O C T O B E R 2 5 , 2 0 0 6 C O C A : P R A C T I C A L G U I D E T O G A S B 4 5 & O P E B OPEB Actuarial and Disclosure Practices S T R I C T L Y P R I V A T E A N D C O N F I D E N T I A L Presented by Brian L. Whitworth OPEB Specialist [email_address] (213) 621-8650
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Potential Problems with OPEB Implementation OPEB Flowchart Funding OPEB is Different Than Funding Pensions 1 1 1 2 11 3 20 C O C A : P R A C T I C A L G U I D E T O G A S B 4 5 & O P E B
A number of public entities are not familiar with what constitutes a Defined Contribution plan. Since GASB 45 relates to Defined Benefit plans, some entities mistakenly assume there is no need for an actuarial study.
“ Defined benefit plans are plans having terms that specify the benefits to be provided at or after separation from employment. The benefits may be specified in dollars (for example a flat dollar payment or an amount based on one or more factors such as age, years of service, and compensation), or as a type or level of coverage (for example, prescription drugs or a percentage of healthcare insurance premiums).
In contrast, a defined contribution plan is a plan having terms that (a) provide an individual account for each plan member and (b) specify how contributions to an active plan member’s account are to be determined , rather than the income or other benefits the member or his or her beneficiaries are to receive at or after separation from employment. In a defined contribution plan, these benefits will depend only on the amount contributed to the member’s account, earning on investments of those contributions and forfeitures of contributions made for other members that may be allocated to the member’s account.” [emphasis added] --Source: GASB 45 Statement, page 2. A description of accounting for defined contribution plans begins on GASB 45 Statement, page 21.
Some public entities don’t see the need for a study because retirees pay the full premium. However, if the employer is providing an implicit subsidy to retirees, it is required to obtain a study by GASB 45.
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Potential Problems: 1. Not Getting a Study (continued)
There are several ways an actuary may see that an a study should be performed, including:
A pension actuary may wonder why no OPEB study is being performed, especially if the pension fund also delivers OPEB
An actuary can typically look at the most recent CAFR in the notes and see if the OPEB description sounds like a study is required
Plan documents and benefit descriptions are frequently available online
Failure to get a required study can cause major problems:
Rating agencies look at failing to get an estimate of a large and material liability as an indication of poor management. This could potentially result in a downgrade, leading to more expensive future borrowings and more expensive bond insurance
Downgrades could result in investor lawsuits
The Securities Exchange Commission may pay a visit, especially if a bond was issued after the GASB deadline and there was not the required OPEB disclosure
Because of the potential legal implications, you may want to encourage clients to talk to bond counsel, or disclosure counsel
Investment bankers do not like to work with clients whose disclosure is questionable
In addition, failure to get a study means failure to know true liabilities, and makes it more difficult to manage or plan for the cost of future OPEB payments
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Potential Problems: 2. Studies Performed by the Wrong Actuary
Fairly frequently, a public entity asks its current pension actuary to perform a GASB 43/45 actuarial study for OPEB
This often happens because the client already knows and trusts their pension actuary, and doesn’t want to do a new RFP.
Some pension actuaries have done a substantial number of OPEB studies. Others haven’t done any.
Pension actuaries can work well with OPEB specialists within their firm and provide valuable client-specific knowledge
Many “outlier” results we have seen were performed by pension actuaries who had little or no OPEB background
Public sector clients often want presentations to a board, city council, etc. Actuaries often present to people who have little finance or actuarial background.
Do you enjoy explaining actuarial concepts to the uninitiated? Hate it?
Getting caught in the middle of a political battle is not for the faint of heart
Some background work before the public meeting can be very helpful
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Typically, you will be delivering the first OPEB actuarial study for a public entity
Often, you are given partial data, or info of questionable quality. Considerable digging may be required
Often, only current plan descriptions are initially provided; later you find out that there have been multiple modifications and other previous plans
Fragmented data is common. Some data may be at HR, some at a pension system, some at Mayor/Governor/Supervisor/Board, and some at finance/treasury
Example: HR may have information on current employees, the pension system may have data for retirees, resolutions relating to benefits may be at the board, and historical aggregate payout data may be at finance
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Potential Problems: 4. Study Delivered at Inconvenient Time
In general, receiving a study earlier allows a public entity more time to plan. Early implementation of GASB 45 is encouraged
However, if you don’t plan well, the study could be delivered:
Just before an election, and become a political football
During labor negotiations when neither side was expecting it
A few days before a bond is issued, requiring revisions to many documents, and perhaps new trips to rating agencies
Near the end of a legislative session
The arrival of a draft study can cause similar results to the arrival of the final version
Draft studies typically have disclosure requirements, just like final studies (good idea to have client check with counsel, especially if a bond issue or CAFR is near completion)
Major revisions are often politically embarrassing, can attract unfavorable attention from rating agencies, and under some circumstances, the SEC.
Compliance is top priority. Planning also helps convenience, accuracy
Lay out the calendars for bond issuance, legislature, elections, and GASB 45 deadline
Try to have a study arrive when staff can devote undivided attention to making sure they believe the numbers, and to making any revisions.
Don’t sit on a completed study. Do the planning before, not after completing the study.
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Potential Problems: 5. Client Misquotes or Misinterprets Your Study
We are surprised at how many clients do not have the actuary review press releases regarding OPEB, or disclosures in annual reports and bond documents
Putting the wrong data in a Comprehensive Annual Financial Report or in a bond Official Statement could cause compliance and rating problems
Most items in a CAFR are updates of prior years. Clients need more guidance than usual for OPEB because:
GASB 45 is a new standard
They typically have not had prior actuarial studies for OPEB
People outside of finance and HR may present other problems, potentially including:
Political objectives, especially quoting the highest or lowest number anywhere in the study
Lack of knowledge of the current OPEB program
Lack of background in math, accounting, finance, or actuarial calculations
Speaking to the media, or at public meetings, without having read the study
Misstating what GASB 45 means or requires
Ask to review disclosures for OPEB used in CAFR or bond official statements
Ask to review the initial press release regarding the study
Try to have someone who fully understands the study at relevant public meetings
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Potential Problems: 6. Mischaracterizing the Commitment
GASB 45 requires calculations related to the “substantive plan.” The actuary might, or might not, have any opinion on vesting, legal commitment, obligation, or similar matters.
The commitment to provide OPEB varies tremendously from one entity to another, even for the same type of entities in the same state. Knowing whether School District X can modify benefits often tells you nothing about School District Y.
We have seen a large number of cases where someone (client, politician, reporter, attorney, even auditor or actuary) mischaracterized the commitment.
Believing you can modify benefits when you cannot may lead to unnecessary and unproductive conflict.
Believing you can’t modify benefits when you really are able to make changes is also common
Many clients can be reasonably certain about potential modifications after doing careful research. For others, the situation remains unclear.
It is very common to see a statement which is true of some employees or retirees stated as if the same is true for everyone
Watch out for statements which are true of employees represented by unions, but not for management or other nonunion employees
There are often statements which are true for those who retire now, but a different arrangement was in place for those who retired years ago
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The highest ranking attorney at a public entity asserted in the media that “these benefits are not vested, therefore we do not need to report them under GASB 45”
Very unusual demographics. One city stated that the number of survivors of retirees exceeded living retirees + current employees. They continue to assert this.
Extremely low or high discount rates. 2% at the low end. 8.25% for an unfunded plan at the high end. Typical numbers for unfunded plans are 3.75% to 4.5%.
Very high medical trend rates, which continue for many years into the future.
Revocable contributions discounted as if they were irrevocable.
Public attempts to sidestep GASB 45, when it clearly should apply.
Trying to push accruals down below reasonable levels, in order to make a better impression on rating agencies. Questionable assumptions actually make the opposite impression.
Assuming 100% participation rates among eligible retirees and/or dependents, when the actual participation rate is available, and materially lower.
GASB 45 actuarial studies performed using FAS 106 rules
Asking actuaries to calculate alternative benefit modifications that are seemingly picked out of the air
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There are differences between private and public sectors. On average, public sector changes will likely be slower and less substantial.
Unionization - Stronger and more widespread unions exist in the public sector
Fewer competitive pressures of the type which have resulted in industries like airlines trying to eliminate OPEB liabilities through bankruptcy. Bankruptcies in the public sector are very rare, and strategic bankruptcies to shed particular liabilities are virtually unheard of. Many public entities are not even eligible for bankruptcy, including state governments and most school districts.
Legal requirements - Many public entities are obligated by charter, law, or State constitution to pay benefits. These are more difficult to change than renegotiating benefits with unions. Changing State constitutions would be especially difficult. These types of changes were seldom required to modify private-sector benefits.
Associations - Public entities are much more likely to be part of associations, joint power authorities or retirement systems which dictate the benefits being provided.
Lower turnover - Public entities typically have lower turnover than private entities. This means that any change in postretirement benefits which affects only new employees will take longer to yield material results, both on a cash flow and accrual basis.
Less desire to change - A 2003 Segal Company poll found that only 15% of state governments said they might consider reducing retiree benefit levels in the next one to three years. None of the states responding to the survey were contemplating eliminating retiree health benefits.
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Funding OPEB is Different Than Funding Pensions OPEB Flowchart Potential Problems with OPEB Implementation 11 1 1 2 11 3 20 C O C A : P R A C T I C A L G U I D E T O G A S B 4 5 & O P E B
OPEB liabilities are more volatile than pension liabilities
Public sector pension funding typically had strong guarantees in state law. OPEB commitments vary tremendously
The typical public sector OPEB funding ratio is currently 0.0%
If you want to prefund money, where can you put it?
Very often, pension funds are not authorized or willing to accept and invest OPEB prefunding
You may need to create a new OPEB trust or similar entity, or join a group investment trust
In California AB 1729 (CalPERS OPEB trust open to any govt entity) was vetoed.
OPEB funding shortfalls are usually larger than pension funding shortfalls -- to fund pensions, many public entities have issued POBs
In CA, one OPEB bond has been issued (two others completed, the first was in Wisconsin, another in Florida)
In CA, it appears that most public entities can issue OPEB bonds (typically subject to a validation proceeding, the client should check with bond counsel on these matters)
In other states, this is not always the case
There are some very good reasons not to try to fund 100% of projected OPEB liabilities, especially in the short term
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Medical premium trends have varied widely Medical Premium Trends Premium trend is per Kaiser Family Foundation (* means that year’s premium trend is interpolated). Annual CPI and earnings trends are per Bureau of Labor Statistics. 13 F U N D I N G O P E B I S D I F F E R E N T T H A N F U N D I N G P E N S I O N S
Funding plan options (yes, there are options!) OVERFUNDED BENEFIT: High level of security for benefit payments. DRAWBACKS: Pressure to provide new benefits; funding holidays, followed by general fund budget pressure when payments start again. MOSTLY FUNDED BENEFIT: High level of security for benefits payments; indicates fiscal responsibility to rating agencies, bondholders, etc; insulates general fund from fluctuations in medical costs. DRAWBACKS: Could cement liabilities if not required by contract; reduces flexibility to change benefits in the future; difficult for most public entities to fund quickly. PARTIALLY FUNDED BENEFIT: Good security for benefit payments in medium term; indicates fiscal responsibility to rating agencies, bondholders, etc; insulates general fund from fluctuations in medical costs. DRAWBACKS: May result in annual contributions that are higher than pay-as-you-go costs in the short run. PAY-AS-YOU-GO BENEFIT: Lower short run contributions in many cases; no need to create or join OPEB trust. DRAWBACKS: Could affect credit ratings, balance sheet; strongly rising costs over time; long term cost & accruals higher than funded plans. (e.g. 110% funded) (e.g. 80% funded) (e.g. 40% funded) (0.0% funded) 14 F U N D I N G O P E B I S D I F F E R E N T T H A N F U N D I N G P E N S I O N S
Potential problems of contributing and bonding to 100% funding level for OPEBs
Much of the benefit of 100% funding can be obtained with a lower level of funding:
Stable general fund budget
Investment returns on assets
Improved security of delivering benefits
Lower booked liabilities and normal cost
If actual investment returns exceed actuarially expected return, the trust becomes overfunded
As seen with pensions in the late 1990s, overfunding often leads to:
Long term benefit increases based on short term overfunding
Temporary contribution holidays, which cause budget stresses once the holiday is over
There may be significant revisions from the first actuarial study to the second study, even if benefits and eligibility are unchanged
Future changes in benefits might be negotiated, and changes in benefits, eligibility, or early retirement might leave the trust overfunded
Others might pay a larger portion of benefits, leaving the trust overfunded (e.g. medicare prescription drug benefit on a larger scale)
Higher debt service than funding a portion of liabilities through bonds
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Problems with NOT funding OPEB liabilities at all
Cash flow differential
Any prefunding results in interest earnings which reduce a client’s long term expenditures
There are good reasons why completely unfunded pension plans are rare, and why completely unfunded OPEB plans will become more and more rare over time
Unexpected increases in medical costs directly affect the current year’s budget
General fund budget strain results in immediate problems paying OPEB costs
Accounting: Unfunded plans generate greater booked liabilities than funded plans
The client could be required to calculate the present value of OPEB liabilities at a much lower interest rate, e.g., 3.5%-4.5% instead of 7.0%-8.5%
Booked liabilities for OPEB could be substantially higher
A present value of $100 million discounted at 8% could be $200 million or more at 4%
Failure to fund could result in a case where unions attempt to negotiate changes at a point where the public entity cannot afford the “give”
Completely unfunded plans leave employees and retirees concerned about benefit security
Bond ratings can be negatively affected as a result being completely unfunded
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Comparison of Interest Costs and Investment Returns Source: JPMorgan Securities and CALPERS Annual Report Funding OPEB liabilities similarly to the pension system could help clients meet its future obligations 17 F U N D I N G O P E B I S D I F F E R E N T T H A N F U N D I N G P E N S I O N S
Financing arrangements can help to mitigate the impact of OPEBs on municipal finance agencies
A public entity may be able to issue debt similar to pension obligation bonds (“POBs”)
Large, often hundreds of millions or billions
Likely taxable, issued with expectation that investment returns exceed borrowing costs
Typically paid to a retirement system, trust, or similar fund
Investment return risk
Most public entities do not currently have an appropriate place to put large amounts of prefunding
Over time, we would expect to see financing activity similar to that experienced for pension obligation bonds
As of January 2006, there had been 435 pension bond transactions totaling over $45 billion
$21 billion in proceeds are from just 10 large bond issues
Many different funding alternatives including fixed, floating and synthetic fixed bonds; capital appreciation bonds; direct interest index or equity index swaps without bond issuance
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JPMorgan has reviewed the historical performance of pension obligation bonds
Comprehensive data on pension bond performance had not previously been published. Last year, JPMorgan conducted a study of pension bonds with more than $100 million in par value issued from 1986 through 2004, evaluated 2/28/05. We repeated a similar analysis as of 3/30/06 (as shown in the chart below), which includes the first OPEB bond (Wisconsin, 2003).
We compared borrowing costs (NIC) to asset returns of CalPERS from date of issuance to 3/30/06.
Higher rated issuers tended to fare better. In one case, different issuers on the same day had 122 bp difference in borrowing cost.
Those who issued during times of generally low interest rates tended to fare better. One issuer borrowed at 200 bp+ cheaper for a later bond than for its prior bond.
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OPEB Flowchart Funding OPEB is Different Than Funding Pensions Potential Problems with OPEB Implementation 20 1 1 2 11 3 20 C O C A : P R A C T I C A L G U I D E T O G A S B 4 5 & O P E B