August 5, 2014 published in Real Clear Markets
Unfunded Retiree Healthcare Benefits Are the Elephant In the Room
By Robert Pozen
When Detroit declared bankruptcy last year, many critics blamed its more than $3 billion in unfunded pension liabilities. At that time, however, Detroit reported approximately $6 billion in unfunded retiree healthcare obligations. These were healthcare benefits promised by the city to its employees who retire before they become eligible for Medicare at age 65.
Detroit is not unique. The 30 largest American cities had over $100 BILLION in retiree healthcare deficits in 2013, as estimated by the Pew Charitable Trust. In that year, New York City showed the most serious retiree healthcare deficits at $22,857 per household.
The retiree healthcare deficits of the States were even larger in 2013 — a total of $528 BILLION according to the credit rating agency Standard & Poor’s. These unfunded healthcare obligations burdened both large and small states — for example, $7,206 per person in New Jersey and $6,152 per person in Delaware.
Why are these deficits so large? Reporting of retiree healthcare benefits began less than a decade ago — in the footnotes to the financial statements of state and city governments. Without public disclosures, these governments could promise healthcare benefits without being held accountable.
Even now, local governments are not required to establish separate trusts with advance funding of such benefits — as they are for pension obligations. As present, only 7 of the 50 States have set aside more than 20% of the assets needed to pay their future healthcare obligations to retirees.
But recent accounting proposals will bring to bear strong pressures on local governments to increase the advance funding and decrease the size of their retiree healthcare deficits. The Government Accounting Standards Board proposed in May that state and city government record these deficits as liabilities on their balance sheets — instead of just being disclosed in financial footnotes. This change is likely to hurt the credit ratings for the bonds issued by local governments with large retiree healthcare deficits.
As important, the Board would require local governments to use more realistic assumptions in calculating these deficits. To understand the significance of this proposal, let’s review the relevant accounting rules.
Local governments estimate their obligations to provide retiree healthcare over the next 20 to 30 years, and then bring back these obligations to their present value by applying a so-called discount rate. This discount rate is supposed to represent the rate of return that would be pretty much assured if local governments currently made investments to finance these long-term obligations.
Under the recent proposals, local governments would be required to use a discount rate equal to the interest rate currently available on high-quality municipal bonds. That would mean 3% to 4% in today’s financial markets. By contrast, local governments are now allowed to discount back their unfunded healthcare obligations at whatever rate of return they believe they will earn on their investments. That “expected” return is 7% to 8% for many local governments.
The lower discount rate required by the Board’s proposal would result in much higher retiree healthcare liabilities for many city and state governments — which would now be recorded on their balance sheets.
For example, Boston reported unfunded retiree healthcare obligations of $4 billion in 2009. In 2011, these obligations allegedly fell to $3 billion — mainly because the city increased its expected return and discount rate from 5.25% to 7.25% If that discount rate had stayed the same, the unfunded retire healthcare obligations of Boston would have risen to approximately $5 billion.
Therefore, many local governments are objecting to the adoption of the Board’s proposals. But these proposals are sound — local governments should assume conservative investment returns in discounting back their retiree healthcare obligations. If local governments are allowed to use their “expected” returns, they will make aggressive investments like hedge funds and run substantial risks of incurring large losses.
Residents of local governments need an accurate accounting of retiree healthcare obligations in order to curb their growth and provide more advance funding. Left unchecked, these obligations will have to be paid out of current tax revenues — thus, crowding out spending for education, public security and environmental protection.
Similarly, holders of municipal bonds need an accurate accounting or retiree healthcare obligations in order to assess the credit worthiness of bonds issued by local governments. Like Detroit, many cities and states will face such large obligations for healthcare and other payments to retirees that their ability to make good on their bonds will come into question.
In short, although the Board’s proposals are not a panacea, they provide the necessary foundation for significant reform of retiree healthcare plans. With accurate estimates of unfunded liabilities, citizens and investors can pressure elected officials to take concrete actions to address the healthcare promises made to retired public employees.