March 12, 2006

The Trillion-Dollar Pothole

CORPORATIONS AREN'T THE ONLY ONES wrestling with surging health-care costs for retirees. America's state and local governments have exactly the same kind of problem, only worse -- and investors in municipal bonds could start feeling the impact next year.
Cities, towns and states are on the hook for as much as $1 trillion to fund the health care of retired workers, with the tab rising daily. And unlike corporate CEOs, who are increasingly willing to renege on promised benefits, government officials face dire re-election consequences for doing the same.
The actual liabilities of particular states and towns have been largely invisible, hidden by accounting conventions. But this will soon start to change -- with new rules to take effect this coming December that will require governments to disclose what their retiree health-care costs are likely to total over the next 30 years.
The numbers are sure to be eye-opening.
Michigan already has discovered that its future costs could total $23 billion, according to Chris DeRose, director of the state's retirement system. Maryland is estimating a $20 billion tab.

Investors are sure to see some eye-popping numbers when states start forecasting their retiree health-care liabilities for the next 30 years.

New York City Mayor Michael Bloomberg recently proposed setting aside $1 billion each year for the next two years to help meet future retiree health costs. In Mountain View, Calif. -- one of the first smaller cities to discuss its liability candidly, and also home to celebrity corporate citizen Google -- the liability is $35 million, or nearly half of what it costs annually to run the city, says City Councilman Mike Kasperzak.
As the new accounting rules are phased in, localities disclosing especially high liabilities could become vulnerable to downgrades of their credit ratings, says Joe Mason of Fitch Ratings. John Mousseau, a portfolio manager and tax-exempt bond expert at Cumberland Advisors of Vineland, N.J., thinks that yields on bonds from issuers with heavy retiree health costs could rise noticeably, compared to those on other bonds, as prices fall. He adds that insured bonds could fare better than uninsured ones, since the insurance could ease investors' anxieties about retiree costs.
"And this is just the tip of the iceberg," he says. "They'll have to rein in some of those benefits, or else they'll have a big hole on their balance sheets."
At the same time, Mousseau says, revenue bonds issued by sewer and water authorities might become an attractive alternative to general-obligation bonds. That's because they have smaller payrolls and retirement liabilities than state and local jurisdictions, making their future costs more palatable to investors.
UNDER EXISTING ACCOUNTING RULES, the current cost of retiree benefits is lumped together with the cost of benefits for active workers, with no hint that the retiree number will mushroom in the future. The new approach calls for breaking out retirees' health-care costs and then projecting them over 30 years. The results are to be disclosed in footnotes to the governments' financial statements.
The accounting-rule change, adopted in 2004 by the Governmental Accounting Standards Board, is known as "Gasby 45'' by the bond-market literati. The standards board had been working on it on and off from 1988. The rule will be phased in starting with reporting by any government with annual revenues of $100 million or more after December 15, 2006. Governments with annual revenues of $10 million to $100 million must comply by Dec. 15, 2007. The smallest cities and towns have until Dec. 15, 2008.
"Many governments will be measuring the liability on an accrual basis [considering future payments] for the first time," says Karl Johnson, project manager for the standards board.
The bond market is sure to take notice. David Hamlin, a managing director and tax-exempt bond expert at Putnam Investments, says it is natural to expect a rise in yields of uninsured muni bonds, relative to uninsured counterparts, at least for the first year or so. But since states and cities ultimately address rising health costs by increasing taxes, he sees no lasting divergence in yields.
"It's good in the long run, because it will improve state finances," says Hamlin. He doesn't expect any knee-jerk reductions in ratings by credit agencies. "They'll wait to see how these jurisdictions will handle it," he says.
Another angle for investors: the stocks of bond insurers. Mousseau of Cumberland says that demand for uninsured munis could make the insurance of munis more dear, lifting the bottom lines of outfits like Ambac Financial Group (ticker: ABK) and MBIA (MBI).
HEALTH-CARE COSTS for state and local governments -- just as for private corporations -- clearly have been getting out of hand, with double-digit increases annually. "There is no exemption for any employer from this," says Steve Kreisberg, director of collective bargaining for the American Federation of State, County, and Municipal Employees.
In fact, states are much more generous than the private sector when it comes to employee health care. In 2004, more than half of the state plans for retirees paid 80% of the cost of medical and surgical procedures; and 36% paid 100%, according to Segal Company, a consulting firm specializing in employee benefits and human-resource plans.
As the baby boomers grow older and the pool of retirees increases, the financial strains on state and local governments will only worsen. The contributions required from active workers will, at some point, become untenable.
In Michigan, school workers now see 6.55% of each pay check go to finance the health care of current retirees. If Michigan were to begin accumulating reserves to retire the retirement liability over 30 years, it would have to take 16.55%, which would cause an uproar.
However, if nothing is done to control the retiree costs, then the state will be forced to take even more than 16.55% from school-employee paychecks in about 15 years, just to cover annual expenditures.
Already, the total liability for state and local governments for funding the health care of current retirees may be as large as $1 trillion, says Steve McElhaney of Mercer Human Resource Consulting. He bases this rough estimate on census data indicating that there are 5 million to 6 million retired public workers with health-care coverage.
STATES HAVE A NUMBER OF WAYS to contain health costs, but none is a magic bullet. And each has political consequences that are not attractive for current office holders.
States, for instance, could set money aside a dedicated trust to pay down the liability gradually, as if it were a mortgage. Rating agencies seem to favor this approach. Because assets in the trust would earn an investment rate of return, money to pay down the liability would accumulate quickly, bolstering balance sheets. But how do you raise the money for the trust in the first place? Tax hikes aren't the easy answer. Most states have been cutting taxes, notes Bob Kurtter of Moody's. "Anti-tax sentiment is widespread," he notes.
Some states are considering issuing retiree-health obligation bonds, modeled on pension-obligation bonds. The latter allow states to pay down their pension liabilities early and save money. The interest paid to the bond holders is less than the pension obligation would have been if it hadn't been pre-funded with earning assets. But, while forecasting the future liabilities of pension plans is relatively easy, predicting health-care liabilities is anything but.
"You don't know who is going to get sick or who is going to have the million-dollar claims," says J. Richard Johnson, a Segal Co. senior vice president. "You are chasing a moving target."
The upshot: Retiree health-care bonds could be very risky for the issuers. And, Johnson says, states issuing the bonds might have to pay higher rates on subsequent bond issues for bridges, roads and schools -- even if their ratings are unaffected by the new debt -- simply to attract more buyers.
Bob Locke, Mountain View's finance director, predicts that there will be a flood of bond issues to finance the retirement liabilities of states and cities. He bases this prediction on scuttlebutt he hears as president of the fiscal officer's department of the League of California Cities.
States and cities, of course, simply could cut their health-care promises. Retiree health benefits aren't protected by law the way pension plans are; this is true for both corporate and government employees.
In fact, many states and cities already are changing the terms of retiree health-care for new hires.
The Bottom Line
Prices of muni bonds from issues with heavy retiree health costs could soon come under pressure. Bonds of water and sewer authorities with smaller payrolls could excel.
Pennsylvania is offering new hires a cash subsidy, based on years of service, that can be used to pay for health coverage in retirement. This is far less expensive than offering coverage itself. In Oregon three years ago, workers acceded to a multiyear wage freeze in order to maintain their health coverage.
Last year, the leaders of the striking New York City subway workers' union, which was fighting to protect its pensions tentatively agreed to pay more for health insurance. And in Georgia, Gov. Sonny Perdue pushed the legislature to adopt a managed-care plan for state workers that he expects to slow the growth in expenditures from 14% a year to 9%.
Few states have gone so far as to renege on promises to retirees, however. Many states promised them handsome retirement benefits as a strategy to keep wage increases low. Segal's Johnson says a spirit of paternalism runs deep at the state level, and few politicians have the stomach to attack the problem this way. But they may have to overcome their queasiness to head off a financial crisis.
Addressing the problems of retiree health care will almost certainly be harder for state and local governments than for corporations. Public workers tend to be five to 10 years older than private-sector employees.
In addition, the retirement packages let state employees stop working at an earlier age. Many retire when they're 50 to 55 years old and thus use their health plans much longer than private-sector employees do. Johnson notes that states are lax in tracking the work habits of their retirees, letting them take part-time jobs and "double-dip." This gives state workers an incentive to retire as soon as they can.
If states don't get a grip on the problem, one thing is certain: America's taxpayers will pay the price.

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