Health care retirement debt surpasses state and local government pension debt

In addition to traditional salaried pensions, many government employers also commit to providing supplementary retirement benefits, such as health care, life insurance, or deferred compensation (lump payments) to their employees upon retirement. These are known as other post-employment benefits (OPEB).  

Unfunded retirement health care obligations for public employees now exceed unfunded pension liabilities, representing a larger share of the long-term fiscal debt held by U.S. states and municipalities. In 2022, the most recent year available with full data, net OPEB liabilities for the largest governments reached $789 billion, surpassing $753 billion in unfunded pension liabilities. This marks a critical shift in the debt composition of American states and local governments

Although total OPEB obligations tend to be much smaller in dollar terms than traditional pension obligations, they now represent a larger share of municipal debt. This is because, while governments generally have lower OPEB liabilities than pension liabilities, they often fail to fund OPEB funds as thoroughly as pensions, leading to a greater degree of underfunding for health care benefits.  

Like pensions, it is safer and more cost-efficient to set money aside in advance to pay out these OPEB obligations. By pre-funding these benefits, governments can invest the funds over time, allowing those investments to grow and generate returns, which reduces the overall cost of providing the promised benefits. However, many governments have not adhered to this approach, preferring a pay-as-you-go (PAYGO) funding approach resembling Medicare—using the OPEB contributions of current employees to pay for the health care benefits of retired employees.  

Another reason for the gap between unfunded OPEB and pension debt is that OPEB liabilities are discounted more conservatively, resulting in a higher present value. The lower discount rate for OPEB liabilities is driven by its significant differences in funding policies, as required by Governmental Accounting Standards Board (GASB) guidelines.

Summed together, unfunded public employee pensions plus the health care benefits of America’s largest state and local governments totaled $1.5 trillion, equivalent to around 5% of the national federal debt or 6% of the U.S. gross domestic product in 2022. 

Fiscal year 2022 is the latest year for which financial records are available for all U.S. state governments and the largest municipal governments at the time of writing. This analysis is based on data from Reason Foundation’s Debt Trends for State and Local Governments project, which compiled financial reports from every U.S. state and the 100 most populous cities, counties, and school districts into an interactive dashboard.

Public employee healthcare funding functions more like Social Security  

While pay-as-you-go (PAYGO) financing of retiree health care benefits reduces immediate costs, it significantly increases long-term costs by forgoing the investment gains that pre-funding would have provided. In fact, the National Association of State Retirement Administrators found over the past 30 years, 63% of public pension revenue came from investment income.  

Public officials might opt not to pre-fund OPEB liabilities because these obligations are generally less protected by law than pensions. Unlike pensions, in the event of a fiscal crisis, governments may potentially default on these healthcare retirement promises. 

Though not as constitutionally protected, state and local government OPEB obligations can be even more volatile than pension obligations, as they expose municipalities to uncertain and rising health care costs—especially as geriatric health care resources become more in demand with the aging of the U.S. population. 

OPEB debt remains stable as pension debt falls 

Overall, unfunded pension obligations in 2022 are lower than they were in 2020, with unfunded OPEB falling about 3.6% from 2020 to 2022 and unfunded pension obligations (NPL) falling by 27% in the same period. This trend, observable in Figure 1, has led to NPL, in total, dropping below unfunded OPEB obligations.  

There are several possible explanations for the 27% reduction in pension debt from 2020 to 2022. Favorable markets have led to outstanding investment returns and growth in public pension assets during this period. At the same time, governments have also dedicated larger supplemental contributions to paying down unfunded public employee obligations.  

During the COVID-19 epidemic, many states and local governments used federal pandemic aid to amortize their pension debt, bypassing explicit (yet, in practice, soft) restrictions in the federal law prohibiting them from doing so. Evidence indicates there was a modest increase in state and local pension contributions relative to the recommended actuarial amounts.  

Not all the change can be attributed to contribution increases. The year 2021 saw record investment return outcomes for public pensions. According to the Reason Foundation Annual Pension Report, the average rate of return in 2021 was 25.3%. Some of the 27% decrease in unfunded pension liabilities that made OPEB surpass NPL from 2020 to 2022 should be attributed to this unusual market appreciation, which is expected to reverse in the next market downturn as returns converge to historical averages.  

A changing municipal debt landscape 

The trend of unfunded post-retirement health care benefits now surpassing unfunded pension benefits is seen across many levels of state and local governments.  

This notable shift in the makeup of state and local government liabilities draws attention to a fiscal challenge that has been developing for the past two decades. The longer governments delay addressing unfunded public employee retirement health care obligations, the more expensive they become.

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Source: https://reason.org/commentary/opeb-debt-surpasses-state-local-pension-debt/