Retiree Health Benefits:  Challenges Faced By Public

Employers Trying to Reduce Costs

The cost of retiree health care is of growing concern for many public agency employers and employees.  As those costs continue to rise and retirees live longer, many employers are faced with a financial burden that few predicted and even fewer are currently able to meet.  Changes in governmental accounting principles have brought the issue and the costs associated with providing retiree health care benefits to the forefront.  This article will discuss these changes in accounting principles, the limited ability of employers to reduce or eliminate retiree health care benefits, and some of the changes recently enacted by various agencies. 

            What Are Retiree Health Care Benefits?

Pensions are the most widely known post-employment benefit provided by employers.  Retiree health care benefits are the most common form of other post-employment benefits (known by the acronym “OPEB”) provided by employers.  Retiree health care benefits are generally established through a promise by an employer to provide an employee with a certain level of continued benefits upon retirement.  Employees work for an employer for a number of years with the expectation that the employer will fulfill this promise of providing continued benefits. 

For many public employers, the promise of retiree health care benefits is found in collective bargaining agreements, personnel policies, or resolutions or ordinances passed by the agency’s governing body.  The details of this promise, including the manner in which it is made and the language of the exact benefit promised all affect the employer’s obligation towards satisfying the promise.  For those public employers who are covered by the Public Employees’ Medical and Hospital Care Act (“PEMHCA”),[i] the promise of retiree health care benefits is found, not only in the documents described above, but also in the statutory provisions of the PEMHCA.[ii] 

            Why Are Retiree Health Care Benefits a Hot Topic Now?

In California, the cost of public pension benefits are funded traditionally through a combination of employer and employee contributions that are made on a regular basis during the term of an individual’s employment.  These regular contributions are then invested until such time as distributions in the form of pension payments occur.  This method of funding pension benefits is commonly described as “pre-funding.”  Pre-funded contribution amounts are determined by an actuarial analysis of the financial status of the pension plan.    

In sharp contrast, most retiree health care benefits have not been pre-funded.  Instead, many public employers fund these retiree health care benefits on a “pay-as-you-go” basis.  In other words, employers fund retiree health care benefits only in those years in which the benefits are actually being provided to a retiree.  Thus, unlike traditional pension plans, neither the employer nor the employee contributes money to pre-fund retiree health care benefits before those benefits are provided. 

New governmental accounting standards have focused attention on the issue of retiree health care benefits.  Under Statement Number 45, issued by the Governmental Accounting Standards Board (“GASB 45”), public employers are now required to measure and report those costs associated with providing retiree health care benefits, and any other OPEB.  Application of this new reporting requirement is being phased in, based on the total annual revenues of a governmental agency.[iii]  The stated purpose of this reporting requirement is to: 

improve[ ] the relevance and usefulness of financial reporting by (a) requiring the systemic, accrual-basis measurement and recognition of OPEB cost (expense) over a period that approximates employees’ years of service and (b) providing information about actuarial liabilities associated with OPEB and whether and to what extent progress is being made in funding the plan.[iv] 

GASB 45 requires only the reporting of unfunded OPEB liabilities, and does not require that employers immediately begin funding those liabilities.  However, as a result of the requirements of GASB 45, many public agencies had to examine the true costs of retiree health care benefits, including the costs of continuing to provide benefits to future retirees.  As the number of retirees grows each year, almost all public employers can expect eventually to be paying more for health care benefits for their retirees than for their current employees.       

To highlight the cost of providing retiree health care benefits, on May 7, 2007, the State of California reported that for the 2007-2008 fiscal year, the State alone will spend approximately $1.4 billion to provide health care benefits to retired state employees and their dependents.  In addition, the State reported an unfunded liability of approximately $48 billion for future retiree health care benefits.[v]  While the financial liabilities faced by individual local agencies are not as great as the liabilities faced by the State, individual agencies who have not pre-funded may be looking at liabilities totaling in the tens of millions and hundreds of millions of dollars.   

Before discussing the limited actions that public agency employers can take to reduce the unfunded liabilities that must be reported under GASB 45, it is helpful to look at how retiree health care benefits are treated under both the general legal theories of vesting and in specific retirement statutes. 

            How Retiree Health Care Benefits are Treated Under the Law

The California Supreme Court has long held that “public employment gives rise to certain obligations that are protected by the contracts clause of the Constitution, including the right to the payment of salary that has been earned.”[vi]  Anticipated pension benefits have been described as “an integral portion of contemplated compensation.”[vii]  Thus, a public employee’s right to “pension” or “retirement benefits” is one such protected obligation.[viii]   

The legal theory for granting constitutional protection to a public employee’s pension rights is based on the concept of vesting.[ix]  The courts have held that the right to pension benefits vests upon employment.[x]  This holds true even if an employee has not satisfied the prescribed service period for receiving a full benefit.[xi]  The California Supreme Court has described the interplay of vesting for purposes of receiving a benefit and vesting for purposes of determining the amount of that benefit, along with the contractual nature of vesting generally, as follows:

It is true that an employee does not earn the right to a full pension until he has completed the prescribed period of service, but he has actually earned some pension rights as soon as he has performed substantial services for his employer. [Citations.]  He is not fully compensated upon receiving his salary payments because, in addition, he has then earned certain pension benefits, the payment of which is to be made at a future date.  While payment of these benefits is deferred, and is subject to the condition that the employee continue to served for the period required by the statute, the mere fact that performance is in whole or in part dependent upon certain contingencies does not prevent a contract from arising, and the employing governmental body may not deny or impair the contingent liability any more than it can refuse to make the salary payments which are immediately due. [xii]  

In other words, once an employee begins work for a public agency that provides pension benefits, the employee and the employer automatically enter into a constitutionally-based “contract” for pension benefits.  The full benefit to be received by an employee will depend upon the employee’s satisfaction of certain terms, which generally include a requirement that the employee perform services for a pre-identified period of time.  A public agency employer that changes the terms of this contract while the employee is engaged in satisfying the requirements to receive the full benefit of the contract may be deemed to have with unconstitutionally impaired its “contractual” obligation to the employee. 

So far, the discussion has focused on the legal treatment of traditional pensions; but what about retiree health care benefits?  Are retiree health care benefits and other OPEB treated in the same manner as traditional pensions?  In one published California decision, the Court of Appeal answered this question in the affirmative, and held that retiree health care benefits do vest in the same manner as pension benefits.  The case, Thorning v. Hollister School District,[xiii] arose from a decision by a school district to discontinue paying health benefits to retiring school board members.  In Thorning, the court decided that once the school board had adopted an “official declaration” of policy that provided fully-paid health benefits to retired board members who had served a specified number of years, the school board could not suspend payment of those benefits as to those members who had retired while that policy was in effect.

Making Changes to Vested Benefits

Once a public employee has vested in the right to a certain benefit, that benefit may not be altered without impairing the employer’s contractual obligation.[xiv]  However, the existence of this contractual obligation does not mean that an employer may never change the type or level of benefits provided.  In fact, over time, many employers have increased retirement benefits.  But what about an employer who attempts to reduce benefits?  To answer this question, it is helpful to look at the very limited manner in which courts have allowed employers to change pension benefits. 

The Circumstances in Which Changes Can Be Made

Once a retirement benefit has vested in an employee, it may only be reduced in two limited circumstances.  The first circumstance occurs when both parties agree to the change.  After all, there is no impairment of a contract if both contracting parties mutually agree to the change in the contract terms.[xv]  This mutual agreement may become especially important when the change being made affects individuals who are currently retired.  Since the theory of vesting is based in contracts, an employer seeking to change the vested benefit of a group of retirees will presumably need to enter into a new contract with each and every one of the retirees affected.   

The second circumstance in which a change to a pension benefit may be implemented occurs when, prior to the time of retirement, the employer makes reasonable modifications to benefits to maintain the integrity of the pension system.[xvi]  The reasonableness of a modification is determined on a case-by-case basis. [xvii]   However, in order to be deemed “reasonable” the courts have held that:  (1) modifications “must bear some material relation to the theory of a pension system and its successful operation”; and (2) modifications “which result in disadvantage to employees should be accompanied by comparable new advantages.”[xviii] 

In order for a modification to be considered reasonable, both prongs of the test must be satisfied.  A modification satisfies the first prong of the test when it relates “to considerations internal to the pension system, e.g., its preservation or protection or the advancement of the ability of the employer to meet its pension obligations.”[xix]  The courts have struck down modifications that are unrelated to the purpose and operation of a pension. 

For example, in Wilson v. City of Fresno,[xx] the Court of Appeal struck down an amendment to a pension plan which terminated all pension rights upon conviction of a felony after retirement.  In striking this amendment, the Court of Appeal held: 

The termination of all pension rights upon conviction of a felony after retirement does not appear to have any material relation to the theory of the pension system or to its successful operation. Rather, the change was designed to benefit the city and, as stated in the city's brief, to meet the objections of taxpayers who would be opposed to contributing funds for the maintenance of a pensioner who had been convicted of a felony.[xxi]

Although a modification may satisfy the first prong of the test, employers proposing to reduce a vested benefit may have difficulty satisfying the second prong.  The judicially imposed requirement that reductions in vested benefits must be offset by “comparable new advantages” to employees can render any attempt to substantially reduce costs illusory.  In determining if a modification results in a comparable benefit or comparable new advantage, the courts “must focus on the particular employee whose own vested rights are involved.”[xxii]  The courts will consider evidence of the effects of the modification and resulting benefit on the particular employees whose vested rights are involved in determining if the modification is permissible. 

For example, in Barrett v. Stanislaus County Employee Retiree Association,[xxiii] the Court of Appeal upheld a retirement board requirement that employees who were reclassified from miscellaneous members to safety members pay the difference between the employee contribution for miscellaneous members and safety members.  The court held that the requirement to pay these arrears contributions was a permissible change because the cost of the arrears payments was far outweighed by the enhanced retirement benefit associated with receiving a safety retirement.  

Similarly, in both Townsend v. County of Los Angeles[xxiv] and Amundson v. Public Employees’ Retirement System,[xxv] the courts upheld modifications to pension plans which related to changes in retirement ages.  In Townsend, the court upheld a modification that reduced the mandatory retirement age from 70 to 65.  This change was offset by an increase in the percentage of benefits provided for each year of service, which resulted in enhanced benefits.  In Amundson, the court upheld a modification that imposed a later retirement age.  The court upheld that the disadvantage of the later retirement age was offset by a decreased employee contribution and a substantially higher pension on retirement.

The Language of the Benefit Could Be Key 

Before an agency looks at modifying retiree health care benefits, the agency should first look to its contractual obligation.  The exact terms of that obligation will impact the employer’s ability to make changes.  The courts will interpret the language that created the benefit when evaluating the permissibility of a modification.  

In 2004, the court issued a decision allowing an employer to limit the health care benefits that it offered retirees based on the language of the agreement which authorized the benefit.  In Sappington v. Orange Unified School District,[xxvi] the school district had been providing retirees fully paid PPO and HMO plans for twenty years.  Due to increasing health insurance costs, the district decided to require a contribution for the PPO plan.  However, the district continued to provide fully paid HMO benefits.  The retirees filed suit, alleging that the district was obligated to continue providing fully paid PPO benefits. 

In support of their position, the retirees in Sappington relied upon language in a district policy which stated, “The District shall underwrite the cost of the District’s Medical and Hospital Insurance Program for all employees who retire from the District provided they have been employed in the District for the equivalent of ten (10) years or longer.” 

In finding for the district, the Court in Sappington held that the language relied upon by the retirees only required that the district provide some type of insurance coverage, not a specific type of coverage.  The court held that the district’s actions in providing full coverage for both HMO and PPO plans did not create a contractual obligation to do so, stating, “Generous benefits that exceed what is promised in a contract are just that:  generous.  They reflect a magnanimous spirit, not a contractual mandate.”[xxvii]  Thus, based on the language of the vested benefit, the court found that the district’s decision to only provide fully paid HMO benefits did not constitute an impermissible change.

Comparison of Different Retirement Laws

One of the sources for determining the scope of benefit will be the statute under which that benefit is provided.  Depending on the applicable retirement law, this statute may allow an employer to take action to modify, or even eliminate, a vested benefit.  As described below, the two statutory schemes under which most public agency employers provide retiree health care benefits are very different.  Employers who provide retiree health care benefits under the provisions of the County Employees Retirement Law (“CERL”) may have much more flexibility with regard to reducing and/or eliminating retiree health care benefits.  In contrast, employers covered by the provisions of the PEMHCA may be more limited and face greater obstacles when attempting to reduce retiree health care benefits.    

A.        Specific Vesting Rules Under The CERL

Government Code section 31691 allows for the provision of retiree health care benefits by two different methods.  Under Government Code section 31691, benefits can be provided either by an ordinance or resolution adopted by the governing body of an agency covered by the CERL or by action of a board of retirement (the trustees of a retirement plan under the CERL).[xxviii] 

The ability of an employer to reduce or eliminate a retiree health benefit granted under Government Code section 31691 is expressly addressed by the CERL.  Specifically, Government Code section 31692 states,

The adoption of an ordinance or resolution pursuant to Section 31691 shall give no vested right to any member or retired member, and the board of supervisors or the governing body of the district may amend or repeal the ordinance or resolution at any time except that as to any member who is retired at the time of such an amendment or repeal, the amendment or repeal shall not be operative until ninety (90) days after the board or governing body notifies the member in writing of the amendment of repeal.  In counties with a population of 5,000,000 or more, the adoption of an ordinance or resolution pursuant to Section 31691 shall remain in effect for any member heretofore or hereafter retired for as long as the board of supervisors or governing body provides similar types of benefits to any active member in current county service. [Emphasis added.][xxix]

While there are currently no published cases discussing application of Government Code section 31692, this may change as more and more agencies look to reduce or eliminate retiree health care benefits and agencies attempt to take advantage of this statute.  For example, on May 17, 2007, the Board of Supervisors for the County of Sacramento voted to eliminate retiree health care benefits for approximately 12,800 current employees but left benefits unchanged for current retirees.[xxx]  Whether the affected employees will seek judicial review of the County’s actions and whether the County’s action will be upheld remains to be seen. 

            B.        Issues Unique to PEMHCA Covered Agencies

The statutory requirements relating to retiree health benefits for those agencies covered by the PEMHCA vary significantly from the CERL.  Under the PEMHCA, employers have two options for providing retiree health care benefits, either under the equal contribution rule or pursuant to a vesting schedule.[xxxi]  Each option poses unique issues for public employers.

The equal contribution rule requires that an employer’s contribution under the PEMHCA “shall be an equal amount” for both employees and retirees.[xxxii]  Employers who provide benefits under the equal contribution rule are required to provide a minimum contribution of $80.80 per employee and retiree during calendar year 2007 and a minimum contribution of $97.00 per employee and retiree during calendar year 2008.  Beginning in 2009, this minimum contribution will be adjusted annually.[xxxiii]

The effect of the equal contribution rule is, in essence, to decrease an employer’s ability to reduce retiree health care benefits.  This barrier exists even if the employees were to agree to the reduction and the reduced contribution amount satisfies the minimum contribution requirements.  The effects of the equal contribution rule are most obvious when considering a common technique used by employers to reduce pension liabilities, namely the creation of a second tier of benefits that will be applicable only to future employees.  Since current employees and current retirees must receive the same contribution amount under the PEMHCA, a tier which provides some employees a lesser contribution than retirees appears to violate the equal contribution rule.  Employers subject to the PEMHCA that seek to create multiple benefit tiers may face legal challenges from new employees who are hired and provided benefits at the lower tier levels. 

As an alternative to the equal contribution rule, employers covered by the PEMHCA might consider exploring the adoption of a vesting schedule.[xxxiv]  Under this option, the actual contribution paid on behalf of each retiree for health care benefits need not be equal to current employees or other retirees.  Instead, the actual contribution paid to a retiree is determined by the individual’s years of service.  The vesting schedule provides that an employee who has ten (10) years of service credit at the time of retirement is entitled to receive a benefit equal to 50% of the employer’s contribution towards retiree health care benefits upon retirement.  Employees receive an additional five percent of contribution for each additional year of service after satisfying the ten years of employment.  Thus, employees who retire with twenty (20) or more years of service are entitled to receive an amount equal to 100% of the employer’s contribution for health care benefits.      

Employers considering a vesting schedule should be aware of two issues.  First, a vesting schedule is only generally applicable to those individuals hired after the vesting schedule is adopted.[xxxv]  The retirement health care benefits of current employees or current retirees are not generally affected by the adoption of a vesting schedule.  Thus, the adoption of a vesting schedule establishes a two-tier benefits program based on an individual’s date of hire, with one level of future medical benefits for current employees and a different level of benefits for employee’s hired after the date on which the vesting schedule is adopted.  The creation of this two-tier benefits system through application of a vesting schedule is the only exception to PEMHCA’s equal contribution rule.     

The second issue that employers should keep in mind regarding vesting schedules is the effect on the required employer contribution.  Contracting agencies that adopt a vesting schedule are required to provide a minimum contribution that satisfies the requirements of the 100/90 formula set forth in Government Code section 22893.[xxxvi]  This formula is dependent upon the weighted average premium of the four largest health benefit plans offered under by California Public Employees Retirement System (“CalPERS”).  Employers are then required to provide a contribution that is equal to at least 100% of the average cost of employee only benefits.  The employer contribution for dependents is an additional 90% of the weighted average for dependents.  The employer contribution under this formula is adjusted annually.[xxxvii]  Based on the formula, a maximum contribution is established.  The applicable percentage of that maximum that must be paid to a retiree is determined by that retiree’s years of service as discussed above.  

Based on increases in health care premiums, application of the 100/90 formula results in a required employer contribution amount that is higher than the minimum contribution amount set forth in Government Code section 22892.  Notably, because the 100/90 formula is based on PERS’ premiums, the adoption of a vesting schedule by those employers who currently provide a fixed amount could result in unexpected increases in required contributions over time. 

Finally, employers will need to consider the interplay between the equal contribution rule and a vesting schedule.  Unlike the equal contribution rule which provides the minimum contribution for both employees and retirees, the vesting schedule option only addresses the minimum contribution that must be made for retirees.  This leaves open the question of the minimum contribution for current employees of an employer who has adopted a vesting schedule.  In answer to this question, employees are likely to assert that the equal contribution rule should be read in conjunction with the provisions that allow for adopting a vesting schedule.  Thus, these employees are likely to assert that the employer’s contribution for current employees should be an amount that is no less than the maximum contribution amount required under the 100/90 formula for retirees.  While there are no cases discussing the relationship between these statutes, this pro-employee approach to contributions appears to have been adopted by CalPERS in guidelines contained in a circular letter.[xxxviii]

            Looking to the Future:  What Can Public Employers Do? 

Given that reducing or eliminating retiree benefits may be a difficult undertaking for many public employers, these employers are exploring a variety of options to help minimize the future impacts of benefits promised today. 

One option being utilized by employers is to maximize pre-funding of retiree health care benefits.  By setting aside money now for future obligations, employers are able to take advantage of the financial benefits associated with long-term investing.  In order to assist employers with pre-funding, CalPERS has created the California Employers’ Retiree Benefit Trust Fund.  In early May of 2007, the City of Thousand Oaks became the first public agency employer to participate in this newly created trust.[xxxix]

Another strategy being utilized by employers is to try to negotiate reduced benefits.  Given the unique constraints of the PEMHCA, the ability to negotiate a reduction may only be feasible for employers covered by the CERL.  This strategy of negotiating reductions has been successful for the County of Orange, which is covered by the CERL.  The County of Orange has entered into agreements with the exclusive representative of most of its employees.  Based in part on these negotiated changes, the County of Orange has been able to reduce its unfunded liability by more than one-half, from $1.4 billion dollars to $598 million dollars.[xl]  

Employers covered by the PEMHCA do not appear to have the statutory ability to what the County of Orange did under the CERL.  The PEMHCA employers may want to consider pursuing statutory changes to the PEMHCA that would allow them to create multiple benefit tiers, either through unilateral action or through the meet and confer process. 

Finally, other agencies are waiting to hear the recommendations of the Public Employees Post-Employment Benefits Commission (“Commission”) before taking any major actions.  The Commission was created by Governor Schwarzenegger and consists of twelve members:  six, including the chairperson, appointed by the Governor, three appointed by the Speaker of the Assembly, and three appointed by the Senate President Pro Tem.  The Commission is responsible for preparing a report that:  (1) identifies the unfunded OPEB liability for California’s governmental entities; (2) evaluates and compares approaches for addressing these unfunded liabilities; and (3) proposes recommendations for addressing these unfunded liabilities.  The Commission is required to provide this report to the Governor and the Legislature by January 1, 2008.[xli]    

                        Conclusion

There are no easy solutions to the reducing the growing costs of retiree health care benefits.  There is no one solution that will apply to all public employers since each faces unique obstacles.  These obstacles include the financial status of each agency (including the amount of any unfunded OPEB liability), the language of the benefit provided, and the statutes by which the agency is governed.  These factors, combined with the increasing costs of premiums, the decreasing levels of plan benefits, and the real pressures that are placed on public employers suggest there may be a long and difficult legal, financial and emotional battle ahead.  Only time will tell if public sector employers will be successful in reducing or eliminated retiree health care benefits.