Stop! Why States and Localities Should Stop Providing Retiree Healthcare

A Citigroup report released this month was only the latest evidence that developed countries have promised far more in pension benefits than they can pay. These dire forecasts are worsened by a parallel, but often overlooked challenge: retiree health care burdens on American states and cities.

Often referred to as “OPEB” (other post-employment benefits), this expensive commitment is being gradually phased out among private corporations, yet persists in the public sector. While only 16 percent of private sector workers can access pre-Medicare health coverage,  that number jumps to 66 percent for local government workers and 86 percent for state government workers.  Yet the private sector isn’t struggling to hire and hold competent employees.

Instead of “prefunding” OPEB, as many have recommended, states and cities need to focus on scaling down, and ultimately eliminating this unnecessary and unaffordable benefit.

Seventy-one percent of the 19 million state and local employees in the United States qualify for some form of retiree healthcare. Government workers are allowed to stay on their health insurance if they retire before Medicare, and frequently have their premiums subsidized. States and cities then often provide supplemental subsidies and benefits beyond Medicare eligibility. Federal Reserve researchers estimate that, nationwide, state and local OPEB promises are underfunded by $1.1 trillion.

Massive OPEB debt burdens are threatening governments’ bond ratings, and their costs are “crowding out” other, more pressing priorities. The more that states and cities spend on retiree healthcare, the less remains for infrastructure, education, health and safety.

OPEB costs are also driving up taxes, creating governments that cost more but do less. In 2014, voters in Newton, Massachusetts approved a property tax increase of $8.4 million—nearly all of which, $8.1 million, was used to pay OPEB costs. That year $750 dollars (or 8 percent) of each Newton household’s property tax bill was spent to cover OPEB costs.

Escalating OPEB costs are due to a number of demographic trends, such as the number of public employees who are now retiring, longer life expectancy, and rising health-care costs generally.

The political power of government workers’ unions is also associated with rising costs. States with unionization rates above the national average (28.5 percent for state and local government combined) have mean per capita liabilities of $2,495, while those below that threshold have an average liability of $745 for state workers. Strong union states thus have nearly three times larger per capita OPEB liabilities. Just six states (California, Connecticut, Illinois, New Jersey, New York, and Texas) accounted for 56 percent of all state governments’ OPEB liabilities in 2014.

But politicians are at least as responsible as unions. The back-loaded nature of government compensation packages make it extremely attractive for mayors, governors, and legislators to keep retirement benefits rich. The bill won’t come due until they’re long out of office.   Many have advocated a “prefunding” solution to OPEB, a financing approach similar to what exists for pensions. Benefits would be paid out of a dedicated trust funded by employer and employee contributions and investment returns.

Though it may seem wise at first glance, prefunding is a mistake. By affirming governments’ commitment to OPEB, it risks strengthening legal protections for the benefit, which, as noted by legal professor Amy Monahan, tend to be weaker than for pensions. Stronger legal protections mean less flexibility for future policymakers to adjust retiree healthcare. 

Furthermore, decades of experience with public pensions shows that too many governments are simply incapable of responsibly managing long-term retirement benefit commitments. Excessively high investment return assumptions, coupled with stock market turbulence, have increased budget volatility. Even though last year was a decent year for the U.S. economy in general, pension costs continue to rise more rapidly than revenues because funds failed to meet their unrealistic benchmarks. 

Instead of pre-funding, states and localities should start planning their OPEB exit strategies. The result will be stronger bond ratings, stabilized budgets, lower taxes, and better-funded public services.

Daniel DiSalvo is a senior fellow at the Manhattan Institute and an associate professor of political science at the City College of New York–CUNY. Stephen Eide is a Senior Fellow at the Manhattan Institute. They are authors of the recent report “The OPEB Off-Ramp: How to Phase Out State and Local Governments’ Retiree Health Care Costs”