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A Lesson from the Wreckage in Detroit: Retiree Health Care Is Ripe for Reform

Wednesday, August 7, 2013

The focus on retiree pensions has eclipsed an equally important target for reform in Detroit and other cash-strapped American cities: retiree health care benefits.

In their attempts to turn the Detroit bankruptcy into a teachable moment, many commentators have focused on pensions, and rightly so. Detroit’s billions in pension debt are a driving cause of its insolvency and inability to provide basic services. Should he succeed in his plan to cut pensions in bankruptcy, Emergency Manager Kevyn Orr would set a powerful precedent for other cities in a similar position.

But the focus on pensions has eclipsed a more promising target for reform: the health care benefits promised to retirees. Retired public employees often qualify for free or low-cost health insurance, a benefit increasingly rare in the private sector. These benefits are available for life as early as age 50 and sometimes cover even the co-payments which Medicare recipients must pay.

Detroit’s retiree health care liability is not only estimated to be larger than its pension liability, it will also be much easier to address, because the legal protections are weaker. In the near term, states and cities should take a lesson from Detroit’s struggles and focus on cutting retiree health care, a more achievable goal than pension reform, and also one with the potential to yield immense savings.

State and local governments provide retiree health care in a variety of forms. Pre-Medicare “early” retirees are often allowed to remain on their workplace health plan, allowing them to pool their risks with younger, healthier employees. This benefit alone (known as the "implicit rate subsidy”) can be worth thousands of dollars in savings each year. Governments then may also pick up some or all of early retirees’ premium costs. When a retiree reaches 65, much of the burden shifts to Medicare, but many governments continue to offer assistance managing the out-of-pocket and premium costs associated with Parts A, B, and D. Finally, there are dependents' and survivors’ benefits, and vision and dental insurance.

The promises associated with retiree health care total over $1 trillion nationwide, which is less than state and local governments owe for pensions when calculated conservatively (around $4 trillion). Detroit calculates that it owes $6.4 billion for retiree health care and $4.8 billion for pensions, including funds borrowed from credit markets to bolster the city’s pension systems. Due to the different accounting assumptions used to determine them, however, comparing the liabilities is an apples-to-oranges proposition.

The promises associated with retiree health care total over $1 trillion nationwide, which is less than state and local governments owe for pensions when calculated conservatively (around $4 trillion).

But regardless of which debt total is larger, state and local governments’ retiree health care commitments are at least as difficult to manage as their pension commitments. The true costs are dangerously uncertain, contingent as they are on medical inflation rates and future changes in federal health care policy. For instance, if Congress raised the Medicare-eligibility age from 65 to 67, adding two more expensive years of coverage, state and local retiree health care liabilities would surge.

A retirement obligation can only be managed responsibly on a pre-funded basis, with a substantial portion of the benefit — perhaps 60 percent in the case of pensions — being paid for through investment earnings. But most governments have not yet set up retiree health care trust funds like they have for pensions, and likely never will. Without prefunding, present taxpayers pay the entire bill, thus effectively compensating retired employees for work they did decades ago.

We thus have a benefit which is expensive, unmanageable, unfair to taxpayers, and not necessary from a personnel management standpoint. According to the Kaiser Foundation, although nearly 80 percent of state and local governments offer retiree health care, only 25 percent of large American employers do.

But as events in Detroit have already illustrated, what truly makes retiree health benefits so much more attractive from a reformer’s perspective is that the legal protections are weaker.

Article IX, Section 24 of the Michigan state constitution specifically shields accrued public pension benefits from being “diminished or impaired.” Nonetheless, Kevyn Orr has proposed "significant cuts in accrued, vested pension amounts for both active and currently retired persons," arguing that in bankruptcy, federal law will overcome state law.

Unions, retirees, and the city’s pension system boards plan have already signaled their determination to fight Orr to the end over pension cuts. Even if they ultimately lose, pension struggles alone could substantially lengthen bankruptcy proceedings and cause legal fees to soar. And that’s to say nothing about resistance to Orr’s other proposed, controversial cuts, such as to general obligation bondholders.

Retiree health care is an entirely different matter, as the Michigan Supreme Court has ruled that the constitutional protections on pensions do not extend to health care. Accordingly, unions and retirees have registered far less formal protest over Orr’s proposed retiree health care cuts.  

Although nearly 80 percent of state and local governments offer retiree health care, only 25 percent of large American employers do.

If Orr gets his way, all retirees eligible to enroll in Medicare will be required to do so. He will also require retirees younger than 65 and any older retirees ineligible for Medicare (of which Detroit has many), to obtain health insurance through the federally-subsidized exchanges mandated by Obamacare. In addition to the subsidies, Orr has offered monthly stipends of $100-$250 to ease the burden on retirees. Detroit workers and retirees will receive less than what they had been expecting, but it should be recalled that, for most American workers, their employer’s commitment to provide them with health care ends abruptly upon their retirement. The stipends alone ensure that, post-bankruptcy, Detroit will still be providing an above-market health care package measured against private sector standards.

Under Orr’s plan, Detroit stands to save at least $100 million in annual spending on retiree health care. To put that figure in perspective, Detroit spent, on net, about $130 million last year on its fire department.

During its 2008-2011 bankruptcy, Vallejo, California cut retiree health care and didn’t touch pensions; Stockton, California, which filed for bankruptcy last summer, has followed a similar approach.

Not that governments can only effect reform through bankruptcy. The legal issues will vary between states and cities, but Orange County, California, for one, managed to reduce health benefits for current retirees in 2007 without entering bankruptcy, a bold reform that has withstood several rounds of litigation.

While no government should be discouraged from pursuing pension reform, they must also understand that the savings from retiree health care reform may be no less significant, and almost certainly more achievable. The vast majority of American cities will not face insolvency any time soon, but their spending on retirement benefits continues to squeeze budgets, leaving less and less available for basic services, just as in the case of Detroit. Retiree health care is a great deal for retirees, but not such a great one for taxpayers.

Stephen D. Eide is a Senior Fellow at the Manhattan Institute’s Center for State and Local Leadership.

FURTHER READING: Ivan Osorio writes “More Than Good Enough for Government Work” and Sita Nataraj Slavov writes “How Politicians Buy Votes By Doling Out Public Worker Benefits.” Andrew G. Biggs asks “Can Detroit’s Pension Benefits Be Cut? Should They Be?” examines “Why Expanding Social Security is a Bad Idea,” argues “Public Pensions Roll the Dice,” and writes “Public-Sector Pensions: The Transition Costs Myth.”

Image by Dianna Ingram/Bergman Group

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