State and Local Government Retiree Health Benefits: Liabilities Are Largely Unfunded, but Some Governments Are Taking Action
Published: 2009-11-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Accounting standards require governments to account for the costs of other postemployment benefits (OPEB)--the largest of which is typically retiree health benefits--when an employee earns the benefit. As such, governments are reporting their OPEB liabilities--the amount of the obligation to employees who have earned OPEB. As state and local governments have historically not funded retiree health benefits when the benefits are earned, much of their OPEB liability may be unfunded. Amid fiscal pressures facing governments, this has raised concerns about the actions the governments can take to address their OPEB liabilities. The Government Accountability Office (GAO) was asked to provide information on governments' retiree health liabilities. GAO described (1) what has been reported in state and local governments' comprehensive annual financial reports (CAFR) regarding OPEB liabilities, (2) actions state and local governments have taken to address retiree health liabilities, and (3) the overall fiscal pressures these governments face. GAO reviewed the CAFRs for 50 states and the 39 local governments with at least $2 billion in total revenue. GAO also reviewed the actions taken to address retiree health liabilities by 10 state and local governments, selected based on geography and variation in approaches to address their liability. Finally, GAO simulated the fiscal outlook for the state and local sector and projected health care costs for state and local retirees.
section_title: What GAO Found
paragraphs: The total unfunded OPEB liability reported in state and the largest local governments' CAFRs exceeds $530 billion. However, as variations between studies' totals show, totaling unfunded OPEB liabilities across governments is challenging for a number of reasons, including the way that governments disclose such data. The unfunded OPEB liabilities for states and local governments GAO reviewed varied widely in size. Most of these governments do not have any assets set aside to fund them. The total for unfunded OPEB liabilities is higher than $530 billion because GAO reviewed OPEB data in CAFRs for the 50 states and 39 large local governments but not data for all local governments or additional data reported in separate financial reports. Also, the CAFRs we reviewed report data that predate the market downturn. Finally, OPEB valuations are based on assumptions about the health care cost inflation rate and discount rates for assets, which also affect the size of the unfunded liability. Some state and local governments have taken actions to address liabilities associated with retiree health benefits by setting aside assets to prefund the liabilities before employees retire and reducing these liabilities by changing the structure of retiree health benefits. Approximately 35 percent of the 89 governments for which GAO reviewed CAFRs reported having set aside some assets for OPEB liabilities, but the percentage of the OPEB liability funded varied. Among the 10 selected governments whose actions GAO reviewed in more detail, officials from the governments that were prefunding at least a portion of their retiree health liability reported using irrevocable trusts. However, these governments varied with regard to the source of the money used to prefund their retiree health liabilities and how they determined the level or amount to commit to prefunding each year. To address their retiree health liabilities, the governments GAO selected made three key types of changes to their retiree health benefits: changes to the type of retiree health benefit plan, to the level of government contribution, and to the eligibility requirements employees need to meet to qualify for retiree health benefits. Changes to the level of government contribution, such as reductions to the amount or proportion of health insurance premiums paid for by the government, was the most common benefit change reported. Some of the selected governments made more than one change to their retiree health benefit structure. The changes were most often applied to the retiree health benefits of newly hired employees or currently active employees. State and local governments face unfunded OPEB liabilities and decisions about addressing liabilities amid increasing fiscal pressure. Assuming the continuation of current policies, by 2050 the size of the projected operating budget imbalance for the state and local government sector is 4.7 percent of gross domestic product, attributable largely to increases in health-related spending. Though Medicaid is the largest health-related expenditure, spending on state and local government retirees' health benefits is projected to more than double as a share of total operating revenues to 2.1 percent by 2050.

section_title: Letter
paragraphs: When state and local governments (referred to in this report as  governments) provide health benefits to their retired employees, they may  do so by paying for a portion of the costs of these benefits. Governments  have typically funded their share of the cost of retiree health benefits  when they are paid or provided to retirees (i.e., during retirement), as  opposed to during active employment. Under accounting standards issued  in 2004, governments are required to account for the costs of  postemployment benefits other than pensions—referred to as other  postemployment benefits (OPEB)—as employees earn the benefits and  the costs are accrued, not when the benefits are paid or provided. The  largest OPEB is typically retiree health benefits. Under the accounting  standards, fiscal year 2008 was generally the first year that the largest  governments were to begin reporting, in annual financial statements, the  amount of government’s obligation to employees who have earned OPEB;  these amounts are known as OPEB liabilities. While the standards include  requirements for the reporting of governments’ OPEB liabilities, they do  not include requirements for funding OPEB, such as retiree health  benefits.
Because state and local governments have historically funded retiree  health benefits when paid or provided rather then when the benefits are  earned, much of their OPEB liability may be unfunded. This has raised  concerns about the fiscal pressures that state and local governments will  face in the coming decades and leads to questions about the actions state  and local governments can take to address their OPEB liabilities, such as  changing their retiree health benefits.
In general, state and local retiree benefits are not subject to federal laws  governing private sector retiree benefits. Nevertheless, there is a federal  interest in ensuring that all Americans have a secure retirement.  Additionally, reporting of governments’ OPEB liabilities has brought  renewed focus on how governments will address these liabilities. Given  concerns about state and local governments’ fiscal challenges and the  potential erosion of retiree health benefits, you asked us for information  on state and local governments’ retiree health liabilities. This report  describes (1) what has been reported in state and local governments’  comprehensive annual financial reports (CAFR) about unfunded OPEB  liabilities, (2) actions state and local governments have taken to address  the liabilities associated with retiree health benefits, and (3) the overall  fiscal pressures these governments face.
To describe state and local governments’ unfunded OPEB liabilities, we  reviewed the most recent CAFRs for the 50 states and 39 large local  governments (cities and counties with total revenue of $2 billion or more  according to U.S. Census Bureau data). We determined that the state and  local government CAFR data were sufficiently reliable for our purposes,  which were to describe the total unfunded OPEB liability reported; the  total OPEB liability, assets, and unfunded liability for each of the  individual governments for which we reviewed CAFRs; as well as the  ranges of unfunded OPEB liabilities, assets, and funded ratios reported. To  complement our CAFR review, we contacted experts on public retiree  health benefits and reviewed various studies and data sets that looked at  state or local governments’ OPEB liabilities. Appendix I provides a more  detailed methodology for that review and the limitations of our work.
To describe actions taken by state and local governments to address their  retiree health liabilities, we reviewed information about actions taken by  10 selected state and local governments. To select these governments, we  reviewed available literature to determine what was known about the  actions state and local governments have taken to address their retiree  health liabilities. Based on that information, we selected the 10 state and  local governments to obtain geographic diversity and variation in the  approaches used to address retiree health liabilities. Officials from the  selected governments responded to questions about the governments’  OPEB liability, retiree health benefits, and activities to address the retiree  health liability. Additionally, to supplement officials’ responses, we  reviewed relevant information from the selected governments, such as  laws and documents describing retiree health benefits. The information  from our selected governments provides insight about state and local  government actions to address retiree health liabilities, but cannot be  generalized to other states or localities. To supplement our in-depth  reviews of the actions taken by the selected governments, we reviewed the  results of a 50-state survey conducted from December 2007 through March  2008 by North Carolina State University researchers and published in  December 2008 by the Center for State and Local Government Excellence  (SLGE). The survey included questions about states’ retiree health  benefits and their current approaches and plans for addressing their  retiree health liability. To assess the reliability of the survey results, we  reviewed the survey methodology and interviewed the individuals  responsible for fielding the survey and analyzing the results. Based on our  review, we determined that the data were sufficiently reliable to provide  general aggregate information about the responses that were most or least  common across the states related to their actions or plans for managing  their retiree health benefits.
To describe the fiscal pressures facing state and local governments, we  used our model that simulates fiscal outcomes of the state and local sector  in the aggregate for several decades into the future. The model is not  designed to highlight the fiscal position of individual states; rather it  projects the levels of aggregate receipts and expenditures of all state and  local governments in future years based on historical spending and  revenue patterns. Appendix II provides a detailed methodology for the  model as related to projection of receipts and expenditures for the state  and local government sector and projections of health care costs for state  and local retirees. A January 2008 report provided a detailed description of  how we constructed the model. In January 2009 GAO updated  information regarding the fiscal challenges facing the state and local  government sector.
We conducted our work from October 2008 through November 2009 in  accordance with all sections of GAO’s Quality Assurance Framework that  are relevant to our objectives. The framework requires that we plan and  perform the engagement to obtain sufficient and appropriate evidence to  meet our stated objectives and to discuss any limitations in our work. We  believe that the information and data obtained, and the analysis  conducted, provide a reasonable basis for any findings and conclusions in  this report.
subsections: section_title: Background
paragraphs: The costs to state and local governments that offer retiree health benefits  can vary based on several factors. These include the design of the retiree  health benefits that governments provide, the eligibility requirements that  retirees must meet in order to receive those benefits, and the degree to  which governments contribute to the cost of the benefits for their retirees.
subsections: section_title: Funding Retiree Health Benefits
paragraphs: As we have previously reported, most governments have typically funded  their share of the cost of retiree health benefits when they were provided  (i.e., during retirement) as opposed to during active employment. This  practice is commonly referred to as pay-as-you-go.
section_title: Accounting for Retiree Health Benefits
paragraphs: Governments have typically accounted for the cost of their retiree health  benefits on a pay-as-you-go basis, reporting just the amount paid each year  for employees who have already retired. Recently adopted accounting  standards, however, require governments to change the way they account  for the cost of retiree health benefits, specifying that governments should  account for these costs on an accrual basis. Under an accrual basis, the  cost of retiree health benefits is recognized when an individual earns the  benefits, not when the benefits are paid or provided. As such, a  government would periodically estimate and report the value of benefits  that are earned for both past and current employees as a liability in its  financial statements. Specifically, in 2004, the Governmental Accounting  Standards Board (GASB)—an independent, private sector organization  that maintains standards for accounting and financial reporting for state  and local governments—issued Statement 45, Accounting and Financial  Reporting by Employers for Postemployment Benefits Other Than  Pensions, which requires state and local governments to measure,  recognize, and report future obligations for providing OPEB, the largest of  which is generally retiree health benefits. Under Statement 45,  governments should periodically have an actuarial valuation performed,  through which an actuary estimates the amount that will be needed to pay  for future benefits, assuming that the current provision for benefits  remains in effect. More specifically, the actuary estimates the following  values, which governments are to report in their financial statements and  related notes.
The “actuarial accrued liability” or “liability” reflects the value of benefits  that are attributable to employees’ past service, assuming the current  provision of benefits.
The “actuarial value of assets” represents the actuarial value of cash,  investments, and other assets that are set aside to fund OPEB.
The “unfunded actuarial accrued liability” or “unfunded liability” equals  the excess, if any, of the liability over the assets. Thus, unfunded liabilities  indicate the amount of benefits earned for which no assets have been set  aside.
The “funded ratio” is assets expressed as a percentage of the liability. The  funded ratio indicates the extent to which a government has set aside  enough assets to pay its liability. For example, a funded ratio of 80 percent  indicates that there are enough assets to pay for 80 percent of the liability.
The “annual required contribution” (ARC) is an estimate of the amount  that if paid in full each year would be expected to fund currently accruing  costs as well as a portion of any unfunded liability. Although referred to as  a “required” contribution, accounting standards do not establish funding  requirements—governments can choose to pay more or less than this  amount.
Valuations of OPEB liabilities are inherently complex because they involve  estimates of future events that affect the amount and timing of payments.  Such estimates are developed through the application of actuarial cost  methods and assumptions, such as health care cost growth, discount  rates, and worker and retiree mortality. For example, there are six GASB- approved actuarial cost methods and each method has a different  approach to allocating the value of future benefits. Under some cost  methods, governments accrue more liabilities in the early part of  employees’ careers than later. Differences in the actuarial cost methods  and assumptions used can result in significant differences in OPEB  liability estimates, which can make it challenging to compare estimates  across governments.
Implementation of the OPEB reporting standards is being phased in over a  3-year period, with the largest governments—governments with total  annual revenues of $100 million or more—to report their liabilities  generally beginning in their fiscal year 2008 financial statements and apply  other requirements of the standard. State and local governments are  required to follow GASB standards to receive an unqualified, or “clean,”  audit opinion on financial statements prepared in conformity with U.S.  generally accepted accounting principles. Additionally, many state laws  require local governments to follow GASB standards, and bond raters  consider whether GASB standards are followed when assessing the fiscal  health of state and local governments.
section_title: Addressing Retiree Health Liabilities
paragraphs: While governments may continue to fund their retiree health benefits on a  pay-as-you-go basis, one option for addressing their liability is to prefund  some or all of the retiree health benefits before employees retire. By  prefunding, governments can reduce the unfunded liability reported in  their financial statements, take advantage of the compounding effects of  investment returns on plan assets, and provide greater benefit stability for  employees and retirees. To reduce a government’s liability, funds must be  deposited into a trust or equivalent arrangement, as GASB Statement 45  only considers funds in such an arrangement as assets. Several funding  vehicles that can be established as trusts are available under the federal  tax code to help facilitate state and local government efforts to prefund  their retiree health liabilities. (See table 1.) While prefunding is generally  more cost effective for a government in the long term, in the short term it  will require a higher level of government contribution.
Prefunding retiree health benefits has its advantages, but it does not  change actual health care costs. Reducing health care costs by making  benefit changes may be another way for governments to address their  retiree health liabilities. The extent to which benefit changes can reduce  a government’s liability depends on the nature of the changes and whom  the changes affect. For example, reductions in the liability would be  greater if the government were to make benefit reductions effective for all  current and future retirees. In comparison, if changes were only effective  for future retirees, it could be some time before the government would  experience significant savings from the changes.
section_title: Unfunded OPEB Liabilities for State and Local Governments Exceed $530 Billion
paragraphs: We found that the total reported unfunded liabilities for OPEB (which are  primarily retiree health benefits) for state and select local governments  exceed $530 billion. The $530 billion includes about $405 billion for states  and about $129 billion for the 39 local governments we reviewed. We  reported in 2008 that various studies available at that time estimated the  total unfunded OPEB liability for the states and all local governments to  be between $600 billion and $1.6 trillion, although the studies’ estimates  were based on limited government data. It is not surprising that our total  is on the low end of that range because we did not review data for all local  governments, though we did review reported liability data for the largest  local governments and all 50 states. Five-hundred and thirty billion dollars  is still a large unfunded liability for governments. As variation between  studies’ totals shows, totaling unfunded OPEB liabilities across states and  local governments can be challenging. This may be attributable, in part, to  some OPEB data being reported in plans’ separate financial reports that  are not included as part of the government’s CAFR. In addition, over time  valuations of OPEB reflect more up-to-date assumptions, policy decisions,  and data. For example, the variety of actuarial approaches used can result  in variations among the OPEB data reported in the CAFRs, such that two  valuations of the same underlying OPEB can differ.
Reported state and local governments’ unfunded OPEB liabilities   varied widely in size. For example, unfunded state liabilities ranged from  $71 million for Arizona to $62 billion for California, and unfunded local  government OPEB liabilities ranged from $15 million for a county in  Arizona to over $59 billion for New York City. (See app. III for individual  state governments’ and large local governments’ aggregate OPEB  liabilities, assets, unfunded OPEB liabilities.) However, the significance of  each government’s unfunded OPEB liability is relative to its ability to fund  those benefits through currently available assets, future revenues, or a  combination of the two. In addition, reported liabilities may vary based on  various factors, including differing plan benefits, assumptions, and  government contributions.
Most state and local governments for which we reviewed CAFRs have not  set aside assets to fund OPEB liabilities (see fig. 1). Approximately   35 percent of the governments for which we reviewed CAFRs—18 of   50 states and 13 of 39 local governments—reported having set aside at  least some assets for OPEB liabilities for one or more entities in the  government, as of their actuarial valuation. Setting aside assets for OPEB  indicates that a government may have prefunded at least a portion of its  liability associated with retiree health benefits. In total, the state and  local government CAFRs we reviewed reported having set aside at least  $25 billion in assets to fund their OPEB liabilities, constituting less than   5 percent of the $559 billion total OPEB liabilities reported. Thus, most  state and local governments included in our review are paying for their  OPEB liabilities for active and retired workers in a given year from their  current revenues.
The total unfunded OPEB liability for state and local governments is larger  than the roughly $530 billion because we reviewed OPEB data in select  governmentwide CAFRs. Although we reviewed CAFRs for all the states  and focused our review on CAFRs for the 39 largest local governments,  and included some of the largest unfunded liabilities, we did not review  OPEB data for all governments. Thus, a review of all local government  CAFRs would show a higher total unfunded OPEB liability than what we  found. In addition, we reviewed governmentwide CAFRs and not  information for component entities or cost-sharing multiple-employer  plans that is reported in separate financial statements and not in the  CAFRs. For example, in fiscal year 2008, $2 billion in unfunded OPEB  liabilities for one state’s public employees’ retiree health and life insurance  plans was reported in the plans’ own financial statements and not in the  state’s CAFR. Consequently, the $2 billion is not included in our total for  states’ unfunded OPEB liability.
In addition, the ultimate cost of OPEB may significantly differ from  estimated OPEB liabilities because (1) the CAFRs we reviewed report data  that predate the market downturn and (2) significant uncertainties affect  the estimation of OPEB liabilities. We reviewed the most recently issued  CAFRs, as of June 30, 2009, which reported OPEB assets valued and  liabilities based on discount rate assumptions set before the market  downturn. In most cases, the most recently issued CAFR was for fiscal  year 2008. The value of those assets has likely fallen, which means the  total unfunded OPEB liabilities are likely higher in mid-2009 than the total  we found, at least for the minority of entities with at least some assets. In  addition, when market interest rates fall, to the extent that actuaries apply  lower discount rates to OPEB valuations, the value of unfunded OPEB  liabilities will increase—all other factors remaining equal. Uncertainties  affecting the estimation of OPEB liabilities include potential differences  between assumptions used and actual experience, as well as potential and  future changes to eligibility and government contributions. Governments  have some discretion in what assumptions they use. Two significant  assumptions used in OPEB liability calculations are the discount rate and  the health care inflation rate. When governments value their OPEB  liabilities, a decrease in the discount rate or increase in the health care  inflation rate used results in higher unfunded OPEB liabilities, holding  other factors, like the benefit plan and employee population, constant. A  July 2009 study prepared for SLGE reported that one state’s unfunded  OPEB liability increased by almost 20 percent based on a 1 percent  increase in the health care inflation rate assumed. As the July 2009 SLGE  study showed, actuarial valuations for state OPEB assumed discount rates  ranging from 3 percent to 8.5 percent. Our review of 10 states’ most  recently issued CAFRs found that 5 states used discount rates on the high  end of that range. Further, in accordance with GASB guidance, when  governments value OPEB liabilities, governments apply a health care  inflation rate based on expected long-term future trends. According to the  July 2009 SLGE study, virtually all state governments assume their  expected long-term future rate to be about 5 percent, although actual  health care inflation rates from 2002 to 2005 ranged from 16 percent to  10.3 percent, respectively.
section_title: Some State and Local Governments Have Taken Actions to Address Retiree Health Liabilities through Prefunding and Making Benefit Changes
paragraphs: Some state and local governments have taken actions to address their  liabilities associated with retiree health benefits by setting aside assets in  order to prefund the liabilities and reducing these liabilities by changing  the structure of retiree health benefits.
subsections: section_title: Some State and Local Governments Have Taken Steps to Prefund Their Retiree Health Liabilities and Have Done So to Varying Degrees
paragraphs: Prefunding at least a portion of OPEB costs is one action that some state  and local governments have taken to address their retiree health liabilities.  As noted earlier, approximately 35 percent of the 89 governments for  which we reviewed CAFRs reported having set aside some assets for  OPEB liabilities for one or more entities in the government as of the time  of their actuarial valuations. Setting aside assets for OPEB indicates that a  government may have prefunded at least a portion of its liability  associated with retiree health benefits. The CAFRs that we reviewed also  showed that the percentage of the OPEB liability funded—the funded  ratio—varied.
Among the 10 selected governments whose actions we reviewed in more  detail, officials from the governments that were prefunding at least a  portion of their retiree health liability reported using irrevocable trusts. As  noted earlier, under GASB accounting standards, only assets held in a trust  or equivalent arrangement count toward reducing a government’s  unfunded liability. Furthermore, officials from some of these governments  reported using a section 115 governmental trust, which is a trust  established by a governmental employer to fund essential government  functions. Similarly, according to results from a survey of state officials  published in December 2008, more states reported having adopted, or  being likely to adopt, a section 115 governmental trust than a section  401(h) health benefits subaccount or a VEBA, two other funding vehicles  available to state and local governments under the federal tax code.
Some of the officials we spoke with, as well as the literature, indicated  that section 115 trusts are simpler and more flexible than the other options  available to governments. For example, officials from New York City told  us that they chose a section 115 trust because it was simple to establish  and operate, satisfied GASB Statement 45 standards for assets, and is  exempt from taxation. According to officials from some of the selected  governments, the governments’ trusts were administered by the same  board or individuals that administered the governments’ pension fund.  Government officials told us that the pension boards were chosen to  manage the retiree health funds because they had the necessary  experience, expertise, and resources to effectively manage the trusts. For  example, the City of Thousand Oaks chose to invest its assets in a trust  established and administered by the California Public Employees’  Retirement System. The trust, called the California Employers’ Retiree  Benefit Trust, is available to all public employers in the state to prefund  retiree health costs. A city official told us that the city chose to use this  pooled trust because the pension system had a successful track record  investing local governments’ pension funds and because of the trust’s low  administrative costs.
The governments we selected varied with regard to the source of funds  used to prefund their retiree health liabilities. Officials from some of the  governments reported utilizing funds from multiple sources. Among the  selected governments, some officials reported that sources of money for  prefunding retiree health liabilities were contributions from government  employers such as agencies—generally, obtained as a specified percentage  of an employer’s payroll—and general revenue. For example, officials  from the City of Thousand Oaks reported that in fiscal year 2010, city  agencies are contributing 4.15 percent of their payroll to prefund the  government’s retiree health liability. Officials from some governments  reported prefunding at least a portion of their retiree health liabilities by  borrowing money, for example, through the issuance of bonds. However,  results from a survey of state officials published in December 2008  indicated that at the time of the survey few states had reported issuing, or  reported being likely to issue, bonds to finance their OPEB liabilities,  including retiree health benefits.
The governments we selected also varied in how they determine the level  or amount to commit to prefunding their retiree health liabilities each  year. While officials from some of the selected governments indicated that  they rely on formulas or plans to help them determine these prefunding  levels, some officials from the selected governments noted that actual  amounts depend on appropriations. For example, officials from New York  City specified that any funding above the government’s pay-as-you-go  costs—that is, the costs for benefits provided at the given time—is  provided if and when sufficient resources exist, as determined through the  government’s budgetary process. Although often dependent on  appropriations, officials from some of the governments reported that their  levels of prefunding were determined based on the ARC—an estimate of  the amount that if paid in full each year would be expected to fund  currently accruing costs as well as a portion of any unfunded liability. For  example, officials from some of the governments we selected indicated  that their governments have prefunded the full ARC, while officials from  another government indicated that a specified portion of the ARC has been  funded each year. Some of the selected governments do not base the level  of prefunding on the ARC. For example, officials from South Carolina  reported that the amount of prefunding is determined by a combination of  factors, including a formula linked to the health insurance plan’s cash  reserves and any annual appropriation the legislature chooses to make for  retiree health benefits.
Officials from the selected governments reported some challenges with  prefunding their liability. Budgetary or fiscal constraints were the most  commonly reported challenge. Officials from one government indicated  that budgetary constraints led the government to stop prefunding its  retiree health liability, while officials from another government reported  scaling back prefunding efforts. Other government officials explained  that declining revenue, resulting from both tax reforms and the poor  economy, created challenges to prefunding. These same officials also  commented that prefunding was challenging because of increasing health  care costs and changes in the demographics of their workforces, namely  changes to the ratio of retirees to active workers. Other challenges noted  by officials from the governments we selected included the need to  educate stakeholders about prefunding and the need to establish the legal  authority to create irrevocable trusts.
section_title: Some State and Local Governments Have Worked to Address Retiree Health Liabilities through Three Types of Benefit Changes
paragraphs: Another action some state and local governments have taken to address  their retiree health liabilities has been to change the structure of the health  benefits they offer retirees. While governments also make relatively  routine changes to the health benefits they offer retirees (such as changing  co-payments, deductibles, or covered benefits) that could affect their  liability, we identified three key types of changes our selected  governments have made to the structure of retiree health benefits:  changing the type of retiree health benefit plan, changing the level of the  government’s contribution toward retirees’ health insurance premiums,  and changing the eligibility requirements employees need to meet to  qualify for retiree health benefits.
Type of health benefit plan: Officials from some of the governments we  selected indicated that since 2004 their governments changed the type of  health benefit plan for retirees as a way of reducing the liability associated  with these benefits. Specifically, officials reported a shift from a defined  benefit retiree health plan to a defined contribution plan. As the term  implies, a defined benefit plan specifies the amount of benefits to be  provided during retirement. The benefits may be specified in dollars, such  as a flat dollar amount, or as a type or level of coverage, such as a  percentage of health insurance premiums paid. In contrast, defined  contribution plans stipulate only the amounts to be contributed by a  government to an employee’s account each year of active employment.  Defined contribution plans do not specify the amount of benefits  employees will receive upon retirement; rather, the amount of benefits a  retiree receives will depend on the value of that individual’s account. Since  a government’s payment under a defined contribution plan is limited to the  amount it contributes to an individual’s retiree health account, the  government’s cost, and hence its liability, is no longer affected by  increases in health care costs.
Level of government contribution: Some of the governments we  selected have changed the level of the contribution they provide toward  retiree health insurance premiums by reducing the amount or proportion  of health insurance premiums paid for by the government or by changing  how the level of contribution is calculated. For example, according to  government officials, some of the selected governments changed the  calculation of the contribution so that it was no longer affected by changes  in premium costs, thereby shifting the risk of rising health care premiums  onto the retiree. Changes to the level of government contribution were the  most common benefit change reported by the governments we selected.  Additionally, results from a survey of state officials published in December  2008 indicate that many states increased retirees’ premium contributions  in the past 5 years—an indication that the states may have changed the  level of government contribution for those retirees.
Eligibility requirements: Officials from some of the governments we  selected reported changing the requirements that determine eligibility for  retiree health benefits, such as increasing the number of years an  employee must work for the government before being eligible for health  benefits upon retirement. Results from a survey of state officials published  in December 2008 indicate that more states have changed their eligibility  requirements by increasing the years of service required for eligibility for  retiree health benefits than by increasing the age at which employees  become eligible to receive these benefits.
Table 2 provides examples of some of the retiree health benefit changes  made since 2004 by the governments we selected. As seen in table 2, in  some cases the selected governments made more than one change to their  retiree health benefit structures. The changes were most often applied to  newly hired employees or currently active employees. As a consequence,  the selected governments may not realize cost saving associated with  these changes for many years. However, they may see some effect on the  amounts of their projected liability within a shorter period of time.
Some of the governments we selected assessed the effect of their health  benefit changes on the amount of their retiree health liability. Specifically,  according to government officials, Gainesville’s change to its government  contribution reduced the city’s liability by $6 million, or 12 percent.  According to state officials, South Carolina’s retiree health benefit changes  are projected to save the state $3.5 billion over 50 years. Additionally,  officials from Oakland County, Michigan, indicated that the county’s  actuary estimated that the change from a defined benefit to a defined  contribution plan would result in decreases to the county’s ARC beginning  in 2017, as the number of retirees receiving benefits through the defined  benefit health plan decreases.
Officials from the governments we selected reported some challenges in  determining and implementing changes to their retiree health benefits. The  most commonly reported challenge was reaching agreement with the  various parties involved in the decision-making process, most notably the  collective bargaining units representing affected personnel. For example,  officials from one government indicated that the government was  currently in arbitration with a collective bargaining unit over its health  benefit changes, while officials from another government indicated that an  unfair labor practice claim had been filed against the government as a  result of its benefit changes. Officials from a third government noted that  given the fiscal environment, it was difficult to make cuts to retiree health  benefits since the government was already negotiating other compensation  changes with collective bargaining units, such as eliminating pay raises for  active employees. Finally, officials from one government noted that the  state’s constitution would prohibit the state from reducing the retiree  health benefits for existing employees or retirees, thereby limiting the  state’s ability to change retiree health benefits for anyone except newly  hired employees.
section_title: Health-Related Spending, Including OPEB Liabilities, Is Increasing State and Local Governments’ Fiscal Pressures
paragraphs: Unfunded OPEB liabilities on their own are large enough to represent a  fiscal pressure for state and local governments but are also likely to be  considered part of the broader fiscal challenge of managing increasing  health care costs. State and local governments faced increasing fiscal  pressures in 2008, in part because of recession-induced revenue   shortfalls. Since the start of the recession in the fourth quarter of 2007 to  the same quarter in 2008, state and local government revenues declined by  3 percent, after adjusting for inflation. During the same period, spending in  the state and local government sector increased by about 1 percent, also  adjusted for inflation.
Our model of state and local government revenues and spending projects  that state and local governments’ fiscal pressures will increase in the  future and will largely be driven by increases in health care spending. We  constructed a model of aggregate spending and revenues for all state and  local governments in the United States in order to provide a general  picture of fiscal pressures facing many state and local governments in the  future. Our model reflects the fiscal implications assuming current  policies remain unchanged. The model’s results are not a prediction of  future decisions on government policies; in the face of growing fiscal  pressure, changes in policies are likely. According to this model, over an  extended period of time the difference between the growth of spending  and revenues could compound to a large overall operating budget  imbalance. As our simulation suggests (see fig. 2), under current policies  the operating budget balance for these governments as a whole could  deteriorate steadily, from surpluses in 2006 to a deficit of 4.7 percent of  rcent of  gross domestic product (GDP) by 2050.  gross domestic product (GDP) by 2050.
Health-related spending represents the fastest growing component  common in government budgets at all levels in the United States. For  state and local governments, the largest spending item for this category is  Medicaid. Although retiree health benefits require a much smaller share of  total spending than Medicaid, health benefits for state and local  government retirees also have projected rapid cost growth. In 2007, at  $324 billion, Medicaid expenditures represented 17 percent of total state  and local government spending. State and local government spending on  health benefits for nearly 3 million retirees was $15.8 billion in 2008. As  shown in figure 3, our model indicates that future spending for purposes  other than health care will fall as a percentage of GDP, but health-related  spending will more than make up for the decline.
The increased share of operating revenues consumed by state and local  governments’ spending on retiree health benefits projected under current  policies indicates the fiscal pressure associated with those benefits.  According to our model, by 2050 the number of state and local government  retirees is likely to grow by about 70 percent from the current level of   3 million to 5.1 million retirees. This implies that the number of retirees  grows at an average annual rate of about 1.3 percent. However, the cost of  retiree health benefits is projected to grow more quickly, at an annual rate  of 6.7 percent over that same period. According to our model, this means  that current spending of $15.8 billion on retiree health benefits will grow  to $237.3 billion by 2050, in current dollars. As a share of total state and   local government operating revenues, the projected spending for state and  local government retirees’ health benefits might not be viewed with great  concern. However, spending on state and local government retirees’ health  benefits is projected to more than double as a share of total operating  revenues by 2050, from 0.9 percent to 2.1 percent. State budget officials  have told us that they face challenges financing future health benefits in  general, including Medicaid benefits and health benefits for active  government employees, not just for their retirees. The rapid increase  projected for retiree health liabilities is just one effect of the escalating  health care costs under ongoing debate by policymakers and others.  Future possible changes in policies could cause actual budget outcomes to  diverge from what our model projects. Such changes could include  reductions in health care benefits, reductions in the number of retirees  receiving benefits, increases in state and local taxes, or a combination of  these.
section_title: External Comments
paragraphs: We provided a draft of this report to GASB and the National Association of  State Auditors, Comptrollers and Treasurers, which provided technical  comments that we incorporated as appropriate.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies of this report to interested  parties. In addition, the report also is available at no charge on the GAO  Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  John E. Dicken at (202) 512-7114 or dickenj@gao.gov or Barbara D.  Bovbjerg at (202) 512-7215 or bovbjergb@gao.gov. Contact points for our   Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. GAO staff who made major contributions to this  report are listed in appendix V.
section_title: Appendix I: Supplemental Scope and Methodology for State and Local Government CAFR Review
paragraphs: To describe what is reported about state and local governments’ unfunded  other postemployment benefits (OPEB) liabilities, we reviewed the most  recent governmentwide comprehensive annual financial reports (CAFR),  as of June 30, 2009, for the states and selected local governments. We  contacted representatives from individual state and local governments to  discuss the reporting of OPEB data in the CAFRs, as necessary.  Specifically, we reviewed the fiscal year 2008 CAFRs for 48 states and the  fiscal year 2007 CAFRs for 2 states that had not released their fiscal year  2008 CAFRs by June 30, 2009. We also reviewed the most recent CAFRs  for the 39 largest local governments (i.e., cities and counties with total  revenue of $2 billion or more, according to U.S. Census Bureau data). Of  those, we reviewed fiscal year 2008 CAFRs for 34 local governments and  fiscal year 2007 CAFRs for the 5 that had not released their fiscal year 2008  CAFRs by June 30, 2009. We based our selection of local governments on  the most recent U.S. Census Bureau data from the 2002 Census of  Governments, “Finances of County Governments” and “Finances of  Municipal and Township Governments,” which includes local governments  with populations of at least 25,000. The 39 local governments for which  we reviewed CAFRs are listed in appendix III, table 4.
We determined that the state and local government CAFR data were  sufficiently reliable for our purposes, which were to describe the total  unfunded OPEB liability reported; the total OPEB liability, assets, and  unfunded liability for each of the individual governments for which we  reviewed CAFRs; as well as the ranges of unfunded OPEB liabilities,  assets, and funded ratios reported. Although we reviewed the most recent  CAFRs, typically fiscal year 2008 CAFRs, the body of OPEB data on which  we report reflects many different actuarial valuation dates. Because the  universe of local governments is estimated at about 88,000 governments,  we limited our review of local government CAFRs to those for the 39  largest local governments, as described above, thus leaving out of our  review the majority of local government CAFRs. We did not analyze the  CAFR data governments reported or review the reasonableness of the  actuarial assumptions used to estimate the OPEB and related unfunded  liabilities. To complement our CAFR review, we contacted experts on  state and local government retiree health benefits, such as national  organizations, including the National Governors Association, the  Association of Local Government Auditors, the National Conference of  State Legislators, the National Association of Counties, and the  Government Finance Officers Association. Other organizations we  contacted include the State and Local Government Benefits Association,  the National Conference of Public Employees Retirement Systems, and  Standard and Poor’s. We also reviewed actuarial literature and different  studies and data sets related to the unfunded OPEB liabilities across states  and local governments. Those sources include Workplace Economics,  State Government Retiree Health Benefits: Current Status and Potential  Impact of New Accounting Standards, 2004; Cato Institute, Unfunded  State and Local Health Costs: $1.4 Trillion, 2006; Standard and Poor’s,  U.S. State and Quantifying OPEB Liabilities and Developing Funding  Strategies as the GASB Deadline Nears, 2007; National Association of  State Comptrollers, Annual OPEB Survey, 2006, 2007, and 2008; PEW  Center on the States, Promises with a Price: Public Sector Retirement  Benefits, 2007; Credit Suisse, You Dropped a Bomb on Me, GASB, 2007;  the Center for State and Local Government Excellence, At a Crossroads:  The Financing and Future of Health Benefits for State and Local  Government Retirees, 2009; and Robert Clark and Melinda Sandler Morrill,  Health Plans for Retired State Employees: Is There a Funding Crisis?  2009.
section_title: Appendix II: Supplemental Scope and Methodology for Description of State and Local Governments’ Fiscal Pressures
paragraphs: To describe the fiscal pressures facing state and local governments, we  used our model that simulates fiscal outcomes of the state and local sector  in the aggregate for several decades into the future. The model is not  designed to project the fiscal position of individual states; rather, it  simulates the potential level of aggregate receipts and expenditures of the  state and local sector in future years based on current and historical  spending and revenue patterns. A January 2008 report provided a detailed  description of how we constructed the model, and sections of that  methodology directly relevant to data in this report are provided below.
As an organizing framework and basic data source, our state and local  government model relies on the National Income and Product Accounts  (NIPA), prepared by the Department of Commerce’s Bureau of Economic  Analysis. We project the growth in each category of receipts and  expenditures using the Congressional Budget Office’s economic  assumptions whenever possible. In several cases, we were not able to  obtain existing projections and needed to develop our own assumptions  about the likely future growth path of certain receipts or expenditures. We  also developed detailed models to project items such as necessary pension  fund contributions, the costs of health insurance for employees and  retirees, and several tax receipt categories. Our base-case model assumes  current policies remain in place. Below, we describe how that basic  assumption is realized. Once all receipts and expenditures of the sector  are simulated forward through 2050, we develop summary indicators of  the state and local government sector’s fiscal status. Because the model  covers the state and local government sector in the aggregate, the fiscal  outcome of individual states and localities cannot be captured. Also, the  model does not identify whether it is the states or the local governments  that face greater fiscal challenges. The following describes (1) the receipts  and expenditures for the state and local government sector; (2) the  measure of fiscal imbalance; (3) how we developed factors for  employment, retirement, and benefits; and (4) how we projected the costs  of health care.
subsections: section_title: Projection of Receipts and Expenditures of the State and Local Government Sector
paragraphs: The model provides projections for each type of receipt of state and local  governments. The Bureau of Economic Analysis assembles the NIPA  based on data from the quinquennial Census of Governments, annual  surveys of government finances, and other sources. In the NIPA, receipts  are divided into five major categories: tax receipts, contributions for  government social insurance, income receipts on assets, transfer receipts,  and the current surplus of government enterprises. Figure 4 shows these  categories as well as the breakdown of receipts within each of these  classifications.
In the NIPA, expenditures are divided into five categories, some much  larger than others. Figure 5 shows the five categories. Consumption  expenditures, the largest category, include such items as the  compensation of state and local government employees. Transfer  payments include Medicaid payments. Smaller classifications are interest  paid on the outstanding debt of these governments, subsidies, and  expenditures for investments in fixed capital and nonproduced assets.
section_title: Measures of Fiscal Balance
paragraphs: In this report, we use the operating budget balance (operating balance) as  a measure of fiscal balance. Operating balance is a GAO-developed  measure that we call the operating balance excluding funds for capital  expenditures. This measure is designed to be roughly akin to the operating  budgets of subnational governments—budgets that these governments are  generally required to balance or nearly balance. We develop a measure of  receipts not available to finance current spending as the difference  between investment spending and the change in medium- and long-term  debt. Subtracting this amount from total receipts leaves the estimated  receipts that are available to finance current expenditures. The  expenditure component of the balance measure excludes both investment  spending and depreciation. Our operating balance measure includes two  further adjustments to NIPA-based totals. First, we exclude the current  surplus/deficit of government enterprises from receipts because state and  local government operating budgets exclude government enterprises. This  adjustment has no effect on our base-case simulations because we assume  the balance is equal to zero, but its incorporation accommodates p alternative assumptions about the current balance of government  enterprises. We also exclude a category of funds that we call the ne balance of social insurance funds. As noted earlier, state and local  employees as well as employers make contributions to social insu funds to pay for such items as temporary disability and workers’  compensation insurance. Payments from these funds are embedded transfer payments that governments pay to workers when they are  disabled or otherwise entitled to payments from these insurance funds. In  our simulations, the balance is assumed to grow with total wage and salary  disbursements. While governments hold b alances in these funds, the funds  are not available for operating expenses.
section_title: Development of Facto for Employment and Beneficiary Levels
paragraphs: Key underlying information for the health care expenditure simulations  relate to future levels of employment, retirees, and wages. In particular, to estimate the expenditure for the postretirement promises the sector h and will continue to make as well as expenditures for health care for active employees, we need to project the number of employees and  retirees in each future year. The cost of health care is discussed later this appendix. We project the number of state and local government  employees and the number of beneficiaries for each year during the  simulation time frame. To project the level of employment in each future year, we assume that state and local employment grows at the same rate as total population under the intermediate assumptions of the Board of  Trustees of the Old-Age and Survivors Insurance and Disability In Trust Funds—that is, we assume that the ratio of state and local  employment to total population remains constant. The Trustees assume  that population growth gradually declines from 0.8 percent during decade to a steady rate of 0.3 percent per year beginning in 2044.  Accordingly, state and local government employment growth displays the  same pattern in our projections. To project the number of benefi we assumed that future growth in the number of state and local  government retirees—many of whom will be entitled to pension and  ciaries,  health care benefits—is largely driven by the size of the workforce in  earlier years. While actuaries use detailed information and assumptions  regarding the age, earnings, service records, and mortality rate applicable  to the entities they evaluate, information in such detail is not available f or  the state and local government sector as a whole. This lack of detailed  data necessitated the development of a method of projecting aggregate  state and local beneficia that actuaries employ.  ry growth that is much simpler than the methods  The method we developed reflects the logic that each year’s growt number of beneficiaries is linked to past growth in the number of  employees. Total state and local government employment from 1929  through 2005 was obtained from NIPA tables 6.4a, b, c, and d. The U.S.  ension  Census Bureau provided data on the number of state and local p beneficiaries from 1992 through 2005, during which continuous  observations were available. Cyclical swings in the employment series  were removed using a Hodrick-Prescott filter. Then both the employment  and beneficiary series were logged and first-differenced, transforming th data from levels to proportionate changes. We developed a routine that  searched across 45 years of lagged employment growth to select a set of  weights for the years in which past employment growth best explained a  given year’s growth in beneficiaries. The routine includ that the weights must be nonnegative and sum to one.
section_title: Projections of Health Care Costs for State and Local Employees and Retirees
paragraphs: Most state and local governments pay for employee and retiree health  insurance on a pay-as-you-go basis—that is, these benefits are generally  not prefunded. We made projections of the pay-as-you-go expenditures for  health care for the sector, as a percentage of wages, in each year until  2050. To estimate expenditures for employee and retiree health insurance  in future years, we used the methods described above to develop  projections of employment in the sector and the number of retirees. An  additional assumption for the health care analysis is that in future years,  the same percentage of employees and retirees of state and local  governments will be enrolled in health insurance through their previous  employers as we observe were enrolled in 2004—the most recent year for  which data were available. For retirees, we developed this measure from  two data sources. The U.S. Census Bureau’s State and Local Government  Employee-Retirement System survey provided data on the total number of  state and local retirees, and the Department of Health and Human  Services’ Medical Expenditure Panel Survey provided data on state and  local government retirees who are covered by employer-provided health  insurance. Through these data sources we found that the share of retirees  with health insurance is 44 percent, and we hold this constant through the  simulations. From the latter data source we also obtained the most recent  year state and local government spending data on health care for retirees.  For active employees we also used the Medical Expenditure Panel Survey  data on employees covered by health insurance and compared them to the  Bureau of Economic Analysis data on the total employment in the sector.  This provided us with a finding that 71 percent of active employees are  receiving health benefits. Again, we hold this value constant during the  simulation time frame.
One of the most central assumptions we must make to estimate the pay-as- you-go health care expenditures for employees and retirees in future years  is the cost growth of health care itself. The cost of health care has been  increasing faster than gross domestic product (GDP) for many years. As  such, we developed assumptions about how much faster health care costs  would grow, relative to the economy, in future years. We developed these  assumptions based on our own research and discussions with experts. In  particular, we assume that the excess cost factor averages 1.4 percentage  points per year through 2035, and then begins to decline, reaching   0.6 percentage points by 2050.
Using these assumptions, we developed projections for the expenditures  on health care for employees and retirees each year through 2050. We  found that the projected expenditures for retiree health insurance, while  not a large component of state budgets, will more than double as a  percentage of wages over the next several decades. In 2006, these  expenditures amounted to approximately 2.1 percent of wages, and by  2050 we project that they will grow to nearly 5.1 percent of wages—a   150 percent increase. Our estimates of these expenditures are highly  sensitive to certain of our assumptions. In particular, the assumptions  regarding health care cost growth are critical. For example, if health costs  were to only rise at the rate of GDP per capita, expenditures for retiree  health care would only grow, as a percentage of wages, from 2.1 percent  today to 3.0 percent by 2050. Conversely, if health costs were to grow by  twice the rate we assume in the base case, these costs would constitute   8.7 percent of wages by 2050.
The percentage of an active employee’s wage expended on health care  amounted to 12.8 percent of wages in 2006 and by the end of the  simulations in 2050 is expected to be 22.2 percent of wages. In the case of  the optimistic scenario—with lower escalation in the cost of health care— we found that expenditures on employee health care will only rise slightly  to 13 percent of wages by 2050. However, under the pessimistic scenario  characterized by more rapidly growing health costs, expenditures on  health care for active employees rise to 37.7 percent of wages in 2050.
section_title: Appendix III: Aggregate Other Postemployment Benefits Liability Data for States and Local Governments We Reviewed
paragraphs: The data for OPEB (which are primarily retiree health benefits) presented  in tables 3 and 4 are those reported in the most recently issued  governmentwide CAFRs, as of June 30, 2009, for the 50 states and the 39  largest local governments. As described more fully in appendix I, in most  cases the most recently issued CAFR was for fiscal year 2008. We  reviewed only the governmentwide CAFRs and did not review separate  financial reports for component entities or cost-sharing multiple-employer  plans that do not report their OPEB data in the CAFR. Also, data below  reflect the data reported by the governments in their CAFRs and not GAO  analysis of financial reports.
section_title: Appendix IV: State and Local Governments’ CAFR Internet Addresses
paragraphs: In conducting our review of the most recent CAFRs for the states and 39  local governments, we obtained the reports from the government’s public  Web sites, as shown, with hyperlinks in table 5. As of August 2009 the  Internet addresses were current. However, as Internet sites change the  Internet addresses may also change.
section_title: Appendix V: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Tamara Cross, Assistant  Director; Kristi Peterson, Assistant Director; Joseph Applebaum; George  Bogart; Robert Dacey; Krister Friday; Kenrick Isaac; Angela Jacobs; Sarah  Prendergast; Michelle Rosenberg; Max Sawicky; and Jacqueline Stewart  made key contributions to this report.