accounting rules.These new rules should stimulate an open and honest debate on the various proposals to limit the growth of unfunded OPEBs, which are legally easier to change than the provisions of a public pension plan.