Local Governments Should Use Budget Surpluses to Pay Down Debt

California Gov. Gavin Newsom says the state has a massive $76 billion surplus, including stimulus money from federal taxpayers. Meanwhile, the nonpartisan Legislative Analyst’s Office puts the surplus at half that figure— $38 billion—due to constitutional spending requirements on where some of the money must go. With cities, counties and state agencies all lining up to request some of this surplus, they should heed the Legislative Analyst Office’s warning that new “spending at this time is shortsighted and inadvisable.”

Most Southern California cities do not need large amounts of money since their own tax revenues held surprisingly firm during the COVID-19 crisis. But many of these local governments also have rising public pension debt and less well-known, but equally troublesome, other post-employment benefit liabilities—typically retiree health care costs— that need to be addressed.

Nationally, unfunded other post-employment benefits (OPEB) liabilities total about $1.2 trillion but vary widely from place to place. One Southern California city laboring under a large OPEB debt load is Bell Gardens. In 2020, the city reported a total OPEB liability of $73 million—almost double its revenue for the fiscal year. Other Southern California cities with high OPEB debt burdens relative to their revenues include El Monte, Hawthorne, and San Fernando.

If these cities and other public agencies are experiencing a large surplus, they should look to pay off debt, including OPEB liabilities. The simplest technique is to contribute to a fund dedicated to paying future retiree benefits. Just as the California Public Employees’ Retirement System (CalPERS) requires cities to prefund their pension benefits, cities should also prefund other post-employment benefits. That way, employees are being fully compensated at the time they provide their public service and the bill is not passed on to future taxpayers.

Another alternative would be to pay an insurance company to assume part or all of that city’s OPEB liabilities. Several private employers have pioneered this concept, but it has yet to be attempted by a public agency. Whether the city pays down the OPEB liability itself or transfers the burden to an insurance company, it is reducing the risk that retirees will lose the health care benefits in a future fiscal crisis—just as Stockton’s retirees did when that city went bankrupt.

As they reduce risk for their employees, cities might also consider ways to “right-size” their other post-employment benefit packages, which may have become quite costly after decades of cost inflation across the health care industry. Among the changes that might be considered are capping retiree insurance premium reimbursements at the cost of an Affordable Care Act bronze plan, tightening eligibility requirements—especially for spouses and dependents who are offered costly coverage by some plans, and re-evaluating whether dental, vision, and/or life insurance should be included in these benefits going forward.

A third option is to transition employees away from defined benefit retiree health care benefits toward health savings accounts. Cities with major surpluses could offer to start retiree health care savings accounts. which could then be later augmented by some combination of employer and employee contributions as well as asset growth. Employee contributions are tax-deferred and the accounts are portable, so employees who leave prior to vesting in a defined benefit come out ahead.

Beverly Hills pioneered the use of these types of retiree health savings accounts in 2010 when it began offering defined contribution medical benefits to all new hires and gave existing employees the option of converting their defined benefit to an “Alternative Medical Retiree Program” funded with city contributions.

As they find themselves with unexpectedly large surpluses, many state and local officials may be tempted to add services and new programs, but doing so risks fiscal problems down the road.

“We recommend using more of the current surplus to build discretionary reserves and pay down more debts,” legislative analyst Gabriel Petek recently wrote of the state’s financial condition.

Governments at all levels with surpluses should be looking to pay down debt, thereby increasing fiscal resiliency ahead of the next crisis. Reducing other post-employment benefit liabilities is one way of doing this.

A version of this column originally appeared in the Orange County Register.