The Problems with the Pension and Retiree Health Insurance Bills

Legislation that creates funding requirements for local government pensions and retiree health insurance benefits recently passed both Michigan chambers. This package is an attempt to address the billions in retirement debt faced by local governments. But the law is problematic because it conflates pension and retiree health care benefits — two things that should not be lumped together — and opens the door to tax hikes in local governments.

Pensions and retiree health care are fundamentally different things to governments in Michigan. The state constitution requires pensions to be paid for as they are earned; they are legally binding debt. Retiree health insurance benefits are not. Local government managers can change their eligibility requirements, trim the generosity of benefits or otherwise alter the insurance benefits they offer to employees and retirees.

Local governments can make sure that employees trust that retirement insurance benefits will be available by setting aside money today to pay for them. But few have done so.

The legislative package, however, creates similar funding requirements for both pensions and retiree health insurance benefits. It recognizes only weakly the very different legal status each benefit has: The state will now consider retiree medical insurance benefits to be underfunded when a local unit of government has less than 40 percent of the cost saved. It will consider pension benefits well-funded when governments have saved enough to pay 60 percent of the liability.

In addition, governments will also be considered “underfunded” when they spend 12 percent of their budget on retiree health care or 10 percent on pensions, even if they exceed the legislation’s funding requirements.

The primary effect of the proposed law is to encourage local governments to fund both benefits. Fund, not cut. And that is a problem. While pensions need to be funded, retiree health care does not. The costs for retiree health care should be lowered, and there is a lot that can be done without making already-retired employees ineligible for insurance. Only after being cutting down to a bare minimum should retiree insurance be prefunded.

The current policy where government officials pledge benefits, kick the costs to future taxpayers, and reserve the option to reduce them later implies that governments need to cut benefits. But that, and prefunding health benefits, should be done only after clearing the mismanagement surrounding the current benefits being provided.

Some local governments may choose to use the funding requirements as a reason to reduce retiree health insurance benefits. For one thing, the 12 percent cap makes it harder to tax their way out of the problem. Yet it’s not impossible, for local government officials are often tempted to see a tax increase as the solution.

If a local government does not meet state funding standards, the state can declare that its benefits are “underfunded” and create a plan to address the underfunding. The plan can be approved or rejected by a state board of political appointees. And that may mean pressure to increase taxes to avoid state involvement.

It is unclear how governments will react to this legislation. Will they be interested in trimming costs, increasing taxes and revenues or will they do something else? The larger problem with the legislative package is that it provides little encouragement in state policy to address these optional retiree health care benefits. Local officials have refused to acknowledge their problems in retirement benefits and instead insist that fiscal issues are entirely the fault of revenue. So it’s likely they will use this process to raise revenue rather than reduce costs for optional benefits.

Legislators can encourage local governments to take steps to lower the costs of retiree health insurance. They can prohibit governments from kicking the costs of new employee service onto future taxpayers and make retiree health insurance prefunding a higher priority than wage increases. They can offer state incentives to lower the costs of these benefits or other kinds of direct encouragement. By not taking steps to move local governments this way, legislators made mismanagement more likely.