How to Spend Stimulus Money to Reduce State and Local Retiree Health Care Debt

The newly enacted $1.9 trillion American Rescue Plan Act of 2021 promises to provide an unnecessary revenue windfall for many state and local governments. The amount of federal aid in the new coronavirus relief and stimulus bill, coming on top of assistance already provided by previous federal stimulus measures over the past year, will far exceed state and local tax revenue losses and increased expenditure requirements attributable to the COVID-19 pandemic. This excessive federal spending further increases the national debt, which is already near record levels as a percentage of gross domestic product (GDP).

But since the massive federal spending bill has already been passed and signed, it would be wise for state and local governments to use this one-time revenue boost to reduce unfunded retiree health care obligations, which total $1.2 trillion nationally.

Because the new federal aid is not an ongoing revenue stream, using it to expand existing programs or start new ones would be imprudent fiscal policy and invite budgetary pressures down the road. Restrictions in the new law added by the Senate prohibit federal funds from being used to reduce taxes or pay down unfunded pension obligations. But the law does not explicitly mention other post-employment benefits, known in the government accounting world as OPEBs, which primarily take the form of health care coverage for retirees.

In some cases, state and local governments show net OPEB liabilities, which is the total amount of benefits already promised to retirees, as large or larger than their net pension liabilities. Although the total future cost of retiree health care benefits is smaller than pension benefits, which are intended to replace income, most governments have at least partially prefunded their pension benefits while setting aside little or no money to cover their future OPEB costs. This is often attributable to the strong legal protections granted to public pensions but that largely do not extend to OPEB benefit promises made to workers in most places. Nonetheless, by failing to set aside funds for retiree health benefits as employees accrue them, government employers are burdening future taxpayers with growing debt. The size of the problem is also raising doubts among prospective retirees about whether the benefits promised to them will really be there when they retire.

In this post, I consider two potential strategies for using the temporary increase in governments’ fiscal capacity to address unfunded other post-employment benefit liabilities: (1) prefunding and reforming defined retiree healthcare benefits, and (2) switching employees to defined contribution retiree health care benefits.

Option 1:  Prefund and Reform OPEBs

Many state and local governments currently finance OPEBs on a pay-as-you-go basis, meaning that they set aside no money while employees are working and then pay their health insurance premiums in retirement as the bills become due.

Under Government Accounting Standards Board (GASB) Statement Number 75, the present value of future OPEB costs (less any assets held to cover these costs) must be shown on a state or local government’s balance sheet. When that government uses a pay-as-you-go funding method, the future costs must be discounted at a “tax-exempt, high-quality municipal bond rate.” Some governments meet this definition by using The Bond Buyer 20 Index, which is the average yield for 20 general obligation municipal bonds with an average rating of AA from Standard & Poor’s and/or Aa2 from Moody’s. This index declined from 3.50 percent on June 30, 2019, to 2.21 percent on June 30, 2020, obliging many governments to report increased net OPEB liabilities for their most recent fiscal year.

But GASB Statement 75 allows governments to apply a higher discount rate “to the extent that the OPEB plan’s fiduciary net position is projected to be sufficient to make projected benefit payments and OPEB plan assets are expected to be invested using a strategy to achieve that return.”

This could be interpreted to mean that if a state or local government adopts a policy of paying its actuarially determined employer contribution each year, it can discount its future OPEB payments at the same rate it uses to discount pension obligations, typically around 7 percent (although the Reason Foundation and other pension reform advocates typically recommend more conservative discount rates).

A hypothetical case can demonstrate the significant balance sheet benefits of implementing an OPEB prefunding policy. Consider a public sector entity that expects to pay $100 million in retiree health caare benefits this year and for its costs to grow 6 percent each year, reaching almost $542 million in 30 years. Discounting this stream of benefits at a rate of 3 percent yields an OPEB liability of $4.55 billion. But, if we apply a 6 percent discount rate to the same set of annual costs, the liability shrinks to just $2.83 billion.

Now, before we continue, a caveat is in order. Many researchers and practitioners would argue that this balance sheet benefit is just an accounting trick. Their contention is that future benefits should be discounted at a rate based on the likelihood of the future benefits being paid rather than the expected rate of return on the assets being set aside to cover these costs. But irrespective of whether such a large balance sheet savings is theoretically justified, few would deny that prefunding benefits is both fiscally prudent and fairer to future taxpayers and retirees, many of whom will be our children and grandchildren.

That said, prefunding OPEB costs is a permanent commitment that lasts long beyond the 2024 deadline for using American Rescue Plan funds. Thus, OPEB prefunding will require an additional budgetary commitment from states in the near and intermediate-term (while saving money in the long-term as investment gains cover a portion of future retiree healthcare costs).

Given the increased short-run budgetary burden, state and local employers should also use any shift to pre-funding as an opportunity to reassess their OPEB packages. Retiree health care benefits were often initiated decades ago at a time when health care costs were much lower. Now that health care insurance premiums are so much higher, especially for retirees who have yet to reach the Medicare eligibility age of 65, benefit enhancements may require a second look. Among the items that should be reviewed are:

• The inclusion of spousal and dependent coverage;
• Whether dental and vision plan premiums should be covered along with medical premiums;
• Whether retiree health plans should incorporate such cost-saving elements as copayments, deductibles, and provider network limitations; and
• Whether to continue offering employer-paid life insurance plans (since this perk is not among those likely to promote employee retention).

Although public employees may not welcome skinnier retiree benefit packages, they would benefit from the fact that prefunding reduces the risk that their post-employment benefits will be suddenly canceled, as they were during the 2012 bankruptcy of the city of Stockton, California. Since OPEBs typically lack the legal protections afforded to pension benefits, employees should be willing to at least consider a tradeoff between the generosity of the OPEB package and the likelihood of ultimately receiving it.

Option 2: Replace Defined OPEBs with Retirement Health Care Savings Accounts

The prefunding approach leaves the Total OPEB Liability in place while increasingly offsetting it with assets. Another alternative is for public sector employers to replace their OPEB plans with defined contribution plans that provide comparable value to retirees.

Retirement health care savings accounts provide employees with 401(k)-like accounts to which both the employer and employees can contribute. Employee contributions and investment returns on the saved assets are not taxable until the account is used to pay healthcare premiums in retirement.

Governments could use some of the extra budgetary space created by the American Rescue Plan’s funding to make initial deposits into each employee’s health care savings account. They could then make smaller annual contributions each year until the employee retires. Although these annual deposits create a similar cost stream to prefunding a defined OPEB plan, they do not create a liability on the government’s balance sheet because there is no commitment to provide a specific level of benefits upon retirement.

Although a shift to retiree health savings accounts transfers risk to employees, it may actually offer a better benefit to shorter-tenured employees—who make up the bulk of people hired into public service today. These employees often do not stay with their government employers long enough to vest in the defined retiree health care benefits. But they could use their retiree health savings account balance at retirement, regardless of where they were last employed.

Conclusion

The two potential strategies outlined here are not necessarily exclusive. Retention of the defined retiree health care benefit with prefunding may be more appropriate for employees nearing retirement, while transitioning to retiree health savings accounts may be a better fit for more junior employees and new hires.

Either strategy, or a combination of the two, can set government employers on a path toward having zero net OPEB liabilities on their balance sheets at some point in the future. The removal of these unfunded obligations would be welcomed by credit rating agencies and municipal bond investors today and would provide a better fiscal legacy for taxpayers and employees tomorrow.