The budgets of many cities and states will soon be disrupted by new accounting rules for retiree health plans. Local governments pay most of the health-insurance premiums for their retired employees—for example, from age 50 until Medicare at age 65, and sometimes for life. Nationwide, the total unfunded obligations of these plans are close to $1 trillion, according to a comprehensive recent study in the Journal of Health Economics.
The accounting rules, adopted in June by the Government Accounting Standards Board (GASB), require local governments for the first time to report their obligations for retiree health care as liabilities on their balance sheets. Local governments must also use a reasonable and uniform methodology to calculate the present value of these liabilities. These are both steps forward, enhancing transparency and accountability.
The new rules further provide an incentive for local governments to establish a dedicated trust with assets invested today to help pay health-care benefits in the future. But here the GASB takes one step backward, by allowing local governments to make overly optimistic assumptions, including excessive returns for the trust.
Local government health plans for retirees are on average only 6% funded, according to the Pew Charitable Trust. Because most cities pay these health-care costs almost entirely out of current budgets, they increasingly face two unattractive alternatives: raise taxes, or cut spending for such services as schools and police.
However, a handful of cities, such as Los Angeles, prefund their retiree health-care obligations. They contribute considerably more than necessary to pay insurance premiums for current retirees, setting aside and investing assets now to help pay future benefits.
The new GASB rules will encourage local governments to join this prefunding club. Here’s an example of the math. Suppose a city currently reports a $1 billion liability for its retiree health-care obligations, based on an average life of 20 years for benefit payments and a discount rate of 5%. Under the new GASB rules it must use the interest rate on high-quality, tax-exempt bonds with a maturity of 20 years, or 3.3% today. That means the city’s reported liability for retiree health care would increase by 35% to approximately $1.35 billion.
Suppose, instead, the city contributes $100 million to a qualifying trust. The city assumes that the trust’s investments will earn an average annual return of 6%, and that each year it will contribute enough to pay the premiums for current retirees so the trust doesn’t run out of money in the future. Under these conditions, a trust will reduce the city’s unfunded retiree health-care liabilities from $1.35 billion to as low as $750 million.
Forcing cities to report to the public their long-term retiree health-care liabilities—calculated under a reasonable and uniform method—should provoke taxpayers to pressure officials to negotiate less-expensive benefits with the unions. It might also give unions a better sense of the trade-offs between asking for wage increases and higher benefits.
Nevertheless, a word of warning. If a city establishes a trust, taxpayers have to ensure that the government follows through with the necessary annual contributions—and that the government doesn’t hide true health-care liabilities by unrealistic projections of investment returns. As former New York Mayor Michael Bloomberg once said, while assuming a conservative investment portfolio will earn 8% a year is “absolutely hysterical,” reducing it to 7.5% or 7% is merely “totally indefensible.”
Mr. Pozen is a senior lecturer at MIT’s Sloan School of Management and a senior fellow at the Brookings Institution. Mr. Rauh is a professor of finance at the Stanford Graduate School of Business and a senior fellow at the Hoover Institution.