In the old tale about two guests at an inn, a very tired traveler absent-mindedly tosses one of his shoes loudly to the floor, waking the person in the room below. The traveler quietly removes his second shoe, lies down and is almost asleep when the guest below shouts, “For the love of Pete, drop the other shoe!”
For local and state governments, costs for their retiring workforce have become budgetary shoes. A lot of attention has been paid to public pensions, including a report in the January fedgazette. The jarring thump came during the financial crisis, when pension investment portfolios took big hits, putting many plans on shaky long-term financial ground and placing governments, taxpayers and active public sector workers in harm’s way.
The other shoe, already on the ground and not making nearly as much noise, is “other post-employment benefits” (OPEBs)—an awkward name for retiree health care and a few other minor, nonincome benefits. Individual state and local governments face long-term obligations from OPEBs that reach seven, eight, nine, even 10 digits—a collision of past promises, an aging workforce and accelerating health care costs. A 2010 report by the Pew Center on the States found $590 billion in unfunded state OPEBs; by comparison, unfunded pensions ran about $450 billion. A 2009 report by the Government Accountability Office calculated a slightly smaller amount of state-level OPEBs ($405 billion), but also uncovered another $129 billion of unfunded liabilities among just 39 large local governments.
Despite their elephantine size, unfunded OPEBs don’t raise the same ruckus as unfunded pensions, for several reasons. For starters, they were identified as a fiscal issue only about seven years ago. Second, OPEBs are an arcane financial matter involving governments' long-term obligations, often relegated to the depths of annual financial reports. Third, OPEBs are not so much a problem today, but a growing problem for tomorrow, and most governments have chosen not to forward-fund long-term OPEB liabilities. Instead, the large majority of governments pay for OPEBs on a pay-as-you-go basis. But those costs are rising and are expected to escalate while local and state governments struggle with tight budgets.
Lastly, the lack of a public profile for OPEBs is related to their dispersed nature: Rather than centralized in a large pool like a state-sponsored pension plan, OPEB obligations are often unique to each unit of government, and no one is responsible for understanding the problem at a macro level.
That’s why the extent of OPEB liabilities in the Ninth District can be labeled good, bad and unknown. The fedgazette investigated the OPEB liabilities of about 70 state and local governments in the Ninth District, including county, city, school district and some special districts like technical colleges.
On the positive side, district governments appear to be in decidedly better shape, on the whole, than those on the coasts, or in certain states like Illinois, where many public sector retirees pay little for generous health care coverage in retirement. Even where liabilities exist in district states, OPEBs have weaker legal protections than pensions and can be modified or vanquished altogether, though it’s not evident that governments typically have the stomach for drastic actions.
On the negative side of the ledger is an unfunded liability reaching $6 billion in the Ninth District. That’s less than unfunded pensions in the district (about $20 billion), but OPEB liabilities were calculated for only a small subset of governments. While this group represents the largest governments and the biggest liabilities in the district, the final OPEB tally does not include thousands of other smaller government bodies (Minnesota alone has more than 3,000 discrete government units), many of which likely have some OPEB liabilities lurking on their balance sheets. And even small governments can have surprisingly large OPEB obligations.
ABCs of OPEBs
OPEBs are any nonpension benefits received in retirement. Health care is the OPEB elephant in terms of cost, but some retirees also receive dental care, life insurance and other benefits.
OPEBs can now be tracked because of new accounting standards set in place by the Government Accounting Standards Board, or GASB. In general, accounting standards dictate that future financial obligations (whether long-term bond debt or retiree benefits) should be estimated and publicly acknowledged. Such obligations have long been closely tracked for public pensions, but until fairly recently the same was not true for health care and other benefit promises made to local and state government retirees.
So in 2004, GASB put in place Statement 45, which said that by the end of 2009, governments had to recognize and publish present and future OPEB liabilities (typically 30 years hence) in their annual financial reports. The first peek at the problem happened with large governments, which were required to complete such reporting in 2006.
Prior to GASB, “it was a big, hidden hole,” said Audrey Bomstad, supervisor of school district finance at the Minnesota Department of Education. She added that OPEBs vary among school districts, but “now we know a lot more than we used to.”
(For more background and some early OPEB warning signs, see “Gasping over GASB” in the May 2006 fedgazette.)
OPEB liabilities come from two sources. The first and most obvious occurs when government directly pays any part of an OPEB cost, like a portion of the premium for a retiree’s health care coverage. Governments with high OPEB liabilities (often benchmarked against annual payroll) typically pay a considerable share of retiree health care premiums. The city of Duluth, Minn., made nationwide headlines in 2005 when it took an early look at OPEBs and discovered it had $280 million in unfunded liabilities—about seven times its annual payroll and more than twice its annual budget at the time—because it was subsidizing retiree health care up to 100 percent. The city has since made some changes and slowly whittled its unfunded liabilities down to $207 million, or about four times payroll.
The less visible expense or liability is incurred when retirees are allowed to buy health coverage—at full price—through their former government employer. Referred to as an implicit rate subsidy, this expense stems from the effect retirees have on an employer’s insurance pool, skewing it older than it would have otherwise been with only active workers. This pushes insurance rates higher for everyone because health care costs generally rise with age. Without retirees, active workers (and the governments employing them) would have lower insurance costs, while retirees would pay higher rates if they had to purchase insurance on their own or were in a separate insurance pool. (See sidebar for an illustration of annual OPEB costs for two school districts.)
The discounted coverage received by retirees is the implicit subsidy (and, thus, OPEB liability) and is typically fairly modest—a couple of hundred to a couple of thousand dollars per member, depending on the generosity of the plan for active workers and the number of retirees participating. But implicit subsidies are also more pervasive among governments; many states, including district ones, have statutes in place requiring local governments to offer retirees access to health coverage until age 65 (after which Medicare kicks in and coverage typically stops, or retirees are put into supplemental purchasing pools for retirees only).
Because they are widespread, implicit subsidies can be substantial. A 2009 survey of school district OPEBs by the Minnesota Office of the State Auditor found about one in three had known liabilities at the time of the survey. (GASB compliance deadlines for smaller school districts had not yet been reached, so the total is likely higher now.) Among those with known liabilities, all had implicit rate subsidies, and some further subsidized monthly premiums. In all, 119 districts reported unfunded accrued OPEB liabilities of $1.4 billion, with implicit rate subsidies making up 37 percent ($517 million).
O + P + E + B
Add up the direct and implicit rate subsidies, across all levels of government, and OPEBs turn from sleepy financial jargon to a three-alarm budget fire.
Data gathered by the fedgazette for about 70, mostly large, local and state governments in the Ninth District identified about $6 billion in unfunded liabilities. The largest individual liabilities are embedded at the state level; the state governments of Wisconsin and Minnesota face long-term OPEB liabilities of about $1.5 billion and $755 million, respectively—not a huge amount given their annual general fund expenditures of about $15 billion annually.
But there are significant unfunded liabilities across the district at every level and size of government. For example, the Montana University System, the Twin Cities counties of Hennepin and Ramsey, the city and school district of St. Paul and the Metropolitan Council (a regional government in the Twin Cities) all have between $165 million and $315 million in unfunded OPEBs.
Those are major government agencies, to be sure. But significant liabilities are evident elsewhere when the size of the community being served is considered. In Montana, for example, the city and school district of Billings, along with the Helena School District, all have unfunded liabilities between $40 million and $48 million. Cass and Crow Wing counties, with a combined population of 80,000 in the north-central lakes region of Minnesota, each face more than $30 million in unfunded OPEBs. The school districts of Hibbing and Grand Rapids, located on Minnesota’s Iron Range, have $66 million in OPEBs—which easily exceeds the annual operating budgets of both. (See sidebar for more discussion of OPEBs among local governments.)
But it’s hard to identify the full extent of unfunded OPEBs across the Ninth District because OPEBs are often unique to each unit of government in every political jurisdiction. In Minnesota alone, there are 87 counties, 854 cities, 1,785 townships and 336 public school districts, as well as hundreds of additional special government agencies and districts, each of which could have some OPEB liabilities.
Districtwide, there are likely more than 10,000 independent units of government, and despite relatively easy access to this information in financial statements, there have been no efforts to collect these data in any comprehensive way. Sources at local government associations across the Ninth District confirmed that no known organization has collected comprehensive OPEB information at any level of government in any state. To date, the most comprehensive look at OPEBs at any local level is the Minnesota state auditor’s survey of school districts, which was completed before GASB 45 compliance was even fully in force.
That does not mean, however, that sizable unfunded OPEBs lurk for all governments. The Dakotas, for example, appear to have very small unfunded liabilities at the state and local levels. The state government of South Dakota, for example, has just $67 million in unfunded OPEB liabilities. They are even lower in North Dakota. Many local governments there have no OPEB liabilities because they don’t offer retirees nonpension benefits. For example, Bismarck Public Schools do not offer retired teachers any health, dental or life insurance coverage, according to a source there. Instead, a modest health care option is available for teachers through the state, which has accumulated liabilities of just over $100 million. But North Dakota has also put away $48 million in assets to pay for those obligations, which makes it an exception among states.
However, the ability of individual government units to set retiree benefits means that significant OPEB obligations can pop up virtually anywhere. The city of Sioux Falls has a comparatively large liability of about $48 million. The city is unique among local governments in South Dakota because it sponsors its own pension plan, which puts it in a different negotiating relationship with workers compared with other cities, most of which have chosen to offer retirees state-based pension and health care coverage.
Pay me now, or …
Governments have dedicated very little money to pay for billions in OPEB liabilities. Instead, they simply cover retiree health care costs on a pay-as-you-go basis. That’s important because without set-aside funding, governments miss any opportunity to use investment gains to pay for future benefits—the central strategy in paying for pensions.
The roughly 70 government entities investigated have less than a combined $300 million in actuarially accrued assets—a funding ratio of less than 5 percent. By comparison, pension plans are considered underfunded when their funding ratio drops below 80 percent. Even for the small pool of assets that exists, a considerable amount is in revocable (rather than irrevocable) trusts, so hypothetically those funds could be grabbed for non-OPEB uses down the road.
There are several reasons governments have saved almost nothing to pay for retiree health care in the future. The simplest is that before GASB 45, OPEB liabilities were mostly out of sight and therefore out of budgetary mind. Now, with obligations running off in a trail of zeroes, governments are so far behind that it’s easier to pay smaller current bills than attempting to pay off the balance, especially in today’s tight fiscal environment and when implicit rate subsidies are largely camouflaged in an annual budget.
A few have managed to buck the funding trend. Sioux Falls, for example, has squirreled away $18 million, or about 37 percent of its OPEB liabilities.
The city of Eagan, Minn., recognized early on that OPEBs could be a problem. “It was penny cheap long ago” to offer health care to retirees, said Tom Hedges, city administrator. But over time, “we started to realize that unfunded liabilities were starting to become an issue,” because rising costs would either rob funds from current operations or deplete the city’s fund balance.
So the city established an irrevocable $4.8 million trust in January 2009, continuing the city’s financial philosophy of paying off debt when able. “We are not interested in kicking the can down the road,” said Gene VanOverbeke, the city’s director of administrative services. The timing proved serendipitous; the funds were invested through the Minnesota State Board of Investment, and the subsequent bull market in the latter half of 2009 pushed the trust’s value to $6.3 million by year’s end. That was well above the city’s $4.3 million in OPEB liabilities, according to the city’s most recent financial statement.
But the city stands out among its peers; it was the only district city or county investigated with an OPEB funding ratio of more than 40 percent. As a peer group, only Minnesota school districts have any significant OPEB assets, and that’s the result of a legislative quirk: Four years ago, the Legislature opened a brief window allowing school districts to issue OPEB bonds without voter approval.
In a financial stampede from the middle of 2007 through October 2009, 93 school districts in Minnesota issued $705 million in OPEB bonds (now set aside as assets), according to data from the Minnesota Department of Education. An MDE source confirmed that no OPEB bonds have been approved by voters since. This suggests that local governments (or at least Minnesota school districts) have more assets in sum than demonstrated by the fedgazette sample of governments. But OPEB liabilities also appear more widespread and sizable, and governments are having difficulty raising the funds necessary to forward-fund these promises to retirees.
… pay me later
Lack of assets is only half of the cost story—actually, less than half.
Much like they do with pensions, actuaries help governments estimate how much they should be setting aside to meet present and future OPEB obligations. This estimate includes the “normal” cost of retiree benefits earned by the existing workforce in a given year, along with additional payments (usually amortized over 30 years) that pay off unfunded, long-term obligations. This combined cost is referred to as the annual (or actuarially) required contribution (ARC).
The fact that governments aren’t setting anything aside isn’t a problem if they are willing to do double time to catch up financially. But few governments are contributing anything close to their full ARC. Among 62 district governments with available data on annual OPEB contributions, the average contribution as a portion of ARC was just 40 percent. In other words, actuaries for these governments said the annual (cumulative) OPEB costs were about $600 million in the latest fiscal year available for current and future obligations, yet these governments contributed only about $240 million. And when liabilities are deferred, accrued liabilities rise higher still.
In many cases, local governments aren’t making full ARC payments because it’s considered the lesser of two budget evils. Last year, the school district of Grand Rapids opted not to dedicate $1.75 million from its general fund to pay for retiree health care expenditures. Otherwise, said Ben Hawkins, the district business manager, “we would have been broke.”
In nearby Hibbing, the school district has $66 million in unfunded liabilities, while it spends a little over $11 million annually on staff payroll. Last year, Hibbing Public Schools spent $2.2 million for retiree health care coverage and premium subsidies, but actuaries said it should have spent almost $5.4 million to address long-term liabilities. But even the lower figure is forcing hard choices, according to Scott Wirtanen, the district business manager. “We have had to make staffing adjustments to cover those expenditures, thus increasing class size and somewhat limiting the course offerings we can provide our students,” he said.
Thanks to generous retiree health benefits offered through its state-sponsored pension plans, the state of Michigan faces more than $40 billion in OPEB liabilities, much of it spread throughout participating local governments, including those in the Upper Peninsula. The Marquette Board of Light and Power, a municipal power company, faces OPEB liabilities of $31 million—a big number given the company’s $4.5 million annual payroll. Last year, it spent $1.1 million on OPEBs, most of it to pay retiree premiums, but the amount also included $200,000 to forward-fund future benefits, according to the city’s annual financial statement. But actuarial estimates suggest that the board should have spent $1.8 million to keep liabilities from growing further.
Paul Kitti, director of human resources and administration, said via e-mail that among many budget priorities, “our [OPEB] liabilities could be characterized as an important consideration in our budgeting process.”
He added that the company is in the process of getting an updated estimate of OPEB liabilities. A joint labor and management committee has made significant progress in controlling health care costs, he said, which he hoped will translate into lower liabilities in the new actuarial estimate. Still, the company is “actively exploring options” regarding funding options and health plan design, including possible modification of a prescription drug plan.
OPEB that cried wolf?
Whether unfunded OPEB liabilities represent a policy or budget problem, and to what degree, is a matter of some disagreement. Many government sources had no expectation that OPEBs would be forward-funded in the future, mostly because the remedy—significantly higher government contributions placed in an irrevocable trust—is a fiscal nonstarter. “To create a protected trust to fund nothing but retiree health care when financial resources are as scarce as they are is not realistic,” said David Janak, director of finance for the Rapid City (S.D.) Area School District.
The state of Montana has questioned the utility of GASB 45 itself and, particularly, implicit rate subsidies. The state has two large retiree health care plans: a general one for local and state workers and another one for those in the Montana University System. Combined, the two plans have implicit rate liabilities of $540 million. In a letter to GASB, Paul Christofferson, state accounting administrator with the Department of Administration, said that the state “does not plan on creating trust funds or funding the actuarially determined liability” for either plan.
The basic argument is that the state has always funded OPEBs on a pay-as-you-go basis, and when costs become unmanageable, the state can—and has—modified benefits or shifted costs to retirees and active employees so it can continue paying for OPEBs this way. And by demonstrating the annual control it has over this budget item, the state has no long-term liability that should have to be recognized in financial statements. In e-mail correspondence, Christofferson reiterated his position. “I do not agree [that] an implied rate subsidy in a well managed, pay-as-you-go plan should be reported as a liability, nor should it ever be funded. I realize this puts me distinctly at odds with GASB, but I believe their approach to this issue is incorrect.”
This position is supported by the fact that OPEBs have less legal protection than pension benefits. OPEBs are not considered earned until retirement, “so there is nothing to protect until a participant retires,” according to Amy Monahan, an associate professor at the University of Minnesota Law School whose work focuses on employee benefits law. Health care and OPEBs also are not vested, or secured, by retirees because of a long-standing legal principle that “welfare benefits don’t vest,” she said, adding that this same principle allows employers to change health care benefits for active employees.
But neither are OPEBs easily disposed of. Governments often struggle to take away benefits that have been promised. And even where there is motivation, OPEBs often reside in collective bargaining agreements and thus must be negotiated out of such contracts—not a simple option or necessarily free.
When the city of Eagan looked to address its long-term liabilities, officials believed “it wouldn’t be fair” to simply take away health care coverage it had promised, said Hedges, the city administrator. “We didn’t feel right.” So the city retained promises to existing employees and negotiated lower OPEBs for new hires, in part by paying additional money upfront so workers can provide for their own health care in retirement.
Legal boundaries are not always etched in stone, either. Washington County, Minn., for example, has unfunded OPEB liabilities of about $53 million, equal to about 90 percent of the county’s annual payroll. But its legal options to address future costs are limited. Two decades ago, county reductions to retiree health care benefits were contested in court, and a settlement was reached that prevents the county from adjusting current benefits for eligible retirees, according to Harley Will, the county’s accounting and finance director. The county closed eligibility to new participants as of 2002.
The known unknowns
To some extent, the severity of the problem depends on the context. Minnesota local governments face significant challenges compared with the average city or school district in the Dakotas. But they are chump change compared with liabilities in nearby Michigan ($40 billion) or in New York ($46 billion); New York City has a staggering $60 billion unfunded OPEB liability.
Some wild cards still lurk that could be game changers. For example, federal health care reform that broadens and subsidizes public coverage before age 65 could have a significant impact on local and state OPEBs, particularly in places where governments are picking up a large share of the cost for retiree health care.
The general trend in health care cost inflation will also play a role, because high medical inflation will increase long-term liabilities even more than current estimates. Most actuarial estimates peg medical inflation initially at between 7 percent and 9 percent—which is historically pretty accurate—but they invariably lower medical inflation over time to about 5 percent, which has little recent precedent. If such projections are wrong, higher medical inflation will silently increase long-term liabilities.
In the meantime, many local governments appear content to deal with the matter on an annual basis. The Eau Claire (Wis.) Area School District has unfunded OPEB liabilities that are four times higher than its unfunded pension liabilities ($86 million and $22 million, respectively), and the annual ARC for each is similarly lopsided ($9.9 million and $2.4 million), according to a school district valuation report published last summer.
“I’m not pushing any panic buttons over OPEB. It exists, and we have to deal with it,” said district business manager Daniel Van De Water. The district uses a pay-as-you-go approach—or $4.4 million this school year—in part because state revenue caps limit large revenue increases from year to year. Any forward-funding of OPEB liabilities would come at the expense of school programs, he said. “So, my guess is that the district will continue to incrementally increase its annual expense.” The valuation report projected that pay-as-you-go costs would rise to about $10 million in 20 years.
And simply having that information is half the battle. David Bean, GASB director of research, said the purpose of GASB 45 is mostly about transparency and accountability; it does not require governments to take any action, regardless of unfunded liabilities.
“What GASB 45 has done is provide much better information” regarding the liabilities that local and state governments face presently and down the road. Before GASB 45, there was a vacuum of information, and its implementation “has given [financial] managers information they’ve never had before,” said Bean. “You manage what you measure. For some, it was a real eye-opener, and for some, it was a nonevent. ... The positive thing is that governments and financial statement users are reacting.”
View more data [xlsx]