OPEB IN PERSPECTIVE GASB Statement No. 45 Four Years Later

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1 AUTHIER G. J N E STEPH OPEB IN PERSPECTIVE GASB Statement No. 45 Four Years Later

2 Typically, a new accounting standard generates limited interest,at best,from those outside the accounting and auditing profession. Even the introduction of a new governmental financial reporting model in 1999 seems to have elicited only passing interest from those not directly involved in its implementation. Such was certainly not the case,however,when the Governmental Accounting Standards Board (GASB) issued Statement No. 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions in July It seems safe to say that no other public-sector financial reporting standard in recent memory has evoked more interest (and passion!) on the part of those not otherwise professionally involved with accounting and auditing. Moreover, in the four years since the standard was issued, the level of interest seems to have increased rather than diminished. The release of GASB Statement No. 45 was met with considerable misunderstanding. Happily, much of the confusion appears to be dissipating as governments approach the deadline for implementation (from the fiscal year ending December 31, 2007, for the largest governments to the fiscal year ending December 31, 2009, for the smallest). Accordingly, now appears a good time to reconsider GASB Statement No.45 in the light of all that has been learned over the past four years. PENSIONS V. OPEB: A TALE OF TWO BENEFITS Other postemployment benefits (OPEB) such as retirement health care are essentially similar to pensions in that both constitute a form of compensation to employees for services rendered. All the same, there are important practical differences between these two types of postemployment benefits. Defined benefit pension benefits are provided to employees pursuant to a formal contractual arrangement between employer and employees that cannot be unilaterally altered. OPEB, on the other hand, typically allow for considerable employer flexibility. Indeed, employers often are free, in principle, to drop OPEB altogether, at their sole discretion. Also, there has long been a consensus that pensions should be prefunded, whereas OPEB have historically been financed almost universally on a pay-as-you-go basis. These differences undoubtedly explain,at least in part,why accounting for OPEB has historically differed from accounting for pensions, even though both are forms of employee compensation. Employers in both the private and the public sectors have long been required to accrue expense for the cost of pension benefits as employees earn those benefits (i.e., over employees active service life). However, it was only in the early 1990s that the Financial Accounting Standards Board (FASB) prescribed this same treatment for OPEB in FASB Statement No.106,Employers Accounting for Postretirement Benefits Other Than Pensions. GASB Statement No. 45 is now doing for the public sector what FASB Statement No. 106 did for the private sector well over a decade ago. HOW THE ACCOUNTING WORKS Accounting and financial reporting for OPEB under GASB Statement No.45 is virtually identical to accounting and financial reporting for pensions under GASB Statement No. 27, Accounting for Pensions by State and Local Governmental Employers. In the case of defined benefits, the approach might be summarized as follows: The goal is to systematically and rationally allocate the present value of the ultimate (i.e., projected ) cost of benefits over the working life of benefiting employees (much like depreciation expense allocates the cost of a capital asset over its useful life). This allocation is accomplished by means of an actuarial valuation. The amount the actuary allocates to a given year is known as the annual required contribution (ARC), which serves as the basic measure of expense. The present value of benefits earned to date by employees is known as the actuarial accrued liability.the difference between this amount and any resources placed in trust is known as the unfunded actuarial accrued liability.in the case of OPEB, this latter amount will include the cost of OPEB benefits earned by employees, but not funded, prior to the implementation of GASB Statement No. 45. Neither the actuarial accrued liability nor the unfunded actuarial accrued liability is ever reported on the face of the financial statements. Rather, the actuary, as part of the calculation of the ARC, includes an amount intended to amortize the unfunded actuarial accrued liability over a period not to exceed 30 years. If an employer pays the full amount of the ARC each year, no liability is reported on the face of the financial statements (although the unfunded actuarial accrued liability is disclosed in the notes to the financial statements). If an employer does not fully fund the ARC each year,the aggregate difference is reported as a liability on the face of the government-wide financial statements (net pension liabili- February 2008 Government Finance Review 9

3 ty/net OPEB liability), but not on the face of governmental fund financial statements.thus, an employer s failure to fund the cost of OPEB has no effect on fund balance in the general fund. As a rule, the cost of health care will increase with age.thus, age-adjusted health-care premiums for active employees can normally be expected to be less than age-adjusted premiums for retirees. Employers, however, commonly ignore this cost differential and establish a single premium for both active employees and retirees that falls somewhere between the two ageadjusted premium rates. They then permit retirees to purchase coverage for themselves at what,for them,amounts to a reduced rate. GASB Statement No. 45 describes such an arrangement as an implicit rate subsidy and mandates that any retiree savings be treated as OPEB,even though the employer makes no payments directly on behalf of retirees. As already mentioned,many employers legally retain the right to unilaterally lower the level of OPEB benefits or to eliminate those benefits altogether. In practice, however, employers rarely exercise this right.accounting in both the public and private sectors emphasizes economic substance over legal form.therefore, GASB Statement No.45 mandates that employers accrue the cost of OPEB as expense whenever there is a substantive plan, including situations like the one just described.that is, so long as both employer and employees share a mutual understanding that OPEB will be provided,the cost of those benefits must be recognized as expense as earned by employees. FEARS REAL AND IMAGINED As the discussion thus far should have made clear, some of the fears initially raised by GASB Statement No. 45 are groundless. For example, neither the actuarial accrued liability nor the unfunded actuarial accrued liability will appear on the face of the financial statements.thus, financial statements will not report a liability overnight for the cost of OPEB earned prior to the implementation of GASB Statement No. 45. In addition, governmental funds are unaffected by the recognition of OPEB expense in the government-wide financial statements.thus,fund balance in the general fund will continue to be reported just as it has been in the past, even once GASB Statement No. 45 has been implemented. Conversely,some employers appear to be proceeding under the misapprehension that they have no OPEB to report,when,in fact, they do offer OPEB as defined by GASB Statement No.45. An employer must normally report OPEB expense even if the entire health-care premium is paid by retirees, assuming that a single rate is used for both active employees and retirees (i.e., implicit rate subsidy = OPEB). The fact that employers may unilaterally change benefit levels or eliminate benefits altogether does not mean that they do not have to report OPEB (focus on substantive plan rather than legal form). The fact that an employer is statutorily prohibited from entering into a binding promise to pay benefits in future years does not mean there is no OPEB (focus on substantive plan rather than legal form). THE PROBLEM IS THE FEVER NOT THE THERMOMETER! GASB Statement No. 45 has provoked strong negative reactions in some quarters. However, it seems only fair to observe that the statement does not so much create a problem as disclose one that has been around for a long time, just under the surface.the real challenge is not so much accounting for OPEB as dealing with their budgetary implications, especially as baby boomers begin to retire in an environment of spiraling healthcare costs. At least such appears to be the conclusion reached by more and more governments as they prepare to implement GASB Statement No. 45. KEEP ON KEEPING ON The most important consideration, of course, is ensuring that whatever benefits are offered are financially sustainable. As already noted, OPEB historically have been financed on a payas-you-go basis, which has tended to give the false impression that OPEB are less costly than they actually are (much like a 30- year mortgage might easily appear less costly to the unsuspecting eye than a 15-year mortgage, based on monthly payments alone). In fact, preliminary estimates indicate that the true cost of OPEB (as represented by OPEB expense calculated on an actuarial basis in accordance with GASB Statement No. 45) is likely to exceed payments made on a pay-as-you-go basis by a multiple of no less than three to one! In the face of this prospect, governments will likely wish to evaluate their plan design for OPEB.Specific aspects of plan design to be considered include the following: Health-care cost containment. Has every reasonable step possible been taken to keep current benefit levels affordable by containing health-care costs? Benefit levels. Are benefit levels appropriate, in light of their true cost? If not, is some modification appropriate or necessary? How can any needed adjustments be made with- 10 Government Finance Review February 2008

4 Exhibit 1: OPEB Decision Points 1 Establish Governance Structure Initial Actuarial Valuation and Financial Reporting Health-care 2 Policy Decision And Funding Strategy Decision Plan Design Communicating with Stakeholders Benefit Levels Implicit Rate Subsidy Health-care Cost Containment Prefund Funding Mechanism Decision Partial Prefund Pay-as-you-go Irrevocable Trust Revocable Trust Earmark Cash Bond Cash Bond 401(h) VEBA Section 115 Cash Bond Cash Bond Cash Bond Notes 1. GFOA extends its appreciation to the GFOA Committee on Retirement Benefits Administration and its advisor. Leslie Thompson of Gabriel, Roeder, Smith and Company, who developed the initial version of this decision tree. 2. While OPEB decisions do not necessarily focus on health care, this decision tree focuses on this particular benefit as the majority of the OPEB emphasis and cost is related to health-care benefits. February 2008 Government Finance Review 11

5 out breaking faith with long-time employees? Should different benefit levels be offered to new employees? Implicit rate subsidy. Should retirees continue to be allowed to purchase health-care coverage at the same rates as active employees? Should they pay at least some part of the differential? PAY NOW, PAY LATER Although many employers will likely make important changes in how they offer OPEB in the future because of GASB Statement No. 45, it appears highly unlikely that many employers will opt to eliminate OPEB entirely. Accordingly, employers still face the challenge of funding OPEB. The first funding decision,of course,is whether to attempt to budget for OPEB expense as calculated under GASB Statement No. 45, or to continue to finance benefits on a pay-as-you-go basis. The latter approach, as explained earlier, would require the employer to report a liability in its government-wide financial statements in the amount of the aggregate underfunding. Many have expressed concern at the potential impact such a liability might have on a government s credit rating. If a government does elect to prefund OPEB, it must then consider the appropriate level of funding. Should the government attempt to fund the entire amount of OPEB expense each period,or just a portion (which would result in a liability being reported in the financial statements for the underfunding)? Some fear that partial funding may be the only realistic option in their specific circumstances, given budgetary constraints. Others generally favor prefunding OPEB, but balk at the prospect of prefunding OPEB resulting from an implicit rate subsidy. Furthermore, governments that offer federally reimbursable prescription drug benefits under Medicare Part D may be resistant to prefunding the full amount of OPEB expense, given that future federal reimbursements are excluded from the calculation. WHICH COOKIE JAR? Once an employer has decided to prefund OPEB, at whatever level, a decision needs to be made regarding how the accumulated resources are to be managed. Should the employer use an irrevocable trust fund (or equivalent arrangement) for the purpose? What about a revocable trust? Or is it satisfactory simply to earmark the resources (e.g., in an internal service fund or as a designated fund balance in the general fund)? A key consideration in making any decision is the accounting implications. For instance, if a government s OPEB expense was $100 and it made a $100 payment to an irrevocable trust fund (or equivalent arrangement), no liability would be reported because the expense would be considered fully funded. Conversely, if the $100 were placed in a revocable trust or otherwise earmarked, the employer would be required to report a $100 liability for underfunding because only amounts placed in irrevocable trust qualify as contributions for accounting purposes. Furthermore, employers who elect to use an irrevocable trust fund must choose which legal vehicle to use for this purpose, such as Internal Revenue Code (IRC) Section 401(h) accounts,voluntary Employee Benefit Association accounts,or IRC Section 115 trusts. YOU VE GOT A FRIEND This issue of Government Finance Review features articles on a number of topics currently generating high levels of interest as governments seek to cope with the challenge of OPEB. Specific topics addressed include health-care cost containment, the use of defined contribution plans, the pros and cons of specific trust fund alternatives, and the use of alternative investments.the GFOA is also offering a new online toolkit of resources designed to facilitate the decision-making process for OPEB (for more information, go to The GFOA also is reviewing its existing recommended practices and considering new ones to address the challenge of OPEB.Two recommended practices specifically devoted to the topic have already been issued: Ensuring the Sustainability of Other Postemployment Benefits and Need for Considerable Caution in Regard to OPEB Bonds.The GFOA has also released Accounting for Pensions and Other Postemployment Benefits in its popular Elected Official s Guide series. FINAL THOUGHTS If a key objective of GASB Statement No.45 was to draw attention to the financial implications of OPEB, there can be little doubt as to its effectiveness! The entire topic of OPEB has by now reached well beyond the world of accountants and auditors. This development is a welcome one, as sound decision making for OPEB demands the active and concerted involvement of professionals from a range of disciplines within public finance. The GFOA is committed to providing every possible assistance to facilitate this effort. STEPHEN J. GAUTHIER is director of the GFOA s Technical Services Center in Chicago, Illinois. 12 Government Finance Review February 2008

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