Editor’s Note: Apart from pensions, the most financially significant “OPEB,” or “other post employment benefit,” typically awarded a government employee is retirement health care. This benefit is designed to fill the health coverage gap during the years between when someone retires and when they become eligible for Medicare, and in many cases, they are also designed to supplement the standard Medicare benefit.
To the extent the employer (taxpayers) fund retirement health care benefits, it is necessary to apply the present value of these future benefits to a beneficiary’s working years as part of the calculation of their total compensation. Because typically retirement health benefits are for insurer funded medical services, and because heath care premiums fluctuate unpredictably, it is difficult to project how much these benefits will cost. And in any case, retirement health care benefits are rarely pre-funded. Instead, government agencies pay health benefits for their retirees out of current budgets, and as the benefits increase and as number of retirees increases, this expense becomes more and more significant.
While retirement health care obligations have not gotten the same attention in the press or among policymakers as retirement pensions, that is changing. And while the scale of these financial obligations do not rival pensions, in California, in aggregate, they are nonetheless measured in hundreds of billions – with hardly any of them pre-funded. Put another way, since nearly 100% of retirement health benefit obligations are not prefunded at all, the size of this liability is comparable to the size of the unfunded pension liability.
To provide an in-depth primer on this complex yet urgent topic of how we may fund retiree health benefits for our public employees, Manhattan Institute senior fellow Stephen D. Eide has just released a study entitled “Reform Before Revenue – Fixing California’s Retiree Health Care Problem.” Eide has agreed to allow UnionWatch to republish two key sections of that report here.
THE ROLE OF OPEB IN LOCAL FISCAL DISTRESS IN CALIFORNIA
California state government has been in a sustained fiscal crisis for almost five years. In every year since 2008, the state government has faced budget deficits ranging from $10 billion to $30 billion.  Expressed as a percentage of the total general fund budget, California’s budget deficits have ranked among the largest of all state governments in both of the last two years.  All three credit ratings agencies have downgraded the state’s bond rating by at least two notches since 2008.  California now has the lowest bond rating out of all 50 states.  A late-August survey of states’ borrowing costs by Barron’s found that California’s were the second-highest among all 50 states. 
Fiscal crisis at the local level is even more pronounced. Four California cities have declared bankruptcy since 2008—three in the summer of 2012 alone.
These fiscal problems cannot simply be attributed to California’s weak economy, though that factor must be acknowledged. California is one of only three American states whose unemployment rate is still above 10 percent. Of the 14 American metropolitan areas where unemployment is above 13 percent, 11 are in California.  California’s GDP growth has trailed most other states in every year since 2008.  California cities made up seven out of the top ten metro areas with the highest rates of new foreclosures in the first half of 2012. 
But economic weakness alone cannot explain government’s fiscal distress. Both unemployment and per-capita income are poor predictors of fiscal distress in a community, as measured by its percentage of workforce reduction between 2008 and 2011 (see Charts 4 and 5). Relatively wealthy communities and communities with low unemployment rates have downsized by about the same amount as communities with lower per-capita incomes and high unemployment rates.
California state and local governments’ deficit is more structural than cyclical. Certainly, high unemployment and the housing collapse have strained budgets. But cities’ spending commitments have left them unable to adjust to changing economic conditions. Among those commitments, retirement-related costs are a major factor.
Unsustainable spending on retirement benefits has played a critical role in three out of the four Chapter 9 bankruptcy filings among California cities since 2008.  In 2009, Vallejo became the first California local government to use the federal bankruptcy law’s Chapter 9 (reserved for municipalities) to reduce retiree health-care benefits. Today, post-bankruptcy, Vallejo’s benefits are $300 per month per retiree, down from as high as $1,500.  The city of Stockton, which filed for bankruptcy last summer, intends to go even further: it seeks to eliminate retiree health benefits entirely and thus erase the city’s $540 million unfunded OPEB liability.  San Bernardino, which also filed last summer, has proposed cutting retiree health payments while in bankruptcy. 
When OPEB is unfunded (which, as we have noted, is the case in most California communities), costs in coming years are set to accelerate rapidly—likely more rapidly than pension costs. When a worker retires and begins to draw benefits, his pension comes out of the pension fund, whereas his health benefits continue to come directly out of the operating budget. Thus, for as long as governments fund OPEB on a pay-as-you-go basis, they will experience the combined force of the baby-boom retirement wave and rising health-care costs. In a prefunded system, the effect is filtered. 
Consider what Stockton was up against before it adjusted OPEB in bankruptcy court (Chart 6). Stockton’s pay-as-you-go OPEB costs were set to nearly triple between 2009 and 2019. The city itself claimed that its “retiree medical benefit is one of the most generous in the state.”  CalPERS was Stockton’s largest unsecured creditor ($147.5 million), and its second-largest unsecured creditor was Wells Fargo, the trustee for Stockton’s $124.3 million in pension obligation bonds. 
Although the size of the overall liabilities is smaller, managing the coming OPEB squeeze may prove just as challenging to public officials as managing pension costs.
WHAT IS TO BE DONE? THE REVENUE QUESTION AND THE LEGAL QUESTION
Despite evidence that governments are in an unsustainable spiral of spending for retirees, a strong current of opinion continues to interpret the California fiscal crisis as a revenue problem. In 2009, the state temporarily raised income, sales, and car taxes. (The hikes had all expired by June 2011, after efforts to make them permanent failed.)
The November 2012 ballot features two tax-increase initiatives: Proposition 30 and Proposition 38. Both would raise income taxes and direct all new revenues primarily to public education. Both contain spending restrictions to prevent the new revenues from being used for unauthorized purposes. Opponents have found these spending restrictions to be a “shell game.” As several argued in a statement in the state’s official voter guide, the legislature “can take existing money for schools and use it for other purposes and then replace that money with the money from the new taxes…. Prop. 30 does not guarantee one penny of new funding for schools.”  Although Proposition 38’s spending restrictions are tighter, they, too, are vulnerable to the shell-game critique.
In light of the looming OPEB crisis, it is fair to ask: Would more revenues be a bad thing? Perhaps what some have alleged to be a weakness of Prop. 30— that the real destination of its new revenues would be retirement benefits, not schools —is a reason to support it.
New revenues eventually will be needed to address OPEB. But new revenues need not mean new taxes. A fairer way to raise revenue for OPEB is glaringly obvious: require current employees to contribute to their future health care. In most of California’s government retirement systems, current employees still pay nothing for their postretirement healthcare benefits.
Instead, it is popular this political season to promote increased taxes on higher incomes (as both Propositions 30 and 38 would do). But high-earner income is a uniquely poor source of revenue to support mounting OPEB costs because that income is volatile. Wealthier people earn more money from investments than do people in lower income brackets, which means that this income fluctuates with the ups and downs of financial markets. As long as new tax revenue comes from high-income earners, it will increase revenue volatility, already a well-documented problem in California. 
Governor Jerry Brown, Proposition 30’s chief backer, has focused on California public employees’ retirement benefits as a problem. When he presented his first tax-increase proposal last year, he paired it with a plan for pension reform. The implicit promise was “reform before revenue,” but the pension bill that Brown eventually signed into law failed to fulfill that pledge for several reasons, not least because it did not address OPEB. 
Recently, some California governments have acknowledged their OPEB problems and attempted to address them, through bargaining (San Diego), ballot initiative (San Francisco), bankruptcy (discussed above), and legislation (Orange County). 
Out of all these options, legislative action—changing the retirement system’s obligations by an act of law—holds the greatest potential for savings. But simply changing the law on benefits represents a unilateral reduction, and this is legally controversial.
Pensions for current employees and retirees in California are protected by the “California rule.” Premised on the notion that pension promises are implicitly contractual, this long-standing legal doctrine mandates that all “detrimental changes” to pensions, whether increasing employees’ contributions or reducing their benefits, can be applied only to new hires. 
Is there such a thing as an implied contractual right to OPEB? In principle, the answer is yes, according to the most recent, definitive statement on the matter by the California Supreme Court (see sidebar).  However, the ruling does not establish that all existing retiree health benefits are protected to the same degree to which pensions are. Local governments’ ability to adjust OPEB, for current employees and retirees, remains unsettled in law.
Some systems have explicitly argued that retiree health benefits amount to a “gratuity.” Like a gold watch at retirement, they claim, continuing health benefits may be expected as a gesture of employer beneficence and gratitude but not legally guaranteed. Before 1974’s Employee Retirement Income Security Act (ERISA) changed federal law, it was commonfor corporations to insert exculpatory clauses into retirement-benefits documents, to define pensions as gratuities and thereby limit liability.  ERISA forbade this; but ERISA does not apply to state and local governments.
Some local governments in California have placed exculpatory clauses like those once found in private industry in their employee-benefit documents. In upholding Orange County’s right to reduce OPEB this past August, a U.S. district judge cited disclaimers that Orange County had appended to its documents over the years.
The legal confusion over what can and can’t be done about OPEB is a consequence of the unsystematic nature of retiree health-care benefits. Pensioncommitments are relatively unambiguous: what was promised was a certain fixed percentage of the final salary.  But retiree health care comes in a few different forms. A court that determines that retirees have a contractual right to expect health benefits must wade into another question: Which ones? Medigap? Implicit subsidy? Part B reimbursement? Dependent and survivor coverage? An explicit subsidy? And, if the last, how generous do they have a right to expect?
44 San Diego County Taxpayers’ Association analysis of Legislative Analyst’s Office research, “Proposition 30: The Schools and Local Public Safety Protection Act of 2012,” August 2012.
45 Center for Budget and Policy Priorities, via California Budget Project, “Measuring Up: The Social and Economic Context of the Governor’s Proposed 2012–13 Budget,” February 2012, p. 26; and “States Continue to Feel Recession’s Impact,” Center for Budget and Policy Priorities, June 27, 2012, p. 5.
46 California Department of Finance, Chart K-5 : California Municipal Bonds Rating History, http://www.dof.ca.gov/budgeting/budget_faqs/information/documents/CHART-K5.pdf.
47 Andrew Bary, “State of the States,” Barron’s, August 25, 2012.
49 Bureau of Labor Statistics, http://www.bls.gov/web/metro/laummtrk.htm.
50 Bureau of Economic Analysis, http://www.bea.gov/newsreleases/regional/gdp_state/2012/pdf/gsp0612.pdf.
51 “California Still Dominates Foreclosure Scene,” cbsnews.com, July 26, 2012. California has the third-highest foreclosure rate in the nation (after Illinois and Florida); Mark Glover, “California Foreclosures Improve, but Still Look Bad,” Sacramento Bee, September 14, 2012.
52 “Local Government Bankruptcy in CA: Qs and As,” Policy Brief, Legislative Analyst’s Office, August 7, 2012, pp. 6–7; Sydney Evans, Bohdan Kosenko, and Mike Polyakov, “How Stockton Went Bust: A California’ City’s Decade of Policies and the Financial Crisis That Followed,” California Common Sense, June 2012; Steven C. Johnson and Chris Francescani, “U.S. Loves Cops and Firefighters—but Not Their Pensions,” Reuters, July 29, 2012; Don Bellamante, David Denholm, and Ivan Osorio, “Vallejo con Dios: Why Public Sector Unionism Is a Bad Deal for Taxpayers and Representative Government,” Cato Institute Policy Analysis No. 645, September 29, 2009; and Jeremy Rozansky, “San Bernardino’s Route to Bankruptcy,” City Journal, July 18, 2012.
53 “Local Government Bankruptcy in California: Qs and As,” Policy Brief, Legislative Analyst’s Office, August 7, 2012; Jim Christie and Peter Henderson, “Court Lets Stockton, California Cut Retiree Health Care,” Reuters, July 27, 2012; Ed Mendel, “City Bankruptcies Target Retiree Health Care Costs,” August 6, 2012; and Ed Mendel, “Stockton Plan Cuts Bond Payment: $197.5 million,” July 23, 2012.
54 Bob Deis, “A Message from the City That Went Bankrupt,” Wall Street Journal, September 27, 2012.
55 Peter Henderson, “Near-Bankrupt San Bernardino Targets Bonds, Retiree Health,” Reuters, July 24, 2012; and Mendel, “City Bankruptcies Target Retiree Health Care Costs.”
56 For clear illustrations of the advantages of prefunding over pay-as-you-go, see “State Budget Crisis Task Force Report,” July 2012, p. 44 (fig. 15); and Adam Tatum, “California’s Neglected Promise: How California Has Failed to Prepare for Its Accumulating Retiree Health Care Obligations,” California Common Sense, July 2012, pp. 7–8 (figs. 5 and 6). “State Budget Crisis Task Force: California Report,” September 2012, p. 26, fig. 7.
57 “City of Stockton, 2011/2012 Annual Budget,” p. P-26.
58 Steven Church, “Stockton Threatens to Be First City to Stiff Bondholders,” Bloomberg, June 30, 2012.
59 Proposition 30, “Official Title and Summary” and “Official Arguments and Rebuttals.”
60 David Crane, “New California Taxes Pay for Pensions, Not Schools,” Bloomberg, April 23, 2012; and “California’s Pension Tax,” Wall Street Journal, April 22, 2012.
61 Legislative Analyst’s Office, “Revenue Volatility in California,” January 2005; and David Block and Scott Drenkard, “Governor Brown’s Tax Proposal and the Folly of California’s Income Tax,” Tax Foundation Fiscal Fact No. 324, August 1, 2012.
62 Brown’s initial 12-point pension reform plan would have made two modest changes to retiree health-care policy: first, increase eligibility for new state government employees from ten to 15 years for minimum health-care benefits and from 20 to 25 for the maximum. Second, Brown proposed addressing “the anomaly of retirees paying less for health care premiums than current employees.” State retirees are eligible for an employer contribution of up to 100 percent of health-care premium costs (90 percent for dependents). The employer contribution rate to active workers’ health care varies by bargaining unit but is generally 80 percent; “A Preliminary Analysis of Governor Brown’s Twelve Point Pension Reform Plan,” CalPERS, November 30, 2011.
63 For a recent survey of the literature on state and local governments’ OPEB changes, see Joshua Franzel and Alexander Brown, “Understanding Finances and Changes in Retiree Health Care,” Government Finance Review, pp. 62–63. The most comprehensive source is probably the annual summaries of retirement benefits changes published by the National Conference of State Legislatures.
64 For an extensive discussion and critique of the California Rule, see Amy Monahan, “Statutes as Contracts? The ‘California Rule’ and Its Impact on Public Pension Reform,” Iowa Law Review 97 (2012): pp. 1029-1083.
65 Retired Employees Association of Orange County, Inc. v. County of Orange, Supreme Court of California, November 21, 2011.
66 Steven Sass, The Promise of Private Pensions: The First Hundred Years (Cambridge, Mass.: Harvard University Press, 1997), pp. 187–89, 272–73.
67 Ed Mendel, “Court Strengthens Public Retiree Health Rights,” Calpensions.com, November 28, 2011; and “Calif. Court Weighs in on Retiree Health Benefits,” Thomson Reuters News and Insight, November 21, 2011.
68 Mendel, “Court Strengthens Public Retiree Health Rights”; and Steven Greenhut, “Public Unions Send Medical Bills to Taxpayers,” Bloomberg, March 15, 2012.
69 Retired Employees Association of Orange County, Inc. v. County of Orange, U.S. District Court for the Central District of California, August 13, 2012.
70 The only exception would be with COLAs. Recent court challenges to COLA reductions or eliminations have centered on whether COLAs are part of the core pension benefit, finding generally that they are not.
Stephen D. Eide is a senior fellow at the Manhattan Institute‘s Center for State and Local Leadership. He was previously a senior research associate at the Worcester Regional Research Bureau. He is a regular contributor to PublicSectorInc.org, a project of the Manhattan Institute. His work focuses on public administration, public finance, political theory, and urban policy. His work has been published in the New York Post, Worcester Telegram and Gazette, Worcester Business Journal, Commonwealth Magazine, Boston Herald, Interpretation: A Journal of Political Philosophy, and Academic Questions. A native of Richmond, Virginia, Eide holds a bachelor’s degree from St. John’s College in Santa Fe, N.M., and a Ph.D. in political philosophy from Boston College.