Two types of health-related costs are of  particular concern at the state and local level: (1) Medicaid expenditures,  and (2) the cost of health insurance for state and local government  employees, retirees, and their beneficiaries. Retirement benefits consist primarily of two components: pensions and  retiree health benefits. In contrast,  state and local law provides much less protection for retiree health  benefits. To the extent retiree health benefits  are legally protected, it is generally because they have been collectively  bargained and are subject to current labor contracts. State and local governments typically do not set aside funds  while employees are working to pay their future retiree health benefits. Strategies Exist to Manage Future Pension Costs, but Not to Meet Escalating Costs for Retiree Health Care

While state and local governments generally have strategies to manage  future pension costs, they have not yet developed strategies to fund future  health care costs for public sector retirees. First,  in our simulation of the fiscal outlook for the state and local sector, we  developed projections of the likely cost of pensions and retiree health  benefits that already have been and will continue to be earned by  employees. Assuming certain historical trends continue and that  there is a steady level of pension contributions in the future, contribution  rates would need to rise to 9.3 percent of salaries—less than a half percent  more than the 9.0 percent contribution rate in 2006. Retiree Health Care Costs Could More than Double as a Percentage of Salaries over the Next Several Decades

Our simulation indicates that projected costs for retiree health benefits,  while not as large a component of state and local government budgets as  pensions, will more than double as a percentage of salaries over the next  several decades, if these costs continue to be funded on a pay-as-you-go  basis. In addition, many of the governments are  still in the process of responding to the new GASB statement calling for  valuations of the liability for the future cost of other postemployment  benefits (OPEB), including health care benefits for retirees, as the  standard is being implemented in phases. Concluding Observations

Across the state and local government sector, the ability to maintain  current levels of public sector retiree benefits will depend, in large part, on  the nature and extent of the fiscal challenges these governments face in  the years ahead. Policy makers, voters, and beneficiaries can use  this new information to begin a debate on ways to control escalating  health care costs, the appropriate level of future benefits to be provided to  public sector retirees, and who should pay for them. These officials provided us with informal technical comments  that we have incorporated in the report, where appropriate. This appendix provides  information on (1) the development of several key demographic and  economic factors such as future employment, retirement, and wages for  the state and local workforce that are necessary for the simulations of  future pension and retiree health care costs; (2) how we project the  necessary contribution rate to pension funds of state and local  governments; and (3) how we project the future yearly pay-as-you-go costs  of retiree health benefits. We found that the model results are highly sensitive to our  assumptions regarding the expected real yield. Standards relevant to state and  local government retiree benefits are listed below. This report summarizes  the current coverage levels for retiree health insurance for public and  private sector retirees.
Why GAO Did This Study

State and local retiree benefits are not subject, for the most part, to federal laws governing private sector retiree benefits. Nevertheless, there is a federal interest in ensuring that all Americans have a secure retirement, as reflected in the special tax treatment provided for both private and public pension funds. In 2004, new government accounting standards were issued, calling for the reporting of liabilities for future retiree health costs. As these standards are implemented and the extent of the related liabilities become known, questions have been raised about whether the public sector can continue to provide the current level of benefits to its retirees. GAO was asked to provide an overview of state and local government retiree benefits, including the following: (1) the types of benefits provided and how they are structured, (2) how retiree benefits are protected and managed, and (3) the fiscal outlook for retiree benefits and what governments are doing to ensure they can meet their future commitments. For this overview, GAO obtained data from various organizations, used our model that simulates the fiscal outlook for the state and local sector, and conducted site visits to three states that illustrate a range of benefit structures, protections, and fiscal outlooks. Cognizant agency officials provided technical comments which were incorporated as appropriate.

What GAO Found

The systems for providing retiree benefits to state and local workers--who account for about 12 percent of the nation's workforce--are composed of two main components: pensions and retiree health care. These two components are often structured quite differently. Importantly, state and local governments generally have established protections and routinely set aside monies to fund their retirees' future pension costs, but this typically has not been the practice for retiree health benefits. A model GAO developed to simulate the fiscal outlook for state and local governments indicates that, for the sector as a whole, (1) estimated future pension costs (currently about 9 percent of employee pay) would require an increase in annual government contribution rates of less than a half percent, and (2) estimated future retiree health care costs (currently about 2 percent of employee pay) would more than double by the year 2050 if they continue to be funded on a pay-as-you-go basis. Because the estimates are very sensitive to the assumed rates of return and projected rates of health care inflation, the model also indicates that if rates were to fall below historical averages, the funding requirements necessary to meet future pension and health care costs could become much higher. Nevertheless, state and local governments generally have strategies to manage future pension costs. In contrast, many are just beginning to respond to the newly issued standards calling for the reporting of retiree health liabilities, and they generally have not yet developed strategies to manage escalating retiree health care costs. Across the state and local government sector, the ability to maintain current levels of retiree benefits will depend, in large part, on the nature and extent of the fiscal challenges that lie ahead--challenges driven primarily by the growth in health-related costs for Medicaid, and for active employees as well as retirees. In future debates on retiree benefits, policy makers, voters, and beneficiaries will need to decide how to control costs, the appropriate level of benefits, and who should pay the cost--especially for health care.