Vol. 1, No. 5, Published September 9, 2015
We Must Address Unfunded Retiree Health Costs, Infrastructure to Stay Competitive In the Global Economy
Good Government Management is Key to Improved Bond Ratings and Lower Borrowing Costs
By Treasurer John Chiang
We began a discussion in Intersections months ago about the three factors that rating agencies evaluate when determining ratings, what we can do to help further boost California’s ratings and how that can ultimately save taxpayer money.
In July, we first focused on how rating agencies evaluate California’s economy -- which if it were a separate nation would rank among the top 10 economies in the world.
In August, we pointed out how the State’s important recent financial improvements – such as building its rainy day fund, adopting timely budgets and improved liquidity -- have all helped boost our ratings four times since the summer of 2014.
Now it is time to focus on how we can improve the management of California’s fiscal affairs, therefore paving the way for even better ratings in the future. I have several ideas about how to do this, which I will outline in a major report at the end of this year. But for now, I would like to preview a couple of proposals for better managing our long-term liabilities. Unfunded retiree health care costs and aging infrastructure are two off-budget areas that often fly silently under the radar. But if left unaddressed, both will continue to pose a large risk to the Golden State’s fiscal health and ability to compete in a global economy.
I believe that focusing on management practices is the very best opportunity we have to improve our ratings, lower our borrowing costs and preserve our valuable borrowing capacity. Standard and Poor’s Ratings Services noted in 2012 that “a government entity's management and administrative characteristics, along with other structural issues it faces, can move a rating up or down more significantly and swiftly than any other element of a credit review.” Highly-rated public finance issuers show common traits, S&P added, including, “(p)roactive budget and liability planning, strong liquidity management, and the establishment of reserves.”1 We’ve made good progress in all of these areas, but we clearly still have work to do.
First, let’s talk about unfunded retiree health care costs, known in state finance circles as other postemployment benefits, or OPEBs.
Last December, when I was still your State Controller, I released a report showing the unfunded liability of providing health and dental benefits for State retirees was $71.8 billion to be paid over the lifetime of current and future retirees. This liability ballooned 50.2 percent from 2007.
The problem centers on the way the State pays for this liability. While State pensions are pre-funded, allowing investment returns to significantly reduce liabilities, California pays for retiree health benefits on a pay-as-you-go basis, only covering the amount needed to fund the costs as they are due each year.
I proposed, and still strongly support, a plan to pre-pay OPEBs. This would allow investment returns on pre-paid monies to cover a good portion of the cost of OPEB payouts, thus significantly reducing the burden on workers and the taxpayers they serve.
Fortunately, we have made important progress in this area in recent weeks. The Governor has reached an important tentative agreement with the Professional Engineers in California Government on how to begin the process of pre-paying these costs through employee contributions. Union members and the Legislature must still ratify the agreement. This is a good start, but it is only a start. I would like to see that practice become more widespread via future collective bargaining between employee unions and the Administration.
Second, let’s talk about infrastructure – particularly roads, bridges, canals and schools. This area poses an even bigger liability, and like OPEBs, we need a long-term strategy.
A California Forward report -- drawing upon recent data from the California Transportation Commission, Public Policy Institute of California and elsewhere -- estimates that California needs more than $850 billion worth of infrastructure improvements in the future. A report card issued by the American Society of Civil Engineers in 2012 says that, among such needs, 34 percent of California’s roads are in poor condition and more than 2,700 bridges are structurally deficient.
I commend the Legislature for taking up the infrastructure issue during the current special session on transportation. Several thoughtful plans on how to pay for deferred maintenance have been proposed. And I commend Gov. Jerry Brown’s 2015 Five-Year Infrastructure Plan, which calls for investing $57 billion in state infrastructure over the next five years.
But to get to the bottom of the problem, we really need a more thorough assessment of how big our infrastructure challenges are. I propose that policy-makers make a commitment to complete a more detailed inventory outlining the condition of all infrastructure, when it will wear out and what it would cost to replace it.
We know the problem is gigantic, but without an analysis that looks at the long term, it is difficult to pay for current needs and responsibly plan for future improvements and replacement. Preparing a funding plan without accurate problem definition is to risk using a precious resource -- our ability to borrow money cheaply -- on things that might be useful, but may not be necessarily important to attain one of our strategic goals: to remain the most highly desirable place to live, work, innovate and prosper.
Look at the challenge as a homeowner would. A homeowner has a limited budget, and if faced with the prospect of replacing an old water heater, that water heater may seem to be the immediate priority. But what if unbeknownst to the homeowner the house has termites that pose an even greater danger to the structure? Wouldn’t it benefit the homeowner to have a broad view of all of the home’s deficiencies – old water heater, termites and other challenges – before making spending decisions? A thorough view of all of the home’s infrastructure shortfalls would allow the homeowner to set priorities and make reasonable, measured plans for repairs and ultimate replacement. Such a thoughtful approach helps the homeowner avoid surprises and make better plans for the future.
Do the 39 million residents of California deserve any less thought and deliberation when it comes to their own infrastructure?
Such a statewide assessment would not be just another study. It would serve as a guide to help us better manage our future, thoughtfully establish a priority list and avoid blind approval of more debt. With a clear understanding of what needs to be fixed, repaired, or upgraded, we can better use our debt capacity and realize important recognition from the people who lend us money that California’s management is characterized by a culture that is “in control,” not “in reaction,” to its growing infrastructure needs.
Starting to prepay our retiree health care costs and completing a detailed infrastructure inventory would go a long way toward setting our priorities first, then developing the most cost-effective ways to fund and finance them.
There is an old parable of three blind men who were led to an elephant to better understand the beast. Each felt a different part of the animal and formed a different conclusion about what they had experienced. They could not fully understand the elephant because they had not examined it in its entirety. Rather than struggle to figure out what we can afford to do piecemeal, we should be dealing with our liability elephants.
If we want to reclaim the California dream of prosperity for all, we need to get a better handle on our long-term liabilities. We owe it to taxpayers to help them understand what retiree health care costs really mean and what it’s going to take to fix the infrastructure they own.
Taking these steps should not be viewed as a cost, but rather as an investment in California’s future. Such an investment will enable California to compete more effectively in a global economy, just as it has so successfully for the past 50 years.
1“The Top 10 Management Characteristics of Highly Rated U.S. Public Finance Issuers,” Standard & Poor’s Ratings Services, July 23, 2012. (Note: this report is an updated version of an article published by S&P on July 26, 2010.)
Intersections is prepared by staff of the State Treasurer's Office. This newsletter should not be used for making investment decisions about State of California bonds or notes. Potential investors always should obtain and read the Official Statement published by the State for each issue of bonds or notes. Send us suggestions and feedback.