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

At the end of its most recent session, the Texas Legislature enacted House Bill (HB) 2365, which was signed by Governor Perry and became law on June 15, 2007. The purpose of HB 2365 is to provide relief, for those local governments and agencies that want it, from the impending accounting requirements of Governmental Accounting Standard Board (“GASB”) Statement Nos. 43 and 45. In this and a following Governmental Newsletter, we explain the requirements of GASB Statement Nos. 43 and 45. A third newsletter will explain the implications of HB 2365 for Texas municipalities and other Texas governmental entities.

BACKGROUND TO GASB STATEMENTS 43 AND 45

Several factors (chiefly, an aging workforce and a medical care cost inflation rate that continues to outpace general price level inflation) have caused a substantial increase in the likely future cost to governmental employers of providing promised retiree welfare benefits. GASB Statement Nos. 43 and 45 would essentially require governmental employers to come to terms with those increased costs through some combination of increased revenues, changed allocation of existing revenues, effective use of available financial and tax strategies, or benefit reductions. Because this is occurring in an environment in which private sector employees (a/k/a, “voters”) are suffering (or, in many cases, have suffered) substantial reductions in, or eliminations of, their own retiree welfare benefits, the new disclosures that would be required by Statement Nos. 43 and 45 are, among other things, politically sensitive.

THE NEW ACCOUNTING STANDARDS AND THEIR EFFECTIVE DATES

Statement No. 45, Accounting and Financial Reporting by Employers for Postemployment Benefits Other than Pensions, prescribes the required financial reporting by governmental employers for postemployment benefits other than pensions (i.e., retiree medical, prescription drug, dental, and vision benefits; life insurance and long-term care insurance, if not provided through a pension plan).¹ These benefits are referred to in Statement No. 45 as “other postemployment benefits,” or “OPEB’s.” A companion GASB Statement, Statement No. 43, prescribes the financial reporting for OPEB funds as entities separate from their sponsoring employers.

The required implementation date for Statement No. 45 depends on a governmental employer’s total annual revenues in its first fiscal year ending after June 15, 1999. The required implementation date for Statement No. 43 depends on the total annual revenues of the plan’s sponsoring employer (or, in the case of a multiple employer plan, the total annual largest participating employer) in the employer’s first fiscal year ending after June 15, 1999, and in all cases is one year earlier than the corresponding Statement No. 45 implementation date. The following table summarizes the required Statement Nos. 43 and 45 implementation dates:

Revenue in first fiscal year ending after June 15, 1999	Reporting required for fiscal years beginning after
Revenue in first fiscal year ending after June 15, 1999	Funds (GASB 43)	Employers (GASB 45)
$100 million or more	December 15, 2005	December 15, 2006
Between $10 million and $100 million	December 15, 2006	December 15, 2007
Less than $10 million	December 15, 2007	December 15, 2008

Thus, for example, a large municipality (i.e., one with total annual revenue for its first fiscal year ending after June 15, 1999 of $100 million or more) with a July 1-June 30 fiscal year is required to report its OPEB obligations in accordance with Statement No. 45 in its financial statements for its fiscal year ending June 30, 2008. If the municipality sponsors or participates in an OPEB fund and the fund also has a July 1 – June 30 fiscal year, the fund would first need to prepare its financial statements in accordance with Statement No. 43 for its fiscal year ended June 30, 2007.

HOW GASB 45 DIFFERS FROM WHAT MUNICIPALITIES AND OTHER GOVERNMENT ENTITIES PREVIOUSLY REPORTED AS OPEB LIABILITY

Governmental employers have traditionally funded OPEB’s on a pay as you go (“PAYGO”) basis. That is, the payment of each year’s premium or benefit expense was simply made from current revenues without prefunding and the annual PAYGO expenditure was reported in financial statements. Under PAYGO accounting, OPEB liabilities are not accrued as they are earned by active employees, and there is no requirement to determine the employer’s total accrued liability to retirees and to active employees for already earned benefits. This is similar to the reporting of OPEB expense in the private sector before the imposition of Financial Accounting Standards Board (“FASB”) Statement No. 106 in 1992.

GASB Statement No. 45, like FASB Statement No. 106, requires that governmental employers determine and disclose in their financial statements: (a) their unfunded actuarial accrued liability (“UAAL”),² and (b) the actuarial value of new benefit rights earned each year by active employees after the implementation date. The employer need not, however, accrue the entire UAAL as a liability on its balance sheet on the implementation date.³ Instead, employers are required to record in their financial statements annually an amount called the “annual required contribution” (“ARC”). The ARC consists of (a) the present value of the future benefits actually earned during the year by active employees (called in actuarial parlance, the year’s “normal cost”), plus an amount necessary to amortize the UAAL over a period of no more than 30 years.

If the employer funds all of the ARC for the year, then there is no increase in the employer’s balance sheet liability for OPEB. On the other hand, any portion of the ARC that is not funded must be recorded as a balance sheet liability and will increase annually thereafter with interest.

The employer’s annual normal cost for OPEB’s, as the present value of future benefit rights currently earned by active employees, is likely in and of itself to exceed the employer’s PAYGO amount. When the cost of amortizing the UAAL over 30 years is added to the normal cost, an employer’s ARC is likely to be a multiple of the PAYGO amount that it has traditionally expensed, resulting in OPEB “sticker shock.”

Actuaries have used an “iceberg” analogy, like the one below to summarize the relationship between an employer’s PAYGO amount, normal cost, and UAAL. The PAYGO amount, which municipalities and other governmental employers have traditionally shown in their financial statements, is the “tip” of the OPEB iceberg, with the present value of future normal costs for the current workforce, and the UAAL, together being the vastly larger portion of the OPEB iceberg submerged beneath the surface of municipal financial statements.

Image of graph representing actuarial iceberg analogy to summarize the relationship between an employer’s PAYGO amount, normal cost, and UAAL.

IMPORTANCE OF IDENTIFYING “SUBSTANTIVE PLAN”

GASB Statement No. 45 requires that valuation of both the employer’s normal cost and its UAAL be based on what Statement No. 45 refers to as the “substantive plan,” which is the plan as its terms are understood by the employer and the plan’s members at the time of the actuarial valuation. The “substantive plan” is evidenced by written documents (e.g., municipal ordinances, board resolutions), employee and retiree communications (e.g., a plan summary prepared by the employer or insurer), and by patterns and practices (e.g., an established pattern of cost sharing between the employer and retirees, even if not prescribed by statute). Under Statement No. 45, legal or contractual limits (“caps”) on an employer’s share of costs are taken into account in determining the “substantive plan” only if the limits may be assumed to be effective based on a past pattern of enforcement. In other words, the “substantive plan” is more of a business concept than a strictly legal one. It is the pattern of future expenditures for OPEB that the employer is considered to be committed to, not the unavoidable cost of its strict legal obligations.

In Part 2 of this series, we will discuss the key actuarial drivers of OPEB liability, ways that municipal and other governmental employers are addressing OPEB liability, and the likely effects of GASB 45 on bond ratings.

¹Because retiree medical benefits are typically by far the most expensive component of an employer’s OPEB, this Governmental Newsletter refers to retiree medical and OPEB interchangeably in places.

²The UAAL is the present actuarial value at the Statement No. 45 implementation date of all plan obligations to retirees and active employees for previously earned benefits, reduced, if the plan is funded, by the present actuarial value of the plan’s existing assets.

³That is, unlike FASB Statement No. 106, GASB Statement No. 45 does not contain a requirement to book a “transition liability. ”