Cities and agencies facing unfunded retiree healthcare benefits with rising expenses can cut and constrain costs

By Isabel Safie, Best Best & Krieger LLP

California’s gap between promised employee benefits and available cash is wide and ever expanding.

Ballooning pension costs and rising deficits are often in the spotlight. But commitments that California’s governing bodies and agencies have made to provide retired public employees with health care plans that pose some of the state’s biggest funding questions.

Unlike pensions, however, costs pertaining to other post-employment benefits, or OPEB, of which retiree health care benefits are the greatest share, can be constrained.

Unfunded and Rising Liabilities

“One of the greatest fiscal challenges facing California is the mounting cost of providing health care benefits to public sector workers,” California State Controller Betty T. Yee, the state’s chief fiscal officer and a board member of CalPERS and CalSTRS, said in a retiree health care cost update early this year.

According to the Controller’s Office, as of June 2016, the state’s cost of retiree health and dental benefits grew to $76.68 billion.

When counties, cities, school districts, trial courts and the University of California system are added in, this OPEB liability number grows to nearly $160 billion (mostly unfunded), as reported by California Common Sense in a survey of 690 California OPEB liabilities in 2014.

Rising health care costs, an increasing retiree population and younger retirees, longer life spans as well as delays in prefunding such benefits until employees reach retirement will only cause these liabilities to  rise.

Pay-As-You-Go v. Prefunding OPEB

While pensions are predominately prefunded, California agencies and local governments typically fund OPEB liabilities on a pay-as-you-go basis.

The Controller’s Office says if no changes are made to the state’s OPEB funding method, its liability costs will grow to more than $100 billion by FY 2020-2021.

But, irreversibly setting aside funds for the express purpose of paying off OPEB could lead to lower long-term costs and reduce liabilities that must be recorded on financial statements.

A dedicated fund within a public agency’s treasury isn’t sufficient, however. Agencies may want to consider OPEB trust options, which include:

  • Section 401(h) Account: This is an account established within a 401(a) qualified retirement plan dedicated to paying retiree OPEB, including payment of expenses for medical, sickness, accidents and hospitalizations. The contribution limitation is 25 percent of the pension contribution.
  • Section 115 Trust: A trust operating independently of the sponsored employer that is used by local governments nationwide to prefund OPEB and pension liabilities. These trusts can be standalone trust or multiple employers’ trusts.  Examples of trusts in which multiple employers participate include the Public Agency Retirement Services and California Employers’ Benefit Trust.
  • Section 501(c)(9): A voluntary employees’ beneficiary association is an independent trust organized to pay life, sick, accident and medical benefits to members and their dependents. These require annual information returns. These trusts can be standalone trust or multiple employers trusts. An example is Nationwide’s Post Employment Health Plan.

If considering an OPEB trust, funding options include: mandatory employee contributions, employer contributions, percentage of salary, flat amounts and OPEB bonds.   

Vested Rights and the PEMCHA Dilemma

In contrast to pensions that are largely considered vested, the question of whether retiree health benefits are a vested right can vary from employer to employer — and employees, from future to retired.

Here’s a look at future, current and retiree vested rights:

  • Future Employees: Employees have no vested rights before they are hired, unless the rights are clearly laid out in controlling documents.
  • Retired Employees: Modifications to retiree benefits are questionable except under certain circumstances where benefit promises remain ambiguous. Some changes may be deemed permissible depending on the circumstances, including requiring retirees pay premium increases and changing carriers or types of coverage.
  • Current Employees (represented): Recent case law (Vallejo Police Officers Association v. City of Vallejo) suggests that, in certain cases, retiree health benefits are a condition of employment and are subject to negotiation.  
  • Current Employees (unrepresented): The question of whether the governing body intended to confer a vested right to retiree health benefits can be answered through the application of the four California League criteria:
    • Are benefits included in the public employer’s declaration of policy pertaining to employment?
    • Is there evidence that benefits are important to employees?
    • Were benefits an inducement to accept or remain in a position?
    • Is benefit a form of compensation earned by remaining in employment?

While recent case law has demonstrated that local governments have more flexibility to adjust a retiree’s health benefits than with pension benefits, it is important to note the California Supreme Court has established retiree health benefits can be vested benefits.

Before making changes, it is important to evaluate what an agency can do to its retiree health benefit program with a thorough analysis of an agency’s resolutions, ordinances, memorandum of understandings and employment policies.

The Public Employees’ Medical & Hospital Care Act, too, adds a layer of complexity to benefit alterations. For example, it requires employers providing health benefits to employees through the CalPERS health benefit program also provide health benefits to retirees. This obligation can be altered either through alternative arrangements available under PEMHCA or through tiered arrangements based on a minimum employer contribution foundation.  

Strategies for Public Agencies

Depending on an agency’s circumstances, here are a few strategies that can be used to constrain OPEB costs:

  • Capping the employer’s contribution to retiree health benefits
  • Altering health benefit eligibility requirements by raising the minimum age and service requirements or placing a limit on benefits until Medicare eligibility
  • Eliminating higher cost plans and/or health coverage for future retirees (consider PEMHCA)
  • Shifting from a defined benefit to defined contribution

If it’s legally feasible, agencies can also consider modifying the OPEBs of current employees and retirees.

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Isabel Safie is a Riverside-based partner at Best Best & Krieger LLP whose practice centers on employee, retirement and welfare benefit plans, taxes and issues relating to pensions and other post-employment benefits. Her work includes advising private-sector and public-agency clients on modifying and reducing retiree health benefit and pension costs. She can be reached at