October 30th, 2012 4 Minute Read Report by Stephen Eide

Reform Before Revenue: How to Fix California's Retiree Health-Care Problem

While much attention has focused recently on the immense cost of pension benefits for government workers, an equally challenging problem has received much less discussion: the cost of retiree health care. This paper examines the ongoing fiscal crisis caused by health-care plans for retirees (known as "other post-employment benefits," or OPEB) in one of the hardest-hit states: California. Already, government workers' retirement costs have played a role in municipal bankruptcies in Stockton, San Bernardino, and Vallejo, and the pressure will only intensify as more workers retire in coming years. Collectively, California state and local governments face an unfunded retiree health-care liability of at least $130 billion. Few governments have set aside sufficient funds to pay for these future costs.

Retiree health benefits in the public sector can exceed $20,000 a year per person in value. Even the most basic form of government-employer-sponsored OPEB is more generous than what most private-sector retirees receive. In fact, only 25 percent of large American employers offer retiree health care; in the public sector, 77 percent of employers do so.

Fortunately, we now have a window of opportunity for effective OPEB reform in the public sector because state and local governments' retiree health-care programs are relatively undeveloped. Pension obligations are often set in stone, but in the realm of OPEB, many important decisions have not yet been made regarding benefit structures, cost-sharing and funding arrangements, and the legal status of benefits. This helps governments avoid repeating the history of pension commitments, which locked governments into rigid and unsustainable benefit commitments.

OPEB is essentially a fiscal problem, and new revenues will be necessary to support these benefits. But it would be a grave mistake to simply fill in the fiscal gap with more taxpayer money. Instead, reform should precede revenue (especially since some reforms may generate revenues). Governments that seek to pay for OPEB only with taxes or budget cuts are being neither practical nor fair.

What is to be done? What actions should state and local governments take to manage OPEB? This paper describes the current crisis, analyzes current OPEB practices and their contribution to the problem, and outlines necessary reforms that should come before tax increases or cuts to government services. These reforms are:

(1) California state and local governments should reassess the need to offer OPEB. Before restructuring their OPEB program, all governments should first evaluate the importance of this benefit. Are retiree health-care benefits necessary to attract and retain a skilled workforce? Cities such as Fresno, which never allowed its OPEB programs to become overly generous, now have manageable long-term liabilities. Governments should understand that they may have more flexibility to adjust retiree health-care benefits than they have for pensions, as was demonstrated in recent litigation between Orange County and its retirees.

(2) Think hybrid. California cities should consider a hybrid model for OPEB, similar to the hybrid pension models recently adopted in Rhode Island, Utah, and the city of San Jose. Hybrids provide retirees with a basic level of retirement security while reducing employers' overall liability.

(3) Raise revenues and begin prefunding. A few governments have shifted from pay-as-you-go methods to a prefunded approach to OPEB (in which benefits are paid by money set aside and invested for that purpose, as is done with pensions). This trend must accelerate and become widespread. The move to prefunding will require that more money go into retiree health benefits. Who should provide it? The first and most obvious candidates are the employees who will benefit. Currently, most California government employees do not contribute to their retirement health-care benefits at all. They should be required to contribute half their OPEB's actuarial normal cost—the amount set aside each year to ensure that the benefit will be adequately funded when the employee reaches retirement. Of course, all new revenues raised by this or any other method should be deposited into an irrevocable trust fund and invested.

(4) State government should provide local governments greater bargaining leverage for OPEB. With the pension reform signed into law in September 2012, California state government requires that public employees pay half their pension costs, with their government employers picking up the rest. This 50/50 split is defined as the California standard, and local governments have the authority to implement it in cases where collective bargaining has come to an impasse on pension issues. This reform should be extended to OPEB.



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