Get a Healthy Dose of Reality on Postemployment Benefits
The Effects of GASB 43 and 45 on Government Finances
Galligan Kelley and Margaret P. Ruggieri
APRIL 2007 -
The cost of medical benefits for state and local government retirees
will soon shock taxpayers. According to a 2006 report from the Cato
Institute, states and municipalities face $1.4 trillion in unfunded
promises for retiree health benefits. Will property and state income
taxes have to increase? Will the healthcare benefits of government
employees be safe? In 2004, the Governmental Accounting Standards
Board (GASB) issued two new standards that require state and local
governments to disclose the true cost of providing postretirement
benefits, in addition to the cost of providing pensions, to current
and retired employees.
Accountants working with
government entities must address the challenges presented by these
standards. Financial advisors should also be aware of the potential
implications, particularly with respect to investments in municipal
new accounting rules require that municipalities measure, recognize,
and disclose future obligations for providing other postemployment
benefits (OPEB), mainly healthcare. This process will be phased
in over a three-year period, starting with the largest states
and cities. GASB Statement 43, Financial Reporting for Postemployment
Benefit Plans Other Than Pension Plans, is a reporting standard
that applies to OPEB plans through which the benefits are provided.
Implementation of GASB 43 began in 2006.
standard, GASB 45, Accounting and Financial Reporting by Employers
for Postemployment Benefits Other Than Pensions, requires
government employers to disclose OPEB in their financial statements.
Statement 45 applies to government employers or other sponsors
of OPEB benefits. Although earlier adoption is encouraged, implementation
is being phased in and is required for municipalities with annual
revenues greater than $100 million for fiscal years beginning
after December 15, 2006. GASB 45 does not require prefunding these
benefits, but once underfunding is disclosed on a government’s
financial statements, a failure to implement a funding plan may
affect a municipality’s credit rating, according to Fitch
Ratings and Standard & Poor’s. Government leaders and
financial professionals are slowly realizing the formidable implications.
It is imperative that government leaders plan for how they will
address OPEB and involve and educate all stakeholders.
the Limitations of Pay-as-You-Go
employees earn postemployment benefits (such as health insurance
and life insurance) over their years of service but do not receive
these benefits until they retire or leave employment. However,
most municipalities fund these future expenses on a pay-as-you-go
basis, which greatly understates the magnitude of the obligation
that is accumulating. Many municipalities have never even calculated
the total cost of their future OPEB obligations. Although GASB
45 has no specific requirement that OPEB liabilities be funded
in advance, public employers, including school districts, must
now record an obligation for all costs and commitments related
to OPEB not funded in the period in which the benefit is earned
rather than when paid. According to Rhode Island Auditor General
Ernie Almonte, not recognizing the future liability as it is incurred
is “putting off the debt to future generations” (Providence
Journal, June 9, 2006). A pay-as-you-go system does not recognize
the cost of retiree benefits to the employer when the related
employment service is earned by the employee. This is misleading,
because it does not reflect the true cost of the employer’s
future cash outflows.
of GASB’s two new standards is to increase transparency
by requiring that state and local governmental financial statements
disclose the future obligations for OPEB being generated by current
employees, as well as the obligations to which the employer is
already committed on an actuarial basis. Municipalities are not
required to set aside funding for these obligations. Any unfunded
obligations, however, must be disclosed in the financial statements.
OPEB Costs Represent a Financial Tsunami?
It is no
secret that healthcare premiums and expenses have experienced
double-digit increases in recent years. Actuaries have estimated
that healthcare costs represent approximately 20% of wages. OPEB
has even been described as a “tsunami.” Historically,
healthcare benefits were often given to public employees in union
negotiations. Actuarial evaluations were not conducted; numbers
were scribbled on the back of envelopes and deals were made. In
this way, many public-safety employees receive 75% of their salaries
as pensions, as well as 75% of their healthcare benefits upon
retirement, with no minimum retirement age. Ten to 20 years ago,
however, healthcare costs were lower and the workforce was younger.
No one expected double-digit increases in the cost of healthcare.
Exacerbating this situation are the changing demographics. People
are living longer and often retiring earlier. The increase in
OPEB liabilities is being driven by healthcare costs that are
very difficult to predict and cannot be easily hedged.
GASB 45 is
focusing national attention on funding retiree healthcare. This
is a real liability, and government entities are reacting differently
to the standard. Some employers are postponing placing their OPEB
liabilities on their books until the last moment, while others
are implementing early to create a plan to meet the challenge,
including the pre-funding of OPEB liabilities.
must manage OPEB liabilities and be mindful of their impact on
financial statements as well as bond ratings. New York City has
estimated that its OPEB liabilities will be $50 billion. The Center
for Government Analysis estimates that California’s retiree
healthcare costs for public employees will be approximately $31
billion per year by 2020. Every state’s cities and towns
must develop a fiscal strategy to manage these liabilities.
Are OPEB Costs?
new GASB rules require that public employers recognize and disclose
both the annual OPEB cost and the actuarial accrued liability
(AAL) for previously accrued costs.
OPEB cost consists of the annual required contribution (ARC),
which can be broken down into two categories:
cost: the present value of future benefits being earned by current
service cost: the amortization of the unfunded actuarial accrued
liability (UAAL), which are benefits already earned by current
and former employees but not yet provided for, using an amortization
period not to exceed 30 years.
If a municipality contributes an amount less than the ARC, a net
OPEB obligation results, which must be recorded as a liability
in the municipality’s financial statements.
will typically appear in a related footnote and be disclosed with
the municipality’s bond offerings. It is not required to
be treated as a liability on the financial statements. Because
the ARC may be significantly greater than actual benefit payments,
net OPEB obligations in the financial statements may grow rapidly
unless additional funds are allocated and segregated each year
to reduce the balance sheet liability.
the amount of OPEB liabilities will vary with each municipality,
it has been estimated that the liability for municipal retirees
may be 10 to 20 times current annual benefit payments, and the
liability for the prior service of current employees will be significantly
greater. The ARC is generally estimated to be five to 10 times
greater than current annual benefit payments. Hence, the amount
of these OPEB liabilities is significant enough to draw the attention
of credit rating agencies.
Can an Employer Manage OPEB Liabilities?
step in managing OPEB liabilities is to determine OPEB benefits
and obligations by answering the following questions: What are
the legal obligations to meet retirees’ healthcare? Is there
a written plan? What was promised, whom is it promised to (retirees;
spouses or dependents; active employees), who is paying for these
promises, and are they vested?
step is to determine the total cost of the OPEB obligations, both
today and in the future. Actuarial calculations should be verified.
The present value of total projected benefits for current employees
and retirees includes past service and future service liabilities.
should determine what actuarial assumptions and cost methods were
made and whether its auditors would agree with them. One critical
assumption is the discount rate used. GASB indicated that a funded
plan may use a higher discount rate than an unfunded plan because
the assets segregated in the funded plan earn a return that helps
offset future liabilities. A higher discount rate can significantly
reduce the annual OPEB cost and UAAL, which is a strong incentive
for municipalities to fully or partially fund their OPEB obligations.
Fitch Ratings has indicated that it will view negatively any assumptions
that are overly aggressive or not applicable with those adopted
for the plan sponsor’s pension system.
employers should evaluate the various options available to them
and determine what actions they plan to take.
Can OPEB Costs Be Mitigated?
must be struck between the level of benefits offered and the reality
of what taxpayers will provide to public employees.
have begun to reduce healthcare benefits for new hires. Simple
steps include increasing copayments or deductibles to healthcare
plans, and capping future employer contributions to a fixed-dollar
amount with an inflation factor based on the consumer price index
(CPI) , rather than a percentage amount. Increasing the years
of service required for retiree benefits is another option. All
of these proposed changes are of course subject to state law.
The use of various vehicles to direct pretax dollars for healthcare
expenses would help employees offset some of their increased costs.
Another practical step would be to divide beneficiaries into two
groups—active employees and retirees—and obtain age-adjusted
premium rates. Employers otherwise naïvely believe that retirees
healthcare plans do not cost money if retirees pay 100% of their
premium cost, even though retirees obtain an implicit embedded
subsidy if both active employees and retirees are treated as one
group and pay the same premium. (Retirees typically have more
medical claims and thus would have higher premium costs.)
are required by GASB to recognize this implicit OPEB subsidy in
their financial statements when annual healthcare premiums are
based on a blended rate for both active employees and retirees.
“Although it may seem that retirees are paying the full
cost of coverage, the GASB disagrees, since it is likely that
the blended premium will be less than the premium for retirees
alone” (Gabriel, Roeder, Smith & Company Consultants
& Actuaries, “The GASB’s Accounting Standards
for Other Postemployment Benefits,” www.grsnet.com/opeb,
of scale have forced many businesses to consolidate. Likewise,
consolidating healthcare plans and pension plans with other public
employers that have similar plans may help meet this challenge.
Employers will need state legislatures to make it happen. Are
they willing to float bonds in addition to facing the accounting
and legal challenges? Public employers will have to convince key
government decision makers, taxpayers, employees, and their unions
and business leaders to work with them. It is important that government
employers be proactive rather than reactive.
an OPEB Trust Fund
If a municipality
prefunds a plan, it can use a higher discount rate because future
investment income will help fund its OPEB expenses. An entity
has this option only if such assets are placed in an irrevocable,
segregated trust fund available only for OPEB. For a trust to
qualify under GASB rules, it must meet certain conditions, including
the following: The irrevocable transfer of assets to the trust
must be under the stewardship of a legally separate entity, such
as a board of directors. These assets must be dedicated to providing
OPEB and must be legally protected from creditors of the municipality
and trust administrator.
may wish to create a retiree health trust with assets separate
from the general fund that are used to fully or partially fund
the AAL. Many municipalities might consider issuing OPEB obligation
bonds, but such a course could be hampered by various factors,
including bond issuance limits and the difference between the
interest that would be owed to the bondholders versus the interest
that would be earned by investing the bond proceeds. With escalating
healthcare costs, municipalities may need the flexibility to invest
in equities to keep pace, even though such returns come with increased
of the advantage of prefunding OPEB liabilities can be found in
Greenwich, Connecticut. As of June 30, 2005, Town Administrator
Edward Gomeau determined that Greenwich’s OPEB cost as a
percent of payroll would be 6.06% if it had been prefunded; whereas
it would have been 11.24% had it not been prefunded.
are not implemented as part of a management strategy to prefund
benefit costs, OPEB (especially healthcare) will increasingly
absorb more of an entity’s budget. Milliman Consultants
and Actuaries conducted a large study of one statewide retirement
system with 10-year projections and found that “the annual
pay-as-you-go cost, expressed as a percentage of annual payroll,
was expected to nearly triple over that time. And, of course,
that was just the start” (Glenn Bowen, “New GASB Rules
for OPEB Finalized,” Milliman PERiScope, September
credit rating agencies have not yet taken OPEB liabilities into
consideration for municipalities because they have not yet had
the information needed to estimate the OPEB liabilities. Not only
are these difficult for analysts to estimate, but until now, even
governments often did not know the amounts. Rating agencies will
not just look at a government’s general fund. They will
look at the government unit as a whole to determine what its future
liabilities are and what the government is doing about it.
& Poor’s report indicates a concern over how quickly
OPEB costs have increased. Fitch Ratings indicates that it will
scrutinize unfunded liabilities when providing credit ratings.
Rating agencies will be asking the following questions: Can the
budget afford the annual required contribution, or even its escalating
pay-as-you-go requirements? What revenue and budget flexibility
exists to accommodate increasing OPEB costs? How does one entity
compare to another, and what are the trends?
To the extent
that OPEB cost-pressures weaken the financial position of an entity,
credit quality may suffer. Management decisions made today as
to how an entity will face the OPEB challenge can impact bond
ratings in the future. A lack of any funding will be deemed a
sign of financial weakness by credit agencies and could result
in lowered credit ratings, which would in turn increase the cost
of borrowing for governments. Hence, if a municipality is not
proactive, it is possible, even likely, that future property and
income taxes will have to be increased in order to meet these
issued a report in June 2005 stating: “Steady progress toward
reaching the actuarially determined annual contribution level
will be critical to sound credit quality” (Mason, Doppelt
and Laskey, “The Not So Golden Years, Credit Implications
of GASB 45,” Special Report, Fitch Ratings, June 22, 2005).
Rating agencies are not looking for immediate prefunding but rather
steady progress. They have stressed the importance of having a
plan and a framework to address OPEB challenges.
Reaction to the OPEB Challenge
that have begun to address the challenge early on have reported
denial and anger from constituents. Governments will need to work
together with employee unions to decrease either existing benefits
or those of new hires. After all the parties involved get past
their anger at the state of affairs, there should come an acceptance
that the OPEB issue must be addressed.
It is important
to note that GASB 45 requires employers to report their
unfunded OPEB liabilities but does not require employers to fund
them—at least not at this point. But when employers fund
their liabilities as they accrue, rather than pay-as-you-go, they
are permitted to use better investment- return assumptions, which
will result in significantly lower reported liabilities. In addition,
rating agencies and auditors will certainly scrutinize unfunded
liabilities before issuing credit ratings or audit opinions. It
would be helpful for employers to receive actuarial numbers and
assumptions using both short- and long-term rates in order to
make wise funding choices. Auditors will also require periodic
actuarial reviews of an employer’s assumptions. One must
wonder if the market will evolve to a standard where an actuarial
certificate in the offering statement becomes a filing requirement.
How auditors will address unfunded OPEB liabilities, in terms
of limiting the auditor’s risk exposure, is another question
to be resolved.
When it comes
to paying for future employee benefits, the bill may be coming
due sooner than municipalities think. The prudent choice would
be for governments to begin preparing now. The disclosure requirements
of GASB 43 and GASB 45 will increasingly focus the attention of
analysts and taxpayers on governments’ management of these
costs and their preparations for the future. It is imperative
that government leaders develop an action plan for how they will
address OPEB, as well as communicate and educate all constituencies
about this looming challenge.
Galligan Kelley, CPA, MBA, CAGS, is an associate professor
of accountancy and director of the business studies program at
Providence College, Providence, R.I. Margaret P. Ruggieri,
CPA, MS (Tax), is an assistant professor of accountancy,
also at Providence College.