By Barry W. Poulson, Ph.D.
Colorado taxpayers are on the hook for more than $1 billion in unfunded liabilities incurred in the defined benefit retiree health plan administered by the Public Employee Retirement Association (PERA). An additional $79 million in unfunded liabilities was incurred in 2008, reflecting both a rapid growth in retiree benefits and losses in the assets held in the Health Care Trust Fund. Prospects are for continued volatility and deterioration in the funding status of PERA’s retiree health plan.
It’s time for the state to move from a defined benefit retiree health plan to a defined contribution plan. Here’s why.
The $1 billion in unfunded liabilities in the Health Care Trust Fund would not be such a looming fiscal crisis if there was some prospect that the liabilities could be paid off within 30 years to meet Government Accounting Standards Board (GASB) standards. But due to flawed actuarial assumptions used by PERA, the funding status in the Health Care Trust fund is actually worse than reported.
A four year smoothing technique is used to estimate the actuarial value of assets in the plan. This means that some, but not all of the decrease in the market value of assets in 2008 is reflected in the actuarial value of assets for that year. The loss in the market values of assets in more recent years is, of course, not reflected in the actuarial value of assets in 2008. These losses in the market values of assets in the plan will be reflected in the actuarial value of assets over the next four years. Thus, even with recovery in the stock market we are likely to see an increase in unfunded liabilities in the plan over the next four years.
Another flaw is to assume an 8.5 percent rate of return on assets in these plans. Because PERA assumes such an unrealistically high rate of return, they engage in a risky investment strategy, with 70 percent or more of assets in equities. The actual rate of return on assets in these plans has been zero or negative over the past decade. The best economic analysis of public sector pension and health plans, such as PERA, suggests that a more realistic rate of return on assets that is about half or less than that actually assumed by PERA.
The fatal flaw in defined benefit retiree health plans such as PERA’s is moral hazard. The reality is that politicians have promised retiree health benefits they can’t pay for. They offer public sector retirees generous health benefits as an alternative to better compensation because the cost of retiree health benefits is deferred to future generations. Public sector employee unions encourage this because it is less likely to generate taxpayer resistance than higher compensation which must be funded from current revenue.
Most private sector employers have either eliminated defined benefit retiree health plans, or replaced them with defined contribution plans. While most state and local governments have not eliminated health plans for their retirees, they have enacted a number of reforms to reduce the cost of those plans, including replacing defined benefit plans with defined contribution plans.
The Colorado Legislature should replace PERA’s retiree health plan with a defined contribution plan. In the recent Independence Institute study, “How to Save a Billion Dollars in Other Post-Employment Benefit Costs,” we estimate that in the short run this reform would reduce the employer annual required contribution to the plan from $72.6 million to $29.0 million. The annual required contribution from the state would be reduced from $24.6 million to $14.5 million, a savings of $10.1 million.
More importantly, this reform would reduce the accrued actuarial liabilities in the plan, and enable the state to pay off the $1 billion in unfunded liabilities over a 30 year period.
Dr. Barry W. Poulson is a Senior Fellow at the Independence Institute. The study referenced in this article may be found at How to Save a Billion Dollars in Other Post-Employment Benefit Costs.
