Facing the Challenge of Retiree Health Care: Liabilities and Responses of State and Local Governments-A conference summary

Chicago Fed Letter, May 2008 by Mattoon, Richard H

On March 12, 2008, the Federal Reserve Bank of Chicago and the Civic Federation held a forum on retiree health care for state and local government employees. The participants focused on strategies to finance and administer other post-employment benefits, or OPEB.

Beginning in fiscal year 2008, many state and local governments will begin reporting the costs of paying for nonpension retiree benefits on their financial statements in response to new accounting standards issued by the Governmental Accounting Standards Board (GASB). These costs are referred to as other post-employment benefits (OPEB), with retiree health care representing the single largest component.

The challenge facing state and local governments in meeting OPEB liabilities stems largely from the unplanned (and accelerating) increases in health care costs. Recent estimates suggest that state and local governments have OPEB liabilities of between $600 billion and $1.6 trillion, and virtually all of this is unfunded. The historical method of using a "pay-as-you-go" system to meet retiree OPEB costs (where current revenues pay for these costs) would crowd out spending on other key government functions. This will be a particular challenge to governments that face both underfunded pension and OPEB liabilities.

Overview of OPEB challenges

Dean Michael Mead, research manager, Governmental Accounting Standards Board, described the rationale behind the new reporting standards in GASB statements No. 43 and No. 45.1 The GASB wants to improve transparency, so it would like large liabilities to be reflected on government financial statements. In the case of OPEB, the benefits employees will receive in the future are factored into their current compensation. As such, these benefits represent part of the cost of today's services and should be accounted for now, not in the future.

Mead stressed that GASB statement No. 45 does not require that governments prefund OPEB liabilities. They can continue to use a pay-as-you-go approach to fund OPEB, although in practice, Mead said, this would place pressure on a government's balance sheet as the cost of these liabilities accelerates relative to other government expenses. More prudent accounting practices will require a funding level that ensures that a government meets the annual required contribution (ARC). Funding at the ARC means that the government is meeting the normal (or service) cost and the amortized unfunded actuarial accrued liability (UAAL).2

Mead noted that the ability of a government to meet OPEB commitments will be greatly influenced by the discount rate that is determined by the government's funding decision. A government that prefunds OPEB will be able to use a much larger discount rate, and it will be able to reduce its OPEB liability at a significantly faster rate than a government that either continues to use a pay-as-you-go approach or fails to fund at the ARC.

Barbara Bovbjerg, director for education, work force, and income security issues, U.S. Government Accountability Office (GAO), provided an overview of the impact of OPEB and pensions on the state and local government sector. The GAO has issued two recent reports on the subject and found that state and local pensions, with a few notable exceptions, are generally pretty solid. Pensions have been prefunded, and assets appear to be reasonably well matched to cover liabilities. The same cannot be said about OPEB. Very few governments have put any assets aside to meet these future costs, and based on GAO projections of expenditure growth in the state and local government sector, it is unlikely that the current pay-as-you-go strategy is sustainable.

Part of the OPEB problem is that retiree health care benefits were established at a time when the costs were more affordable. The rise in insurance premium costs and general health care inflation were not contemplated by most governments. Governments offered OPEB, believing that they could afford them out of current revenues. One important difference with OPEB liabilities is that, unlike many pensions, OPEB are usually not guaranteed benefits, so governments can modify them over time to help contain costs.

Bovbjerg concluded by quantifying the magnitude of pension and OPEB costs based on a fiscal outlook simulation model developed by the GAO. The model found that to fully fund the state and local obligation for pensions, governments would need to raise their pension contributions from a current level of 9% of employee salaries to 9.3%. However, to fund OPEB, their contribution would need to rise from a current level of 2% of salaries to 5%. She concluded that, given this rapid rise, the most important thing for state and local governments is to have a plan that will put them on the path to addressing OPEB costs.

Bert Nuehring, partner, Crowe Chizek and Company LLC, provided an auditor's perspective on reporting OPEB funding. Nuehring emphasized that the actuary has a critical role in establishing the OPEB liability for any government. The actuarial assumptions establish the future benefit costs. These assumptions include demographic trends (rates of employee termination, retirement, mortality, and disability); economic trends (investment return along with the discount rate, salary increases, and medical inflation); and the implicit rate subsidy from current employees' health insurance premiums to retirees.