May 9, 2007
Questions and Answers:
California’s First Retiree Health Valuation
The Legislature required the Controller to contract with actuaries for California’s
first valuation of unfunded state retiree health liabilities. On May 7, 2007, the
Controller reported that the state’s estimated unfunded liabilities total $48 billion.
This report answers key questions concerning the valuation and identifies actions
the Legislature could take to address the state’s liabilities.
In The 2006-07 Budget Act, the Legislature
required the State Controller to contract with actuaries for California’s first
valuation of its liabilities for health and dental benefits for retired state employees.
(These benefits are referred to generally as “retiree health benefits.”) The valuation
is necessary for the state to comply with new public sector accounting rules that
require the listing of retiree health benefit liabilities in the state’s financial
statements beginning no later than 2009 (when the state’s 2007-08 financial records
are finalized). Like the vast majority of governments across California and around
the country, the state has not funded the estimated costs of future retiree health
benefits as they accrue. As a result, a large unfunded liability for these benefits
exists. The valuation, which was released by the State Controller’s Office (SCO)
on May 7, reports the size of this liability under several sets of actuarial assumptions.
As we discussed in our February 2006 report,
Health Care: A Growing Cost for Government, the Legislature will be facing
key decisions on how to address these liabilities.
The Valuation: Questions and Answers
What Health Benefits Do State Retirees Receive?
Current law provides state contributions for retiree health benefits on the basis
of a “100/90 formula.” Under the formula, the state’s maximum contribution to a
retiree’s health costs is equal to 100 percent of a weighted average of health premiums
and 90 percent of a similar weighted average for additional premiums necessary to
cover eligible family members of retirees. The formula bases payments on the weighted
average of premium costs for single enrollees in the four basic health plans with
the largest state employee enrollment during the prior year. This results in a 2007
maximum state contribution of $439 per month for a single retiree, $823 per month
for a retiree and a family member, and $1,042 per month for a retiree family.
Most state employees hired since 1985 receive full state contributions only after
a certain number of years of service. Retirees and their eligible family members
generally receive no state health contributions with less than ten years of service.
They receive 50 percent of the maximum contribution with ten years of service, increasing
5 percent annually until the 100 percent level is earned after 20 or more years
of employment. State employees hired prior to 1985 receive the 100/90 formula for
health benefits upon retirement. Legislative approval of funding for retiree health
and dental benefits occurs in the annual budget bill, following the California Public
Employees’ Retirement System’s (CalPERS’) negotiation of health plan rates for the
upcoming calendar year.
What Is an Unfunded Retiree Health Liability?
In simplified terms, a retirement liability is the estimated amount of funds that
would need to be set aside today, which, when combined with assumed future investment
returns, would be sufficient to cover costs of all future retirement benefits earned
to date by current and past employees.
The unfunded portion of that liability is the amount remaining once existing assets
are considered. In the past, unfunded liabilities have been discussed primarily
in the context of public pension systems. The average public pension system in California
has enough assets on hand to cover about 88 percent of its estimated liabilities
for future pension benefits earned to date by current and past employees. Therefore,
the average public pension system has an unfunded liability equal to about 12 percent
of these liabilities. By contrast, in most cases, 100 percent of governments’ retiree
health liabilities are “unfunded” since no funds have been set aside to cover future
benefit costs earned by current and past workers. Instead, governments fund the
costs of these benefits on a “pay-as-you-go” basis. That is, the medical insurance
costs of retirees (and their dependents) are paid from current revenues as the benefits
are provided, not from funds set aside during the working life of that retiree.
What Is the State’s Unfunded Retiree Health Liability?
The valuation indicates that the state’s unfunded retiree health liability as of
July 1, 2007, will be an estimated $47.9 billion. Under Governmental Accounting
Standards Board (GASB) guidelines, the investment return (or “discount rate”) that
governments using a pay-as-you-go financing system may assume when reporting their
liabilities is low. This is because there is no pension-type investment fund generating
returns to help cover future costs. The $47.9 billion unfunded liability calculation
assumes a discount rate of 4.5 percent, which is consistent with the historical
earnings of the Pooled Money Investment Account (PMIA). The General Fund’s balances
are invested in short-term securities in the PMIA, which is administered by the
State Treasurer’s Office.
What Is the Liability if the State Starts To “Prefund” Retiree Health Costs?
In the valuation, the actuaries also report on what the state’s unfunded liability
would be under two different scenarios. Specifically, as required by the Legislature
in the 2006-07 budget, SCO asked the actuaries to report on what the state’s reported
unfunded liabilities would be if the Legislature committed the state to prefunding
the estimated future costs of retiree health benefits on a consistent annual basis,
rather than the current pay-as-you-go funding practice. According to the valuation,
if the state committed to consistently
set aside funds each year—in addition to the over $1 billion spent for benefits
under the pay-as-you-go system—the reported unfunded liability for retiree
health benefits would be $31.3 billion. (This method to eliminate unfunded liabilities
is known as the “full funding strategy.”) In other words, the unfunded liability
required to be reported in the state’s financial statements under the full funding
strategy is $16.6 billion less than the liability that would have to be reported
under the current pay-as-you-go system. The reason for this difference is that if
the state starts to set aside billions of dollars in assets to cover future benefit
costs, these assets are assumed to generate a significant investment return (at
a higher rate of 7.75 percent), which will cover a portion of the costs the state
itself would have to pay under the current pay-as-you-go system. The final scenario
reported is for a partial funding strategy. The values for this strategy are roughly
halfway between the pay-as-you-go and full funding amounts.
How Much Does the State Spend Now on Retiree Health Benefits?
The valuation estimates that the state will spend about $1.4 billion on retiree
health benefits in 2007-08 under its pay-as-you-go policy. This includes roughly
$1 billion in explicit state payments toward retiree benefits (primarily through
the retiree health and dental item  in the annual budget act), as well as
about $336 million as an “implicit subsidy.” This implicit subsidy relates to the
fact that some of the state’s retirees are in the same insurance risk pool (with
the same health care premiums) as active state employees. The retirees tend to utilize
more and costlier health care services than active employees due largely to their
ages. Premiums paid by the state on behalf of its active employees, therefore, subsidize
the retirees to an extent. This is the implicit subsidy captured in the valuation
under GASB guidelines; its costs have never previously been estimated for state
How Much Does the State Need to Set Aside to Address the Liabilities?
The valuation identifies what actuaries and accountants refer to as an “annual required
contribution” (ARC) under each of its discount rate scenarios. The ARC consists
of two parts:
Estimated normal costs (the amount that
needs to be set aside and invested in order to fund future retiree health benefits
earned during that year by active employees).
An amount estimated to be sufficient to retire existing unfunded liabilities over
no more than 30 years. In general,
exist because no funds have been set aside to cover past normal costs.
The ARC includes the costs necessary to provide each year’s benefits to past retirees—those
benefits currently funded under the pay-as-you-go system. Governments do not have
to fund the ARC each year, but choosing to do so allows them to reduce and perhaps
even eliminate their unfunded liabilities over the long term (thereby lowering long-term
As shown in Figure 1, in the pay-as-you-go valuation scenario (which reports a $47.9
billion unfunded liability), the ARC is estimated to be $3.6 billion. This is $2.2
billion above what the actuaries estimate the state would spend in 2007-08 for annual
retiree benefits under current funding policies. In the full funding scenario (with
a $31.3 billion unfunded liability), the ARC is estimated to be $2.6 billion, or
about $1.2 billion more than the state would spend for retiree benefits in 2007-08
under current funding policies. This means that, according to the valuation, if
the state (1) started committing $2.6 billion each year to retiree health benefits—or,
about $1.2 billion more than currently budgeted beginning in 2007-08—and (2)
invested the funds in an irrevocable, pension-type trust fund, retirees’ benefits
would be fully funded, and unfunded liabilities could be eliminated within 30 years.
(The actual amounts to be spent in each future year under any scenario would tend
to increase above the amounts listed in the valuation due to growth of the state
workforce and the effects of inflation on wages and benefits.)
Comparison of Pay-As-You-Go and Full Funding Scenarios
(Dollars in Billions)
Annual required contributiona
Assumed annual investment return
State currently pays $1.4 billion of these amounts.
Which Employees and Retirees Are Included in the Valuation?
The valuation includes over 130,000 retired state and California State University
(CSU) employees and nearly 250,000 active state and CSU employees, as well as their
dependents who are eligible for retiree health benefits. This valuation does not
include liabilities associated with University of California (UC) employees and
retirees, who are covered in a separate plan. An October 2006 valuation identified
UC’s unfunded retiree health liability at $7.6 billion. Local government liabilities
also are not addressed in the state’s valuation. School districts, community college
districts, cities, counties, and special districts all are beginning to report unfunded
liabilities under the new accounting rules. Based on information known to date,
we estimate that the unfunded aggregate retiree health liabilities of all of these
local governments will be far in excess of the state’s own liability. The Public
Employee Post-Employment Benefits Commission—appointed by the Governor and
legislative leaders—is currently surveying local governments on the size of
their retiree health liabilities.
What Assumptions Do the Actuaries Use to Estimate the Liabilities?
Actuaries use a complex set of demographic, economic, and investment assumptions
to make the estimates included in these valuations. There are no standard assumptions
applied to every public employer, since each retiree health benefit program requires
assumptions based on its particular characteristics. Above, we discussed the discount
rate assumptions. In our opinion, the other key assumption in these valuations concerns
annual employer health premium growth in the future. Assuming continuation of the
state’s current benefit package for its retired employees, the valuation assumes
an average 10 percent increase in health plan premiums set by CalPERS in 2008. The
valuation then assumes that the annual CalPERS premium increase declines steadily
each year until it reaches 4.5 percent per year in 2017 and beyond. This assumption
is consistent with those generally adopted by actuaries in these valuations.
Is the Valuation an Accurate Reflection of State Liabilities?
The valuation appears to conform to standard actuarial methods. Other retiree health
valuations of state and local governments have been using assumptions similar to
those used in this actuarial valuation. Accordingly, we believe that the valuation
represents a solid initial estimate of the state’s liabilities. As actuaries and
accountants gain more experience analyzing the data concerning state retiree benefit
costs and as additional data sources are developed to assist them in this effort,
it is possible that reported liabilities and related cost calculations may increase
or decrease—similar to the experiences of other governments after receiving
their first retiree health valuations. In addition, liability valuations tend to
change over time based on actual trends in health care inflation, investment return,
and other factors. Finally, since unfunded liability estimates reflect costs related
to benefits earned to date and, each year, employees earn additional future retiree
health benefits, unfunded liabilities tend to increase each year unless funds are
invested to cover each year’s added costs as they accrue.
Is the Assumed Rate of Health Premium Growth Too Optimistic?
The valuation uses standard actuarial assumptions for future health care premium
growth that are used across the country in similar reports. We are concerned that
one assumption—specifically, that the annual rate of premium growth will decline
considerably over the next decade and be sustained at a low level thereafter—is
optimistic. These valuations effectively assume that health care reforms at the
state or federal level will not only be enacted, but will reduce annual employer
health care premium growth to a significantly lower level within the next decade.
Should such reforms not prove successful and employer premiums continue to increase
at high single-digit or double-digit rates each year, the state’s unfunded liabilities
may turn out to be tens of billions of dollars more than estimated in this valuation.
What Suggestions Does LAO Have for Future Valuations?
We expect that actuaries will work with SCO and CalPERS to refine and improve the
data available to them concerning retiree health costs and utilization trends. Earlier,
we described how the state’s current funding approach for retiree health benefits
includes both explicit and implicit costs. The valuation does not exactly match
budgeted amounts for the explicit costs. Specifically, the
2007-08 Governor’s Budget estimates that 2007-08 direct state payments
for retiree health benefits will total $1.14 billion, while the explicit costs listed
in this initial valuation are $1.03 billion. Actuaries and SCO inform us that it
is possible that some of these cost differences are already included in the reported
estimate of implicit costs, but it will probably take some time and additional refinement
of the data to make sure. As noted above, given the lack of prior experience in
producing retiree health valuations, it is common for actuarial and accounting professionals
to refine the data and report significantly higher or lower costs in subsequent
What Are the Benefits of a Full Funding Strategy?
A full funding strategy achieves two key objectives.
First, it fulfills a fundamental tenet of public finance that
costs should be paid for as they accrue. When governments agree to provide
post-retirement benefits, it is critical that the estimated costs of those future
benefits be fully acknowledged and funded.
Second, by setting aside moneys to prefund future benefit costs, the state can take
advantage of compounded investment returns to cover a portion of benefit costs and
reduce the amount taxpayers must contribute to provide a given level of retiree
benefits. This strategy has been the standard for public sector pensions in California
for generations. It also makes sense for retiree health benefits.
What Legislative Actions Does the LAO Recommend?
The state’s unfunded liability is within the range we projected in our February
2006 report. The costs identified by the actuaries to fund and eliminate the state’s
unfunded retiree health liability within 30 years, however, are much less than we
expected. In the February 2006 report, we recommended that the Legislature ramp
up to paying part of the ARC over several years as a first step to reducing unfunded
liabilities. With this valuation’s estimate that the state needs to commit to setting
aside an additional $1.2 billion (in current dollars) each year in the future under
a full funding strategy, we recommend that the Legislature ramp up state contributions
to this identified amount over the next several years. The portion of the state’s
ARC payments not needed to fund current retiree benefits would be invested in a
manner specified by the Legislature in order to generate investment returns to cover
portions of future benefit costs. While fitting these expenditures into an already
difficult budget would require prioritization, it would accurately reflect the accrual
of new liabilities each year, as well as implement a plan to eliminate unfunded
retiree health liabilities over the next 30 years. If the Legislature were to pursue
such a full funding approach, it would face a number of technical policy issues—such
as which entity should invest the funds, which entity should control those investment
decisions, and how could the payments be structured to preserve future legislative
What Other Strategies Are There for Addressing the Unfunded Liabilities?
There are two general strategies for addressing unfunded liabilities: (1) setting
aside additional funds (as described above) and (2) changing benefits in some way
to reduce future costs. The latter strategy generally involves shifting financial
costs or financial risks for health benefits to employees or retirees. To the extent
that the state has committed—in statute, collective bargaining agreements,
or elsewhere—to paying a portion of these health care costs during retirement,
it is not clear that such benefits can be unilaterally altered.
Whether the Legislature would want to change retiree health benefits for any group
of past, current, or future employees depends on several factors, including (1)
whether this part of the employee compensation package is necessary to recruit and
retain qualified state workers, (2) the preferences of state workers to receive
compensation now or in a deferred manner, and (3) the ability to fund these benefits
within the context of other state priorities.
Given the current legal uncertainty regarding the state’s authority to modify health
benefits, we recommend that the Legislature clarify whether it wishes the state
to have the ability to change retiree health benefits for employees hired in the
future. Legislative intent should be specified
in statute as well as collective bargaining agreements. Whatever level of benefits
is specified, these costs should be paid for as they accrue.
What Should the State Do About Other Unfunded Liabilities?
In addition to unfunded liabilities for retiree health benefits, there are existing
or potential unfunded liability issues with other state retirement systems, such
as the California State Teachers’ Retirement System and the UC Retirement Plan,
which the Legislature should address during the next few years in order to contain
future costs of those systems. (Actions to address these systems’ liabilities may
involve additional state funds, as well as funds from other governmental entities
and employees themselves.) While CalPERS’ Public Employees’ Retirement Fund has
a $26 billion unfunded liability, there is already a mechanism in place—through
state and local employer contributions—to address this liability over time.
In addition to statewide retirement programs, school district, city, and county
retiree health programs often have significant unfunded liabilities. In many cases,
these unfunded retiree health liabilities would require payment of significant moneys
by these local entities—often equivalent to a large percent of the local entity’s
annual budget—to be fully addressed over the long term. In the
Analysis of the 2007-08 Budget Bill, we recommend that as part of a long-term
Proposition 98 funding roadmap, the Legislature direct a portion of increased Proposition
98 moneys in coming years to school district fiscal solvency in order to address
unfunded retiree health liabilities, among other fiscal issues.
Should the Legislature wish to continue providing eligible retired state employees
with a comprehensive health benefits package, we recommend that it fund those benefits
according to a long-term, actuarially based strategy. This has been the strategy
used by state and local governments in California for defined pension benefits for
generations. This strategy has allowed the state’s public retirement systems to
become substantially funded and to cover the majority of benefit costs using compounded
investment returns, rather than relying solely on taxpayer and employee contributions.
The retirement of the “baby boom” generation, the fiscal pressures on Social Security
and Medicare benefits provided by the federal government, and the likelihood of
scientific breakthroughs that will extend retirees’ lives significantly all create
major risks that future retirement costs could increase further for the state and
other public employers. Because of these risks for additional costs in the future,
now is the time to begin addressing the
significant amount of unfunded retiree health liabilities that already exist. The
state’s first valuation is an important tool for policy makers to use in this task.
This report was prepared by
Jason Dickerson and reviewed by
. The Legislative Analyst's Office (LAO) is a nonpartisan office which provides
fiscal and policy information and advice to the Legislature.
To request publications call (916) 445-4656. This report and others, as well as
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, are available on the LAO's Internet site at www.lao.ca.gov. The LAO is located
at 925 L Street, Suite 1000, Sacramento, CA 95814.
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