Municipalities Get a Healthy Dose of Reality on Postemployment Benefits
The Effects of GASB 43 and 45 on Government Finances

By Ann Galligan Kelley and Margaret P. Ruggieri

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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 bonds.

New GASB Standards

GASB’s 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.

The other 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.

Disclosing the Limitations of Pay-as-You-Go

Government 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.

The goal 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.

Do 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.

Employers 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.

What Are OPEB Costs?

The two 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.

The annual OPEB cost consists of the annual required contribution (ARC), which can be broken down into two categories:

  • Normal cost: the present value of future benefits being earned by current employees; and
  • Past 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.

The UAAL 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.

Although 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.

How Can an Employer Manage OPEB Liabilities?

The first 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?

The next 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.

An employer 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.

Finally, employers should evaluate the various options available to them and determine what actions they plan to take.

How Can OPEB Costs Be Mitigated?

A balance must be struck between the level of benefits offered and the reality of what taxpayers will provide to public employees.

Many employers 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.)

Employers 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, August 2004).

Economies 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.

Creating 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.

Public employers 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 volatility.

One example 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.

If trusts 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 2004).

Rating Agencies

The major 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.

Standard & 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 obligations.

Fitch Ratings 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.

Public Reaction to the OPEB Challenge

Municipalities 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.


Ann 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.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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