The Alert – Public Agency Coalition by Amy Brown, August 15, 2016

Even though pension liabilities seem to get all the media attention with controversy forever surrounding issues like the appropriate discount rate, for years the experts have been telling us that OPEBs are the bigger issue. OPEBs, other post-employment benefits—which predominantly include retiree health benefits, represent the greater unfunded liability for many public employers.

Although pension benefits may be more valuable, the higher liability for OPEBs stems from a long history of public employers in California prefunding pension benefits but paying for retiree health benefits on a pay-as-you-go basis. As the state’s biggest public employer, the State of California, which employs over 228,000 active employees, offers an example of how the conversation around pension and OPEB liabilities has shifted along with the introduction of GASB’s new rules.

Back in 2007, a commission was tasked by then-Governor Schwarzenegger to research pension and OPEB benefits and their funding statewide generally concluded that while the State had a significant pension liability, CalPERS was well-funded at the time at 89 percent. While some reforms were recommended, there was no sig-nificant concern about the pension program. Instead, the commission urged public employers to focus attention on OPEB liabilities.

In California, public employers are legally obligated to adequately fund pension obligations. Whatever pension fund boards determine is required from an employer to cover each year’s liabilities, along with a contribution toward paying off any unfunded liabilities, the employer must pay. This you already know. When budgets are tight, somehow an employer comes up with the cash to cover those obligations. But employers have no such obligation with respect to OPEB liabilities. The employees’ right to an adequately funded pension system does not extend to retiree health benefits, even when employees have a vested right to those benefits.

That report was published just as the financial markets began their steep plummet that wiped out about a quarter of all pension funds’ assets, and it didn’t take long for those market losses to translate into higher employer contribution requirements. Whatever momentum that report may have generated for OPEB prefunding quickly fizzled. Most public employers understandably put the topic on the backburner as they grappled with simultaneous lower revenues and higher pension contribution requirements.

It’s hard to believe it’s been almost 10 years since that report was published. We’ve weathered one of the most significant crises our financial markets have ever experienced, which is quite an accomplishment. But we’ve come out on the other side of that experience in a more precarious position. OPEB liabilities are still the same enormous issue that they were 10 years ago. Despite the fact that prefunding OPEBs are unquestioningly the best long-term financial strategy, few employers have made any significant steps toward prefunding. And although OPEBs can’t seem to get their day in the sun, OPEB liabilities have continued to multiply over the past decade. For example, in 2007, the State’s OPEB liability was $47.88 billion but has since grown to $74.10 billion in less than 10 years.

But unlike a decade ago, any person would be hard-pressed to say that pension liabilities are of no concern and that we’re managing just fine. Our pension funds need our attention to make sure appropriate adjustments are being made to manage the ongoing low investment earnings that are expected in the near future. There’s no end to the higher employer contribution rates that we’ve seen since the market crisis; and unless the markets start performing quite a bit better (at least meeting return assumptions), employer contributions will continue to increase.

This means that pension liabilities are likely to continue dominating the conversation for the foreseeable future. Pension liabilities – and their unavoidable employer contributions – may continue straining your budget. Our question is this: Can we shine our own spotlight on OPEB liabilities without waiting for public criticism to drive the discussion? What will it take to make room in your budget for prefunding OPEBs? Is it possible?

It’s easy to lose sight of the big picture when it takes so much of our resources to deal with the urgent (meaning those unavoidable, current employer contribution requirements for pension benefits). But despite the rollercoaster our pension funds have experienced, the overall situation is unchanged. Even after riding out the financial crisis, the State’s $49.6 billion pension liability (as of June 30, 2016) is still significantly outpaced by its $74.10 billion OPEB liability (as of the June 30, 2015 valuation). At the end of the day, when our pension funds are re-stored to health, the biggest expense of our pension funds’ decade of peril may be the diversion of both attention and funding from dealing with OPEB benefits.

Governor Brown is trying to stop that from happening at the State level, with varying success, but we admire his dogged pursuit to keep the issue on the table.

California’s OPEB Liabilities

The State’s OPEB liabilities have grown steadily over the past 10 years to their current $74.10 billion, representing one of the State’s most significant long-term debt obligations. With medical costs consistently growing fast-er than general inflation, there’s no question that OPEB benefits will continue to eclipse other long-term obligations unless employers either begin prefunding or cut benefit costs (or both, as Governor Brown has tried). It should come as no surprise that public labor unions have been generally supportive of helping employers find methods to begin prefunding – it’s much preferable to the alternative.

According to State Controller Betty Yee, in 2001, retiree health care costs accounted for 0.6 percent of the State General Fund budget. By contrast, in FY 2015-16, retiree health costs totaled $1.9 billion or about 1.6 percent of the budget. That growth is primarily fueled by the increasing cost of premiums. And the stat that took our breath away: If no changes are made to the State’s method of funding retiree health care costs, the current $74.10 billion unfunded liability will grow to more than $100 billion by the 2020-21 fiscal year (just 5 years away) and $300 billion by 2047-48.¹ *gulp*

What would it cost to change that picture? Last fiscal year, if the State had made the annual required contributions for prefunding along with its pay-as-you-go obligations, the State would have needed to pay over $5 billion rather than the $1.9 billion it budgeted. Seemingly a daunting difference in expense, yes?

Rather than getting stuck on that hurdle, however, State Controller Yee is urging the State to make incremental steps, which would result in a meaningful reduction of the State’s liability. For example, prefunding just 10 per-cent of the annual service cost (in excess of pay-as-you-go expenses) would increase current annual costs by $250 million but reduce the total unfunded liability over time by $3.29 billion. Prefunding 50 percent would cost $970 million more each year but ultimately result in savings of $13.17 billion in the unfunded liability. Dealing with unfunded liabilities for already accrued service is a monstrous endeavor, but paying current annual costs would at least stop the State from digging a deeper hole.

Employers are responsible for determining appropriate funding strategies for OPEBs. And even though the financial mechanics are relatively the same between pensions and OPEBs (i.e., prefunding allows investment earnings to defray a significant amount of the long-term costs), most employers have chosen to focus on the cur-rent, unavoidable financial pressures facing their agency and continue to punt this ‘long-term’ liability down the road. It’s understandably tempting for elected officials to punt the problem to their successors while they focus on issues that have the public’s attention today. The problem is that this liability isn’t a fixed amount, it’s growing every year. Each year an employer makes retiree health benefit promises without setting aside money to fund those obligations, the problem grows.

And starting in the 2017-18 fiscal year, GASB will begin requiring state and local governments to incorporate OPEB costs in their financial statements which, for most, will result in substantial new unfunded liabilities. At the very least, you’re likely to have some renewed media attention on this issue, at which time it would be nice to be able to say that you’re taking steps; no one has their head in the sand.

The Governor’s OPEB Strategy

Governor Brown seems to be trying to chip away at the State’s OPEB obligations in every way he knows how. Currently, he’s calling on all State employees to cover half the cost of prefunding retiree health benefits. Deals reached with the Correctional Peace Officers, Engineers, Scientists, Craft and Maintenance Workers, and Public Safety Officers included these prefunding agreements, representing four of the 21 state employee bargaining units. His Administration has a long way to go. The State’s 2016-17 budget includes a one-time allocation of $240 million to pay down the state’s unfunded OPEB liabilities (Yee’s suggested step of 10 percent of the annual service cost) which will be apportioned to the trust fund account of bargaining units that reach agreement with the Administration by November 1st. The $240 million is being funded by Prop 2 (passed by voters in 2014) revenues which are earmarked for paying down long-term debts and establishing a rainy day fund.

The State anticipates that by the end of FY 2016/17, its prefunding OPEB trust balance will exceed $500 mil-lion. And if Governor Brown’s plan is executed the way that he envisions (not likely), the State would be prefunding its entire liability by the 2044/45 fiscal year with the help of its employees, estimated to save the State more than $240 billion in unfunded liabilities.²

In addition, Governor Brown is trying to reduce the OPEB liability by cutting back benefits. In prior years, the Legislature passed legislation increasing the period required to qualify for retiree health benefits for new employees (a change public agencies in PEMHCA don’t have the luxury of considering without their own legislation). Two bargaining units also agreed to a reduced employer contribution toward retiree health benefits for new hires. It’s unclear how hard the Administration will push other employee groups for similar concessions.

Governor Brown has also repeatedly – and as of yet, unsuccessfully – advocated for the CalPERS Board (or sought legislation to compel the Board) to offer a new health plan with a lower benefit design. This has been talked about as a high-deductible health plan to be offered along with a medical savings account. State employee unions, and particularly retiree groups, have adamantly fought against this for the same reason that Governor Brown wants to have it. Sure, there are some lower wage and/or younger employees who might financially benefit from such a plan, but that’s not really the issue.

The issue is that a health plan with significantly reduced benefits would likely charge a much lower premium than the four most popular health plans currently offered to active state employees. And it’s the premiums of those four biggest plans that get averaged to determine the State’s monthly contribution for retiree benefits each year. So if a lower cost plan became one of the four most popular plans, the State contribution for both active employees and retirees would go down. This would not only save the State money, but it would also lower its OPEB liabilities for one of the most difficult groups of people to touch – those already retired. Retiree groups won’t give this one up easily, and Governor Brown may not be around long enough to gather the leverage that he needs to score a victory on this issue.

This all just goes to highlight that there are potential creative solutions to be evaluated other than just setting aside money for prefunding or eliminating retiree health benefits for new hires. Governor Brown, for one, has continued focusing on chipping away at the problem. And the State, with this one powerful advocate, is making baby steps in the right direction.