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The Little-Known Reform That Could Improve States’ Fiscal Health

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The Little-Known Reform That Could Improve States’ Fiscal Health

October 3, 2019

Many states across the nation are struggling with long-term financial liabilities. But not all liabilities are the same. Some are riskier than others. While we all intuitively know this, the way that the liabilities of state and local governments are reported often disguises and understates (or overstates) risks and costs.

Presenting policymakers and the public with the range of potential outcomes could avert some fiscal crises. Between 2003 and 2007, for example, the Chicago Public School system issued $1 billion in adjustable-rate bonds with interest rate swaps. The adjustable rate bonds were presented as a way of saving $90 million in interest costs relative to traditional, fixed-income bonds.

But, unbeknownst to the average taxpayer, that was a best-case scenario. An analysis by the Chicago Tribune estimated that the adjustable rate increased the interest cost for the city by more than $100 million.

Had the choice to issue the bonds been presented as an array of possible outcomes, ranging from saving $100 million to losing $100 million (relative to a more traditional bond), the Chicago Public School system might have issued fewer adjustable rate bonds with interest rate-swaps.

A similarly risky and difficult-to-estimate liability is OPEB (other post-employment benefits), which includes health care for public-sector retirees. In a recent Manhattan Institute report, I outline reforms that would help reduce the risk -- and ultimately the cost -- of OPEB liabilities for state and local governments across the country. The first, and most ideal reform, would be to follow the private sector (and states like South Dakota and Kansas) and eliminate OPEB subsidies altogether.

In cases where governments have eliminated OPEB subsidies, they often allow retirees to purchase the state-sponsored health-insurance plans, meaning that retired employees pay the employer and employee share of the plan premium. Another option is for public-sector unions to establish Retiree Medical Trusts (RMTs). RMTs are retirement health benefits that would be provided by unions and supported by employee and employer contributions. These trusts would provide a solution that would protect workers from politically motivated underfunding of retirement benefits and protect the public from large, unfunded liabilities.

There are, of course, barriers to eliminating OPEB subsidies. For example, workers who have intensive physical requirements may benefit from the incentive to retire earlier. Furthermore, retirement benefit reform usually faces intense political and ideological opposition. In places where a subsidy and its associated liability are maintained, they should at least be simplified.

There are several ways this could be accomplished. First, OPEB plans provided by governments could have a cutoff at age 65, when retirees are eligible for Medicare. In fact, many plans already do this. Second, the benefit could be shifted to a fixed sum, indexed to inflation, and given to retirees directly to purchase health insurance. In 2016, the New Jersey Pension Commission proposed this method of providing retiree health care, via “retirement reimbursement accounts.” Lastly, when managed correctly, establishing an OPEB trust can reduce total costs and provide a way of smoothing shocks, such as recessions.

For example, an explicit OPEB premium subsidy, indexed to inflation, balanced with an early retirement pension penalty, can reduce the barrier to early retirement while lowering the state’s net retirement benefit liability if the actuarial value of the pension penalty exceeds the explicit subsidy. This would allow employees to retire early without facing high health insurance costs and do so without accruing large, unfunded liabilities that can crowd out public services.

OPEB plans are diverse in their scope, generosity, and risks. Ideally, governments would move away from these defined benefit plans and their long-term liabilities in favor of benefits where the cost is experienced in the present, such as increased salaries or defined contribution retirement plans.

In addition to empowering employees to make their own decisions about their retirements, such reforms would remove the ability of governments to underfund employee retirement benefits or, worse, to raid them during economic downturns.

Thurston Powers currently works as a data analyst for the Mercatus Center at George Mason University and is the author of the recent Manhattan Institute report, “Post-Employment Benefits in New York, New Jersey, and Connecticut: The Case for Reform.”

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