Most governmental entities pay for the health benefits of retired employees on a pay-as-you-go basis. This means that retiree health services are funded when retirees use them. The alternative is to pre-fund benefits.

If governments were starting from scratch today and offering retiree health benefits for the first time, pre-funding could be accomplished by paying the normal costs each year - the estimated amount that needs to be set aside and invested to pay for health services after employees enter retirement. However, since the state and other governments have offered these benefits for decades and have not set aside funds, they would have to pay considerably more to fully pre-fund all benefits. GASB 45 requires the calculation of a full pre-funding annual required contribution (ARC) consisting of: (1) estimated normal costs and (2) an amount needed to eliminate the unfunded liability for unpaid past normal costs within 30 years.

Pre-funding is the Approach Used for Pensions

In California, for example, the board of the California Public Employees Retirement System (CalPERS) requires the state to pay an amount each year that is set aside and invested to pre-fund future retiree pension benefits. This annual amount paid to CalPERS is similar to the full pre-funding annual required contribution that will be calculated under GASB 45. There is virtually no dispute that pre-funding is the best way to fund a pension system. In time, it is likely that retiree health benefits will be looked at in the same way.

Reasons to Pre-fund Retiree Health Benefits

A pay-as-you-go approach to funding retiree health benefits is problematic in that it shifts current costs to future taxpayers. The alternative, pre-funding benefits, not only avoids this problem, but also results in the following:

• More Economical Over Time. Over the long term, investment earnings would supplement any contributions for retiree health costs. This would allow the government to pay for a given level of benefits with fewer budgetary resources and reduce unfunded liabilities for retiree health care. Paying more now can dramatically reduce costs over the long term.

• Helps Secure the Benefits Expected by Employees. Pre-funding creates a pool of assets with which to support future benefits that public employees expect to receive. These assets would strengthen the entity’s ability to provide these benefits over the long term.

• Contributes to Higher Bond Ratings. Bond rating agencies, whose evaluations help determine the interest rates paid on state debt, monitor the funding status of the retiree health program. There is no indication that rating agencies will rush to downgrade ratings once GASB 45 reveals large retiree health liabilities. However, unfunded pension and retiree health obligations are viewed by bond analysts as similar to debt. For rating agencies and bond investors, more debt can be a negative consideration. As more states and local governments address retiree health liabilities, rating agencies may compare those governments that have acted with others that have not.

Partial Pre-funding Is an Option

Given the large amount of what it might cost to cover the future retiree health costs of today’s employees, plus pay off the unfunded liability over 30 years, it may be unrealistic for some entities to move immediately to a full pre-funding contribution level. Another option is funding part of the GASB 45 annual required contribution. Any amount of pre-funding reduces the exposure to future increases in health costs. Investment earnings from funds set aside today would help reduce future budget pressures.