The budgets of many states and cities are soon going to be challenged by the new accounting rules for retiree healthcare plans. These plans reflect the promises made by local governments to pay most of the healthcare premiums for their retired employees. Many cities and states will pay most or all of the health insurance premiums of their employees who retire early—for example, ages 45 or 50—until they go on Medicare at age 65. Some cities and states go further by paying the Medicare premiums of their employees, as well as premiums for supplemental health insurance to fill gaps in Medicare coverage.

The total obligations of local governments for retiree healthcare have been rising over the last few decades. They were estimated to be around $700 billion in 2009 by the Government Accounting Office, and are now close to $1 trillion according to a more recent and more comprehensive study by Byron Lutz and Louise Sheiner published in the Journal of Health Economics. These unfunded retiree healthcare obligations stayed under the radar screen until 2006, when they first had to be disclosed in a footnote to the financial statements of local governments under the rules of the Government Accounting Standards Board (GASB).

For fiscal years beginning after June 15, 2017, GASB Statement 75 requires that local governments include their obligations for retiree healthcare as liabilities on their public balance sheets. GASB Statement 74 mandates a uniform method for calculating the present value of such liabilities, which plans will be required to adopt for fiscal years beginning after June 15, 2016.

The additional reporting requirements will enhance transparency and accountability for local governments with large unfunded liabilities for retiree healthcare. The measurement standards also provide the incentive of lower reported liabilities for local governments that establish trusts with financial assets today to help pay healthcare benefits in the future. But the rules give local governments too much discretion in making assumptions about premium contributions and investment returns in the future—thus, obscuring the true financial picture. 

While the weakest city pension systems like those in Chicago are less than 40% funded, retiree healthcare plans of local governments are on average 6% funded (that is not a typo) according to the Pew Charitable Trust. This reflects the fact that most cities have just paid these costs out of current governmental budgets, rather than setting aside any assets to cover the promises as they were being made. As a result, just to keep up with the need to pay these rapidly growing costs, local governments face two unpopular alternatives—raise local taxes; or cut spending for local services like schools and police.

A very few cities, such as Los Angeles, have chosen to prefund the obligation. They contribute considerably more than just what would be required to make the health insurance payments for current retirees (e.g. 8% of the budget instead of 2%), setting aside and investing assets now to help pay healthcare benefits in the future. The new accounting rules will boost the incentive to join the prefunding club, by allowing the cities and states to reduce the amount of unfunded liabilities they show on their public balance sheets.

Under current rules, a local government estimates the future flow of healthcare obligations to its retired employees, and then calculates the present value of such obligations by using a discount rate of its choosing. The government bases the discount rate on the returns it assumes it could achieve on invested assets, even if there are no assets to be invested. The lower the assumed discount rate, the higher the local government's liabilities; the higher the assumed discount rate, the lower the government's liabilities.

At present, the discount rates used by cities and states varies widely, ranging from 4% to 8% depending on whether the local government has prefunded. The new GASB rules will require that all local government financing retiree healthcare on a pay-as-you-go (fully unfunded) basis must use the interest rate on a high quality tax exempt bond with a maturity of 20 years. Today that would mean a discount rate of approximately 3.3%. The new rules therefore remove the discretion that unfunded plans have to choose discount rates, and require them to value the retiree health obligation as a solemn promise analogous to the promise to repay general obligation government debt.

Consider City C that currently reports an unfunded liability of $1 billion for its retiree healthcare obligations, based on an average life of 15 years for benefit payments and a discount rate of 5%. If City C were instead to use a 3.3% discount rate under the new GASB rules, its reported liability for its retiree healthcare obligations would increase by approximately 35% -- from $1 billion to $1.35 billion. That increase would have a meaningful impact on the public balance sheet of City C. 

At the same time, the new GASB rules allow a local government to reduce its reported liabilities for retiree healthcare on its balance sheet by subtracting the projected value of any assets invested in a qualifying trust. To qualify under these rules, a trust must be dedicated solely to retiree healthcare costs—with irrevocable contributions and strong protections against creditors. 

To illustrate how this works, consider City C in the same situation as discussed above, but with one big difference—it promptly contributes $100 million to a qualifying trust dedicated to paying future healthcare benefits for retirees. The City also makes two further assumptions. First, it assumes that it can pay out of its current budget enough to meet the healthcare premiums of current retirees, which under a typical trajectory will grow by over 5% per year in the near term, and more if costs cannot be kept under control. Second, it assumes it can earn an average annual return of 6% on trust assets by investing them in a diversified portfolio.

The establishment of such a trust, together with these two assumptions, would allow the City to reduce its publicly reported liabilities for retiree healthcare by roughly $600 billion—from $1.35 billion to roughly $750 million.

Some of this reported reduction in liabilities is real. Setting aside funds now dedicates assets to pay for future liabilities. As a result, prefunding can hopefully reduce the burden on future taxpayers.

But no financial engineering can magically turn $100 million into $600 million. The assumption that premium contributions out of the current budget can grow by more than the economic growth rate of the state or city in question implies a hidden and increasing tax burden on the city’s residents. This is especially true in cases where there is a large group of employees who might be retiring soon, or in cities with declining taxpayer bases.

And using an excessive investment return assumption has an even stronger effect. Suppose City C assumed that trust assets would earn 8% per year. Under that assumption, City C would be able to reduce its reported liabilities all the way down to $540 million, or by a total of $800 million. But an assumed return of 8% from a conservative investment portfolio would be “absolutely hysterical” according to former Mayor Michael Bloomberg.

Thus, the new GASB rules will encourage local governments with pay-as-you-go plans to be more forthright about the extent of their retiree healthcare obligations and to begin contributing assets to qualifying trusts dedicated to helping pay these future obligations. Those effects would be positive for their residents and their employees. The residents would have a better grasp of the budget impact of these healthcare promises made by their local officials. Local residents would likely pressure local officials to negotiate with public employees for a narrower package of healthcare benefits in retirement. And the public employees would know that, whatever benefit package were agreed to by local officials, It would be backed to some degree by hard assets, rather than unfunded promises.

However, local residents should probe to understand the assumptions used by any local government that reduces its reported liabilities for retiree healthcare by setting up a qualifying trust. It is not reasonable for a city to assume that it can meet rapidly rising healthcare costs of its retirees entirely out of its current budget. Similarly, it is not reasonable to assume that a qualifying trust will regularly have returns of 7 or 8% per year from a conservative investment portfolio. Even lower return assumptions carry considerable risks in an environment where today’s long-term government bond yields are so low.

The net result of the new GASB rules is to force governments either to disclose a more accurate measure of retiree health liabilities, or to start funding those liabilities. If cities begin to fund, they have too much discretion over the assumptions that they make. GASB has therefore given cities the incentive to prefund their healthcare liabilities, but in a way that substantially understates the true costs of these long-term promises.

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