CHICAGO — If governments put off for too long addressing unfunded other post-employment and health care benefit liabilities, they could pose a credit risk in the coming years as double-digit health care cost increases are expected to continue for five years, Standard & Poor’s analysts warned in a report this week.
“There could be some intermediate-term credit pressures, possibly as soon as three to five years, as governments grapple with funding solutions amid rising health care costs,” analyst Peter Block said, adding that the increased costs are likely to pressure some municipal budgets and could affect their spending priorities and reserve levels.
The near-term risks are limited as governments work to meet the Governmental Accounting Standards Board’s deadlines for reporting OPEB liabilities on a accrual basis, like traditional pension costs have long been counted. Most governments have reported and covered OPEB costs on an annual pay-as-you-go basis for current retirees.
Using the accrual method, governments must also take into account the cost of paying for benefits for future retirees and the annual required contribution or ARC that is needed to amortize the liability over 30 years. Governments must report the difference between their current funding level and the ARC. Governments with revenues of more than $100 million must report their actuarial accrued liability in the fiscal years that end after Dec. 15, 2006. By the end of 2009, all states and localities are expected to adhere to the new reporting standards.
While most local and state governments are expected to come up with funding solutions with their credits intact, some might struggle. Older local governments, especially ones with stagnant property tax base growth where generous health care benefits were offered to attract workers, could face the toughest time addressing their OPEB liabilities, especially given the added weight of coping with traditional pension funding expenses.
Many governments also face statutory or constitutional requirements to honor the benefits and, in the case of smaller governments and school districts, often face property tax caps.
“Some will have to find other ways to cover these escalating costs,” Block said. “It’s not just the OPEBs. It’s OPEBs plus pension, and they could pose risks if they are not dealt with quickly and effectively.”
States typically have greater tax-raising flexibility to generate more revenue, but they could face the added burden of covering some local governmental and school district costs depending on how aid to localities and districts is structured. For instance, Wisconsin covers, on average two-thirds, of a school district’s expenses.
An analysis from Standard & Poor’s late last year noted that so far 40 states have reported OPEB liabilities totaling $400 billion. Health care costs are expected to increase by 10% over the next five years and then fall, but there’s no guarantee of the future drop.
While GASB 45 doesn’t require governments to come up with a plan to address OPEB liabilities, Standard & Poor’s in another recent report forecasted a possible pension obligation bond “revival” for both pension and OPEB liabilities.
“If a government chooses to prefund OPEB liabilities, management must be cognizant of the pressure to achieve outsized investment returns to stabilize and reduce contribution rates. For these reasons, Standard & Poor’s will also focus on the OPEB fund’s structure, governance, investment allocation, and return assumptions” in analyzing plans, analysts wrote. “This analysis is identical to the way in which we view a government’s pension plan and its impact on a government’s general credit.”
While pension-related liabilities are considered debt-like, they represent a “soft” debt with some repayment flexibility, unlike debt service on a pension bond that is considered a “hard” liability.