The state of Michigan has officially adopted nation-leading standards for how local governments report their finances and manage concerns about the solvency of their pension systems and retiree healthcare plans. Local units of government in Michigan — cities, counties, villages, towns, commissions, authorities, libraries, and hospitals — are collectively facing over $18 billion in unfunded pension and retiree healthcare liabilities, a crisis that motivated policymakers to act.
In December, the Michigan House and Senate passed a package of 16 bills establishing the clearest and most comprehensive set of reporting standards for municipal pension and retiree healthcare nationally. The legislative package, which passed almost unanimously and was signed by Michigan Gov. Snyder shortly thereafter, also established a Municipal Stability Board (MSB) to provide funding standards and a state-level solvency evaluation process for local government pension systems and retiree healthcare plans. The MSB, operating within the state Treasury Department, will mandate “corrective action plans” for local government units whose retirement benefit systems are in danger of insolvency, or whose budgetary outlays toward retirement benefits exceed certain thresholds.
Reason Foundation’s Pension Integrity Project team was engaged with a range of stakeholders throughout the process of developing the local government reporting standards and evaluation system. We provided technical assistance and policy design advice to legislative leadership, governor’s office, treasurer’s office, and Michigan Municipal League, including the creation of UnfundedMichigan.org, an interactive website reporting pension and retiree healthcare data that we collected from over 2,700 local comprehensive annual financial reports and pension or health care plan valuation reports.
In the landscape of reporting standards, Michigan’s new legislative changes stands out in its scope. Other states have reporting requirements for municipal pension and/or retiree healthcare benefits that provide certain centralized information. But Michigan will require all local governments to annually submit pension and retiree healthcare plan summary reports to Treasury using a standardized set of assumptions and methods that will allow the MSB to more accurately measure financial solvency and fiscal stress.
The process established is a model that other states should consider adopting in coming years in order to better manage the threat of pension and retiree health care insolvency at the local level.
1. The Problem for Michigan Local Governments
Statewide, local governments have over $18 billion in unfunded liabilities for pension and retiree healthcare benefits. This pension and retiree health care debt is spread across the state, not isolated to one geographic part of Michigan or specific to just poor communities or particular types of government agencies.
The majority of counties and cities in Michigan provide some retirement benefits through a defined benefit pension plan and/or retiree healthcare insurance package (often referred to as “other post-employment benefits,” or OPEB). Many other local government units also provide the same kind of retirement benefits.
Unfortunately, 81 of 83 counties in Michigan have at least one local unit of government with a pension system or retiree healthcare plan less than 60 percent funded, a level typically considered critically underfunded. In fact, a total of 245 of Michigan’s cities, counties, townships and other municipal units have saved less than 1 percent of what is necessary to pay for retiree healthcare benefits.
The widespread problem with unfunded liabilities carries two key problems:
- First, financial insolvency for pension benefits and OPEB puts retirees themselves at risk, particularly those dependent on the benefits.
- Second, the growth of unfunded liabilities means rising costs to provide pension benefits and OPEB, requiring an increasing amount of revenue from today’s taxpayers to finance these retiree benefits. The growing costs of pension systems and retiree health care have been crowding out the ability for local governments to fund basic services, road improvements, libraries, parks, and fully staffed police and fire departments.
2. The Solution
The adopted legislation creates a new, uniform set of reporting standards to improve transparency, along with a 4-phase process for assessing and addressing pension or retiree healthcare benefit insolvency and a new state board designed to help local government units tackle their underfunding challenges.
New Reporting and Funding Standards
All local units of government — including counties, cities, towns, villages, and other independently managed governmental units such as commissions, districts, hospitals, etc. — will report their pension system and retiree health care plan funded status to the state using a uniform set of actuarial and funding assumptions to be determined by the treasurer’s office:
- These assumptions do not have to be adopted for funding purposes by the municipalities; they are for reporting purposes, intended to ensure that the solvency of a retirement benefit is being accurately determined and measured using consistent standards.
- The uniform set of assumptions will include, at a minimum, the assumed rate of return, the discount rate, payroll growth rate, salary growth rate, inflation rate, health care cost inflation rate, amortization method, and mortality tables.
The legislation also requires that local units providing retiree healthcare benefits must at least pay the annual retiree health care premiums on their plans, as well as the full normal cost for any retiree healthcare plan offered to new hires as of 2018.
Municipal Stability Board
The Treasury Department will create a Municipal Stability Board to provide oversight of local government pension and retiree healthcare solvency and corrective action plans. The MSB will consist of three members appointed by the governor, representing state officials, local officials, and employees/retirees, respectively. The appointed members will generally serve four-year terms and must have relevant experience and skills to perform the duties of an MSB board member.
The MSB will be tasked with developing strategies, plans, methods, and best practices that local governments can implement as part of a corrective action plan that will improve financial solvency and reduce fiscal stress. In addition, the MSB will monitor compliance with corrective action plans (as outlined in Phase 4 below).
Phase 1: Annual Transparency Reporting from Local Units of Government
All local units of government offering pension or retiree healthcare benefits will annually report various funding metrics for those systems and plans to the treasurer using the pre-determined actuarial standards. Those reports will be posted online to a Local Government Dashboard.
Phase 2: Solvency Assessment by Treasury
Treasury will undertake a solvency assessment for all pension systems and retiree healthcare plans:
- Any pension system with a funded ratio less than 60% and with pension contributions exceeding 10% of local government operating revenues will be deemed “underfunded.”
- Any retiree healthcare plan with a funded ratio less than 40% and with OPEB contributions exceeding 12% of local government operating revenues will be deemed “underfunded.”
Retirement benefits that pass the solvency assessment will not require any further action until the following fiscal year. Any system or plan determined to be underfunded will move on to the next phase.
(It is important to note that there is no magic to the 60% and 40% thresholds adopted by this legislation. As noted below in “Next Steps,” these rates were the result of negotiation in the legislative process. A more robust threshold would gradually rise over time until 100% funded becomes the standard to meet.)
Phase 3: Fiscal Stress Assessment by the Treasurer’s Office
Generally speaking, any pension system or retiree healthcare plan that is “underfunded” should be a cause for concern. However, there are several mitigating factors that may reasonably suggest that no action be taken on an underfunded retirement benefit. For example, a plan may be poorly funded, but also very small relative to the size of a municipality and its operating budget, making it unlikely to create fiscal stress. Alternatively, a municipality might have recently adopted a set of benefit or funding policy changes that are projected to improve solvency over time.
Given these concerns, any municipal unit with a pension system or retiree healthcare plan deemed underfunded will subject to a fiscal review by the treasurer’s office to determine whether a one-year waiver should be granted (based on the lack of fiscal stress caused by the underfunding or a pre-existing plan to correct insolvency being in place), or whether the municipal unit and its underfunded retirement benefit(s) should be placed into phase 4 for corrective action.
Phase 4: Corrective Action for Insolvency and Fiscal Stress
All local units of government that are not granted a waiver in Phase 3 will be required to meet with the MSB and develop a corrective action plan within 180 days of the determination of underfunded status.
Corrective action plans can include changes to contribution rate policy (such as increased payments or cost-sharing requirements), changes to assumptions and methods, changes to the actual benefits offered, closing existing defined benefit plans and providing new kinds of retirement benefits, increases in revenue, or other strategies and practices.
These corrective action plans must be submitted within 180 days of being declared underfunded, and the MSB will have 45 days to review and approve the plan or reject it. If a corrective action plan is rejected, the local government unit will have 60 days to provide a revised strategy.
Once a corrective action plan is approved, the MSB will monitor the local government for compliance and implementation. The MSB is also authorized to adjust the corrective action plan over time as necessary to ensure the goals of financial solvency and fiscal stability are met.
3. Areas for Future Improvement
Applying More Robust Funding Requirements
The majority of the new standards Michigan adopted are related to reporting requirements. The primary substantive funding requirement provided for in the legislation is related to retiree healthcare plans, but only requires that minimum payments be made for existing OPEB. The could be improved by setting funding requirements broadly, including a requirement that all pension and OPEB normal costs be paid annually. Limits on the length of amortization schedules allowed for pension systems should also be considered, along with a cap on the assumed rate of return that local governments are allowed to use.
Gradually Increasing Definitions of Solvency
The definition of “underfunded” in the adopted legislation makes sense for the state’s current political climate, but is not designed to be effective in the long run. The thresholds of 60% funded for pension systems and 40% funded for retiree healthcare plans should gradually rise over time, for two reasons:
- In the interest of both retirement security and fiscal responsibility, corrective action plans should be designed to bring retirement benefits to 100% funding – i.e. full funding. But in this case, all that a pension system or retiree healthcare plan will technically need to do is cross the static 60%/40% thresholds, with no expectation of subsequent continuous improvement.
- Over time it would be prudent to place pressure on systems and plans that today are considered acceptably funded to improve themselves. Ultimately, being 60% or even 80% funded is not adequate — retirement systems and plans should always consider anything less than 100% funded to be underfunded and thus unacceptable.
Avoiding the Implicit Phase 5: Municipal Bankruptcy
A weakness in the whole process is that while the MSB can only promulgate corrective action plans, it cannot enforce them. Local government units will theoretically be allowed to ignore any corrective action plan approved by the MSB.
As a result, the only “teeth” in the evaluation process is the threat of the appointment of an emergency manager and potentially even municipal bankruptcy. In effect, municipal bankruptcy is the unstated Phase 5 for local governments who do not appropriately address the financial challenges of their pension systems and retiree healthcare plans and ignore the MSB.
The overall process in Michigan would be improved by providing the MSB with some kind of enforcement mechanism, such as the ability to require a corrective action plan under the authority of the judiciary, or by granting the MSB with certain authority currently provided to emergency managers. Another solution would be to allow the MSB or treasurer to remand a local government to an emergency manager or emergency manager panel if they are not cooperative with the MSB or do not implement a corrective action plan. Whatever the policy approach, the ultimate area for improvement is providing greater capacity for enforcement of approved corrective action plans.
4. Pension Integrity Project’s Role and Reform Objectives
Our Pension Integrity Project team provided technical assistance to many stakeholders throughout the process of developing reforms to local government pension and retiree healthcare reporting and evaluation. We also collected data for every local government pension system and retiree health care plan—drawing data from over 2,700 comprehensive annual financial reports and valuation reports—and made this data available to the public on the interactive website, UnfundedMichigan.org. We also provided legislators with independent fiscal analysis of how various proposed provisions would address the existing problems, as well as policy design advice to legislative leadership, governor’s office, treasurer’s office, and the Michigan Municipal League.
Whenever we evaluate a proposed set of changes to a public sector pension system or retiree healthcare plan we always compare it to our objectives for good retirement system reform. Ultimately, the effort to reform reporting and evaluation standards for Michigan municipal pension and retiree healthcare plans compared very favorably to our matrix:
- Keeping Promises: The adopted legislation does not impose a state mandate to make any specific changes to existing benefits. The Michigan Constitution protects all earned pension benefits from being impaired. Any prospective changes to pension benefits or changes to retiree healthcare benefits will be made at the local level in a collectively determined process with input from employees, retirees, and local officials.
- Provide Retirement Security: The evaluation process is designed to promote retirement security by avoiding sweeping state-level changes to benefits and setting goals for financial solvency. The MSB and local governments will still need to take care when designing corrective action plans that any changes made do not impair retirement security.
- Stabilize Contribution Rates: The definition of an underfunded plan in the legislation explicitly puts a cap on the size of employer contribution rates as a percentage of operating budgets, thus providing a clear ceiling on the growth of rates in the future.
- Reduce Risk: The funding requirements in the legislation, albeit as minimal as they are, will provide minor risk reduction that new hire retiree healthcare benefits will become severely underfunded. The actual degree of risk reduction provided by the legislation will be dependent on the nature of corrective action plans, and whether they are designed to get pension systems and retiree healthcare plans to 100% funded or just over the threshold of underfunded as defined in the new statutes.
- Reduce Long-term Costs: All corrective action plans will provide for cost reduction, either directly through changes to benefits or in the long-run by adopting contribution rate changes and revenue increases that will reduce the growth of unfunded liability payments, saving taxpayers money in the long-run.
- Ensure Ability to Recruit/Retain: The legislation explicitly leaves to local units of government how to best recruit and retain for their specific functions and communities.
The Michigan Legislature, governor, and treasurer should be commended for adopting nation-leading local government reporting standards and a robust evaluation system that will support improvements in pension and retiree healthcare solvency and financial transparency. Other states should look carefully at the design of these standards and the corrective action process for inspiration in addressing widespread local pension and retiree healthcare underfunding.
Stay in Touch with Our Pension Experts
Reason Foundation’s Pension Integrity Project has helped policymakers in states like Arizona, Colorado, Michigan, and Montana implement substantive pension reforms. Our monthly newsletter highlights the latest actuarial analysis and policy insights from our team.