State and local taxpayers are in trouble. Over the years, state
and local governments have promised, but not paid for, roughly $1.5
trillion dollars in retiree health care and other non-pension
post-employment benefits--and the bill is coming due as millions of
baby boomers begin to retire. Until recently, few officials even
knew the size of their obligations but a new accounting rule will,
for the first time, hold state and local governments to a similar
standard that applies to private sector employers, forcing them to
calculate their unfunded liabilities and publicly disclose them on
their financial statements. David Walker, Comptroller General of
the United States, warns, "there are no quick fixes" and that stark
fiscal challenges need to be "addressed with a greater sense of
urgency by policymakers since time is currently working against
us."[1]
State and local officials should not expect a bailout from
Washington, which is facing its own challenges with the rising
costs of Medicare, Medicaid, and Social Security. State and local
officials must solve this problem themselves. Fortunately, there
are several creative, market-based solutions that could fit the
bill.
How Governments Calculate Retiree
Health Benefit Costs
For decades, state and local governments failed to accurately
account the costs and obligations of retiree health and other
non-pension benefits. Most officials relied upon a "pay-as-you-go"
accounting approach. Under this approach, officials report these
costs when benefits are received by retirees instead of each year
as employees render services in exchange for compensation,
including promised retirement benefits. Pay-as-you-go accounting,
therefore, obscures and underreports the true costs and obligations
that state and local governments have accrued. For private
companies, this sort of obfuscation would be illegal and in
violation of their fiduciary responsibilities.
In 2004, the Government Accounting Standards Board corrected
this problem. The Board issued a new accounting standard (GASB
45)[2]--similar to the Financial Accounting
Standards Board's (FAS 106) statement issued for publicly traded
private companies in the early 1990s or current financial practices
for pensions--which established an accrual accounting approach. By
following this approach, government officials will now be required
to calculate and report the cost of benefits as an expense during
the years in which an employee is providing services in exchange
for future benefits.
This change will more accurately reveal the total cost of
services a state or local government provides, make transparent the
annual cost of health care and other non-pension post-employment
benefits, and disclose the amount that these benefits are funded
each year. The new accrual accounting approach will report changes
in the funding status of benefits over time and then prospectively
disclose the unfunded actuarial accrued liabilities of state and
local governments.
The Size of the Unfunded
Liabilities
Although state and local governments began calculating estimates
of their expected costs and obligations for retiree health care and
other non-pension post-employment benefits in 2007, the first
reports on their liabilities will not be disclosed until fiscal
year 2008, when those financial reports are released between
December 2008 and March 2009. In the meantime, actuaries and other
experts have completed preliminary estimates of the size of the
bill that is facing the taxpayers.
In 2006, analysts for J.P. Morgan estimated that state and local
governments' unfunded liabilities for non-pension post employment
benefits--primarily retiree health care--were between $600 million
and $1.3 trillion.[3] Since the initial J.P. Morgan estimate, two
subsequent studies have corroborated the higher estimates. In
October 2006, the Cato Institute put the figure at $1.4 trillion,[4] and in
March 2007 Credit Suisse uncovered $1.5 trillion in unfunded
liabilities--$558 billion for state and $951 billion for local
governments.[5] The most recent study on the topic, by the
Pew Charitable Trust,[6] conservatively estimated the unfunded
liabilities for only state governments to be $370 billion. If the
Pew study had included local governments in its analysis, it would
have confirmed that the total liabilities of state and local
governments add up to more than one trillion dollars.
What State and Local Officials Should
Do
It is quite possible that many state legislators and local
officials will do nothing. But taxpayers should realize that this
irresponsibility would come at a high price: State and local
governments will have to substantially increase taxes or cut other
spending as the bill for retiree health care and other non-pension
benefits comes due. Also, state and local officials who fail to act
to scale back the size of these obligations will see their bond
ratings drop and the cost of borrowing rise commensurately.
State and local officials may try to pressure the President and
Congress to intervene with a bailout. Under no circumstances,
however, should the federal government agree to divert increasingly
scarce federal tax dollars to any kind of bailout for state or
local unfunded liabilities. Taxpayers should hold state and local
officials directly accountable for the decisions they have made and
the rising costs of those decisions. Those officials should be
forced to solve the problem themselves.
The first thing state officials can do is to start converting
their current and promised health benefits for their workers and
retirees from a defined benefit model to a defined contribution
model. This would make health costs reliable and predictable. In
addition, a defined-contribution model could harness market forces
to help control costs while ensuring the delivery of high-quality
health care.
To complement such a change in financing, state officials should
also reform their states' health insurance markets. Many states'
health insurance markets are dysfunctional, burdened with
over-regulation, excessive mandates, and underwriting rules that
drive up health care costs. The best fix is for state officials to
create statewide health insurance exchanges to enable state
employees and retirees to choose from among competing private
health plans, while keeping the generous federal tax benefits that
accrue to group health insurance, thus making plan choices more
affordable and fully portable.[7] This can be done in
accordance with applicable federal employment law. An exchange
should also be part of a larger statewide health insurance market
reform that reduces the number of benefit mandates and creates
superior pooling mechanisms to assure both choice and coverage
options for high-risk individuals.[8]
Within a properly designed exchange, state and local employees,
joining with employees of private businesses, could benefit from
more affordable coverage in a statewide market where risks are more
broadly distributed than they are today.
Conclusion
Taxpayers are increasingly becoming aware of a new challenge:
The rising costs of retiree health care and other non-pension,
post-employment benefits for state and local employees, which
amount to approximately $1.5 trillion in unfunded liabilities.
State and local officials must somehow pay for these promised
benefits, while reforming the way these benefits are financed and
delivered. A failure to act responsibly guarantees a negative
impact on the state and local government bond ratings.
Meanwhile, the challenge offers an opportunity for state and
local officials to become creative in addressing the problem.
Rather than pressure the President and Congress for a federal
bailout--substituting federal tax dollars for state tax
dollars--they can start to make changes in the way in which they
finance and deliver health care benefits to both employees and
retirees. One option is to move from a defined-benefit system to a
defined contribution system, which would make the cost of health
benefits more predictable and reliable. A related measure would be
to reform the state health insurance market in a way that enables
employees and retirees to purchase health plans of their choice,
with pre-tax dollars, and own these policies regardless of their
employment status. This could be done within the strict confines of
federal employment law and could result in affordable, personally
owned and controlled health insurance policies that would be fully
portable.
There are no quick fixes and no escape from the consequences of
inaction. This is another reason taxpayers should keep a close
watch on their local and state elected officials.
Greg D'Angelo is a Policy Analyst for
the Center for Health Policy Studies at The Heritage
Foundation.