Legacy costs tough for Michigan local governments: Part one – Introduction to legacy costs
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.
Local governments across the country are feeling the financial stress of commitments made to employees in past years. This fiscal crunch is due to a combination of limitations on revenue growth and the costs of promises made to employees, largely in the form of pensions and post-retirement benefits. Dr. Eric Scorsone, Director of the Michigan State University Extension Center for Local Government Finance and Policy, recently spoke to the Northern Michigan Counties Association, a group of county commissioners in northern lower Michigan, about these issues.
Scorsone explained that these costs are commonly referred to as “legacy costs”, which he defined as “promises made by past generations to be paid by future generations”. Defined benefit retirement plans are one of these costs. Commonly used by many businesses and governments, this type of retirement plan has mostly been replaced for new hires by defined contribution plans. The name of each describes the type of plan. Defined benefits are those where the organization invests an amount of money they think will be adequate to provide a pre-determined, or defined, amount of money to pay the employee after retirement for the rest of their life. When investment options are not robust enough, or the organization has not invested enough money, there is a shortage of funds to make the promised payments, and the organization, whether government or business, has to make up the difference out of current revenue. Defined contribution plans solve this problem by only promising to make contributions to the retirement savings plan, which is often managed by the employee. Employees generally also make contributions and may also have other retirement investments. It is up to the employee to calculate the amount they will need and time their retirement to have enough to last for the rest of their life. The employer no longer has to be concerned about making a sufficient investment.
Employers also have historically paid for some portion or all of the cost of other post-employment benefits, also known as OPEBs. OPEBs present a similar problem in that they are typically funded from current revenue. Health insurance is probably the most common OPEB. Longer life spans of retirees, coupled with health care costs, which for years have risen faster than inflation, make OPEBs another serious financial concern.
The rising costs of health care have contributed to a trend among local governments and many businesses: to require employees, and sometimes retirees, to cover a percentage of their health care premiums. Scorsone referred to future healthcare costs as “the great unknown”.
In part two of this Michigan State University Extension news series, we’ll cover challenges for local governments as they plan for legacy costs, and we’ll look at some suggestions and strategies in part three.
The Michigan State University 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.