It's time to re-wire the way retiree medical benefits plans are designed, financed and operated. Increasingly, the benefits promised in the past are unsustainable. In addition, public officials have unwittingly let the actuarial model used by the Governmental Accounting Standards Board for financial disclosures determine the way these plans are actually structured -- even though that was never GASB's intention. It's now time for a paradigm shift that enables public employers to make promises they can actually keep -- with an affordable, sustainable plan design.
The market meltdown and the recession have changed the landscape for public employee retirement plans for decades to come. Public pension plans have lost a half-trillion dollars in market value in the past 18 months, which will compel them ultimately to raise employers' pension contribution rates by 3 to 5 percent of payroll on average. I just returned from a state pension conference where actuaries were telling tales of 20 to 40 percent increases in some plans' employer contribution rates in the coming year. Constitutionally required pension funding will squeeze out other benefits.
Retiree medical benefits -- known as "other post-employment benefits" (OPEB) plans -- face more budgetary competition for their initial employer contributions than ever before. As a result, most OPEB plans remain unfunded, which means their liabilities will likely grow from $1.5 trillion to $2 trillion before most employers actually start the process of actuarial funding. Their ultimate costs continue to skyrocket as employees age and medical costs increase.
Changing the mindset. This recession will push most public employers past the tipping point in their ability to pay the OPEB bill. State and local government leaders and managers must begin to shift the mindsets of their employees, retirees and politicians about the nature of retirement medical benefits. Otherwise, the vast majority of governments that promised full, lifetime benefits will inevitably be forced to raise taxes or cut services simply to feed an "OPEB monster" -- a monster created unwittingly years ago when medical insurance costs were a fraction of today's levels. Sadly, future taxpayers will get nothing in return for payments to retirees who served their parents and grandparents.
Funding an undefined, escalating benefit. Here's the problem: Most public employers naïvely use a defined benefit (pension-like) financial model to fund an undefined and escalating benefit. Unlike pensions, which can be reasonably predicted by their payout formulas, future retiree medical inflation rates are completely unknown. Where pensions pay a fixed benefit or one based on an inflation allowance, retiree medical costs are typically unlimited and have run well ahead of inflation, wages, tax revenues and any other common municipal financial metric.
Nobody on this planet can accurately and honestly predict what will be the cost of a year's post-retirement insurance premiums in the year 2030. In many states, medical inflation rates have run nearly 10 percent in the past decade. Medical technology continues to attract huge payments to prolong life in the final years of our lives, and every baby boomer wants the best health care money can buy. If that continues, there is no government in this country that can afford to keep paying these costs when their revenues grow no faster than the 2 percent general inflation rate targeted by the Federal Reserve Board. In that scenario, the unfunded actuarial liabilities of most OPEB plans would nearly double in 10 years, because the actuaries typically assume that medical inflation will normalize to a lower single-digit number.
Even those public employers who can afford to fully fund their OPEB plans at the actuarially required contribution level (and there are very few today) are now realizing that they may not be able to sustain future cost increases. That's because medical inflation could outstrip their actuary's assumptions or their investments return less than the plan's discount rate.
What are the options for public employers? How can they continue to provide a meaningful, but affordable, benefit?
One approach is to cap the dollar value of the defined retiree medical benefit, and make the entire program look more like a pension plan. Some employers are going even further and reducing the benefit level to achieve a lower contribution rate. This still leaves the employer on the hook for all actuarial shortfalls. If investments underperform, for example, the taxpayers are obligated to make up the difference. State and local leaders are now looking for a better way to share OPEB funding risks as part of a comprehensive retirement financial strategy.
A better system. A promising new technique is the "collective defined contribution" (CDC) plan design I have mentioned in previous columns. Under this plan structure, the employer makes predetermined annual contributions, usually as a percentage of payroll. Employees can also be required to contribute a fixed percentage of their pay. The money is then invested in an institutional portfolio similar to a pension fund. Unlike an individualized defined contribution plan such as a 401(k) or 457 plan, there are no personal accounts for each employee. Plan trustees typically hire an investment consultant or a discretionary money manager to guide the investment process, again like a pension fund. They also hire an actuary, just like a pension board.
But here's the key difference: Any actuarial difference between plan assets plus future contributions on the one hand, and the projected future liabilities on the other, is compensated by changing the benefits rather than the employer's contributions. For example, if a plan's unfunded liability increases because of weak investment performance, there will be less money available to pay benefits, so the actuary is required by the trust to calculate a new benefit level commensurate with the new asset level. If retiree mortality or plan demographics change, the benefits level is changed, instead of the employer contribution rate.
This does not mean that an employer may never increase its contributions. If the actuarial analysis requires a benefits reduction and the employer elects or bargains instead to increase its future contributions, that option remains. But the plan does not presume that the employer will ever or always foot the bill. This is a radical break from the dysfunctional public pension straddle option in which taxpayers always lose, as I have described in a previous column.
This CDC plan design is far more honest and consistent with the ability of public employers to keep pace with their OPEB promises than the ill-suited defined benefit model. If investments outperform the actuarial assumption, the trustees can decide to either hold the excess returns in a market stabilization reserve in anticipation of the next recession, or they can recommend a benefit increase to the plan sponsor.
Obviously this kind of system will never be popular for public employee pensions, which often have constitutional protections and civil-service expectations of immutable pension benefits. For a retiree medical benefits plan, however, this CDC model fits the realities of public-sector employment and fiscal capacity much better. OPEB benefits are secondary benefits, not primary benefits. Public employers with exhausted tax capacity cannot be expected to guarantee constantly increasing benefits. Given the sad reality that most working taxpayers who support these plans have no retirement medical benefits, public employees should be grateful indeed that their employers have made provisions as generous as they have.
Advantages and efficiencies. In addition to the greater investment and lower-fee professional management of an institutional investment pool, the CDC trust structure has another great advantage over individualized accounts that might otherwise be used in retiree health savings plans. The collective plan absorbs the mortality risk, so retirees can be assured that the group's benefit payments will continue for the individual's entire lifetime. Even if the level of the group benefits is adjusted in the future to reflect investment and actuarial experience at the plan level, the employee doesn't need to worry about outliving the benefit. In addition, the plan can afford to keep investing in stocks in its pooled investment account (like a pension fund) because the overall plan population also includes younger employees.
Given these advantages, the CDC-OPEB structure offers a natural solution for OPEB plans. When combined with a supplemental employee savings account (which I will present in the next Management letter), these arrangements can assure taxpayers that their retiree medical benefits are affordable, sustainable and sufficient. This plan design also enables employers to make a gradual, incremental transition.
How to install. This brings us to the transition question: How does a public employer convert from today's unaffordable "defined benefit" plan structure to an affordable OPEB-CDC format? Fortunately, it's not all that difficult. The key operational ingredients are basically the same: a trust, an actuary, a board of trustees, an investment manager. (Except perhaps for the actuary, they typically will be different individuals and firms -- not the same ones as presently engaged.)
There are two basic approaches. The easiest is to convert the plan immediately with a fixed employer (and possibly employee) contribution rate and have the actuary determine the affordable benefits level for all participants. For a startup plan, this is a viable approach. But for a legacy plan with existing retirees, there is the problem of unfunded liabilities for past service. Unless the employer separately funds those liabilities immediately or issues OPEB bonds, there could be an intergenerational problem of reducing benefits to retirees to accommodate current workers.
Therefore, most public employers will take a customized, incremental and phased-in approach to the problem. Here are the basic action steps, first in bullets and then in strategic guildelines:
o Fix the benefits level for retirees
o Address unfunded liabilities
o Revisit and revise vesting and eligibility hurdles
o Customize solutions for senior incumbents
o Fix the contribution rates
o Establish the CDC trust
o Implement an investment program
1. Determine the ongoing level of benefits for retirees. Those who have already retired may have a moral claim to continue receiving unreduced benefits. The plan sponsor must therefore decide whether actuarial reductions in the future would apply to current retirees as well. In some cases, there may be legal reasons that this is impossible or inadvisable. However, it is reasonable and usually possible to "cap" the current retirees' benefits in dollar terms or with a CPI inflation adjustment. In either event, the new plan should begin with a clear definition of the benefit payable to existing retirees. Legally and structurally, it is feasible to guarantee the current benefit level for those retirees and to pay a reduced, capped or variable benefit to future retirees. These are all plan-design decisions for the plan sponsor to make or bargain.
2. Make a commitment to pay the unfunded liabilities for employees' past service, as a separate employer contribution determined actuarially. Some employers can pay off this liability by issuing OPEB bonds if market opportunities arise. By separating out this financial commitment, employers can reassure retirees. Of course nothing can ever guarantee that future benefits will be fully funded. That's because of uncertain investment performance, medical inflation and retiree mortality. However, this bifurcation allows the actuary to then estimate a sustainable benefit level for incumbent and future employees based on the employer's future rate of normal contributions.
3. Determine a vesting level and eligibility age for incumbent employees (and possibly a different schedule for new employees). This may involve a re-definition of retirement eligibility for incumbent employees. For example, such employees may be assured a full retirement benefit upon completion of 25 years of service after attaining age 65. For older incumbents, it may also be appropriate to permit full benefits after 10 years of service and attainment of normal Social Security benefits (age 66 or 67). For younger workers who retire earlier, their benefit amount can be discounted by a formula or by using an actuarial reduction factor. In one county, for example, an employee who works 15 years in a system that requires 25 years of service would receive 15/25 or 60 percent of the full retirement benefit received by co-workers who have put in their full 25 years.
Another pragmatic approach for early retirees is to limit the number of years that retiree medical benefits are paid to the number of years worked. Lifetime benefits are thus payable only to those who work a full career. This approach strongly encourages workers to achieve full retirement service requirements.
4. Accommodate senior incumbents fairly in the new plan design. As with retirees, senior employees with who fall short of the new plan's eligibility rules may require additional service credits or other formula adjustments to achieve equity during the plan conversion.
In California, for example, the state pension system allows retirement at age 55 with five years of service, which often makes municipal employees eligible for retiree medical coverage under current labor agreements. This is an unsustainable system that is begging for reforms. However, it is unfair to unilaterally raise the eligibility age and thus pull the rug out from older workers who joined the workforce in expectation of this benefit.
One realistic way to make this adjustment is to grant special service credits, such as two years of credited service for certain years worked previously or in the future. Each employer will need to approach this conversion issue separately. My advice is to be generous in these seemingly petty adjustments, without giving away complex or windfall benefits. The general economics of the plan redesign are more important financially than these outliers. Anything less than lifetime benefits will ultimately save costs.
5. Determine employer and employee contribution rates. In some cases, an employer will simply determine that X percent of payroll is all their budget can afford. In other cases, these numbers must be determined through collective bargaining. Usually, an iterative process with the actuary, using the data points determined in the above steps will provide insights into what is a good balance.
From this process, it will then be possible to estimate the future, sustainable benefits levels for retirees, incumbent employees, and new employees. These can all be calculated as a single number, or the plan can create benefits tiers with differential benefits for each group of participants.
Some employers may decide to fund their new CDC plan at today's actuarial rate for the previous DB plan. They will then tell employees and retirees that they have now reached their upper limits and future adjustments will be made at the plan level, not the taxpayers' expense.
6. Create the OPEB-CDC trust. As with a conventional defined benefit OPEB trust, a legal structure is needed to house the assets, and empower trustees and their actuary to perform their functions. Trustees must be appointed. A majority of them should be disinterested parties for the obvious reason that benefits changes will be voted by the trustees. Having employee and retiree members on the trust board, or at least serving as an advisory board (which I prefer) is important to assure consideration of sometimes conflicting interests between retirees and incumbent employees. Trustees must be selected who are capable of making objective decisions especially if the economics of the plan require benefits reductions in light of changing financial markets.
The trust should require the trustees to balance the books actuarially by making benefits adjustments as necessary to achieve sustainability. The trust can also establish limits on the investment earnings assumptions used by the actuary or require plan sponsor approval of those assumptions. This would prevent unrealistic discount rates that would over-promise and under-deliver the benefits. Nobody wants their OPEB plan to look like Social Security and Medicare, after all!
Trustees must be required to reduce benefits to achieve actuarial balance if necessary. If funding conditions later improve, they can make restorations or recommendations to the plan sponsor for benefits increases but the final decision on the upside remains an employer prerogative and reversible. (This would be exactly opposite of the historical pattern in pension funds which are biased toward permanent irrevocable increases whenever funding ratios turn positive.) Each employer can decide what powers are assigned to trustees and what decisions on benefits must be approved by elected officials.
If the plan sponsor is willing to consider the future possibility of issuing OPEB bonds to finance part or all of the liabilities at a potentially reduced cost to taxpayers, the trust documents should include special provisions to govern the investment process and protect the bond issuer, bond investors and taxpayers. These provisions can be added as a later time, but it is preferable to include general language in the trust document at the outset. My prior columns on benefits bonds and model legislation for OPEB plans provide some insights into the considerations here.
7. Establish the investment program. The final step in the OPEB-CDC conversion is to install an investment program. The trust documents should lay out the basic features including the investment policy parameters or methodology that trustees will follow. These documents can also determine whether the trustees will be expected to make investment decisions upon recommendation of an investment consultant, or to delegate that responsibility to a co-fiduciary discretionary investment advisor. The trust document can designate the initial Trust Administrator and the investment advisor or consultant, if the plan sponsor so chooses.
8. Employee and retiree education and communication. Because benefits will change over time, it is very important to communicate effectively and often with employees and retirees about the progress of the plan, the current benefits levels, and any factor that could affect the plan's ability to pay sustaining benefits in the future. The Trust Administrator can assist the employer's human resources team in this function, working with the actuary and any other professionals who are engaged by the plan.
Public managers interested in learning more about the OPEB-CDC strategy and implementation measures can e-mail me.
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