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BENEFITS BEAT
Broken Benefits Promises?
Will public employers be able to actually afford their past promises for retiree health care? They need to conduct a formal sustainability audit.
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The first rule of getting out of holes is to stop digging. Sometimes it takes a reality check to realize that the hole you're standing in is getting deeper. That's the situation now faced by many state and local governments that have awarded generous but unsustainable medical benefits to their retirees.
It has now been four years since the Governmental Accounting Standards Board (GASB) issued its Statement 45, which requires public disclosure of the financial liabilities and costs public employers face with regard to retiree medical benefits plans and similar "other post employment benefits" (OPEB) outside their pension plans. GASB phased in these new accounting rules from 2007 through 2010, so many public employers are just now posting the numbers. Nationwide, the total liabilities for these plans are estimated to be $1.5 trillion, almost entirely unfunded.
Given the imminent revenue losses plaguing states, cities, counties and school districts, many of these employers are simply unprepared to start properly funding these benefits. They must record an expense on their books, but they may not actually fund that cost with a cash contribution. In essence, they are continuing to "pay as they go" rather than fully fund their OPEB benefits obligations.
The 2008 bear market retirement funding crisis. To make matters worse, public pension funds have lost billions in the 2008 stock market washout, which has now reduced their average funding status from roughly 85 percent to 65 percent. As a result, public employers will ultimately face higher bills for their primary pension obligations, somewhere in the range of 2 to 4 percent of payroll in many states — and for the next 20 to 30 years. This new development leaves even less taxpayer money available to be spent for retiree medical benefits already awarded. Strictly speaking, in many states and localities, there is no revenue available whatsoever to offer retiree medical benefits to new employees.
This is just the tip of the iceberg for many jurisdictions. What hasn't been reported in the media is the risk that the numbers will get worse. Actuarial estimates of future liabilities and the real costs of providing public employees with retiree medical benefits could easily fall short of the actual bills to be paid in the future. For example, many actuaries assume that medical-cost inflation will subside from recent high double-digit levels to a more subdued rate (like 4 percent) in the future. That may prove to be wishful thinking. Yet most actuarial reports treat those embedded assumptions of decelerating costs as the most likely case, without any convincing empirical evidence.
Likewise, the GASB Statement 45 rules permit employers to amortize their unfunded liabilities over 30 years, when the actual service lives of incumbent employees is less. And for retirees, it's even worse, as the expected lives of 65-year-old retirees is about 18 years, not 30. This often means future taxpayers will inevitably be paying for amortized, deferred costs of today's workers and retirees long after they have ceased working and, in many cases, ceased living.
Most public managers who work with OPEB financial issues are struggling just to keep their heads above water. There is an old saying that "When you are up to your @$$ in alligators, you don't have time to drain the swamp." Thus, few public officials have even focused on whether the taxpayers can actually afford the benefits already promised, on an ongoing basis. Inertia and policy paralysis have taken hold, as policymakers despair for long-term solutions.
A formal sustainability audit. Here's a suggestion for public officials whose budgets cannot afford the actuarially required contribution (ARC) for OPEB: Make a much smaller immediate investment to begin the process of reducing your OPEB costs. Conduct an OPEB sustainability audit (or 'assessment' for those who cringe at the term 'audit'). An OPEB sustainability audit can be performed independently by trained and experienced financial experts, or internally by staff members who have the requisite skills and tools to conduct the analysis, evaluate alternatives and map a strategy.
Somewhat similar to a performance management audit, an OPEB sustainability audit will tell policymakers, taxpayers, employee groups and local businesses leaders the following:
1. Does the public employer's tax and revenue base have sufficient growth capacity to afford the benefits already promised?
2. Could continuation of the status quo eventually result in a lower bond rating or higher borrowing costs as investors begin to focus on this huge unfunded liability?
3. Will continuation of the current retiree medical benefits plan require future policy-makers to reduce or forego services to taxpayers?
4. Will increased pension costs "crowd out" your capacity to fund OPEB benefits?
5. Are the benefits now awarded to employees appropriate and necessary for the employer to continue, in light of local labor market conditions?
6. Is total compensation including the OPEB benefits both fair and affordable, and thus sustainable?
7. What levels of medical cost inflation are sustainable, and at what point would employer costs under the current plan lead to financial stress?
8. Should the employer consider retiree medical-benefits plan modifications? These could be along the lines of:
· Changing benefit levels, deductibles, co-pays and inflation caps,
· Increasing vesting periods and eligibility requirements,
· Requiring employees to pay a fair share of the costs of the plan as a payroll deduction,
· Freezing the current plan and phasing in a lower-cost plan for future employee service,
· Scaling back the benefits to be earned for future service by current employees ("tiering" the plan), and
· Instituting a defined contribution OPEB plan for new hires and younger employees?
9. Can such benefits be redesigned in a way to assure they provide sufficient benefits to future retirees?
10. Could the present plan's unfunded liabilities be better funded through debt financing at a lower cost than the investment returns available in the capital markets (OPEB bonds)?
In addition to an objective analysis of these issues, an OPEB sustainability audit report should include a strategic summary that outlines a viable direction for future benefits policy actions, plan designs and financing options. A professional-quality report will prioritize the key strategies that would lead to more viable and sustainable financing, investment and plan structures.
Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities.
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