A Shock To The System

States and cities are now discovering just how staggering their retiree health-care burdens are

On Nov. 16, Delores Campbell heard the words she'd been dreading for months. Seated at the back of a packed conference room in Charleston, W. Va., she listened carefully as a consultant to the state's Public Employees Insurance Agency outlined a dire scenario. West Virginia is spending $100 million a year on retiree health-care benefits, he said, and if nothing changes, the tab could hit $1 billion a year in just five years. On top of that, the state, which now estimates that it has promised current and future retirees $8 billion in health care over the next 30 years, could see that figure balloon to $50 billion in 2040. West Virginia has nothing saved against that pledge and to lower costs is considering doing away with a program that supplements Medicare for those over 65. "It looks pretty bad for us," says Campbell, 67, who taught social studies to sixth graders for 38 years before retiring in 2004.

The wrenching choice West Virginia faces is more than an isolated drama. It's a harbinger of bad things to come across the country. A new rule by the Governmental Accounting Standards Board (GASB) that begins to take effect next month requires states, cities, and school districts to tally up and disclose the value of the health care they've promised their retirees. Faced with the numbers, governments are scrambling to find ways either to cut back on the cost or raise money to start funding it. Many plan to do both.

PAINFUL TRADE-OFFFew companies still offer health care to retirees. But governments continue to provide it, often to compensate for lower wages. Now that looks like a bad trade-off. Health-care inflation has been far higher than wage growth, so, as they're painfully discovering, public-sector employers substituted a very expensive benefit for a less expensive wage.

Only a few have disclosed what they may owe over the next 30 years, but some of the numbers that have come out are staggering. New York State, including all cities and counties, might have a liability of $250 billion. The Los Angeles Unified School District could owe $10 billion, the City of Nashville $1.5 billion, and the state of Maryland $20.4 billion. Those are estimates, of course, filled with assumptions, including guesses at what health-care inflation will look like 30 years out.

Even so, Cecilia Januszkiewicz, secretary of Maryland's Budget & Management Dept., said that state's number was "shocking" to her. The previous estimate from several years earlier had been $3 billion to $6 billion. Actuaries have told Maryland that if the state were to begin funding retiree health care the way it does pensions, i.e., by creating a special fund aimed at ensuring it will have enough cash to pay benefits in the future, annual spending on retiree health care would jump to $1.9 billion a year, from $311 million today.

Nationwide, the 30-year tab could total $600 billion to $1.3 trillion, according to JPMorgan (JPM ) benefits specialist Brian Whitworth. "They're finding just how big the promises are they've made," says J. Richard Johnson, head of Segal Co.'s public-sector health practice. "And how do you describe enormous?"

Dealing with the issue won't be easy. Cutting the benefits of lifelong teachers, firefighters, and policemen is not only distasteful, for politicians it's dangerous. These groups all vote, and elected officials controlling state purses know it. Many states also make it illegal to cut government retiree benefits once they've been promised. And some retirees, worried that governments will opt to cut benefits rather than come up with the billions needed to cover future costs, are opposed to a knee-jerk response. "I don't think you can get an accurate number on it," says Robert W. Pickett, who retired in 1998, having served as chief financial officer for Alabama's Transportation Dept. for 26 years. "You've got to guess how long the retired will live, how long active employees will work, how long they will live after they retire. There are so many unknown variables."

CREDIT-RATING CONCERNSSome employers are biting the bullet and beginning to save. This year New York City, flush with taxes from Wall Street bonuses and a roaring real estate market, put $1 billion toward its $50billion estimated liability and promised another $1 billion next year. The Peralta Community College District in Northern California issued bonds against the $153million it will have to pay out, choosing a $4 million annual debt payment (starting in 2009) over health-care inflation they argue was starting to cut into their ability to serve the students.

In fact, the new accounting rules don't require states to fund the projected liability, just disclose it. But the bond market may. The major rating agencies have urged governments not to panic, saying they consider many factors when judging default risk. But the projected shortfalls are starting to become a problem for some. In a Nov. 9 report on Contra Costa County in California, Standard & Poor's analysts explained their negative outlook on the county as partly due to pressures from its $2.57 billion retiree health-care obligation. And in Alabama, finance chief Jim Main has been pushing for the state to create a trust for retiree health care to help his bid for a better bond rating for an upcoming $500 million offering. Alabama's liability for teachers and state employees, at $20billion, is hefty compared with its annual revenue.

Not all states and cities are facing a funding crisis. Either they offer few benefits and therefore owe very little or nothing at all or, like Ohio, California's Santa Clara County, and Los Angeles, they started funding these promises years ago and are close to halfway covered.

Cities and counties with large groups of firefighters and police who retire relatively early may be among the worst off. It's an issue that "is not going to get resolved quickly here or in any other city," says David Manning, Nashville's director of finance. Or painlessly, either.

By Nanette Byrnes

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