Strasburger Governmental Newsletter - New Governmental Accounting Rules for Retiree Medical and Other Welfare Benefits

GASB 45 ACTUARIAL AND FUNDING ISSUES

In Part I of our series on recently enacted HB 2365 and the impact of Governmental Accounting Standards Board (“GASB”) Statement Nos. 43 and 45 in Texas, we explained the requirements and effective dates of the GASB’s new accounting rules for “other postemployment benefits,” or “OPEB’s.” In this Part 2 we explain how prefunding may be used to reduce OPEB liability under GASB Statement No. 45, the vehicles that exist for prefunding, other ways of reducing OPEB liabilities, and the likely impact of GASB 45 on bond ratings.

The two key actuarial factors in determining an employer’s liability under GASB 45 are: (a) the future trend of medical care cost increases, which is outside the employer’s control, and (b) the assumed rate of return on assets set aside and invested by the employer to fund its future OPEB liability, which to a great extent is within the employer’s control.

To the extent that an employer continues to fund annually only its PAYGO amount, thus leaving the remaining portion of its GASB No. 45 “Annual Required Contribution,” or “ARC,” unfunded, as it likely did pre-GASB 45, plan assets are zero and the rate of return on plan assets is zero. If the employer funds annually more than its PAYGO amount, but does not set the excess funds aside in a trust or equivalent arrangement protected from the employer’s creditors that commits the funds irrevocably to satisfaction of the employer’s OPEB liabilities, then the rate of return on the plan’s assets assumed for GASB 45 purposes will be the typically low rate of return earned by the employer on the short-term investments made for the employer’s general fund, e.g., 1%. However, if amounts in excess of the PAYGO amount are set aside irrevocably in a trust or equivalent arrangement established to fund OPEB and protected from the employer’s creditors, then the assumed rate of return on plan assets will be the much higher rate of return that can reasonably be expected to be earned on a well-diversified portfolio of long-term investments.

Because each year’s accrual of future OPEB liability is projected into the future using the expected rate of medical care cost inflation, while the value of the plan’s assets is projected into the future using the expected rate of return on the plan’s investments, the use of a trust or equivalent vehicle to fund OPEB liabilities can make a very significant difference in the amount of an employer’s reported OPEB liabilities. The following diagram illustrates the relationship between the growth in future value of a booked OPEB liability versus the expected rate of return on plan assets:

The image illustrates the relationship between the growth in future value of a booked OPEB liability versus the expected rate of return on plan assets.

TAX-EFFICIENT VEHICLES FOR ACCUMULATING PLAN ASSETS TO FUND OPEB LIABILITIES

There are three main approaches to funding OPEB: IRC § 401(h) medical benefit accounts in defined benefit pension plans; IRC § 501(c)(9) voluntary employees’ beneficiary associations (“VEBA’s”); and IRC § 115 trusts. All of these approaches will generally have the desired results of:

Enabling the employer to use a favorable assumed high rate of return on investments to reduce its UAAL

Providing retirees and active employees with confidence that the employer will fulfill its OPEB commitments

Avoiding federal income tax on fund investment income and benefit payments

Under IRC § 401(h) and related Treasury regulations, a defined benefit plan may include a feature for the payment of nontaxable medical benefits to retirees. The medical benefits must be paid from a separate account maintained within the plan, and the funds to pay medical benefits from the plan must be separately accumulated. Annual funding of the 105(h) benefit may not exceed 25% of annual contributions for retirement benefits (i.e., 20% of total plan contributions, including the 401(h) amount).

The annual contribution limit on the funding of a 401(h) account is a substantial limitation on its use in certain situations, e.g., if the pension plan is fully funded or, because of a shrinking base of active employees, the retiree population is large relative to the active population. Nevertheless, in some situations, a 401(h) account could be an important part of an employer’s GASB 45 strategy.

A VEBA under IRC § 501(c)(9) is a separate, tax-exempt entity, typically a trust. VEBA’s have traditionally been employed by both private employers and tax-exempt and governmental employers to pre-fund welfare benefits for active and retired employees. However, because VEBA’s generally do not provide any benefits that are not also offered by “Section 115 trusts,” and have somewhat greater IRS filing and reporting requirements, most employers that do not already sponsor VEBA’s are likely to opt for “Section 115 trusts” for prefunding OPEB’s. The only exception is likely to be where an employer wishes to use mandatory or voluntary employee contributions to fund part of its OPEB liability, since VEBA’s can except after-tax employee contributions,¹ while Section 115 trusts, discussed below, most likely cannot. Even then, a Section 115 trust for the employer’s portion of the contributions might still make sense.

Section 115(1) of the Code exempts from income tax any income derived from an essential governmental function and accruing to a state, political subdivision of a state, or state instrumentality. A “Section 115 trust” is an irrevocable trust established by a governmental employer or group of employers to fund OPEB. The IRS has recently issued several private letter rulings holding that where a governmental employer or group of governmental employers establishes and contributes to an irrevocable trust for the prefunding and payment of retiree medical expenses: (a) The trust will enjoy the IRC § 115(1) exemption from tax on its income; (b) contributions to the trust will not be taxable to retirees or their eligible dependents; and (c) medical benefits or insurance received by retirees or their eligible dependents from the trust will not be taxable to them. See Ltr. Ruls. 200606007, 200619014, 200626027, and 200703015. Some Section 115 trusts are being formed jointly by groups of governmental employers. Generally, this is being done not to pool risk, but rather to achieve economies of scale with respect to legal, custodial, actuarial, and accounting fees.

Because IRS private letter rulings are directed only to the requesting taxpayer and cannot be used or cited as precedent, and because Section 115 trusts used to fund OPEB are a relatively recent phenomenon that are based on the application of broad tax principles and not any detailed published guidance, it is suggested that any governmental employer or group of governmental employers contemplating the formation of a “Section 115 trust” obtain its or their own private letter ruling from IRS approving the arrangement. Additionally, each employer must determine whether it has the authority to establish such a trust, and if not, to obtain it (e.g., by enactment).

In California, and perhaps in other states as well, multiple employer Section 115 trusts are being promoted to governmental employers wishing to prefund at least some of their OPEB liability without “reinventing the wheel.” See, CalPERS Formally Launches Prefunding Plan for Retiree Health Benefits, CalPERS Press Release March 1, 2007; California State School Boards Association GASB 45 Solutions program (www.csba.org/ds/gasb45.htm).

OTHER WAYS TO REDUCE OPEB COST

Most employers will want to consider modifying their OPEB promises in order to reduce OPEB cost. Such modifications may take many forms:

Eligibility of retirees and their dependents can be restricted, e.g., by increasing the number of years that an employee must work for the employer to be entitled to OPEB, increasing the retirement age, or both.

Retiree co-pays and coinsurance percentages may be increased in the underlying plan.

Retiree premium cost sharing may be introduced or increased.

Employer contributions for retiree medical benefits may be capped, essentially transferring liability for medical care cost inflation to retirees.

The employer may shift from a defined benefit to a defined contribution approach, i.e., establishing Health Reimbursement Accounts (“HRA’s”) or encouraging employees to establish Health Savings Accounts (“HSA’s”), for providing retiree medical benefits, which will have the effect of capping the employer’s cost and shifting future medical care cost inflation to retirees, while also providing retirees with greater control over their medical expenditures and care strategies.

Any modification to existing retiree benefits that has the effect of reducing the employer’s cost will obviously not only be perceived as, but actually be, a “take-away,” and thus runs human resources, political, and legal risks. If the benefits are provided under a collective bargaining agreement, then generally the legal issues presented are subject to applicable labor laws and collective bargaining agreement provisions. Outside the collective bargaining arena, retirees may mount legal challenges based on contract law, statutory interpretation, promissory estoppel, or state constitutional protections. Our experience has been that in most cases, governmental employers will find that the basis for legal challenges to modifications to retiree welfare benefits are weak, and thus that the human resources and political hurdles to benefit reductions are higher than the legal hurdles.

NCPERS recently commissioned a state-by-state study of cases dealing with challenges to reductions in retiree benefits by governmental employers. A summary of the study’s findings can be found at www.ncpers.org/artman/
uploads/health_benefit-protections.pdf. Although brief, and many states do not appear to have any cases on point, the NCPERS study is a good place for any governmental employer contemplating changes to its retiree medical benefits to start its investigation of legal risks.

EFFECT OF GASB 45 ON BOND RATINGS

Fitch, Standard & Poors, and Moody’s have all indicated, generally, that the sudden appearance of increased OPEB liabilities in the financial statements of governments and governmental agencies will be recognized for what it is, i.e., an increased awareness and more elaborate and disciplined measurement of an existing exposure rather than a new liability. The rating agencies have indicated that they will be more concerned with the way that governmental employers address their OPEB obligations on a going-forward basis than with the initial amounts of those obligations. However, the rating agencies are looking for an active approach by employers to managing OPEB liability, e.g., by prefunding, gradual benefit reductions, or both, and have indicated that an employer’s indefinite deferral of the difficult task of dealing with OPEB’s will likely be damaging to its credit rating.

HB 2365

Part 3 of our GASB 43 and 45 series will explain the impact of recently enacted HB 2365 in Texas.

¹ Pre-tax mandatory or voluntary employee contributions to fund OPEB are likely not permissible under the Internal Revenue Code.