What does it mean to “pre-fund Retiree Health Benefits”?
Pre-funding means setting aside and investing money now to cover the cost of obligations that come due in the future. One of the most common examples of pre-funding is pension funding – governments that provide pension benefits to their employees generally set aside money in a pension fund and then invest it to get the highest possible returns, so that the money is there when it comes time to pay out those pension payments to retirees.
Why is pre-funding the best approach?
First, it costs a lot less in the long run. A large portion of the money you pay out in the future can come from investment returns instead of taxpayer’s money. Pre-funding also makes sense because you are paying now for costs you are incurring now (benefits are earned by employees while they work), instead of putting off those costs for future taxpayers to have to pay.
But in these tough fiscal times, why are we setting aside money for Retiree Health Benefits?
Good fiscal management means addressing your obligations even when times are tough. The County needs to show that it is committed to addressing this long term obligation, just as it addresses other long term obligations such as pension funding.
Why are we changing from a five-year phase-in to eight-years?
During the Fiscal Year 2008 budget process, the County Executive recommended, and the County Council approved, a resolution calling for a five-year phase-in to the full annual pre-funding level required to fund our OPEB obligations. However, in developing the FY09 budget, and facing a $401 million budget gap, the County Executive had to make some tough choices. While committed to addressing the unfunded Retiree Health Benefit obligation, the Executive determined that we could not afford, in current fiscal circumstances, the previous five-year phase-in plan. The FY09 budget calls instead for an eight-year phase-in, or seven additional years after taking into account the funding already set aside in FY08.
I have heard that we need to do this for the bond rating agencies. What do the rating agencies have to do with retiree health benefits?
Remember that the rating agencies are rating the County on its willingness and ability to make debt service payments on its bonds. Among other things, the rating agencies consider unfunded pension and OPEB liabilities in the rating analysis and quantify them similarly to debt. They are interested in how the County is managing all of its long term obligations, and according to one agency, “a large and growing unfunded pension liability combined with a sizeable OPEB obligation would negatively affect an otherwise strong debt profile.”
What is the new accounting requirement?
It’s an accounting requirement that says you have to estimate what the cost for retiree benefits will be, and report that cost in your financial statements. You not only have to report the cost, but also how you are managing and addressing it – how much of it you have funded already and how much of it is still an unfunded liability. We are already doing this for pension benefits, now we have to do it for other benefits for retirees, such as health, life, vision, etc.
Why does it cost so much?
The revised total estimated OPEB liability of $3.2 billion represents an estimate of all the future payments that will have to be made for retirees of the County – both current retirees and current active employees. For current active employees, estimated future payments represent benefits in retirement that active employees have earned to date.
How are we going to pay for it?
We have come up with a plan that calls for setting aside a certain amount of money each year and investing it, so that it will grow to the point where we will have enough money to pay the bills when they come due. The amount we are setting aside will be higher each year for the first eight years and then it will level out, but continue on an annual basis. The annual amount we will need to set aside is estimated to level out at about $270 million a year. That is a large amount of money, but it is needed to move towards funding the total current estimated liability, which is approximately $3.2 billion.
What is the affect on me?
Setting aside the money for Retiree Health Benefits is going to be tough when the County is already facing many other budget challenges. Because some of the County’s resources, including taxes, fees and other revenues will have to go to this, that revenue won’t be available for other uses such as services to residents. But we can all appreciate that the County is acting in a fiscally prudent manner by doing this, and that saves everyone money in the long term.
What’s new and changed?
Starting with last fiscal year (FY2008), the value of retiree benefits provided such as health and life coverage must be calculated and recognized as a financial obligation to each County agency. For many years, this has been the case with pension benefits, but up until now, other types of post employment benefits such as health and life coverage were simply considered expenses when they were paid.
What does all of this mean?
For the County agencies, this means that a rather large financial commitment must be both recognized and managed. One way to manage this liability is to “fund” it on an annual basis. This means setting aside money today while an employee is in active service to cover the cost of the employee’s health and life benefits after they retire and leave active service. We can do this for current active employees. But we also need to set money aside for current retirees, who already provided their service. Since no money was set aside while they were in active service, the amounts we now need to fund, whether focusing on the total $3.2 billion liability or the $305 million on-going annual contribution, include this retiree portion also. Therefore, beginning in fiscal year 2008, the County agencies are funding this liability on an on-going basis, with a portion of the money set aside each year until we reach the annual contribution level calculated by the actuary.
Why is this important to me as a County employee or retiree?
Just as I care that the County has enough money to pay out any pension payments it owes to me in my retirement (defined benefit plan recipients), I also want to know that the County will be able to pay for its share of my health benefits in retirement, regardless of which pension plan I am in. For employees and retirees of County agencies, this means that the County is recognizing the future cost of retiree health and life benefits now and is setting aside money today to meet those expenses in the future. It also means that the County will continue to evaluate ways to manage benefit costs. All of the retiree benefits plans are reviewed on a continuing basis to determine if plan changes may be appropriate for consideration. In addition to the review of retiree benefits plans, active plans are also reviewed on a continuing basis. Eligibility criteria for retiree benefits may also be a subject for review as well.
What does this mean to me as a taxpayer and County resident?
For residents of the County, this means that the County is taking fiscally prudent steps to protect its overall financial health, not only from a funding perspective, but also from a cost management perspective. While pre-funding places a strain on the budget now, if we don’t pre-fund, it will cost us more in the long run, requiring more in taxpayers’ dollars.
What is the new accounting requirement and where did it come from?
This requirement comes from the Governmental Accounting Standards Board or “GASB.” GASB establishes standards of financial accounting and reporting for state and local governments. These standards guide the preparation of external financial reports. External financial reporting demonstrates financial accountability to the public and is the basis for investment, credit and many legislative and regulatory decisions. In June 2004, GASB issued Statement No. 45 which addressed Accounting and Financial Reporting for Postemployment Benefits Other Than Pensions. These non-pension benefits are commonly referred to as “other post employment benefits” or OPEB. They include health and life coverage offered to retirees. It is this Statement No. 45 that speaks to how state and local governments should now account for and report their costs and financial liabilities related to OPEB.
Prior to this new requirement, how was OPEB accounting and financial reporting done?
Governments usually followed an approach of “pay-as-you-go,” meaning that the costs of retiree benefits other than pensions were treated as an expense when actually paid rather than as an obligation that accumulates or “accrues” over the period of active employment.
What is the new requirement intended to accomplish?
This new requirement is intended to improve the relevance and usefulness of financial reporting for state and local governments. When governments finance OPEB plans on a pay-as-you-go basis, and their financial statements do not report the financial effects of OPEB until the benefits are actually paid, the users of these financial reports do not have a clear understanding of the governments’ liabilities and whether or not they are properly funded.
In 1994, GASB had established somewhat similar standards for how governments should account for and report the cost associated with pension benefits. As is the case with pension benefits, OPEB are considered part of an employee’s total compensation during active service, even though the benefits are not received until after employment has ended. Therefore, the cost of these future benefits is part of the cost of doing business and providing service today. From an “accrual” accounting perspective, the cost of OPEB, like the cost of pension benefits, now will be associated with the period of active service in which these benefits accumulate, rather than with the periods (often many years later) when they are actually paid. This will provide the users of governmental financial reports more accurate information about the total cost of services to residents and what the government’s true financial liabilities are.
What do OPEB obligations have to do with the County’s bond rating?
In addition to the interest of current and future retirees about whether the money will be there in the future to pay out benefits, other institutions, such as the bond rating agencies, are interested in how the County is managing and addressing this sizeable financial commitment. In a fiscal sense, commitments to pay out benefits to retirees compete with commitments to pay debt service on bonds, so the rating agencies have an obligation to report to the County’s investors how well prepared the County is to meet all of its future commitments.
This is all a part of the bond rating process. A county’s bond rating impacts the costs associated with borrowing money. Montgomery County currently has a AAA Bond rating, which is the highest rating given to public entities. But if the County is not found to be satisfactorily addressing its liabilities, this could impact the County’s rating.
What are the County agencies doing to meet the new requirement? How do we know how much we need to set aside?
First, the County agencies estimated the dollar liability of OPEB attributable to its current employees. That included, under the current level of benefits offered, not only the estimated benefits earned by employees in the current year, but the benefits that employees have already earned (because the County agencies had not been previously recognizing these costs). The costs associated with current service are referred to as “normal costs.” Normal costs and those costs associated with prior service, including all estimated costs associated with current retirees, are referred to as an “actuarial accrued liability” or AAL. The amount of the AAL that does not have assets set aside towards it is known as the “unfunded actuarial accrued liability” or UAAL. Payment of the UAAL is spread out or “amortized” over a period of up to 30 years in level amounts (the period of time used is usually reflective of the length of active service for employees). This is similar to the way a mortgage is spread out in equal amounts over a number of years. The County agencies have completed this step through what is known as an “actuarial valuation” that was performed by their benefit consultants. The total AAL across all County agencies was estimated to be approximately $3.2 billion as of the latest actuarial update.
What information and assumptions did the consultant use in the valuation?
Looking at the current level of benefits offered, the consultant or “actuary” used information such as turnover and retirement assumptions, medical inflation and claims cost assumptions, mortality assumptions, and discount rate assumptions (the present value of the future benefit payments in terms of today’s dollars).
What impacts this liability?
This liability is impacted by the number of retirees receiving benefits, the number of active employees who will be eligible for benefits under current policies, the costs of the retiree benefits for the current benefit levels, and the investment return on any funds set aside.
Is there a legal requirement for the County to set funds aside toward this liability? If not, why are we doing this?
No, this is not a legal requirement, nor is it even a specific accounting requirement to set aside the funds. What changed is the new accounting requirement to report the amount of unfunded liability, and due to that reporting requirement, there is more attention on the liability and what the County is doing to address it. As described in the General section of these FAQ’s, we are setting funds aside since it wouldn’t be fair to leave that bill for future taxpayers to deal with, and, because by putting aside the money now and investing it, it will cost us less over the long run.
How much money is required to fund OPEB?
The amount required annually to fund the OPEB liability is called the Annual Contribution. This amount consists of several pieces – (1) the normal costs earned by active employees during the year, (2) the portion of the Unfunded Actuarial Accrued Liability or the UAAL attributable to that year, and (3) interest on the unpaid UAAL. The normal costs and the UAAL pieces were discussed above. The total UAAL estimated for FY09 is $3.2 billion.
That is a large amount of money. Will the County agencies be contributing this amount in fiscal year 2009?
No. The County agencies will phase-in this contribution over an 8-year period, starting with the money already set aside in FY2008. This means that 7 years from now, the annual contribution will be at the full Annual Contribution amount. The Annual Contribution will then be set aside on an ongoing basis each fiscal year. For the County agencies, a total of $32 million was set aside in fiscal year 2008. Under the current plan, an increasing amount will be set aside each year until the full Annual Contribution is reached in fiscal year 2015. The revised 8-year phase-in was determined by the County Executive to be the most fiscally prudent method to manage the OPEB liability in the current fiscal situation, and the $55.15 million to be set aside in FY2009 was part of the County Executive’s recommended fiscal year 2009 budget submitted to the County Council.
What is good about GASB 45 and this new reporting requirement?
GASB 45 gives us an understanding of the magnitude of the liabilities of retiree health and life coverage. We will be better able to plan for the cash flow in coming years to pay for these benefits. We will also be in a position to better evaluate the full cost impact of proposed benefit changes.
OPEB – Other Post Employment Benefits
GASB – Governmental Accounting Standards Board
GASB 45 – a specific set of accounting rules on OPEB put out by the GASB including when those new rules must be implemented
AAL – Actuarial Accrued Liability, or total cost of retiree benefits for current retirees and actives that is associated with prior service as an employee
UAAL – Unfunded AAL, or the portion of the AAL that does not have assets set aside towards it
AC – Annual Contribution, or the amount required annually to fund the OPEB liability
Pay-As-You-Go Costs – The amount of retiree benefits actually paid out during the year