Analysis of the 2007-08 Budget Bill: General Government

Health and Dental Benefits For Annuitants (9650)

Through this budget item, the state contributes toward health and dental insurance premiums of more than 210,000 retired state government and California State University employees, their family members, and other eligible annuitants. The California Public Employees’ Retirement System (CalPERS) administers the state’s health benefit programs for its employees and retirees. Retirees and other annuitants may choose to enroll in one of several plans from health maintenance and preferred provider organizations. Retirees receive a state contribution—the amount of which is set pursuant to a statutory formula—of up to 100 percent of monthly premium costs for a CalPERS plan. The CalPERS plans often require participants to pay for various costs—such as deductibles, office visit charges, and prescription drug copayments—“out of pocket.”

The administration proposes expenditures of $1.06 billion for retiree health and dental benefits in this budget item—with 96 percent of the funds to be appropriated from the General Fund. Although the costs initially are paid from the General Fund, the state recovers a portion of these costs (by about one-third) from special funds through pro rata charges. (The rest of the expenditures in this item would be paid from the Public Employees Contingency Reserve Fund [CRF], as described below.) In addition, the Governor’s budget plan sets aside $80 million from the General Fund in an “off-budget” line item to address possible additional costs related to CalPERS’ health premium increases for calendar year 2008. (In other words, the use of this additional $80 million to cover rising premiums would not reduce the reserve included in the Governor’s budget plan.) Combined, these amounts would result in total state spending of $1.14 billion for state retiree health and dental benefits—an increase of 12 percent from estimated 2006-07 spending levels.

Administration’s Estimates Appear Too Optimistic

We withhold recommendation on the request for $1.14 billion for retiree health and dental costs pending the California Public Employees’ Retirement System’s (CalPERS’) determination of calendar-year 2008 health premiums in May or June. Given the recent track record of the CalPERS Board of Administration concerning premium increases, we doubt that costs will remain within the budget assumptions. Under the statutory formula that sets the amount of these benefits, the Legislature probably will have to appropriate additional funds for this item.

Administration’s Budgeting Practices Differ From Those of Prior Years. In contrast to the practices of some prior years, the budget and documents released by the administration contain little information about the reasoning and assumptions supporting the amounts included in this budget item. (Such assumptions include the net growth in the state’s retiree population and CalPERS’ annual rates of health premium increases.)

Budget Assumptions Appear to Be Somewhat Optimistic. Despite the lack of information from the administration, it is obvious that, in order for the Governor’s budget plan in this area to be achievable, CalPERS would have to negotiate lower rate increases and/or see a smaller increase in the net number of enrolled retirees and dependents receiving benefits than has typically been the case in recent years. Figure 1 shows the recent trend of steep spending increases for this item. While all funds in the budget plan would cover a 12 percent growth in retiree health and dental costs in 2007-08, the average annual rate of spending growth for this item actually has been 16 percent during the last seven years and 14 percent during the last three years. This spending growth results primarily from CalPERS’ premium increases, but also from growth in the population of retirees and dependents receiving benefits. If spending requirements for retiree health and dental benefits end up increasing 14 percent in 2007-08, for instance, instead of the 12 percent assumed in the Governor’s budget plan, the Legislature would need to appropriate about $25 million more than the amounts proposed by the administration.

CalPERS Board Rejected Plan to Slow Premium Increases Last Year. Under current law and practice, the Legislature delegates to the CalPERS Board of Administration broad powers to (1) design health plans for employees and retirees, (2) set premium rates, and (3) set other charges paid by plan members. In June 2006, the CalPERS’ staff recommended that the board approve several benefit design changes—for example, increases of office visit copayments from $10 to $15 and emergency room copayments from $50 to $75 for some plans—that would have reduced the 2007 premium rate increase paid by the state and plan members by as much as 2 percent for some health plans. The staff provided the board with information from published studies that indicated the changes would:

The board did not adopt these changes. The resulting 12 percent average premium increases for 2008—along with a 5 percent increase in the net number of state retirees enrolled in the program—caused the estimated 15 percent total spending increase in this item during 2006-07. The board’s recent track record in containing annual premium increases results in our pessimism concerning the budget proposal for retiree health costs. Should the CalPERS board reconsider its decision and adopt a similar plan design proposal to take effect in 2008, the state’s cost increases for retiree health benefits may be less in 2007-08 than in some recent years. In such an event, it is more likely that the amounts proposed by the Governor would be sufficient to pay for the state’s benefit commitments.

Valuation of Retiree Health Unfunded Liabilities Should Be Released This Year

As we discussed in The 2006-07 Budget: Perspectives and Issues, new governmental accounting rules soon will require the state and other public entities to identify unfunded liabilities for retiree health and dental benefits. We expect the state’s first valuation of these liabilities to be released during 2007. A new 12-member commission to be appointed by legislative leaders and the Governor is expected to consider issues concerning public employee retiree health and pension systems during 2007. We continue to recommend that the Legislature (1) begin to set aside money to address state retiree health liabilities and (2) require improved disclosure of these liabilities by local governments, including school districts.

State and Other Public Employers Have Large Retiree Health Liabilities. As we discussed in the 2006-07 P&I, the vast majority of public entities nationwide that offer health benefits to retired employees—including the State of California—pay for such benefits on a “pay-as-you-go” basis. This means that the governments pay for the benefits used by retirees and their eligible dependents each year. In contrast, most governments—including the state—have prefunded pension benefits for decades. When governments prefund retirement benefits (rather than funding them on a pay-as-you-go basis), they avoid forcing future taxpayers to pay for the compensation provided to public employees for services rendered in prior decades. Prefunding retirement benefits also reduces governmental costs over the long term. Since funds can be invested, the resulting investment returns (instead of current tax revenues) can cover large portions of benefit expenses. In the public sector, prefunding defined pension benefits and limiting the amounts of unfunded pension liabilities are well-established public policies at the state and local level. Because most governments do not prefund retiree health benefit costs at all, the unfunded liabilities to be reported under new governmental accounting rules often will be massive. Nationwide, state and local unfunded retiree health liabilities now are forecast to exceed $1 trillion. The State of New York and New York City have reported unfunded retiree health liabilities of about $50 billion each. The State of California’s retiree health program is similar in size to those of each of these New York governments.

Awaiting Release of the State’s Liability Valuation. In the 2006-07 Budget Act, the Legislature appropriated $252,000 to the State Controller’s Office (SCO) to contract with actuaries to produce the state’s first retiree health liability valuation, consistent with the new accounting rules. The valuation is expected to be released in calendar year 2007. Based on the results of other valuations being released by public entities nationwide, we continue to believe that (1) the state’s unfunded retiree health liabilities total between $40 billion and $70 billion and (2) the annual amount that the state would have to appropriate to eliminate this unfunded liability over 30 years could be somewhere around six times the current level of spending for retiree health and dental benefit costs ($6 billion). The actual amounts to be released by the SCO’s actuaries could be less or more than these amounts, depending on the assumptions they use for health care premium inflation in the future, investment returns that would be generated by funds the state might invest for this purpose, demographics of state employees and retirees, and other factors. At the local level in California, some governments already have released their retiree health valuations. We expect that hundreds of additional local governments will release their first valuations during 2007.

Governor’s Public Employee Post-Employment Benefits Commission. In December 2006, the Governor established this commission and directed it to report to him and the Legislature by January 1, 2008, on the following topics:

The commission will include three appointees of the Speaker of the Assembly, three appointees of the President pro Tempore of the Senate, and six appointees of the Governor.

LAO’s Recommendations on Retiree Health Care. In the 2006-07 P&I, we discussed some of the matters that the commission is expected to study, including methods that the state and local governments could adopt to address unfunded retiree health liabilities. In general, these methods fall into two categories: (1) identifying new funding and investing it to prefund retiree health benefits—an approach that we recommended that the Legislature begin to implement—and (2) changing benefits so as to reduce increases in future costs. In the 2006-07 P&I, we also recommended several measures to improve the disclosure of retiree health liabilities by local governments, including school districts, so that elected leaders and citizens will have information to make informed choices concerning state and local policy.

Approve Plan to Use Medicare Employer Funds For Retiree Health Costs

We recommend that the Legislature approve the administration’s proposal to use an estimated $38 million of Medicare Part D employer subsidy funds received in 2006-07 to pay a small portion of 2007-08 state costs for retiree health benefits. If the proposal is not approved, then General Fund costs would increase by $38 million. We further recommend technical changes to the proposed budget bill language to conform with this action.

Congress Provided Subsidy Funds to Reduce Employer Costs. The federal Medicare drug plan—known as Medicare Part D—went into effect beginning January 1, 2006. As of that date, Medicare began to pay for outpatient prescription drugs for certain individuals. Since some employers—like the state—already provide prescription drug benefits comparable in scope to those provided under the Part D program to their eligible retirees, Congress created a subsidy program, the Retiree Drug Subsidy (RDS) program, to encourage employers to continue offering drug coverage to retirees. The RDS subsidy equals 28 percent of allowable drug costs between $250 and $5,000 per calendar year for each Medicare-eligible health plan member and their dependents. In the 2006-07 budget, the Legislature directed CalPERS to apply for RDS subsidies and provided a small appropriation for additional staff positions necessary to handle the subsidy applications. The CalPERS estimated that 2006-07 RDS receipts would total about $38 million for the state. The Legislature directed that state RDS receipts be deposited to a special account and not spent (except to support the staff costs mentioned above), pending a later decision on how to spend the funds.

Attorney General Opinion Says Subsidies Should Be Deposited to CRF. Following the legislative action described above, the CalPERS Board of Administration requested the state Attorney General to opine on the legality of the decision to hold the funds in a special account for future legislative determination. The Attorney General opined that RDS funds must be deposited in the CRF, a state fund that is continuously appropriated for the purpose of funding CalPERS health benefit plans. The law provides that funds in CRF may be utilized “to reduce the contributions of employees and annuitants and employers” in CalPERS’ health plans. We understand that RDS subsidy receipts have begun to be deposited to an account in CRF, consistent with the Attorney General’s opinion.

Legislative Direction Is Crucial to Ensure Funds Are Used as Intended. The Governor’s budget includes language directing that the $38 million of RDS funds received in 2006-07 and now being deposited into CRF be used to offset costs that otherwise would be paid from the General Fund for retiree health costs. While the CalPERS board has asked that the funds be deposited to the CRF, some members of the board also have demanded that the funds be spent as they deem appropriate. These members have suggested that the funds should be used largely or entirely to reduce retirees’ out-of-pocket prescription drug costs. As discussed earlier, reduction of out-of-pocket costs tends to increase utilization of services and employer premiums. This would increase the state’s General Fund costs for retiree health benefits, rather than decrease the costs, as the administration proposes. Because the CalPERS board may wish to divert CRF moneys to this purpose and increase General Fund expenditures, legislative direction concerning the usage of the funds is crucial.

Recommend That Funds Be Used to Reduce Employer Costs, as Intended. Congress established the subsidy program to offset cost increases of employers that offer drug coverage to retirees, so as to encourage them to keep offering the coverage. The RDS funds were intended to be used as the administration proposes—to reduce employer costs and to help employers continue to afford to provide these benefits. In fact, an April 2006 letter to governmental accounting board officials from the National Conference of Public Employee Retirement Systems, the national organization for teachers’ retirement systems, and several of the nation’s largest public employee unions made this case forcefully. The letter stated, “The subsidy is built into the program to retain these benefits and to lower costs to taxpayers. By its action in drafting the original legislation, Congress declared its intent that these subsidy payments should reduce employer obligations.” The funds were not intended to be used as some on the CalPERS board propose—to reduce retirees’ out-of-pocket costs. The administration’s proposal, by contrast, would fulfill congressional intent in this regard, and therefore, we recommend that the Legislature approve it. We further recommend that the Legislature adopt technical changes to the proposed budget bill language to conform with this action.

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