Legacy costs tough for Michigan local governments: Part two – Legacy cost challenges
Commitments to pensions and other post-employment benefits (OPEBs) have created financial problems for local governments trying to balance budgets with stagnant or falling revenues and rising costs.
In his recent presentation to the Northern Michigan Counties Association, MSU Extension Center for Local Government Finance and Policy director, Dr. Eric Scorsone, started by describing legacy costs, which we discussed in part one of this MSU Extension News article series. He then went on to talk about challenges for local governments in planning for legacy costs. Those challenges include changes in lifespan or health care costs, changes in benefit levels and changes in the amortization period and/or investment assumptions.
Changes in lifespan, costs and benefit levels are pretty clear to understand. When people live longer, benefits are increased or costs of benefits go up, and then the cost to the local government goes up as well. The investment assumptions get a little more complicated.
To determine how much money must be invested, you need to know what kind of return, or interest rate, you will be receiving on that investment. You also need to know how much you expect to make in payments when the person retires. The amount you will eventually need requires the local unit to make assumptions about employees’ lifespans and the inflation that will be factored into payments over that lifespan. Actuarial tables based on historical life expectancy can help. Larger retirement plans have the benefit of being able to use an average lifespan, knowing that in a large group of people, the group will be reasonably distributed over the entire range of possible lifespans. Smaller groups have to plan more conservatively, since their smaller number of people may all live shorter or longer than average.
The other significant assumption is the rate of return on investments. Not too many years ago, when interest rates were higher, investment managers could count on 10 percent returns fairly regularly with a well-managed portfolio. Today, those who promise 7 or 8 percent are looked at with concern, as if they are overpromising or perhaps making more risky investments. Scorsone used the following example: If I need to pay another party $1 million in 10 years, how much would I have to invest? If invested in 3 percent treasury bonds, which are a pretty certain investment, I would need to invest $744,000. On the other hand, if I want to earn 6 percent in a more risky investment like equities, where my principle may go down if stock prices drop, then I would only have to invest $558,000. So, local government units and their retirement investment advisors have some tough decisions to make about the level of risk they can tolerate in their investments. The defined contribution plans offered to many newer employees transfer this assumption of risk to the employee.
Occasionally, local governments will consider operating their own retirement plan. Scorsone said the experience of those who have taken this route has often been higher fees, due to their smaller portfolios, and returns that are rarely higher.
Part three of this series on legacy costs will look at some strategies for local governments.
The MSU Extension Center for Local Government Finance and Policy has a number of resources on its website. One is Funding the Legacy: The Cost of Municipal Workers Retirement Benefits to Michigan Communities, published in 2013. Another is an update to Funding the Legacy, titled Legacy Costs Facing Michigan Municipalities, published in 2016.