Harvard Business School

Taking the Measure of Detroit: Helping with Health Care

When Detroit reported $18 billion in liabilities as part of its bankruptcy calculations last week, most people were prepared for the $3.5 billion in unfunded pension liabilities. Many people were surprised, however, to see the much larger amount of $6.4 billion in other post-employment benefits ( OPEB ) – primarily obligations to pay healthcare premiums for retired public employees.

Detroit is not unique. The unfunded healthcare obligations of most cities are larger than their unfunded pension obligations. To avoid fiscal disasters like this one, other cities should slow down the growth of their unfunded retiree healthcare liabilities.

Last January, the Pew Charitable Trust did a study of both pension and OPEB shortfalls in the 30 largest cities in the United States. The unfunded pension deficits for these cities amounted to $99 billion, while the unfunded retiree healthcare benefits totaled $118 billion.

Why are OPEB deficits higher than pension deficits for most cities? In part, the answer is that OPEB liabilities were for many decades never reported on municipal balance sheets. Without such reporting, it seemed that cities’ healthcare promises did not have serious financial consequences.

That came to an end in 2006, when the Government Accounting Standards Board (GASB) required local governments to publicly report their OPEB liabilities. But GASB did not require cities to fund their OPEB shortfalls. As a result, even the worst funded city pension funds are 50% or 60% funded, while almost all cities have minimal advance funding of their healthcare obligations. Instead, these obligations are almost always financed on a pay-as-you-go basis.

On the other hand, from a legal perspective, it is usually much easier for a city to change its healthcare obligations than its pension promises. Indeed, pension obligations that are already accrued for city employees are legally protected by many state constitutions. The key constraint in changing health care obligations, however, is usually political, especially pressure from public employee unions.

If healthcare benefits can be legally reduced, subject to political constraints, what are the most fruitful strategies for cities to pursue? The following seem politically palatable, though their actual impact on a city's finances would depend on how these strategies were implemented:

  • Many cities have reduced retiree healthcare promises for new municipal employees. Unfortunately, it will take years for these reductions to have a material impact on a city's unfunded liabilities. In fact, many cities are downsizing employment, rather than hiring new workers.
  • Cities could require all public employee retirees to join Medicare when they turn 65. While many cities are imposing this requirement, some continue to pay a substantial portion of Medicare premiums for their retirees. Moreover, other cities finance better benefits for their retirees than those provided by Medicare.
  • Cities could require public retirees before age 65 to obtain healthcare through the new state connectors under the Affordable Healthcare Act. Although the federal government offers a range of subsidies for healthcare policies obtained through these connectors, cities would still have to decide who should pay the remaining premiums on these policies.

More dramatically, cities could reduce their retiree healthcare costs by adopting three other strategies, although each would probably trigger a political battle:

  • Cities could change their healthcare policies for retired workers by increasing deductibles and co-payments. They could also cut back on the scope of care provided -- for example, by making retirees pay the full cost of dental work and eyeglasses.
  • They could increase the number of working years for their employees to become eligible for retiree healthcare. In some cities, public employees are eligible after only 10 or 15 years of full-time work; this period could be extended to 20 or 25 years.
  • Finally, cities could begin to fund their healthcare obligations in advance, as they do for their pension obligations. This funding could come partly from general municipal revenues and partly from public employees. Such advance funding would significantly reduce their reported healthcare liabilities and thereby decrease the interest rates on their municipal bonds.

Health care obligations to retired employees are the hidden bombshells of municipal finance. Any changes in such obligations will be politically controversial. Be that as it may, if cities don’t begin to reduce these obligations and fund them in advance, there’s trouble ahead. They will soon pay higher interest rates on their municipal bonds and ultimately may face a financial crisis like the current one in Detroit. That’s not what the doctor ordered.