What you need to Know About GASB 45 and OPEBs

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What you need to Know About GASB 45 and OPEBs
Presentation to OMFOA 2006 Northwest Government
Finance Institute
Monday, October 23, 2006 Portland, Oregon Carol
Samuels, Seattle-Northwest Securities
Corporation Michael Schrader, Orrick, Herrington
Sutcliffe LLP Harvey Rogers, Preston Gates
Ellis LLP
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What is GASB 43 and 45?

• The Governmental Accounting Standards Board
  (GASB) approved Statements 43 and 45 in 2004.
• Addresses how Other Post Employment Benefits
  (OPEB) are recorded in financial statements.
• Similar to private sector accounting rules under
  FAS 106.
• Underlying theory financial statements should
  reflect benefit costs as they are earned, not on
  a pay as you go basis.
• Current employees are accruing retirement
  benefits now, even though benefits are actually
  paid later.

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Implications of GASB 45

• Will force recognition of large employer
  subsidies of retirement medical benefits which
  are largely unfunded.
• Some estimates have suggested unfunded liability
  could be 50 times current health benefit
  expense.

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Multi-Employer Plans vs. Single Employer Plans

• GASB separates pooled cost sharing plans from
  separate employer accounts.
• Cost sharing employers are covered by GASB 43.
• Single employers are covered by GASB 45.

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What is OPEB?

• Other Post Employment Benefits
• Benefits OTHER than Pensions

Medical Dental Vision Hearing
Life Insurance Long Term Care Legal Benefits
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Who is Affected?

• All public employers who follow GAAP and offer
  post-employment benefits other than pensions.
• Even if retirees pay 100 of premium for their
  other post-employment benefits, new rules will
  likely result in additional employer cost being
  recognized (the Implicit Subsidy).

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Current Practice

• Pay-as-you-go
• Actual cash outlay on behalf of retirees is
  recorded.
• Expenses reported as they occur.

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Why the Change?

• OPEB is part of compensation.
• Benefits are earned throughout career rather than
  simply when funds paid out to retiree.
• Current practice does not adequately reflect true
  financial impact of future obligations or
  implicit subsidies.

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The Elephant in the Closet The Implicit
Subsidy

• Paying the same premium rates for all employees
  results in hidden subsidies.
• Health care costs are higher for disabled
  employees and retirees than for active employees.
• If all participants are paying the same premium
  rates as active employees, implicit employer
  subsidy due to blending of claims experience.
• GASB 45 says subsidy must be included in
  liability calculation even if participants pay
  100 of premium rate assessed.
• In some places, subsidy may be explicit as some
  districts pay portion of retiree costs.

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The Implicit Rate Subsidy
If retirees have access to benefits at the same
rate as current employees, the liability needs to
reflect the Implicit Rate Subsidy, as the basis
for charging retirees may be much less than the
true cost of providing such benefits.
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Pay As You Go Accounting
Year 1

• Bill
• Age 24
• Pay 30,000
• Health 3,000
• Fringe 5,000
• Total 38,000

Jill Age 59 Pay 50,000 Health
3,000 Fringe 5,000 Total 58,000
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Pay As You Go Accounting, cont.
Year 2 Jill Retires
Jill Age 60 (retired) Pay 0 Health
3,300 Fringe 0 Total 3,300
Bill Age 25 Pay 31,000 Health
3,300 Fringe 5,150 Total 39,450
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Implicit Subsidy
Employer subsidy for Jill 5,000 -3,300
1,700
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Terminology
Annual Required Contribution (ARC)
Normal Cost
Amortization of UAAL


Total
Earned this Year
Earned in Past Years
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Funded vs. Unfunded Plans

• Actuary will reduce expected future cost by
  discount rate.
• Discount rate is the expected long term yield on
  assets to be used to pay benefits.
• The higher the rate used, the lower the amount of
  the liability.
• Funded plan A jurisdiction that sets aside funds
  in segregated account to cover liability is
  deemed funded. Expected yield would be 7 to 8
  because funds are assumed to be invested in long
  term securities.
• Unfunded Plans No funds set aside. Expected
  yield would be 2 to 4 because assumption is
  paid by cash on hand.
• Gives incentive to jurisdictions to create fund
  to use higher discount rate and disclose lower
  OPEB liability.

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An Illustration
Funded plan Jills employer has set up a trust
to pay medical benefits. The trust funds
will be invested in equities and bonds with an
expected rate of return of 7. The value today
of what the employer expects to pay for Bills
retiree medical benefits is 30,000.
Unfunded plan Jills employer has chosen not to
prefund medical benefits but to continue to pay
them on a pay-as-you-go basis. The expected rate
of return for the employers general fund is 2.
The value today of what the employer expects to
pay for Bills retiree medical benefits is
102,000.
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Calculation of the Total LiabilityCurrent Costs
for Current Retirees
Cost of current claims for current retirees
409,000.
Source Milliman USA
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Future Costs for Current Retirees
PV Costs of future claims for current retirees
6.4 million.
Assumes 7 discount rate.
Source Milliman USA
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Future Costs for Future Retirees
PV Cost of future claims for past service of
future retirees (activeemployees) 11.9
million.
Assumes 7 discount rate.
Source Milliman USA
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Future Costs of Not Pre-Funding

• If benefits are pre-funded, use higher long term
  discount rate.

• If benefits are not pre-funded, must use lower,
  short term discount rate.

PV Cost of not pre-funding 36.1 million.
The total liability that will appear on the
municipalitys financial statement will be almost
55 million.
Assumes 2 discount rate.
Source Milliman USA
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The cost of pay-as-you goAnnual benefit
payments begin to ramp up.
City Payroll 80 million Employees
1,000 actives 600 retirees Same premium
for actives and retirees.
Annual payments nearly triple in 10 years.
Source Milliman USA
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Estimates of Unfunded Liabilities

• Unfunded liabilities may be amortized over as
  long as 30 years.
• Actuarial estimates of the size of unfunded
  liabilities
• 25 times annual medical claims for plans that ARE
  funded (higher discount rate)
• 50 times annual medical claims for plans that are
  NOT funded (lower discount rate)

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And that means
Average annual employer cost
3,600 Total participants x
1,000 Total annual cost 3,600,000 GASB
unfunded liability If funded x 25
90,000,000 If unfunded x 50
180,000,000
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What will the actuary do?

• Jurisdictions of greater than 100 members need to
  retain actuarial services to calculate liability.
• Actuary will take similar approach as to
  calculation of pension liabilities.
• Will look at participant data, plan provisions
  and various assumptions, including
• Turnover
• Retirement rates
• Mortality rates
• Covered dependents
• Expected claims paid by plan
• Medical inflation

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Determine Applicable Effective Dates

• Annual revenues determined for fiscal years
  ending after June 15, 1999.

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Determine Frequency of Valuations

• Frequency based on size of membership
• 200 members (including actives, retirees and
  beneficiaries), at least every 2 years
• lt 200 members, at least three years
• Valuation should be obtained more frequently if
  significant changes have occurred since the most
  recent valuation
• Changes in benefit terms
• Changes in composition of number of plan members
• Other changes (legal, regulatory, etc.) that may
  affect long-term actuarial assumptions
• Annual cost can be based on a valuation date of
  up to 24 months prior to the beginning of the
  fiscal year

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Top 10 OPEB Questions for Local Governments

• What do we have to do to comply with GASB 45?
• Do we have to change how we currently fund OPEBs?
• Can we reduce OPEB costs through reduced or
  redesigned benefits programs?
• What are the advantages of pre-funding OPEB
  liabilities?
• What are the risks associated with pre-funding
  OPEB liabilities?
• Can we issue OPEB bonds?

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Top 10 OPEB Questions for Local Governments
(cont.)

• Can amounts in the OPEB trust be pledged as
  security or available for the payment of OPEB
  bonds?
• What can an OPEB trust invest in and what about
  these life insurance funding proposals?
• Will a decision not to pre-fund OPEB liabilities
  result in a rating downgrade?
• What disclosure obligations do we have to our
  bondholders with respect to OPEB liabilities?

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What do we have to do to comply with GASB 45?

• Retain Actuary
• Jurisdictions of greater than 100 members will be
  required to obtain actuarial services.
• Valuation must be completed by recognized
  actuary.
• Cost is likely to be substantial.
• Given limited number of recognized actuaries, it
  will be important to retain firm as soon as
  possible.
• City County Insurance Services (CIS) Milliman
  actuarial study
• Determine Effective Date and Valuation Periods
• Begin actuary selection process NOW to ensure
  compliance with GASB 45 requirements.
• Issue Complying Financial Statements

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Do we have to change how we currently fund OPEBS?
No You can continue to fund OPEBs on a
pay-as-you-go basis. There are advantages and
disadvantages in doing so.

• Advantages
• Municipality's financial resources can be
  deployed for immediate needs.
• Other financial resources may become available in
  the future or benefits may be modified such that
  liability is reduced.
• Federal insurance programs (i.e. Medicare Part D)
  may reduce future funding needs.
• Disadvantages
• Failure to pre-fund increases risk that future
  benefits, the costs of which are expected to rise
  exponentially, can actually be funded.
• Failure to pre-fund requires use of lower
  discount rate leading to higher long-term
  liability.
• Failure to pre-fund may have negative affect on
  bond rating and therefore increase costs of
  borrowing.

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Can we reduce OPEB costs through reduced or
redesigned benefit programs?
POSSIBLY But there are a number of issues and
considerations.

• What are the legal underpinnings of the benefit
  packages that are available to municipal
  employees?
• Based on contractual or legislative language?
• Vesting requirements?
• What impairment of contracts limitations are
  there?

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Can we reduce OPEB costs through reduced or
redesigned benefit programs? (cont.)

• Considerations
• Tie availability of benefit to length of service
  Pension benefits are usually based on length of
  servicewhy not OPEBs?
• Reduce pre-65 health care benefits Pension
  benefits are normally reduced for employees who
  retire early, but retiree medical benefits are
  more valuable the earlier an employee retires.
• Eliminate other early retirement benefits.
• Reduce dependent benefits.
• Cap future medical inflation covered by employer.
• Consider deferred contribution benefit program.
• Manage medical costs.

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What are the advantages of pre-funding OPEB
liabilities?

• There are several but will likely require
  issuance of OPEB Bonds to pre-fund
• Paying ARC
• Advantages
• Current costs will increase, but will stabilize
  over time.
• Preserves flexibility to not fund in a given year
  and utilize resources differently.
• Preserves flexibility to modify benefit package
  later without limitation on use of trust funds.
• Funding ARC is considered pre-funding for GASB
  purposes, and higher discount rate can be used.

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What are the advantages of pre-funding OPEB
liabilities? (cont.)

• Disadvantages
• While liability will be reduced over
  pay-as-you-go, there still will be considerable
  reported liability on books.
• The flexibility to not fund may be seen as a
  negative by rating agencies and investors.
• Lose opportunity for arbitrage from borrowing
  at lower rate.

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What are the advantages of pre-funding OPEB
liabilities? (cont.)

• Pre-funding at levels above ARC
• Allows the use of a higher discount rate leading
  to a lower long-term liability.
• May reduce negative affect on bond ratings and
  therefore lower cost of borrowing.
• It may provide a more consistent actuarial match
  of expenses with anticipated cash outlays.
• Pre-funding will increase the likelihood that
  future benefits, the costs of which will rise
  exponentially over time, will actually be funded.
• Substantial borrowing costs may be further offset
  by positive arbitrage. Governments may fund
  trusts with no tax implications through Section
  115 trusts.

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The benefits of arbitrage

• Use of higher discount rate and earning of
  positive arbitrage will probably depend on
  ability to invest in wide rate of investment
  vehicles, stocks, etc.

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The benefits of arbitrage
SP 500 Yearly Rates of Return, 1977-2005
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What are the risks associated with pre-funding
OPEB Liabilities?

• There are several
• Reliability of revenue stream dedicated to
  payment of OPEB Bonds.
• Total annual OPEB costs will increase over
  pay-as-you-go, as debt service on OPEB bonds
  will reflect some relationship to accrued costs.
  Total costs should, however, stabilize over long
  term.
• Because the OPEB trust must be a segregated,
  irrevocable trust to utilize higher discount
  rates, there is little flexibility with regard to
  use of trust funds.
• Arbitrage profits are not guaranteed.

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Can we issue OPEB bonds?

• YES
• Oregon issuers could potentially issue OPEB Bonds
  as revenue bonds pursuant to the Uniform Revenue
  Bond Act, as limited tax bonds pursuant to the
  Pension Bonding Act or as full faith and credit
  obligations under the issuer's charter or
  enabling legislation.
• Bonds may offer jurisdictions a means of funding
  their liability less expensively than other
  options
• Bonds would allow some or all of the obligation
  to be pre-funded, enabling favorable higher
  discount rate to be used in determining
  liability.
• Although bonds would have to be issued on a
  taxable basis under federal law, current rates
  are still at historic lows (approximately 6).
• Because long term investment rates have
  historically been much higher than current
  borrowing rates, funds invested have a high
  probability of arbitrage profits.

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Can we issue OPEB bonds? (cont.)

• POBs have commonly been utilized to fund pension
  UALs over past five years across the country. In
  Oregon, municipalities have issued over 5
  billion in pension obligation bonds and are
  projected to save over 1.5 billion.
• OPEB bonds have recently been issued by municipal
  governments to fund OPEB liabilities Peralta
  Community College District (California) City of
  Gainesville, Florida Philadelphia School
  District.
• While bonding authority in Oregon for OPEB bonds
  is relatively clear special legislation to
  establish OPEB trusts and confirm investment
  authority may be needed to implement a OPEB
  bonding program for Oregon issuers.

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Can we issue OPEB bonds? (cont.)

• Advantages
• Allows use of discount rate benefit in
  computation of liability.
• May present opportunity to obtain benefit of
  positive arbitrage.
• If used to fully fund OPEB liability, stabilizes
  long-term annual cost.
• Disadvantages
• May lead to substantial immediate increase in use
  of resources to pay debt service, or extremely
  back weighted debt service.
• May diminish financial flexibility to deal with
  other issuer needs.
• May not be immediately available due to need for
  legislative action.
• Potential arbitrage works both ways losses are
  also possible.

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Can amounts in the OPEB trust be pledged as
security or available for the payment of OPEB
bonds?

• NO A qualifying OPEB trust must be irrevocable
  and trust assets must be applied only to the
  payment of OPEB obligations.
• Because OPEB trust is irrevocable, trust assets
  are "locked up" and cannot be used for bond or
  other obligations of the issuer.
• Various consultants have proposed use of OPEB
  bonds to fund purchase of life insurance product
  the cash value/investment component of which
  would be split from the death benefit component
  with the cash value/investment component
  contributed to the OPEB trust and the death
  benefit component remaining with the issuer
  thereby creating a future unrestricted revenue
  stream to the issuer.
• Policy considerations and need for comprehensive
  enabling legislation.

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What can an OPEB trust invest in?

• NOT CERTAIN UNDER CURRENT LAW Legislation may
  be needed.
• Section 115 trusts most likely vehicle for OPEB
  investment
• Will ensure exemption of earnings from federal
  taxation and ensure that contributions are not
  counted as income to the employee
• Will be irrevocable meaning there will be
  limited, if any, flexibility in use of moneys.
• May be single or multi-employer trust.
• Not clear if funds invested in an irrevocable
  trust will be public funds for purposes of
  State law.
• For pre-funding to be viable, funds in trust must
  be able to be invested in a broad spectrum of
  investments to maximize returns.
• Peralta Community College issued 50-year bonds to
  pre-fund OPEB obligations, but did not put in
  irrevocable trust because of loss of flexibility.

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Will a decision not to pre-fund OPEB liabilities
result in a rating downgrade?

• PROBABLY NOT IN THE SHORT-TERM . . . .
• Currently
• No immediate adjustment to rating levels
  expected.
• Ratings agencies have all expressed concern over
  magnitude of OPEBs, but generally see GASB 45 as
  positive step toward illuminating costs and
  creating incentive for addressing.
• Ratings agencies will look to issuers to not use
  overly optimistic assumptions in determining
  amount of liability.

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Will a decision not to pre-fund OPEB liabilities
result in a rating downgrade? (cont.)

• PROBABLY NOT IN THE SHORT-TERM . . . .(cont.)
• Once GASB 45 is implemented and issuers have
  quantified liability
• Rating agencies will develop cooperative rating
  criteria.
• If issuers have substantial liability and do not
  develop plan, ratings will suffer and borrowing
  costs may rise.
• Similarly, if corrective plans for dealing with
  OPEB liabilities are not developed, bond insurers
  and institutional investors may require higher
  premiums and interest rates to offset perceptions
  of increased long term risks.

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What disclosure obligations do we have to our
bondholders with respect to OPEB liabilities?
ISSUER'S DUTY IS TO PROVIDE ACCURATE AND COMPLETE
INFORMATION TO INVESTORS AND POTENTIAL INVESTORS
ON A TIMELY BASIS WHENEVER STATEMENTS OF MATERIAL
FACT ARE BEING MADE.

• Financial Statements issued followed applicable
  effective date must comply with GASB 45.
• Disclosure documents for current bond sales
  should address OPEBs and the process the issuer
  expects to follow in the near term
• Description of what GASB 45 entails.
• Brief description of benefits currently provided
  by issuer.
• Plans for compliance with provision
• Timeline that applies to issuer.
• Has issuer hired an actuary? If so, who is it
  and what is the timeline for their work? If not,
  what is timing and process for hiring one?

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What disclosure obligations do we have to our
bondholders with respect to OPEB liabilities?
(cont.)

• Going forward
• Description of efforts to change benefits, if
  any.
• Description of legislative or judicial actions
  that might affect liabilities.
• Once actuarial valuation is completed, disclosure
  of the amount of the liabilities.
• Discussion of plan to address liabilities.
• SEC has suggested that OPEB disclosure obligation
  may arise prior to GASB 45 implementation date.
• If issuer has knowledge of scope of OPEB
  liability, it may be obligated to disclose
• Recent SEC settlement on Big Dig project
  Knowledge of cost over runs not disclosed in
  official statement.
• State of Maryland did not disclose existence or
  scope of OPEB actuarial study in official
  statement.
• SEC expected to take harder stand on municipal
  disclosure given its recent interest in area.
• Expect further developments.

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Dispel OPEB Myths

• Our benefits are self-insured, so this doesnt
  apply to us.
• We allow retirees to continue coverage through
  our medical plan, but they pay their own way, so
  we dont have any OPEB.
• We still have plenty of time before we have to
  deal with this.
• "We have to fund OPEB to get a clean opinion from
  our auditors."
• "GASB 45 requires us to report our entire OPEB
  liability."
• "GASB 45 doesn't apply to us because our benefits
  aren't mandated by a collective bargaining
  agreement."

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Developing an OPEB plan

• Educate Staff, governing body, constituents,
  legislature and press.
• Key messages
• Valuation and reporting are mandatory under GASB
  45.
• While funding of benefits can continue on a
  pay-as-you-go basis indefinitely, the REAL cost
  of current benefit packages is reflected by these
  estimates.
• Up front funding is not mandatory under GASB 45,
  but the ability of the municipality to fund
  benefits in the future may be threatened if
  adequate funds are not set aside.
• Size of OPEB liability and funding status may
  have impacts on the municipalitys ability to
  access the bond market, cause increases in
  interest rates, and threaten bond ratings.
• Options include reviewing and standardizing
  benefit packages, and potentially borrowing for
  some portion of the anticipated liability.

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Developing an OPEB plan (cont.)

• Develop a funding plan.
• Identify negative impact of continuing to fund on
  a "pay-as-you-go basis.
• If OPEBs cannot be reduced sufficiently to
  substantially alleviate problem
• Assess ability to fund liability through
  contributions from existing or new resources.
• Evaluate use of OPEB bonds if other tools do
  not offer satisfactory solutions.
• Evaluate investment options.
• Identify disclosure obligations and potential
  impact of OPEB liability on investors, ratings
  agencies and ability to issue debt in the future.
• Consider legislative and collective bargaining
  solutions.