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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.

Summary: 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. 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.