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Gasping over GASB

Post-retirement health benefits could bring a shock to governments, retirees.

May 1, 2006


GASB 45. Gaz-bee forty-five.

If you're unfamiliar with this little bit of arcane government lingo, you're hardly alone. But retirees, current government workers, taxpayers and policymakers are likely to become better acquainted with GASB 45 over the next few years because it has important consequences for all four parties.

GASB 45 is a (thankfully) abbreviated reference to Statement Number 45 from the Government Accounting Standards Board, an independent, not-for-profit agency designed to improve financial accounting and reporting standards for state and local governments. The rule has to do with nonmonetary retirement perks called "other post-employment benefits," or OPEBs. By far, the most important OPEB is retiree health care, but dental coverage and life insurance are also fairly common.

In 2003, GASB announced new rules requiring all government entities to calculate the accrual of OPEB liabilities over the expected working career of plan members (rather than on a pay-as-you-go basis) and to expense those accrued liabilities over the same period of time. (In fact, these new requirements involve both Statement Number 43 and 45, but we'll use GASB 45 as shorthand. A similar requirement has been in place in the private sector for 15 years, thanks to the equally arcane FASB 106.)

In days past, OPEB costs were fairly minor. But as the number of pension beneficiaries increases, and the cost of health care skyrockets, those costs are predicted to climb steeply, eating into annual budgets. Because these are retirement promises—legacy costs just like a monthly pension check—GASB figured governments needed to determine the future cost of those OPEB promises, and how exactly they planned to pay for them.

Wake me when this gets important, right? Well, nudge-nudge: The first wave of GASB 45 reports is due by the end of this year. A few governments have already looked under the blanket of OPEB liabilities, and some think they are seeing double, or worse. In California, a February state report on GASB 45 put future liabilities at $40 billion to $70 billion, "and perhaps more." Michigan's are estimated to be as high as $30 billion, and a 2004 report by Citizens Research Council estimated that by 2020, OPEB obligations in that state could reach 20 percent of payroll expenditures.

Karl Johnson is a project manager with GASB, and he has talked with actuarial firms about early reports being done for local and state governments. One firm, which Johnson chose not to disclose, "said the first reaction is that people are just stunned. … People think you added an extra zero," Johnson said. The shock effect is wearing off, he said, but only because elected and pension officials are becoming more familiar with the topic and the potential financial hazard.

Sources widely agreed that the full effect of GASB 45 will likely be substantial, but also that little is known about the full extent of the problem. Although the nation has gotten a sneak preview of this horror movie from a few states, the largest governments (those with over $100 million in annual revenue) have until mid-December to report OPEB liabilities. Governments with revenue between $10 million and $100 million have an additional year to report, and those under $10 million have until December 2008.

Unlike most retiree benefits, OPEBs are typically not administered through pension plans. Among the largest pension plans, it appears that only Michigan's have formal OPEB commitments. But that doesn't mean other district states have steered clear of GASB 45. Most OPEBs come directly from (and are paid out of) annual budgets of local and state government, just like benefits given to the existing workforce. Nobody has a clue as to how many governments will be affected—and to what degree—by the new GASB 45 requirements. But we do know that the vast majority of "however many" have set nothing aside for a retirement benefit and financial liability that is expected to grow immensely over time.

Excuse me, I have to GASB

When it comes to retiree health coverage, sponsoring governments subsidize retired employees in two ways, both of which contribute to OPEB liability.

The first is giving retirees the opportunity to buy health insurance at the government-purchased group rate, which pools all employees and covered retirees. This is called an implicit rate subsidy to retirees, because it lowers the average cost of health insurance for retirees compared to what they would pay for a policy at the retail level. It also increases government's health care costs because retirees raise the pool's average age, and age is directly related to health care costs. The second type of subsidy is the extent to which government buys down retirees' monthly insurance premiums.

According to a September 2003 report by the Kaiser Family Foundation, virtually all states offer early retirees some level of health coverage. Medicare kicks in for retirees at age 65, and that's when states tend to diverge in their generosity. According to Kaiser, 12 states (representing 44 percent of Medicare-age retirees) fully subsidize most or all of the health care costs for retirees, meaning retirees also pay little of the monthly policy premium.

Michigan is one of those states that heavily subsidizes retiree health care, both before and after age 65. According to information from the Michigan Public School Employee Retirement System, a retiree not yet eligible for Medicare can get health coverage for herself and a spouse at a monthly premium of $1,170, thanks to group purchasing. But the retiree will end up paying just $141 a month out of pocket—about 12 percent of the monthly premium—with the system picking up the remainder. Once Medicare kicks in, the subsidy for the same couple drops in terms of total dollars, but the retiree pays just 5 percent of the monthly premium ($27 of the $571 total monthly cost).

The cost of those subsidies is huge, and growing. Last year, the teachers' pension fund spent $761 million on retiree health care benefits—23 percent of all benefit expenditures, and an increase of $100 million over 2004. Gabriel Roeder Smith & Co., an actuarial and benefit consulting firm, told a Michigan local government task force last December that GASB 45 will require the disclosure of "potentially huge" retiree health care liabilities (virtually all of them unfunded) that could reach 30 percent to 70 percent of pension liabilities. About the same time, UBS (a global financial firm) estimated that OPEB liabilities "may approximate 20–25 times the current pay-as-you-go payment benefits" for retirees.

States in the rest of the Ninth District appear to offer retirees, at most, the opportunity to purchase health care policies at group rates, which likely reduces unfunded liabilities by a substantial amount. Dave Stella, deputy director for the Wisconsin Department of Employee Trust Funds, said the only liability facing the state is the implicit rate subsidy, which he said "will not be a significant amount." (Wisconsin allows retirees to convert unpaid sick days into health care accounts, which they can draw upon until the account is empty. By definition, however, it is prefunded.)

Other district states express more concern about the financial implications of GASB 45. According to a source with the state of Montana, a "quick and dirty" analysis has been done to get a quick glimpse of the potential liabilities, "and as things stand now, there will be a significant liability—no specific number—to book in the state financials."

Just put it on my tab

But getting a firm grip on comprehensive OPEB liabilities is like trying to nab flies out of the air. Most investigation to date has been focused at the state level. But that misses the thicket of local government entities—literally hundreds, sometimes thousands in larger states, and not all of them small—that could hypothetically offer OPEBs, and thus face major unfunded liabilities in the future. Exactly how many offer retiree health care, and to what extent, is anybody's guess: Most are not even required to report on the matter until 2007 or 2008.

Though it was not required to comply with GASB 45 for another year and a half, the city of Duluth, Minn., got a head start several years ago, asking an actuarial firm to add up the lifetime liabilities for retiree health care, which includes spouses and dependents up to age 26. The tab came to almost $180 million, more than twice the city's total budget. The city took a deep breath and asked for another tabulation last year. The good news: The original estimate was wrong. The bad news: The city's liability was even bigger, $280 million.

Duluth might be an extreme case, but it is not likely to find itself alone in discovering unfunded OPEB liabilities. Erin Rian, benefits manager for the League of Minnesota Cities, said GASB 45 "impacts potentially any city in the state with group health plans."

To what degree? "We don't know," said Rian. "We suspect in some cases it's insignificant. But in some cases it will be a large cost. … There are some Duluths out there."

Chris Grabrian is an actuarial consultant with Stanton Group of Minneapolis who works with local governments on GASB 45 estimates. He said he could not divulge which governments he worked with, or individual results. But experience has led him to believe that GASB 45 "is going to have a significant effect" on local governments' unfunded liabilities.

As Grabrian sees it, virtually all Minnesota local governments will have at least some GASB 45 liabilities because they are required by state statute to continue offering group health care coverage to early retirees (and oftentimes their spouses and any dependents). Once retirees turn 65, Medicare kicks in and governments can push retirees into cheaper, supplemental purchasing pools limited to seniors.

Rian believes that many other states also had statutory language guaranteeing access to group health coverage for public retirees. In past meetings with association peers from other states, she said, "many have voiced similar concerns" about GASB's effect on cities. To repeal those statutes, Rian said, "we'd have to have a legislative change, and I doubt that's going to happen," at least not until much more is known about the extent of any problem.

In South Dakota, only a small fraction of communities might have any GASB 45 headaches to worry about. "I'm finding that there is a sprinkling of it out there," said Deene Dayton, director of local government assistance with the South Dakota Department of Legislative Audit.

There are more than 500 school districts, cities and counties in the state, as well as hundreds of smaller special government districts and townships. Although no local governments in South Dakota had yet to complete the new reporting requirements, Dayton estimated that 50 might have some liabilities to report. Given the state's conservative nature, many could be small, he added. A school district might have some unfunded OPEB liabilities, "but it might only be for the superintendent, and not for the rank and file (employees)."

What now, magic 8 ball?

Part of the financial difficulty with OPEBs is that they are typically earned once a worker becomes vested, a period of just three to five years in many states, including most in the district. That means a retiree with several years of service receives the same OPEB perks as those working 30 years. Perceived inequities like this are likely to get revisited if large unfunded liabilities start popping up.

The GASB controversy does potentially offer one major release valve for sponsoring governments: Retiree health care and other OPEBs can be revoked, unlike monetary pension benefits. Well, at least maybe—the matter is far from settled.

A December 2005 brief on OPEB liabilities by Standard & Poor's called their legal status "frequently unclear" and predicted that some attempts to alter benefits "will end up in the courts." The president of the American Federation of State, County and Municipal Employees, the nation's largest public employees union, has promised a fight if GASB is used to eliminate retiree health care. Rian, from the League of Minnesota Cities, said, "We're still trying to sort that issue out."

The matter has already seen the inside of a courtroom in Michigan, where retiree health benefits are significant. Case law and past experience there suggest that "at least some changes are possible in health care benefits," according to Chris DeRose, with the Michigan Office of Retirement Services. For example, back in 1997, when the state introduced a defined-contribution plan, eligibility for health benefits was changed to an accrual model. Rather than becoming eligible for virtually free health care in retirement after just 10 years of service, an employee earns a 3 percent credit toward the monthly premium for every year of service.

Another important point here: Governments will not be required to financially backfill unfunded liabilities. GASB 45 merely requires governments to acknowledge their existence and size.

But there will be consequences for governments that sit on their hands, because liabilities will compound over time as the number of retirees increases and the cost of health care continues to outpace almost everything. As this red ink pools, it will increasingly color the financial outlook of local governments, influencing public service levels, future benefits of workers and retirees, future tax rates and even such mundane things as borrowing costs.

Grabrian, for example, pointed out that once a local government has even an estimate of future liabilities, it is required by the Securities and Exchange Commission to disclose those estimates when it is in the process of issuing bonds. "You can't keep that (GASB 45 liability) up your sleeve," he said.

Dayton, from South Dakota, said some governments might feel the urge to ignore the new rules, "but they will be forced to do something if they want a clean audit." And without a clean audit, there may be an impact on a government that is selling bonds for that new school building or county highway.

What to do? That's a good question with no right answer. Duluth faces unfunded accrued liabilities about two and a half times its annual budget—and just for retiree medical benefits. The recent report on the matter stated bluntly: "It would be difficult, if not impossible, to overstate the financial crisis looming for the City of Duluth. ... The granting of free medical coverage for retirees beginning in 1983 has turned into a disaster for the city, totally unforeseen by those who entered into making that decision 22 years ago."

The city estimates that it would cost an additional $20 million annually—close to 20 percent of the city's total annual budget—to catch that dog's tail down the road, given rising retiree and health costs. Literally everything is on the table: a final, mea culpa report of sorts lists 22 possible actions, including higher cost-sharing by retirees and employees (and taking the matter to court, if necessary), importing drugs from other countries, increasing property taxes, tapping into other unrelated tax and fee revenue, and even begging the state for help.

One government source, not connected to the Duluth matter, said that the sticker shock of GASB 45 might convince many governments to reconsider certain benefits for retirees. "I'm thinking they'll drop (OPEBs), and that's not all bad."

But for the near future, there will be a fair amount of feeling around in the dark.

"Until quite recently, these are things that have never been measured," said Johnson, from GASB. "I don't think there's any trend of what governments are planning to do about this."

photo of Ronald A. Wirtz
Ronald A. Wirtz
Editor, fedgazette

Ron Wirtz is a regional outreach director at the Federal Reserve Bank of Minneapolis. Ron’s primary responsibilities involve tracking current business conditions, with a focus on employment and wages, along with sector-tracking in construction, real estate, consumer spending and tourism. In this role, Ron networks with local businesses in a six-state region, both in person and via various communication channels, and gathers other traditional and nontraditional sources of information to assess current business activity. Ron also gives customized speeches on regional economic activity, and handles advance planning for regular outreach trips to Ninth District communities by Bank President Neel Kashkari. Prior to this role, Ron was the long-time editor of the fedgazette, the Bank’s regional business and economics publication, where he conducted research on such topics as employment trends, health care pricing and consolidation, housing, entrepreneurship, public pensions, income mobility, the Bakken oil boom and other topics.