The Basics of GASB 45

Long-term Costs of Retiree Health Care To Be Treated Like Pension Liabilities

(Funded by the Texas House of Representatives, the House Research Organization employs a non-partisan staff to analyze legislation and key issues facing state lawmakers. In September 2006, the HRO published a comprehensive explanation of GASB-45’s potential impact on state and local governments. Below is an excerpted version of the article. The original article was written by Research Analyst Betsy Blair.)

A new accounting rule will change the way public pension systems, including those of counties, cities and states, must show their longterm obligations to cover retiree health costs and other non-pension benefits. In order to be considered actuarially sound, public pension systems now must demonstrate that they have sufficient assets available to fund pensions for retired employees for years in advance. However, for retiree health care and other benefits, most public pension systems, operate on a “pay-as-you-go” basis, covering these expenses as they occur. In an effort to make clear the effects of such benefit commitments on a public employer’s overall financial condition, new national accounting standards soon will require these pension systems also to demonstrate that they have funds available to cover retiree health care and other benefits costs for years in advance, as they now do for pension costs. This change could result in large liabilities occurring on the books of public pensions systems that, if not addressed, could undermine the credit rating for state and local governments and ultimately increase the cost of government.

The new standards

The new accounting standards were adopted by the Governmental Accounting Standards Board (GASB), an independent nonprofit organization that sets financial accounting and reporting guidelines for state and local governments. In June 2004, the organization issued GASB Statement No. 45, “Accounting and Financial Reporting by Employers for Post-Employment Benefits Other Than Pensions,” which establishes new accounting standards for state and local governments for reporting such non-pension costs as retiree medical care, prescription drugs, and life and dental insurance. These costs, referred to as “other post-employment benefits” (OPEB), consist primarily of costs related to retiree health care.

GASB 45 applies to any public employer that provides health insurance and other non-pension benefits for retirees. The new standard requires these employers to switch their method of accounting for OPEB benefits from “pay-as-you-go” to the “accrual” method, in which the cost of providing the benefits is reported as an expense during the years that employees perform services in exchange for the benefits. The amount to be reported as an expense each year will include that year’s normal cost, or service cost, and an additional amount sufficient, if contributed regularly, to amortize the accrued obligation for unfunded past service cost over a period not to exceed 30 years. This is the method currently used to calculate pension liabilities.

According to GASB, the purpose of the change is to “provide those who use government financial reports with improved information about the cost of providing post-employment benefits, the commitments that governments have made related to those benefits, and the extent to which those commitments have been funded.”

GASB standards do not have the force of law but are “generally accepted accounting principles.” Therefore, government auditors and financial institutions normally consider compliance with GASB standards as a benchmark for financial reporting. According to Fitch Ratings, a credit rating firm, “failure to comply would prevent auditors from releasing a ‘clean’ audit opinion.”

Under GASB 45, governments are not required to fund their OPEB obligations, only to measure and report them. However, most analysts expect governments to consider alternative funding mechanisms in an effort to offset at least a portion of the unfunded liabilities that are expected to be highlighted as a result of the accounting change.

Implementation timeline

The new accounting standards are being phased in over several years, based on the amount of revenue collected by each government. The state and local governments that collect more than $100 million will begin reporting OPEB liabilities in fiscal 2007 while those with revenues of $10 to $100 million start in 2008. Those that are under $10 million will begin reporting in 2009.

Every two or three years, depending on the number of members in the plan, employers will have to complete an actuarial valuation of their OPEB plans to determine their liabilities. The actuarial valuation also will be used to determine the amount that the employer must contribute annually to cover normal cost – the amount of benefits that is “earned” in the current period – and to amortize any unfunded liability.

An employer initially will not have to report its entire unfunded OPEB liability as a financial statement liability. The new standard allows governments to apply GASB 45 prospectively, which means that in the first year of implementation employers will begin with zero financial statement liability. But they will accumulate a liability called the “net OPEB obligation” from that point forward if the employer contributes less towards OPEB costs than this annually required contribution.

According to GASB, “The net OPEB obligation will increase rapidly over time if, for example, a government’s OPEB financing policy is pay-as-you-go, and the amounts paid for current premiums are much less than the annual OPEB cost.”

The standards also will require disclosure of the funded status and funding progress of the OPEB benefits, including disclosure of the total unfunded obligation and disclosure of the percentage of the annual OPEB cost that the employer actually paid or contributed.

Expected growth in unfunded liabilities

For large states such as Texas that have significant OPEB obligations, analysts expect OPEB liabilities to build rapidly, particularly if no efforts are made to reduce net OPEB obligations. The state of New York recently estimated OPEB obligations of $47 billion spread over the next three decades. A study conducted for Maryland estimated that state’s OPEB liabilities at $20.4 billion. A recent report by the California Legislative Analyst’s Office projected that California would have OPEB liabilities of between $40 billion and $70 billion.

“Identifying and quantifying the OPEB liability will, for many entities, result in the realization of a potentially significant unfunded liability,” according to an April 2005 article by the bond rating company Standard & Poor’s, “because in the vast majority of cases assets have not been set aside to fund these future OPEB costs.” The company predicts that the costs of delivering OPEBs will continue to grow as they have in the past. This factor, combined with the increasing life expectancy of beneficiaries, likely will compound the OPEB liability of many entities, although Standard & Poor’s acknowledged that there will be significant variation in OPEB liabilities from one government to another because of differences in the level of benefits and benefit structures. “It is possible,” the company concludes, “that an employer’s unfunded OPEB liabilities could exceed the level of its unfunded pension liabilities.”

Effect on bond ratings

One of the primary concerns about the new accounting standards is the effect that rising unfunded liabilities will have on bond ratings and credit costs. A state or local government’s bond rating determines the cost of credit for a variety of projects funded by general obligation bonds, such as road and jail construction as well as other capital improvements. Any adverse change in the government’s bond rating could result in higher interest rates, which would increase the overall long-term cost of these projects. Conversely, a positive change in bond ratings could result in more favorable interest rates and lower project costs.

Although large states such as Texas may accumulate significant OPEB liabilities, bond rating companies are taking a “wait-and-see” approach in determining how they will respond to the change. Fitch Ratings expects that the departure from the “pay-as-you-go” funding method may substantially affect a state’s credit rating, although the company believes that “meeting actuarial funding requirements for OPEB will be a stabilizing factor and protective of credit over time.” According to Fitch, the ability of a state government to devise a sound plan for addressing its OPEB liabilities will be key to determining its credit worthiness. Evidence of “steady progress toward reaching the actuarially determined annual contribution level,” according to the company, “will be critical to sound credit quality.” Fitch also expects that governments may alter benefit plans or take “other actions to ensure longterm solvency.” Similarly, Standard and Poor’s, in a December 2005 report, says that credit ratings will depend in part on how successfully each state manages its OPEB liabilities and the extent to which these obligations affect an employer’s financial position or flexibility.

Funding alternatives

While some public employers already have initiated program changes in anticipation of GASB 45, most still are studying the new requirement and examining funding alternatives. Some of the most widely discussed measures include advance funding of benefits, debt financing, and benefit redesign.

Advance funding of benefits.

One way to reduce future retiree health care liabilities would be to prepay all or a portion of the projected cost in the same way that pensions are funded, primarily by payments made to a pension fund during employees’ period of active employment. While most governments cover retiree health care on a pay-as-you-go basis, some have chosen to pre-fund retiree health care as well as pensions. More governments are expected to consider this approach after GASB 45 takes effect.

Employer-sponsored health care trust funds are one method of pre-financing retiree health care costs. For its employees, the State of Texas established TRS-Care in 1986 as a pre-funded separate trust, but since 2001 has been funded on a biennial basis. By contrast, Ohio’s retirement system, OPERS, has been pre-funding retiree health care for the past several decades, with current employees and employers each contributing a share of health costs. In 2005, the state’s health care trust fund had nearly $12 billion in assets, and OPERS estimates that it has funds set aside to adequately fund 17 years of health care costs.

The Fire and Police Retiree Health Care Fund, San Antonio, is a health trust established in statute (Vernon’s art. 6243q) in 1997. Under this statute, active employees and the city of San Antonio each contribute a portion of current payroll to fund both current and future retiree health care costs. Contribution levels are determined as part of the collective bargaining process.

An actuarial study conducted in 2004 determined that current funding and benefit levels were not sufficient to make the fund “actuarially sound.” Without any changes, the study concluded that assets in the fund would be depleted in 2027.

In 2005, the House passed HB 2747, which would have established fire and police retiree health plan contribution levels for the San Antonio fund in statute, rather than their being determined as part of the collective bargaining process, and would have changed certain retiree benefits. The bill died in the Senate.

As an alternative to employer-sponsored trust funds, some employees participate in voluntary employees’ beneficiary association trusts (VEBAs), in which assets and earnings are earmarked for the sole purpose of providing the intended benefits to members of the association, their dependents, or their beneficiaries. Other possible funding mechanisms include establishing retiree medical accounts within a pension plan and stand-alone health savings accounts (HSAs) that replace traditional health coverage with highdeductible policies and contributions to accounts established to pay for health costs in the future.

Debt financing

In 2003, the 78th Legislature enacted SB 1696 by Wentworth, which authorizes Texas municipalities to issue pension obligation bonds to cover all or part of their unfunded liability for pensions. Dallas and Houston since have issued pension obligation bonds to fund a portion of the liabilities for their municipal employees’ pension funds, and El Paso currently is considering issuing pension obligation bonds.

Counties in Texas have not been granted the authority to issue pension obligation bonds.

A city that sponsors a pension plan may issue pension obligation bonds and deposit proceeds from bond sales into a pension trust fund for investment. The issuing government repays the bonds with general funds. According to Standard & Poor’s, “The goal is for the sponsor to realize savings by paying lower carrying charges for pension contributions and debt service than what is earned by their asset pool.” In other words, the interest payable on the bonds should be less than pension investment earnings. For example, if a city’s pension plan earns 8 percent in investment returns while paying 6 percent interest on pension obligation bonds, the city comes out ahead.

Opponents of pension obligation bonds argue that these financing instruments amount to a “kiting” scheme in which a city borrows from one source of credit to pay another. In issuing these bonds, cities would have an expectation of paying a lower interest rate on bonds while earning a higher percentage rate over time with fund monies. However, if the pension fund did not achieve overall earnings, the losses on the bonds would be added to the pension fund’s unfunded accrued liability, compounding overall costs. Cities could be confronted with the double burden of owing on pension obligation bonds while still failing to cover the unfunded liabilities of their pension funds.

Authorization for the municipal use of pension obligation bonds could be extended to allow issuance of similar debt instruments for the full or partial funding of OPEB liabilities. However, additional statutory authority would be required for cities or other local governments to issue OPEB bonds. If state lawmakers wanted to use general revenue to fund state OPEB bonds, voters likely would need to approve a constitutional amendment specifically authorizing the state to issue general obligation bonds for this purpose in accordance with Art. 3, sec. 49 of the Texas Constitution, which otherwise prohibits state debt.

Benefit redesign.

Another alternative that some employers have considered is cutting back on retiree health benefits to reduce current and future liabilities. Although health care benefits do not have the same specific constitutional protections as pensions, many analysts believe that reducing vested benefits for current employees or retirees would be problematic. One option would be a tiered structure with different benefits for future employees to limit long-term benefit costs. Another would be to increase current state or retiree contributions to cover a portion of current costs.

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