Unfunded State and Local Government Health Costs Reach $1.4 Trillion

State and local government retiree health benefits are underfunded by $1.4 trillion nationwide, according to our review of data for 27 jurisdictions. This underfunding comes on top of state and local government bond debt that has soared to $1.9 trillion, and state and local pension plans that are underfunded by about $700 billion.

All of these liabilities represent a looming threat to taxpayers and indicate the need for major reform of government benefit plans and other spending activities.

State and local governments put aside assets to pre-fund their pension plans, and thus the level of underfunding can be eased if plan assets rise in value. By contrast, retiree health benefits provided by state and local governments are generally not pre-funded. Instead, they are funded on a pay-as-you-go basis.

18% Annual Hikes in New Jersey

The cost of those benefits will soar in coming years as large numbers of state and local workers retire.

The state of New Jersey, for example, recently estimated that spending on its employee health plan will grow at 18 percent annually over the next four years. The plan has built up $20 billion in unfunded obligations for retiree health benefits.

In the past, few governments disclosed information about their unfunded health costs. But concern about the potential size of that liability prompted the Government Accounting Standards Board to create new rules for all state and local governments to follow when reporting on the finances of their health plans and other post-employment benefits (OPEB).

To comply with those rules, many jurisdictions are examining their unfunded health costs, but there has been no accurate data available on total costs nationwide.

$135,313 for Each Employee

Some jurisdictions have made public their estimates of unfunded retiree health costs, which are projections of future costs measured on a present value basis. The accompanying table summarizes data we found for 16 states and 11 local governments. For each jurisdiction, we calculated the unfunded health costs per active employee in the related health plan.

The average of unfunded health costs for the sampled governments was $135,313 per employee.

We used this average to make a national estimate of unfunded state and local retiree health costs. If the average of $135,313 per worker is representative of the total state and local workforce that receives retiree health benefits, it indicates a total unfunded cost of $1.4 trillion.

There are 15.9 million state and local workers in the United States. About 10.3 million, or 65 percent, are covered by employer health plans during retirement.

Fiscal Binds

The large funding gaps in retiree health and pension plans are putting state and local governments in a fiscal bind.

If governments adopt no reforms, worker retirement costs will create a rapidly increasing drain on state and local budgets. That, in turn, would put pressure on governments to raise taxes–a losing strategy in today’s competitive global economy.

Another option is for states to issue bonds to convert some of their unfunded obligations into explicit debt. Many states have issued debt to partly cover future pension costs, and some are planning to do so for unfunded health costs.

That increases transparency, but it does not cut overall liabilities, and it limits the flexibility to cut excessive benefits going forward.

Savings Systems, Benefit Cuts

A better option is to convert traditional pension and retiree health plans into individual savings-based systems so that workers pre-fund their own retirements.

Two states, Alaska and Michigan, have moved to savings-based (known as defined-contribution) pension plans for new employees.

For pension plans, there are often legal hurdles to surmount before benefits can be cut. But most governments have substantial flexibility in cutting health benefits for workers and retirees.

State and local governments typically have much more generous health benefit plans than those in the private sector. Federal data show the average cost of health benefits provided to state and local workers is $3.91 per hour worked, which compares to an average of just $1.72 in the U.S. private sector. While 65 percent of governments provide health benefits to retirees, only about one-quarter of large private businesses do.

Chris Edwards ([email protected]) is director of tax policy studies at the Cato Institute. Jagadeesh Gokhale ([email protected]) is a senior fellow at the Cato Institute. A version of this article appeared in the October 2006 issue of Cato’s Tax & Budget Bulletin, available online at http://www.cato.org/pubs/tbb/tbb_0925-40.pdf.