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    GASB 45: Is Your District Confronting The Challenge?

    Dealing effectively with GASB 45 will take leadership, analysis, time, discipline, and a team of objective legal, actuarial, and financial advisers. If you've been waiting to deal with the challenge, the time to act has arrived…

    As recently as six months ago, the questions many public agencies were asking about GASB 45 were, "What is it and what's the big deal?" Now, while some remain in denial about the magnitude of the challenge it presents, for others the questions have become, "How do we fund our GASB 45 liabilities and where do we start?"

    This article describes several common stages that public entities are going through or will go through soon enough in dealing with GASB 45 compliance – denial, awareness, acceptance, and action (or inaction).

    Stage 1: Denial

    As has been said, effective leaders know that taking action involves risks and costs, but that they're usually far less than the risks and costs of the inaction that results from denial. Yet while a number of public entities are beginning to address their other postemployment benefits (OPEB) liabilities, many typically well-managed public entities have done nothing. This state of denial (analysis-paralysis or head-in-sand-itis) might be attributable to:

    • The size of the problem.
    • The perceived "long-term" nature of the problem.
    • The relatively short-term appointments of many governing bodies.
    • The highly sensitive and political nature of any public discussions pertaining to possible benefits changes (especially for retirees) or budget shortfalls.
    • The existence of unions and union-negotiated benefits in the mix.
    • The legal precedents that make it very difficult to reduce public employees' benefits without their consent – or in the absence of a financial emergency.

    Stage 2: Awareness

    Awareness typically dawns on those who begin to fully appreciate what failure to address the challenge head-on could mean: impacted audit reports, lower bond agency ratings, increased borrowing costs, media scrutiny, and the erosion of public trust. 

    In a nutshell, GASB 45, when phased in, will require public agencies to provide more accurate measurement, recognition, and reporting of the costs and liabilities associated with providing OPEBs (see sidebar for effective dates). OPEBs typically include health insurance and dental, vision, prescription, or other healthcare benefits provided to retirees and their dependents. They essentially consist of any employee benefits provided to retirees (and, in some cases, their dependents) other than pension benefits.

    This change in the method of reporting OPEB liabilities was necessitated by the fact that most public entities have been reporting their OPEB liability on only a "pay as you go" or "paygo" basis – reflecting only their current cash payments for providing OPEBs each year. For example, this might consist of the premiums, or the agreed-to portion of premiums, paid for eligible retirees' health insurance coverage. What they have not been reporting is the cost to the entity of OPEBs earned by employees in that year. As a result, public entities have been significantly understating the actual and potential liabilities associated with these obligations – a bit like filling out a personal financial statement that mentions the amount of your annual mortgage payments without mentioning the size of your mortgage obligation.

    A reasonable person might ask, "How can something 'cost' more than I am paying for it on an annual basis?" The answer to this question lies in the difference between defined benefit OPEB and defined contribution OPEB (see sidebar describing differences). There is a tremendous difference between the way the new GASB statements treat defined benefit OPEB and defined contribution OPEB.

    Because, in the case of a defined benefit OPEB plan, the employer is guaranteeing the availability of certain benefits or amounts when the employee retires (and these benefits are being earned now while the employee is still working), the GASB rules require a public entity employer to determine the current "cost" of providing OPEB by:

    a. Projecting the employer's future cash outlays for benefits (for example, this might involve projecting how much it would cost to provide post-retirement medical insurance coverage for an employee and the employee's spouse assuming that the employee is currently only 35 years old, but could retire with fully paid medical insurance coverage at age 60);

    b. Discounting the future value of the projected benefits to determine the present value of benefits (for example, the cost in today's dollars of providing a $500,000 benefit, fifteen years from now, assuming a 6% annual discount/interest rate would be approximately $208,000); and

    c. Allocating the present value of benefits to past and future periods. Assuming that the goal is to spread the cost of providing benefits over the employee's working career, this step distinguishes between the portion of the benefit that relates to past service, current service, and future service.

    Using this methodology, and certain actuarial methods and assumptions, an actuary for a defined benefit OPEB plan can determine the annual required contribution (ARC) of the employer, which would normally be sufficient to fund the plan – if the plan is starting from scratch, or a partially or fully funded position.

    Unfortunately, most defined benefit OPEB plans have already accumulated a substantial "unfunded" OPEB liability without sufficient assets to cover the obligation. Public entities that have significant, unfunded OPEB liabilities will have much larger ARCs because they will have to include an extra expense to amortize (pay down) the already accumulated, but unfunded, obligations.

    By comparison, the annual OPEB cost for a defined contribution OPEB plan is simply the annual required contribution to the plan. Since defined contribution OPEB plans do not give rise to significant unfunded liabilities, they are not the true focus or concern of the new GASB statements (and do not require the services of an actuary). They are important in the sense that more and more employers, public and private, will opt to utilize defined contribution OPEB plans instead of defined benefit OPEB plans – if they continue to offer OPEB at all.

    So far, all of this seems pretty academic and theoretical – what makes it vitally important for practically all public entities providing defined benefit OPEB is the relative size of the numbers emerging from the first round of actuarial valuations.

    John Bartel, of the Bay Area actuarial firm Bartel Associates, LLC, has first-hand experience with the magnitude of the problem. His firm has performed close to 200 GASB 45 valuations for public agencies throughout California, approximately 40% of which were for special districts.

    Although there are numerous ways to quantify or assign a relative value to OPEB liabilities, Bartel feels that it is best to describe such liabilities by reference to the portion of an agency's payroll that counts for retirement plan purposes – sometimes referred to as "pensionable pay."

    Based on the numerous actuarial valuations performed by his firm to date, Bartel indicated that a couple of rough trends seem to be evolving:

    • The average amount of unfunded retiree health plan liability is approximately 150% of each entity's pensionable wages (with the vast majority falling anywhere within a range of 25% to 400%).
    • The average ratio of ARC to an entity's paygo cost is five to one.
    • In the majority of cases, ARC ranges from 5 percent to 25 percent of pensionable wages.

    The failure of a special district to comply with these rules could cause it to receive less than clean audit reports, lower its bond agency ratings, increase its borrowing costs, and create credibility/confidence issues with respect to the public and the media.

    Stage 3: Acceptance; Taking The First Steps

    As mentioned earlier, a number of public entities seem to recognize that they have a problem and are taking first steps to deal with their GASB liabilities. The most common initial strategy that is being adopted is to begin to "fund" OPEBs.

    In the past, most OPEBs were "unfunded" – with all benefits paid out of the general assets of the public entity. In order to fund or partially fund OPEB, some or all of the assets needed to pay OPEBs must be irrevocably set aside in a trust or trust equivalent.

    By creating a funded or partially funded OPEB plan, a public entity can (a) point to specific "dedicated" assets that have been set aside for the purpose of funding its OPEB obligations, and (b) take advantage of actuarial rules that generally allow it to use a higher interest or discount rate for determining the present value of its OPEB obligations. The use of a higher interest rate (than would be available in the case of an unfunded arrangement) has the effect of lowering the size and amount of the public entity's OPEB obligation. Based on this rule, we expect to see many public entities that have previously "self-funded" their OPEBs move to funded arrangements. CalPERS' actuarial staff estimates that the use of a funded arrangement could reduce some agencies' OPEB liabilities by 50% or more.

    Of course, there is more than one way to fund OPEBs. The three most common methods are:

    • Contributing to a section 115 trust (this is a trust established by a government agency or joint powers authority for the purpose of funding an essential government function);
    • Contributing to a section 501(c)(9) trust, also referred to as a Voluntary Employees' Beneficiary Association (VEBA); and,
    • Contributing to a special "401(h) account" that has been established as part of an existing defined benefit pension plan for the entity's employees (this is typically seen in the case of districts that already are contributing to the defined benefit pension plan of a '37 Act County).

    Depending on the situation, these funding vehicles can be utilized on a single-employer basis (that is, one district with its own trust) or on a multiple-employer basis (that is, a group of districts contributing to the same trust).

    A number of these new OPEB funding arrangements have been established recently by newly formed JPAs. Although they contend that they can save contributing districts money based on a pooling of investment dollars and efficiencies in trust administration, it is incumbent on each employer to make sure that the proposed arrangement makes complete sense for it and its employees. Along these lines, CalPERS has established a multiple-employer section 115 trust to help its participating employers to pre-fund their GASB 45 obligations. At this time, there is legislation pending that would, if enacted, allow CalPERS to offer participation in its section 115 trust to agencies and districts that are not currently participating in CalPERS.

    While there are pros and cons to each funding vehicle, and no one method is best for all situations, it is especially important for a district to carefully study and analyze the terms of any multiple-employer arrangement it is considering. For example, it is critical to understand the basis upon which each contributing entity is allocated a share of the assets and liabilities of the funding vehicle – and how (and when) this determination will be made if the district ever decides to pull out of the arrangement. We have seen a number of districts "forced" to join county-sponsored 401(h) account vehicles without a clear understanding of how they would get their money out of the account if they ever leave the arrangement. Because these smaller districts were unprepared to deal with the changes required by their counties, their only choices were to go along with the county or leave the county system.

    Stage 4: Action – Or Inaction

    If your district provides defined benefit OPEBs, it must at some point come to grips with GASB 45. We have spoken with a couple of member districts who believe that they have several years before they have to deal with GASB 45, due to their relatively small size. While this may be "technically" true, we have seen circumstances where smaller special districts have been "rushed" or even "railroaded" into adopting certain retiree health changes before they were ready. The principal reason for this rush to action is the fact that most of the larger public agencies (the State, the larger cities and counties and the larger districts) were required to comply with the new financial accounting rules beginning with their 2007 – 2008 fiscal year. Although a significant number of CSDA's members do not have to comply with the new rules until 2008-2009, or even 2009-2010, many are being caught up in retiree health plan changes and retiree health plan funding initiatives originating at the State, county, or municipal level. In many cases, the special district has little choice but to go along with the retiree health plan changes being made by the county retirement system that provides its retirement benefits.

    What options are available to special districts that provide defined benefit OPEBs?

    1. Do nothing and deal with the consequences.
    2. Establish, or join, some type of funding arrangement (to limit the size of OPEB liability) and begin actually funding these liabilities.
    3. Evaluate and implement changes to retiree health benefits in an effort to control costs – or at least control the rate of increase in costs.
    4. Some combination of options 2 and 3.

    While denial may nudge some toward option 1, we do not recommend this approach. Governing bodies and the management of public entities owe a fiduciary duty to their district's constituents to properly manage the resources of the district. Doing nothing could be viewed as a dereliction of duty.

    Option 2 may be a good first step to take for many districts, but in many cases, it may not be enough. For special districts with restricted budgets and limited sources of revenues, it may become necessary to make hard choices between providing certain levels of benefits on an ongoing basis and fulfilling the basic mission of the district. Districts should ask themselves, "If we can't afford to pay the full ARC, can we afford to maintain the same level of benefits?" Here is where option 3 must be considered. This is a very difficult and sensitive course of action, but may be absolutely necessary is certain cases. In order to minimize the inevitable discord of any such proposal, we recommend that the governing body and management of any district that is potentially impacted to this extent:

    1. Move forward as quickly as possible to ascertain the extent of its unfunded OPEB, even if it is not yet subject to GASB 45 yet.
    2. Determine through projections and actuarial modeling whether it can "sustain" the current level of retiree health benefits on an indefinite basis.
    3. Begin the process (if the answer to 2 is no) of informing and educating all stakeholders of the problem and attempt to define areas of common interest among all of the stakeholders with respect to the necessary changes. By the way, this can be done – if the situation warrants it. Witness the fact that General Motors and UAW negotiators have recently agreed to establish a VEBA for the purpose of funding a portion of GM's retiree health liability and then turning responsibility for providing retiree health benefits over to the UAW!

    As mentioned in 3 above, it is far easier to negotiate these types of changes with affected employee groups or unions than it is to unilaterally attempt to make such changes and then face the wrath of employees in the public media or courts.

    Dealing effectively with the challenges of GASB 45 will take a fair amount of analysis, time, leadership, discipline, and, perhaps, negotiation. Member districts will be best served by a team of objective legal, actuarial and financial advisers – those without a special agenda with the district's best interests in mind. Due to the variances among districts, it may not be prudent to follow, or copycat, the actions of other districts. If you've been waiting to deal with the challenge, the time to act has arrived.

    This article was originally published in "California Special District," Volume 2, Issue 6, November-December 2007. It was reprinted with permission from the California Special Districts Association.