To Fund or Not To Fund Your GASB 45 Obligation

By Roberto Crawford,2014-11-25 19:53
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To Fund or Not To Fund Your GASB 45 Obligation

To Fund or Not To Fund Your GASB 45 OPEB Obligation

    By Donald J Rueckert, Jr.

    As discussed in my inaugural article “GASB 45 is it Just a Change in Accounting?” , state and local governments are now required to measure, recognize and report their post-retirement healthcare benefits(aka OPEBs) on an “accrual basis” instead of the recent past practice of “pay-


     Under the GASB 45 accounting statement, an employer must now begin to calculate and accrue a cost known as the Annual Required Contribution (ARC). Many employers are finding their ARCs to be substantially higher by a magnitude of 5 to 10 times - than their previous “pay as

    you go costs”. In addition, there is significantly more reporting information regarding the Unfunded Actuarial Accrued Liability (UAAL), as well as the potential to establish a liability in the Statement of Net Assets which is defined as the Net OPEB Obligation (NOO).

     This Net OPEB Obligation will generally start at zero, but has the potential to grow at the rate of 20 to 40 times the previous “pay as you go costs”. The UAAL represents all the annual OPEB

    expense accumulated prior to the release of GASB 45 and similar to the NOO, the magnitude of this amount is many times that of the “pay as you go cost”.

     While the ARC will receive some notoriety in the general public, the lion’s share of attention will most certainly go to the NOO and the UAAL. Rating agencies, lenders, taxpayers and bondholders are going to be quite keen on following the growth of the public entities NOO and UAAL. Through enhanced measurement and disclosure, all of these constituencies will be able to follow the growth of the NOO and UAAL and use it in determining the credit quality of the entity as well as the expertise of the current administration in managing these obligations.

     While GASB 45 does indeed change an employers accounting for these benefits, it does not impose any requirements what so ever that an employer actually begin to contribute to pre-fund these benefits. Unlike many of their defined benefit plan counterparts, most post retirement

    health benefits plans have historically been unfunded. It would appear that had GASB 45 not come along that process would have continued on into the future.

     But now faced with reflecting items in ones financial statements that are many magnitudes greater than previous entries, many entities have seriously begun discussing funding their OPEB obligations as a way to help control these costs. And with good reason; after all, funding these obligations have many advantages such as:

    ; Discount rate relief

    ; Reduction or elimination of the NOO

    ; Reduction in future years ARC

    ; Accumulation of a fund to reduce the UAAL; and

    ; Securing promised benefits to retirees

    Before further examining the benefits of funding ones OPEB obligation it is first necessary to discuss one of the key economic actuarial assumptions that go into calculating the expense and liability amounts under GASB 45; the discount rate.

The Discount Rate

    The calculation of all OPEB expense and liabilities involve the projection of future claims for the entire employee population (typically consisting of actives, retirees and vested terminations) “discounted” for the time value of money to the present. All of the

    GASB 45 financial entries including the ARC, Net OPEB Obligation and Unfunded Actuarial Accrued Liability are derived from these calculations.

    Probably the most important economic assumption used in the actuary’s calculation of the OPEB expense and liability amounts is the discount rate. It is the interest rate used in the “discounting” of the future claim stream to the present value. As with all present value calculations, the discount rate and the resulting present value have an inverse relationship. That is to say, if the discount rate goes up, the present value of benefits goes down. Likewise, if the discount rate goes down, the present value of benefits goes up.

     An actuarial rule of thumb, which serves to approximate this relationship is as follows; for each change of 100 basis points in the discount rate, the present value of benefits may change by 10% to 20%.

Discount Rate Relief

    The accounting standard is quite specific as to how one determines their own discount rate. The discount rate is the expected rate of return on those assets that will be used to pay for benefits. For unfunded plans the discount rate is typically tied to those asset categories that are highly liquid and are to be found in the general fund. This asset category tends to reflect short term rates (2% to 5%) associated with either money market or other highly liquid instruments.

    For those plans considered funded under the GASB rules, the discount rate would reflect the rate associated with a diversified pool of assets invested in a dedicated trust for a long time horizon. This discount rate would typically be in the range of 6% to 8%.

     By allowing those plans that are funded - as opposed to those that are unfunded - to use a much higher discount rate, the GASB allows funded plans to calculate much lower expenses and liabilities than those of their unfunded counterparts. I like to use the term discount rate relief to reflect the discount rate arbitrage that is occurring between the two different scenarios. I also refer to this circumstance as an embedded “incentive” for

    plan sponsors to now begin funding their post- retirement healthcare obligations.

    As you will see in the following exhibits, allowing a plan sponsor to use a much higher discount rate certainly allows one to help control and manage the costs and expense associated with these obligations.

    Below is shown an actual case study of a plan sponsor that wished to have their GASB 45 calculations prepared on both an unfunded and funded basis.

Scenario #1 Employer retains current “Pay As You Go” Basis

    In the diagram above the plan sponsor had a “pay as you go cost” of $328,561 which represented claims paid on behalf of current retirees. It was the plan sponsors intention to continue on in an unfunded manner paying the “pay as you goclaims each year up until 2020. By that time annual

    healthcare claims would ultimately trend to $959,445.

    Since the OPEB liabilities were not being funded in advance, the return on assets were expected to be quite low. Accordingly a discount rate of 3.5% was chosen. Applying GASB 45 methodology, the ARC in the first year was determined to be $1,609,230. The annual expense was ultimately projected to grow by the year 2020 to $5,104,750. In addition, and as shown in the following exhibit, the Statement of Net Assets was now reflecting a growing Net OPEB Obligation which over the very same period of time would escalate to almost $40,000,000.

Scenario #2 Employer contributes at least the ARC

    The alternative scenario allowed for the very same plan sponsor to put aside funds each year at least equal to the ARC. The contributed ARCs were to be placed into an irrevocable trust that invested those monies across a spectrum of varying asset categories. By allowing such diversification and setting an investment horizon farther out into the future, allowed the plan sponsor to chose the much higher discount rate of 7.25%.

    Observing the following exhibit one cannot help but notice the substantial decrease as shown in both the Income Statement and Statement of Net Assets. In the prior exhibit, the initial ARC was calculated to be $1,609,230 and it is now $1,078,524. Further illustrating the dramatic effect an increasing discount rate can have, especially coupled with investment earning on the contributed ARCs, are the comparable amounts shown in year 2020. Under the unfunded scenario the ARC was projected to be $5,104,750; under the funded scenario the ARC is projected to be $1,559,279. A difference equal to $3,545,471. Keep in mind that as long as this sponsor continues to contribute the ARC there is no Net OPEB Obligation to report on to the Statement of Net Assets.

Below is a side by side comparison from 2005 to 2020 of the funded and unfunded ARCs.


    Prior to GASB 45 there were very few governmental employers that considered funding their OPEB liabilities. The State of Ohio was recognized as one of the very few large governmental employers to do so. However many other employers, both large, and small are considering this as a viable option in controlling the cost and expense associated with ones OPEB benefits.

     Take for instance New York City, which faces a $53.5 billion obligation for it’s post-

    retirement medical program. Late last year Mayor Michael Bloomberg made the decision to set aside some of the city surplus into a trust for future retiree health costs. This prompted S&P to raise its rating on the city’s debt to AA-, the highest ever.

S&P analyst Robin Prunty said of the New York City, “The fact that they took non-

    recurring surplus revenues and dedicated that to a trust fund to offset future liabilities, I think we view that very positively”. She went on further to add, “It clearly is the most substantial contribution to any trust like that we’ve seen on the governmental side.”

     thEven more recently; on April 10 the City of Duluth Minnesota passed Council

    Resolution 07-0281R which authorized the creation of an irrevocable trust to fund their retiree health care obligation. City officials estimate that pre funding will reduce their future OPEB obligations by up to one-third.

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