An OPEB Exit Strategy: How to Eliminate your Retiree Health Care Liability/Costs

October 25, 2016 – Charlie Francis


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Health insurance for retirees and their dependents, life insurance, dental insurance, and long term disability or care coverage are representative benefits typically included in a city’s OPEB program. Even though employment has ended, cities have a contractual obligation to deliver the promised benefits to eligible former employees and/or their family members. This benefit is no longer needed to attract and retain qualified employees. More significant is that escalating OPEB costs can cause structural imbalance of your General Fund. Cities can maintain a skilled labor force without OPEB, It’s time to exit from providing this gratuitous benefit.

Prior to 2004, your annual budget included a line-item for retiree health care that was probably off your radar screen. The amount paled in comparison to health benefits for current employees. That is, until GASB 45 was issued in June 2004. GASB 45 is an accounting and financial reporting provision requiring government employers to measure and report the liabilities associated with other (than pension) post-employment benefits (or OPEB). Although GASB encouraged earlier implementation, GASB 45 became effective for periods beginning after December 15, 2006, for phase 1 governments (those with total annual revenues of $100 million or more); after December 15, 2007, for phase 2 governments (those with total annual revenues of $10 million or more but less than $100 million); and after December 15, 2008, for phase 3 governments (those with total annual revenues of less than $10 million).

Such was the case with the City of Sausalito. The following graph depicts the growth of OPEB (Other [than Pensions] Post-Employment Benefits) in the City of Sausalito since FYE 2002. As the graph depicts, by the time GASB 45 was implemented, Sausalito’s Pay-Go costs were growing at an annual rate of 5.5% – a rate faster than the 2% growth of General fund expenditures. Yet, the percentage of these costs to normalized operating expenditures never exceeded 1.6%. I.e., the relative cost to the City was immaterial to our structural balance.


Many cities (including Sausalito) reviewed the required OPEB actuarial studies and decided to continue funding OPEB on a Pay-Go basis, rather than pre-funding OPEB liabilities (click here for a discussion of pre-funding).

Then came the Great Recession. The stock market crash of September 2008 wiped out more than 20% of the equity market. Those cities that elected not to pre-fund and remained on a Pay-Go basis breathed a sigh of relief that they didn’t invest into a Section 115 trust.

Declining city revenue during the recession focused scrutiny on reducing major operating costs to continue balancing budgets. There was no appetite for reallocating money from providing essential services to contributing an OPEB ARC (Annual Required Contribution) into an OPEB Trust Fund. There was also an aversion to equity market risks.

Fast forward to today’s headlines and the news focus on mountains of OPEB debt and unsustainable health care costs. Almost every story references prefunding OPEB irrevocable trust funds as the only viable solution. Bond rating agencies will even put a cap on a score from having an OPEB burden that is considered very high and management’s lack of a credible plan to address the situation.

Now before we begin to fault cities that decide to stay on a Pay-Go basis, let’s examine the pros and cons of prefunding. There are three major positions that are supported by prefunding advocates:

  1. Prefunding costs less
  2. Prefunding promotes intergenerational equity
  3. Prefunding prevents crowding out

Today’s blog examines these three positions and concludes with a surprise recommendation for OPEB reform.

Costs Less

Is Prefunding a lower cost for the City than Pay-Go in a sense that a given OPEB benefit can be provided with a lower contribution rate under funding?

Proponents of prefunding assert: “Although pre-funding requires higher contributions in the short term, it is actually the cheaper option in the long term.” Graphs such as the one lifted from the above linked report, are presented that juxtapose retiree health care costs with prefunding alternatives, giving supporting visualizations that are actually somewhat misleading. Despite parenthetical warnings such as “(if assumptions are met and absent catastrophic investment losses)” the ability to relieve OPEB cost pressure is offset by relying on the stock market to pay for a substantial portion of the benefit! I.e., the Pay-Go approach is in nominal dollars, but the prefunding alternative is betting heavily that sustained growth in equity markets will pay for the difference!


Source: United States Common Sense

IS THE UNFUNDED LIABILITY A REAL LIABILITY?

It’s not due and payable at a moment’s notice. Nor does it represent a legal debt obligation. It’s not like a car loan – you pay it off and it’s gone forever. It is an actuarial calculation built on assumptions that may or may not happen.

There isn’t a credible actuary who would assert that an 80% funded OPEB plan is better off that a 50% funded OPEB plan. The real deciding factor is can the entity sustainably afford to pay for its’ retiree health care obligations.

For many years, public pensions have relied on over 60% of their revenues from investments in Wall Street. And look at how underfunded they are! Under the red -herring of “Costs less”, governments were driven to invest more heavily in stock equities, increasing fiscal volatility. Let’s not make the same mistake with OPEB.

Cities that decided to remain on the Pay-Go system minimized their exposure to increasingly volatile financial markets and saved their cities substantial amounts of money from recent stock market downturns or investment returns less than the assumed discount rate. On the other hand, the impact of GASB 45, and the upcoming GASB 74 & 75 results in higher unfunded actuarially accrued liabilities (UAAL) because discount rates are lowered.

Takeaways –

  • There is no true cost difference between the two approaches, only different investment scenarios.
  • If you are going to set up a trust fund, do not invest in stock market equities expecting unreasonable investment returns! Rather target asset allocation in your trust fund closer to risk-free investment returns, such as US Treasury bonds.

Intergenerational equity

Is full-funding more fair from the standpoint of intergenerational redistribution than Pay-Go?

While it’s true that today’s taxpayers are essentially paying for health care for services that were rendered to the public decades ago, this has always been the case for cities and their retirees. Yes, this arrangement violates a cardinal principle of public finance—namely, that each generation of taxpayers should be responsible for funding the services that it enjoys. However, it was the tacit societal contract that each generation of taxpayers pays for the preceding generation retirees’ health care costs, on the understanding that the next generation of taxpayers will pay for the current workforce’s retirees’ health care costs. This can be advantageous to successive generations if population growth and health care costs are increasing at a steady state, and exceeding real interest rates. This was the case until recently. Increasingly longer life expectancies, escalating health care costs, and low fertility rates are not growing proportionately as was the case historically, and it has only begun to become unfair to successive generations.

Takeaway – Remember there is a transition cost in the decision to shift from Pay-Go to prefunding. It double loads the current generation with paying for past AND current health care services.

Crowding out

Is the real problem created by rising retiree health care costs “crowding out” other government priorities?

Structural balance is the goal of preparing annual balanced budgets. (See GFOA’s best practice “Achieving a Structural Balanced Budget”) Simply put, you have a structurally balanced budget when recurring revenue growth meets or exceeds recurring expenditure growth. Whenever a major expense category increases faster than revenues, another expense must be reduced.

Takeaway – Fully funded trust funds are not the goal of OPEB reform. The ultimate goal of OPEB reform should be General Fund structural balance. This means making sure that revenue growth keeps pace with all expenditure growth.

What’s the Answer?

When health care costs inflate faster than all other expenditures, Pay-Go funding will consume larger percentages of government’s annual budget plans. But, so will prefunding because of the intergenerational equity transition cost discussed above! In other words, both approaches work against structural balance.

Here’s an approach to successfully manage structural balance. Phase in a comprehensive OPEB reform program!

1. Close OPEB benefits for all new entrants! – By terminating total medical benefits OPEB for all future employees your accrued actuarial liability and normal cost will be eliminated when all current and legacy retirees/annuitants are deceased.

2. Offer to transition current employees from defined benefit OPEB to defined contributions – Many employees will voluntarily elect to take cash now rather than wait for a future benefit, especially newer workers that are in occupations that have high mobility or turnover. Take advantage of this! Offer cash into a deferred health plan, or deferred compensation plan and have them waive any rights to future defined OPEB benefits. When current employees elect to shift from the defined benefit OPEB to a defined contribution plan, there are significant decreases in accrued actuarial liabilities and normal costs.

3. Set up an irrevocable OPEB trust fund – An irrevocable trust fund is the only vehicle where assets can be shifted into that offset the accrued actuarial liabilities (remember key takeaway from above – don’t bet your trust fund on stock market volatility!) In setting up the irrevocable trust fund, do not limit your permitted investments to cash and cash equivalents, but also include capital income producing assets to generate income for paying for retiree health care benefits.

4. Move income producing capital assets into the irrevocable OPEB trust fund – Typically governments only invest cash into their irrevocable trust funds. The impact on the statement of net assets is a corresponding reduction in unrestricted net assets. However, by moving capital assets into the irrevocable trust fund, the book value of the capital asset is offset by a corresponding reduction in restricted net assets! By moving assets into the irrevocable trust fund that have market values approximating the UAAL, you effectually eliminate the UAAL, and the ARC reverts to the Pay-Go amount. To preserve the integrity and purpose of the irrevocable trust fund, only move assets that are producing significant income such as cell towers, municipal buildings that are rented to the private sector or other government agencies, parking lots, etc. (Yes, this takes the income out of your General Fund – see next step)

5. Pay all retiree health care costs out of the irrevocable OPEB trust fund – by paying all retiree health care benefits out of the irrevocable trust fund, these expenses are also moved out of the General Fund offsetting the impact from previous step.

6. When there are no more PAY-Go annuitants, close the irrevocable OPEB trust fund and return all income producing assets back to the original fund of origin – Talk about leaving a legacy for your grandchildren! A revenue source that was previously dedicated to paying retiree health care costs becomes unencumbered when an actuary certifies there are no more annuitants subject to the benefits of the trust. These income-producing assets are now transferred back to the government’s balance sheet generating fresh cash flows of added revenues. They can be used to reduce or eliminate taxes, or increasing capital investment in infrastructure. Thus unleashing true grass-roots economic stimulus for your local government.

Conclusion

There are other subsets of OPEB reform mechanisms such as removing the implicit subsidy element of health care provision and making use of medical exchanges to lower retiree health care costs. Of course, it’s always smart to monitor the progress of political efforts to nationalize health insurance and make changes in Medicare (e.g. co-pay rules). Look for guidance from your state association of cities: the League of California Cities has a very comprehensive document outlining many OPEB reform ideas. Incorporate these into the above to focus on structural balance of your General Fund.Conclusion

But just don’t stop there! There is tremendous political and labor union pressure to continue with OPEB, a gratuitous benefit that reduces funding for essential public services. The real focus of this article is to convince you to close out your retiree health care program! Make meaningful OPEB reform your number 1 priority, not just marginal changes on the edges.


A new OPEB liability and cost-reduction option now available to California cities is participation in the League’s Health Benefits Marketplace (HBM) (click here for more information)


Charlie Francis is a municipal finance expert. He has more than forty years of local government financial management experience in both the public and private sector, including twenty years of experience as a Chief Financial Officer. Most recently, he served as the Director of Administrative Services and Treasurer for the City of Sausalito where he earned the unofficial title of “OpenGov super user”.  He has also served as a finance manager for the Town of Colma, CA, and as CFO and acting City Manager for the Cities of Indian Wells, CA and Tracy, CA.

Questions or comments? Email Charlie at cfrancis@opengov.com.

Category: Government Finance