The Other Debt Bomb in Public Employee Benefits [Brookings Institution]

Unlike pension plans, governments are not required to contribute to separate trusts to support health-care promises. As a result, only 11 states have funded more than 10% of retiree health-care liabilities, according to a November 2013 report from the credit-rating agency Standard & Poor’s. For example, New Jersey has almost no assets backing one of the largest retiree health-care liabilities of any state—$63.8 billion.

Only eight out of the 30 largest U.S. cities have funded more than 5% of their retiree health-care obligations, according to a study released last March by the Pew Charitable Trust. New York City tops the list with $22,857 of unfunded liabilities per household.

What exactly are retiree health-care obligations? State and local governments typically pay most of the insurance premiums for employees who retire before they are eligible for Medicare at age 65. That can be a long commitment, as many workers retire as early as 50. Many governments also pay a percentage of Medicare premiums once retired workers turn 65.

Total U.S. unfunded health-care liabilities exceeded $530 billion in 2009, the Government Accountability Office estimated, but the current number may be closer to $1 trillion, according to a 2014 comprehensive study released by the National Bureau of Economic Research.

Governments usually finance health-care spending with current revenues from property taxes and other sources. They’ll need to reverse this spending growth to have enough revenue to pay for essential services such as schools and police.

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Unfunded Retiree Healthcare: The Elephant in the Room

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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  1. 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
  2. This set of slides will turn the search light on retiree health care benefits in 4 steps:
    1. Define these benefits and how they are reported by states/cities,
    2. Outline the huge amounts of unfunded liabilities for these benefits,
    3. Compare the rules on public pension to those on public retiree healthcare, and
    4. Evaluate various proposals to curb the growth of unfunded healthcare liabilities.
  3. 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.
  4. 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.
  5. 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.
  6. 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).
  7. 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.
  8. 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.
  9. 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.
  10. 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.
  11. 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.
  12. 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.
  13. 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.
  14. 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.
  15. 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.
  16. 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.
  17. 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.
  18. 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.
  19. 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.

Will More Small Firms Self Fund Their Healthcare Plans? [Real Clear Markets]

The Affordable Care Act (ACA) was intended to increase access to quality and reliable healthcare, partly through the employer mandate. However, the ACA may inadvertently push small firms toward riskier activities by financing their own healthcare plans.

In the past, most large firms took the risk of financing their own healthcare programs, rather than buying traditional insurance. By contrast, self funding has historically been limited to 8% to 16% of small firms – defined as 1 to 100 full-time employees (FTEs).

In the future, these statistics may change dramatically because the ACA creates new regulatory incentives for small firms to self fund their healthcare plans. If these incentives lead to a substantial increase in self funding by small firms, this would pose significant risks to these firms and the insurance market for small groups.

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Incentives for Small Firms to Self Fund Their Healthcare Plans [Brookings Institution]

Coauthored with Anant Vinjamoori

When firms offer healthcare plans to their employees, they have two main choices. They can buy insurance from traditional health insurers like Aetna or Blue Cross Blue Shield, or they can self-fund their own healthcare plan.

In self funding, the employer usually hires a third party administrator ( TPA ) to help run the healthcare plan – establishing a network of doctors and hospitals; and then collecting premiums from employees (which would otherwise be paid to insurers) and making payments for claims that are incurred.  Most importantly, in self-funding, the employer bears the risk that the costs of providing healthcare to its employees will exceed the premiums collected.

Most large firms self fund their healthcare programs, rather than buy insurance. By contrast, just 8%-16% of small firms (between 1 and 100 full-time employees) choose to self-fund.

However, the Affordable Care Act ( ACA ) creates new regulatory incentives for small firms to self fund their healthcare plans: If these incentives lead to a substantial increase in self funding by small firms, this would pose significant risks to these small firms and the insurance market for small groups.

This article will first explain the ACA’s regulatory incentives for small firms to self fund their healthcare plans. Second, it will review the potential risks involved with self funding by small firms even with stop-loss reinsurance.  Third, it will discuss various proposals to reduce these risks within current political and legal constraints.

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SEC’s new rules give US money market funds a floating feeling [Financial Times]

Coauthored with Theresa Hamacher

After years of heated debate, the Securities and Exchange Commission, the US regulator, recently adopted stricter rules for US money market funds. The new rules are intended to limit the potential systemic risks of money market funds by reducing the likelihood of runs on these vehicles.

The rules will have the biggest impact on money market funds serving institutional investors, which will have to move from a constant to a floating net asset value. The rules will also put pressure on most institutional and retail money market funds to impose liquidity fees and suspend redemptions during financial crises. But neither set of rules will apply to money market funds holding 99.5 per cent or more of government securities.

Thus, the two critical questions are what constitutes a government security, and what differentiates an institutional from a retail money market fund?

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How to Not Outlive Your Retirement Savings [Real Clear Markets]

The U.S. Treasury recently amended its rules to encourage workers with retirement plans to purchase life annuities within these plans. Life annuities generally make fixed monthly payments from the date of retirement until the death of the purchaser.

For years, many economists have recommended that workers use all their retirement savings to buy life annuities in order to avoid outliving their savings. Nevertheless, few workers want to put their whole retirement nest egg into a life annuity.

Why? In one word, optionality. Retired workers want to have substantial resources available to deal with medical emergencies or unexpected disasters during their retirement years. Alternatively, retired workers want to bequeath any remaining savings at death to their families, friends and favorite charities. However, if workers buy a life annuity, all payments typically end at death — even if it occurs shortly after retirement.

To achieve their multiple retirement goals, workers should use PART of their assets within their retirement plans to buy a deferred life annuity that starts paying out at age 75,80 or 85. Then they would have the rest of their retirement assets available to deal with medical emergencies or to make bequests at their death.

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Unfunded Retiree Healthcare Benefits Are the Elephant In the Room

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.

Pozen is the former chairman of MFS Investment Management, a senior lecturer at the Harvard Business School, a Nonresident Senior Fellow in Economic Studies at the Brookings Institution, and author of the book The Fund Industry: How Your Money Is Managed.

Fight Against Short-termism Is Misdirected [Financial Times]

What do the Prince of Wales, the chief executive of BlackRock and the Chief Justice of the Delaware Supreme Court have in common? All have spoken out against short-termism in business.

In their eyes, corporate executives are putting too much emphasis on profits over the next three to six months, and not enough on making investments that could produce sustainable growth over the next decade.

While there are legitimate concerns about short-termism, many of its critics misunderstand both its causes and effects. Many of their proposed remedies would undermine the legitimate rights of corporate shareholders.

Instead, to combat short-termism, corporate boards should lengthen the time horizon for determining executive pay and stop their executives from publicly predicting the next quarter’s earnings…

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