Low interest rates and dwindling reserves have decimated municipal budgets that once relied on short-term investment income. This year will see the lowest revenue numbers yet, as investments bought three and four years ago at higher rates now mature and must be reinvested at near-zero yields. But now there is another interest-rate problem for municipalities that participate in self-insurance pools for workers compensation: their actuarial assumptions are falling short because of low investment yields.
Many readers are familiar with the actuarial and funding problems facing pension funds and similar issues for OPEB (retiree medical benefits) trusts, as bond yields have plummeted and the expected returns from stocks have been muted by a weak global economy that is deleveraging. Accountants and actuaries rely on the expected investment return of these retirement plan portfolios to calculate the discount rate that is used to value future liabilities. Lower expected investment returns translate into lower discount rates (in the denominator of the formula), which result in higher calculated liabilities and higher annual required contributions for employers.
The same principle applies to workers compensation plans. Although the claims of public employees for workers comp are typically paid off long before the tail-end of a pension obligation, the same math is used. Reserves are established to pay for benefits to these employees, and those can run for five to ten years in some cases. Whether the insurer is a private company or a public self-insurance pool, the actuarial impact of a lower discount rate is similar: the cost to fund future payments through investments made today must be higher, which results in higher insurance premiums, everything else being equal.
Of course, the claims experience of the employer is often a more important single factor in determining loss reserves and premium costs, so I don't want to make a mountain out of a molehill. But I've seen some reputable actuaries put their public clients on notice that traditional assumptions of 4 percent returns on government securities won't hold water in today's market for five-year government bonds paying 1 percent. That 3 percent annual shortfall can add up to a 15 percent cumulative funding deficiency for claims payable in five years.
The interest-rate impact for employers who purchase private insurance may be less pronounced because insurance companies are allowed to invest their reserves in corporate bonds with higher yields. The same can be true for self-insurance pools in the handful of states that allow public-sector investments in comparably diversified portfolios. So the actuarial shortfall is very state-specific and employer-specific.
The shortfalls facing these self-insurance pools are a drop in the bucket compared with the pension-funding deficiencies that can result from lower expected returns on their investments, but it's just one more headache for municipal budgeters to cope with.