There is a lot of discussion about OPEB liability and how municipalities can control it. OPEB (Other Post-Employment Benefits) refers to a municipality’s obligation to provide retiree healthcare. Most municipalities fund these costs from the annual operating budget without setting aside funds to cover the entire liability. The shortfall is estimated to be in the trillions of dollars when aggregated over the entire country.
GASB 45, the standard issued by the Government Accounting Standards Board for financial reporting of OPEB liability by municipal employers, has done a service to taxpayers by bringing this discussion to the forefront and forcing municipalities to put a number on their balance sheets for this long-term obligation. However, like many well intentioned efforts, this has had some negative, unintended consequences.
Given the focus on OPEB liability by the media, rating agencies and, to a lesser extent, the public, it is not surprising that municipal managers are worrying about how to reduce it. Unfortunately, due to the way the number is generated, a focus only on bringing down OPEB through manipulating accounting assumptions will have no meaningful impact on the underlying cost of providing healthcare to retirees.
Thus to reverse this trend, it’s essential to understand how the OPEB valuation is calculated, its short comings and why focusing solely on the OPEB liability will not solve municipalities’ retiree healthcare problems. In this paper I will provide a non-technical explanation of how the number is calculated.
What are the assumptions that generate OPEB liability and how can they be manipulated?
The OPEB liability on a municipal balance sheet is an attempt by the actuarial profession to turn the continuing liability for retiree healthcare into a reliable present value. While there clearly is a liability for future healthcare costs, the amount calculated by the actuarial analysis may be divorced from reality in many ways. That is not to say that the number is not valuable. However, if municipal officials don’t understand how the value of the OPEB liability is generated and what its limitations are, the number can be misused.
In calculating the OPEB liability, an actuary looks at how many people currently work for the municipality, how many have retired and what benefits have been promised to them. They determine the age of the workers, when they are likely to retire, and how long they will be receiving benefits after retirement. The actuary also looks at life expectancy in order to estimate how long the retirees will be receiving benefits.
Lastly, the actuary reviews the various health plans that the municipality offers retirees and the costs of those plans, as well as the retiree cost share. At this point, the actuary must make some big assumptions in order to generate the OPEB liability.
Big Assumption Number 1: Medical Cost Trends
The actuary needs to estimate how much the cost of providing health care in the future will rise or fall. To do this they typically start with a growth rate, say eight or nine percent, and then reduce it by 0.5% each year until it reaches a terminal growth rate of five percent some number of years later.
As a simplifying assumption for ease of calculation, this method seems reasonable on the surface. But what are municipalities actually paying for healthcare in the marketplace? What, if anything, are they doing to achieve this yearly reduction in the cost trend of providing retiree health care? Unless the municipality is taking specific actions to lower the cost trend, the OPEB number will be significantly underestimated. Furthermore, the actuarial analysis assumes that the OPEB costs are compounding annually at lower and lower rates which further underreports the number.
What does an actuary do when they return two years later to do the bi-annual OPEB valuation and the municipality has not seen the rate of growth drop by one percent? More often than not, they just reset the schedule at eight to nine percent and push back the terminal date.
Big Assumption Number 2: Cash Flow Valuations
The calculation of current cost, cost trend growth assumptions, the number of people receiving benefits and the timing of those benefits are designed to generate a set of future cash flows required to pay for retiree health benefits.
The next set of assumptions is used to turn those cash flows into a present dollar value, i.e. the OPEB liability.
To understand the next couple of concepts about OPEB liability, it is helpful to think of it as a 30-year mortgage. Anyone with a mortgage understands that the mortgage payment comprises two cash flows, the principal and interest. In the early years of the mortgage, the principal payments are small and the interest payments are large. Over time, the principal payments reduce the balance of the mortgage and the interest cost becomes lower and lower. Eventually, the mortgage is paid off.
The corollary to the mortgage payment in the OPEB world is the ARC, or Annual Required Contribution. This is the amount calculated by the actuary to fully fund the OPEB liability.
As a simplifying assumption, the actuary chooses a timeframe over which the municipality can amortize the cost of providing its retiree health benefits. Typically, a 30-year timetable is chosen. This is the maximum allowed under the GASB regulations.
However, given budget constraints, most municipalities fund less than 50% of the ARC. Instead retiree health insurance is generally funded by municipalities on a “pay-as-you-go” basis, in which current costs are to be funded annually from the operating budget. In a municipality’s annual financial report, there is usually a chart that shows what percentage of the ARC the municipality has been funding over the last few years.
Why is that important? What would happen if you paid only the interest on your mortgage? Assuming your lender did not foreclose on you, your mortgage balance would never go down. The same thing happens with OPEB, if the municipality does not set aside money for the full amount of the ARC, the OPEB liability never goes down.
Big Assumption Number 3: Interest Rates
Another critical element is the interest rate assumptions made by the actuary. If the municipality was making the full ARC payment, they would be generating a significant fund that, in later years, would pay its retiree healthcare costs. The rate of return on funds set aside is a large determinant of the amount of ARC. The greater return you get on the money you put aside, the less you actually have to save. So the higher the assumed rate of return, the less money you have to save, and also, the lower the present value of the OPEB liability because the cash flows are discounted at the same rate as the return on assets.
OK, that may be a little bit hard to follow but it is very important to understand some of the potential manipulation of OPEB liability. There are two interest rates that the actuary can choose from in order to calculate its present value, the funded rate and the non-funded rate. The non-funded rate is the interest a municipality earns from its assets if it has not started to put aside money to cover the OPEB liability. Typically, this rate is around four percent. If the municipality has formed an OPEB trust and started to fund it, it is allowed to choose a much higher rate of return on assets, say around eight percent.
The first thing to think about is the likelihood that in the current economic climate an OPEB trust fund achieves a return of eight percent over the next 30 years. Ten-year U.S. Treasury notes offer yields below two percent and even with corporate profits near all-time highs the stock market has a historically low dividend yield and high price-to-earnings ratio (the S&P yields 2.05% and sports a trailing price-to-earnings ratio of 17 at September 21, 2012). Since beginning valuation measures are a major determinant of prospective returns, the chance of getting an eight percent return on a blended equity / fixed income OPEB trust from this starting point is pretty small.
A significant flaw in the GASB 45 regulation is the triggers under which a municipality can change from a non-funded to a funded rate assumption. All that is required is to form an OPEB trust, put a “plan” for funding in place and place some money in the trust. The amount of money the municipality puts in the trust can be significantly less than the total OPEB obligation. The municipality also does not have to fund the trust every year to keep applying the higher assumed rate of return. Going from a four percent to eight percent return/discount rate assumption can drop the OPEB liability as much as 50 percent.
Think about that. The OPEB liability is supposed to accurately reflect the cost of providing retiree health benefits. Forming a trust with a nominal dollar balance does nothing to affect the cost of providing the benefits, but it can reduce the OPEB liability on paper by tens of millions to hundreds of millions of dollars for larger cities.
What lessons can be learned from this process for generating the OPEB valuation?
The OPEB valuation itself is generated through a complex process with a number of critical assumptions, which can have a significant impact on the size of the liability. None of these assumptions deals directly with the actual cost of providing healthcare benefits to retirees. If municipal managers are focusing only on the accounting value of the OPEB liability, they are not tackling the real problem—why the costs are rising and how best to control them. Addressing these issues rather than manipulating interest rates or health care cost growth assumptions will help solve the underlying problem.
For more information on this topic, visit our website at www.ktpadvisors.com or contact us directly.
Barry Eyre is Vice President of Product Development at KTP Advisors, Newport, Rhode Island.