Funding Retirement Benefits on $75 a Month

A multi-pronged approach can slash retiree medical costs.
by | June 10, 2010

Although pension reform dominates the headlines today, the nation's worst financial problem with public employee retirement plans is their retirement medical benefits. Pension funds have used actuarial principles for 60 years in most states, but fewer than 5 percent of public employers nationwide have even bothered to create a qualifying irrevocable trust to fund their "OPEB" (other post employment benefits) for retirees' medical needs — let alone fund them. Three years ago the estimated unfunded liabilities for OPEB plans were about $1.5 trillion. That number will soon reach $2 trillion since public employers have failed to fund their plans and medical inflation continues to escalate unchecked.

After meeting with hundreds of state and local government managers to address the sustainability of their OPEB plans, I have learned that:

• Although public employers tend to offer similar retirement medical benefits in a given local labor market, there is very little uniformity nationwide or even statewide in most states. Some employers offer full lifetime benefits to retirees and their families at taxpayer expense, while other employers offer retirees only the option to buy their insurance at cost. Many fall somewhere between those two extremes. So it's dangerous to generalize.

• Most public employers that do offer a retirement OPEB benefit have chosen to use a "defined benefit" formula that guarantees a specific benefit, rather than a defined contribution plan.

• A third to half of the employers providing material OPEB benefits offer a fixed monthly or annual stipend, and the remainder provide full or near-full coverage of insurance benefits.

• Most public employers provide full OPEB benefits — for the remainder of the employees' life and often their spouse's — as soon as an employee becomes eligible for a pension.

• Unlike pensions, state laws usually allow employers to tinker with the OPEB benefits formula, even for incumbents. In many states, however, the law in this area is unsettled. Constitutional protections for employees in the eight states that prohibit prospective pension plan design changes for incumbents are sometimes less constrictive for OPEB benefits.

• Relatively few public employers now require an employee contribution for OPEB benefits.

• Most employers have set no date for making full actuarial contributions for their OPEB plans. Their budgets are so tight that they have no choice for now but to pay as they go, which guarantees that their unfunded liabilities will escalate.

Eventually, public employers must begin funding their OPEB benefits on an actuarial basis. The do-nothing result of pay-as-you-go is that costs will escalate geometrically in five to ten years and become runaway expenses. Thus, the only realistic actions that fiscally stressed public employers can undertake today are to constrain the liabilities through plan design changes and collective bargaining where required.

Here's how public managers can materially reduce their OPEB liabilities and future costs, even before they can afford to pay their full actuarial contributions:

1. Require employees to contribute. As I've written elsewhere, the first action available to public employers in solving their pension predicaments is to increase employee contributions. The same logic applies to OPEB benefits. Employees should begin contributing to this valuable benefit program, with the long-term goal of a 50-50 cost sharing. If employee pension contributions are insufficient now, it may be best to solve that problem first, but a token employee OPEB plan contribution of 0.5 percent of salary or $25 a month will establish the principle of shared costs and provide a basis for future balancing of employer and employee contributions. Employee contributions must be deposited in a qualified OPEB trust fund, so this stratagem does require taking that first important step toward eventual long-term fiscal responsibility. Here's the bonus: This action will almost always reduce the OPEB liability as the actuarial discount rate for the OPEB plan will be higher (and thus, the unfunded liability lower) as soon as money begins to trickle into the trust fund.

2. Establish new benefits for new employees and (if legally possible) revise the benefits formula for incumbent employees. Here, state laws and labor relations issues will determinate the feasibility of making changes for incumbent employees. If incumbent benefits are untouchable, then an immediate employer demand for a larger incumbent-employee payroll contribution can provide fairness in benefits between unsustainably benefit-rich incumbents and new employees receiving leaner benefits. Incumbents should be given fair actuarial value for the benefits they have earned to date. This makes the re-design of the plan for them slightly more complicated, but is manageable. In some cases, it may be simpler to "freeze" the current OPEB benefit and start anew for future incumbent service, or to give incumbents the better of the frozen benefit and the lower redefined benefit. Professional assistance from actuarial, fiscal-sustainability and labor relations experts may be needed to provide plan design alternatives for employers seeking to change incumbents' OPEB benefits. The cost of that professional help will be a small fraction of the liability reduction.

3. Re-define the benefit to a monthly stipend. For employers that now pay a full insurance premium at retirement, or a large fraction thereof, the next step in OPEB reform is to re-define the benefit as a finite monthly stipend. Each employer can set the benefit at the level which they find to be actuarially sustainable. An emerging standard in the "new normal" economic environment is to provide a benefit to full-service retirees that is approximately equal to cost of the Medicare-supplement insurance policy. That may work out to about $500 a month in some higher-cost urbanized states and less in others. The stipend is payable during the employee's life, and not their dependents', unless the employee elects to receive an actuarial reduction to purchase a survivor benefit.

4. Define the benefit as an annual accrual. Instead of granting "cliff vesting" of 100 percent of the OPEB benefit as soon as employees become eligible for a pension, public employers must move toward an annual accrual formula so that they do not assume full responsibility for workers' retiree medical benefits regardless of what fraction of their working lives they have been employees of that specific organization. In California, for example, many public employees can gain lifetime retiree medical benefits after achieving age 55 with only five years of public service, and in some instances, the five years can be worked at another employer! In a few cities, employees win lifetime retiree medical benefits with one day of service if they have achieved pension eligibility at another employer in the state's pension system. (Talk about a signing bonus!)

A more rational plan begins with a minimum vesting period. My clientele is generally leaning toward a 10-year vesting requirement, with the view that service of fewer years should not qualify an individual for this benefit. Those who leave earlier receive a refund of their employee contributions plus interest and that's all. Those leaving after they vest will receive a deferred benefit upon attaining the re-defined retirement age (below).

Each year, the employee acquires an annual accrual, such as $20 a month in OPEB benefits for each year of service with that employer. This gives a 25-year employee a monthly stipend of $500 and a 30-year worker a monthly benefit of $600 of tax-free benefits. I personally would favor indexing the monthly benefit to the CPI, so that it gains value automatically and avoids the temptation to award unfunded ad hoc benefits increases in the future, which will only cost the employer more in the long run.

5. Re-define the OPEB retirement eligibility age. All employees, including vested inactive employees, should be eligible to receive their monthly OPEB benefits upon reaching the Medicare eligibility age. Medicare will almost inevitably increase the eligibility to conform with Social Security (now 67 for those born after 1960) when Congress gets around to federal retirement reform, so public managers should begin using that language in their plan documents and labor agreements. This establishes the basic and normal OPEB benefit.

Then, employers can define the earlier OPEB eligibility age for retirees who are qualified for a full-service career benefit. For example, the OPEB benefits can begin before age 65 for civilian employees who reach age 62 with 30 years of service, or for public safety employees who attain age 57 with 25 years of service. Those who retire earlier must wait until they attain an eligible age given their service record, or they can take an actuarial reduction for early retirement.

6. Establish a sidecar supplemental OPEB defined contribution plan. This will enable employees to save more money for early retirement, family benefits or other retirement objectives. The sidecars can take the form of a tax-free voluntary, beneficiary association (VEBA) with union involvement, or a Section 115 governmental purpose trust. The general rule for IRS qualification is that employee contributions cannot be discretionary, although employees can be given an irrevocable option to participate or not participate when they begin service or the plan is instituted. These individual savings plans can include a feature to convert accumulated sick leave into an OPEB savings account for tax-free medical expenses, which enhances their popularity and can be used by employers to mitigate those costs (by re-valuing excess leave at 50 cents on the dollar, for example). Employers can offer two plans: one for high savers who need to stash away money for spouses, early retirement plans or possible career mobility, and a leaner plan with a lower contribution rate for single employees who plan to retire at or near the normal age. New employees can pick either one or none, and must then stick with it.

My ballpark estimate for the annual normal cost of a plan such as that outlined above would be a monthly total cost per employee of $150 for civilians and $200 for public safety, which can be split between the employer and the employees on a locally-determined basis. If employees contribute 50 percent pretax, the normal cost to an employer would be $75 per month for civilians and $100 for public safety — which is both sustainable and sufficient for many employers. (An actuarial analysis would be required to estimate costs precisely to include workforce demographics, investment assumptions and various local factors.) For many employers, this will represent a huge cost reduction from their current "full insurance for full family for life" benefits plans. This is not an academic exercise: It can be achieved in the real world with the right team. Those needing help to get started can contact me via e-mail.

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