How Cities Can Prepare for the New OPEB Accounting Requirements

The new Government Accounting Standards Board changes described in this posting have implications for all cities. Here are some suggestions for cities that offer retiree healthcare benefits and sponsor those benefits themselves.

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One way cities that focus on reducing health plan claim and administrative costs can reduce their liability without cutting benefits is to encourage healthy behaviors by implementing a wellness program. (Getty Images)

Beginning in the fiscal year ending June 30, 2018, cities who sponsor “other postemployment benefit (OPEB)” plans (e.g., retiree healthcare) will have to recognize the unfunded liabilities of those plans on their balance sheets. OPEB plans provide benefits other than pensions in retirement: typically health coverage, but sometimes life insurance or other benefits. Cities that participate in statewide OPEB plans will soon face new accounting requirements, but will have limited ability to manage their liabilities – so this article is directed to cities that sponsor their own plans.

Unlike pensions, most employers who sponsor their own OPEB plans have not been setting aside assets in a trust to fund these benefits, which means they are already carrying an OPEB liability on their balance sheets. The disclosures under the new OPEB accounting standards, GASB 74 and 75, require a new methodology for calculating that liability, and the results may be startling to stakeholders like ratings agencies, unions, and taxpayers – with perhaps the biggest surprises coming in communities that thought their OPEB liabilities were well-defined and manageable.

Given the potential magnitude of this disclosure, it is important for municipal leaders, residents, and employees to know that the coming change in the OPEB liability calculation is due to a change in accounting rules, not any error or malfeasance. In fact, this disclosure can serve as a wake-up call that can encourage all stakeholders to take action to help build a sustainable OPEB plan. Unfunded OPEB liabilities can be reduced by lowering plan liabilities (some type of plan benefit or administration change), increasing plan assets (increased plan contributions), or a combination of the two.

It is crucial that city leaders understand the legal and collective bargaining barriers to any strategy they wish to employ to lower OPEB liabilities. Then, assuming the primary benefit under the OPEB program is retiree health coverage, consider the following:

Seize the low-hanging fruit. Because OPEB plans deliver a non-cash benefit, cities that focus on reducing health plan claim and administrative costs can reduce their liability without cutting benefits. For example:

  • When was the last time you sought competitive bids from healthcare coverage providers? If more than a couple of years ago, it may be time to seek proposals.
  • Encourage healthy behaviors by implementing a wellness program. These programs cover items such as smoking cessation and weight loss. These have been shown to lower health claims.
  • Add a new option to your health plan offerings, featuring lower premiums but a higher deductible. Encouraging consumer-driven behavior has been known to lower health plan costs.

Consider funding the OPEB plan. The act of accumulating plan assets to pay future benefits allows the plan’s actuary to use a higher discount rate to determine plan liabilities, thus lowering them. This can have a significant impact on the size of the OPEB liability. It makes good economic sense as well, because benefits will be partly paid by investment income on plan assets, not just by current year revenues. Of course, the down side to funding is that, initially, plan cash requirements will be higher than a pay-as-you-go funding scheme.

Consider benefit reductions. There are many possible design options to be considered. For example:

  • Increase the portion of the health premium paid by the retiree. This can be done by: (i) increasing retirees’ monthly premium payments; (ii) setting a cap on the amount of the premium paid for by the employer; or, (iii) increasing plan deductibles and copayments.
  • Shorten the period of time over which the health coverage is provided. This can be done by raising retirement eligibility requirements for the health benefits or by curtailing coverage after the retiree becomes eligible for Medicare.
  • Offer fewer benefits, by eliminating such items as Medicare Part B premium reimbursements, vision care, or dependent coverage.

Legal and collective bargaining barriers are especially important when considering benefit reductions such as these. In some cases, it may be necessary to apply these changes only to future retirees, or even only to new employees going forward.

When considering any of these strategies, it is important to consult with your legal and actuarial advisors. However, when applied thoughtfully, one or more of these actions can mitigate the impact of GASB’s new OPEB accounting standards on your balance sheet, and can help you take better control of your OPEB plan’s costs.

les_richmond_125x150About the author: Les Richmond is the in-house pension actuary for Build America Mutual (BAM), which NLC’s preferred provider of municipal bond insurance and the leading insurer of municipal bonds sold by small- and mid-sized governments in the U.S. He reviews the pension risks for every issuer BAM considers for insurance, and is an expert on the impact of the new accounting rules on municipal financial statements.

Here’s What City Leaders Need to Know About Pension Budget Discussions

Incorporating an active policy discussion about pension funding into the budget process – even in well-funded cities – is important, because the earlier pension funding problems are confronted, the less costly they will be overall, and the less burden will be placed on future generations of taxpayers.

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Poor investment returns typically mean increased pension contribution requirements for cities, which in turn create (or worsen) budget pressures. (Getty Images)

This is a guest post by Les Richmond. This is the fourth post in a series on NLC’s public sector retirement initiative.

Fiscal year 2016 marked the second consecutive ugly year for investment returns on public sector pension funds. Most funds target a long-term return on assets between seven and eight percent. In the fiscal year ending June 30, 2015, the median return was three to four percent, and in FY 2016 the median is anticipated to be closer to one to two percent.

Why this Matters

Poor investment returns typically mean increased pension contribution requirements for cities, which in turn create (or worsen) budget pressures. Case in point: 71 percent of cities reported in NLC’s recent City Fiscal Conditions survey that the cost of pensions increased over the past year; 30 percent reported that these costs were one of three top negative budgetary stressors. As a result, government bond rating agencies and other stakeholders will be monitoring the actions of local government leaders closely on this issue.

The policy debate has already begun in cities with well-known pension challenges, such as Houston, Texas, and Jacksonville, Florida. Similarly, the FY 2018 budgeting process can provide a wealth of opportunities for actions in cities across the country that can improve, or stabilize, a city’s pension situation. Incorporating an active policy discussion about pension funding into the budget process – even in well-funded cities – is important, because the earlier pension funding problems are confronted, the less costly they will be overall, and the less burden will be placed on future generations of taxpayers.

Taking Action

City leaders will likely be called to consider a number of actions during these discussions. Here’s what they mean:

Funding policy decisions: Governments whose investment returns underperformed their expectations are likely to see their costs increase. In some cases, the investment return shortfall may even lead to a conclusion that the plan faces a “depletion date” (an actuarial projection that the pension fund assets may be completely exhausted at some point in the future), which must be disclosed in a city’s financial statements under government accounting standards.

Financial analysts prefer to see cities continue to contribute in accordance with their established funding policy, because it provides tangible evidence of the sustainability of the plan. It is also important how the additional spending is covered in the budget, with recurring revenues or sustainable cost cuts (whether from within the pension plan or elsewhere in the budget) favored. These items, which have a lasting impact, are preferred because the FY 2015 and 2016 poor asset returns will influence contribution rates for years to come.

Funding policies should amortize or pay off (like a mortgage) the city’s unfunded pension liability over a reasonable number of years (certainly no more than thirty years, with a shorter period preferred). The city should work with its actuary to determine that any changes to funding policy will not only demonstrate that the contributions will continue to sustain the plan (prevent fund depletion), but also help the plan to thrive.

Reduction of the investment return assumption: The median return assumption among public pension funds is still between seven point five and eight percent. But pressure to reduce those estimates is likely to climb, as more large, high-profile pension funds join CalPERS and the Illinois Teachers’ Retirement System in reducing their return assumptions. Ratings agencies, bond insurers and other stakeholders generally view a reduction in the investment return assumption positively, because it should improve plan funding by increasing contribution requirements and perhaps stimulate less risk-taking with plan assets.

Consideration of new pension reforms: There’s probably no stronger impetus for pension reforms than an unaffordable pension contribution requirement. A thoughtful approach to pension reform can be viewed positively from the perspective of a bond holder, with a strong preference for benefit adjustments that have an immediate impact on liabilities, or enhanced contributions backed by recurring revenues. Headline-grabbing reforms that adjust benefits only for new employees are less meaningful, because they can take many years to have a material impact on unfunded liabilities.

These are just a list of options to consider in the current financial environment. There are no one-size-fits-all answers, and it is always important to consider the effects on your city’s workforce before taking action.

About the author: Les Richmond analyzes public pensions nationwide as the in-house actuary for Build America Mutual (BAM), a leading insurer of municipal bonds for cities. BAM is an NLC business partner and NLC’s preferred provider of municipal bond insurance.

6 Ways Cities Can Reform Their Pension Systems

There’s no silver bullet, and it will take the implementation of several steps to actually address problems in a meaningful way.

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The Kinder Institute calculated that if the city of Houston’s municipal workers contributed to their pension plans at the average level of public employees nationwide, by 2025, Houston would be saving $100 million annually. (Getty Images)

This is a guest post by Ryan Holeywell. This is the third post in a series on NLC’s public sector retirement initiative.

Cities are still struggling with soaring pension costs, and Houston, Texas – home to my organization, Rice University’s Kinder Institute for Urban Research – is among them. Mayor Sylvester Turner pegged Houston’s unfunded pension liability at $7.7 billion when he introduced a reform proposal on September 14, 2016.

Our newly-published report, “The Houston Pension Question,” explains how Houston can get its pension costs under control. But the solutions we highlight aren’t unique to Houston, and they can be considered by any city seeking to improve the stability of its pension system. Moreover, these options aren’t intended to be a specific policy prescription; instead, they’re more like a menu that Houston and other cities can choose from. Below are our six reform options:

1) Change investment assumptions associated with the pension plans

Since 1992, Houston’s plans have assumed a rate of return on its investments of 8 to 8.5 percent, even though they’ve earned less than that recently. Those shortfalls result in higher unfunded liabilities. In Houston’s case, we estimate that shortfall has contributed a combined $872 million to the city’s unfunded pension liability since 1992.

Plans nationwide are starting to respond to this pressure. Nationally, the assumed rate of return on investments dropped from an average of 8 to 7.6 percent from 2001 to 2015. In Houston, Mayor Turner has proposed using a 7 percent assumption. Every pension system should use investment projections that align with its recent financial performance.

2) Change funding methods

“Amortization” means paying off a liability through installments, as opposed to paying it off in one lump sum payment. Today Houston – and many other cities – use a “rolling amortization” schedule that effectively resets the clock on the annual pension payment schedule, ensuring the liability will never be fully paid.

Cities such as Phoenix and Baltimore have switched to “closed amortization” schedules, which commit to fully paying the unfunded liability within a set period of time, generally 20 to 30 years. Mayor Turner has proposed this reform in Houston. While the technique can help cities pay off the liability in a more timely fashion, it often increases the already-rising payments required of those cities.

3) Consider new funding sources

Because many of the steps needed to shrink the liability necessarily result in increased payments, cities may need to consider other funding sources. This might entail new or increased revenue, or it might mean diverting resources from other public uses.

In Houston, rescinding a voter-imposed revenue cap that has limited the city’s budget flexibility could result in an extra $40 to $60 million in annual revenue. Mayor Turner says he’ll ask voters to do this next year, though he hasn’t explicitly tied that strategy to pension reform.

Of course, increasing revenue or cutting services are steps that could be unpopular with taxpayers, and in some cases, state law may preclude local governments from increasing revenue.

4) Increase employee contributions

Employee payroll contributions are the norm in the public sector. We calculated that participants in the Houston municipal workers’ pension plan contributed 2.77 percent of their city income to their pensions. Nationally, participants in large local plans contribute 7.6 percent.

Several cities, including Phoenix, Jacksonville and Baltimore, have increased employee contributions as part of their pension reform efforts. We calculated that if Houston’s municipal workers contributed at the average level of public employees nationwide, by 2025, Houston would be saving $100 million annually.

But this reform comes at a cost, too: effectively, it reduces total employee compensation, making a city a less competitive employer. Mayor Turner has not included this reform option in his publicly-announced plans.

5) Switch to a defined contribution system or a “hybrid” defined benefit/defined contribution system for new hires

This can slow the growth of the pensions’ unfunded liability because it shifts financial risks from the employers to employees. The technique has been used in places such as San Diego and Fort Lauderdale.

While a defined contribution plan like a 401(k) can help stop future liabilities from mounting, it doesn’t erase previously-accrued liabilities. A defined contribution plan – in the absence of other steps – cannot immediately fix a pension system’s financial woes. For that reason, Mayor Turner said, he did not include this element in his Houston reform package.

6) Reduce benefits for current employees

Generally cities are legally prohibited from cutting benefits for current and former employees. They have some flexibility, however, with annual Cost of Living Adjustments (COLAs) and reforms to Deferred Retirement Option Plans (DROP), which allow retirees to claim pension benefits while continuing to work.

Mayor Turner says he’s worked with the city’s three pension systems to reduce the liability by about $2.5 billion, largely through negotiated cuts in these areas. But these reforms effectively reduce total employee compensation and may increase the likelihood that retirees could lack sufficient retirement income.

For cities considering pension reform, all of these options may be part of a solution, and all of them are painful. Taxpayers may have to pay higher taxes or enjoy fewer services. Retirees may face lower benefits. Current employees may face higher contributions, potentially coupled with reduced benefits.

Each city, its employees and taxpayers will have to figure out which combination of options will work best in their situation. There’s no silver bullet, and it will take the implementation of several steps to actually address pension system problems in a meaningful way.

About the author: Ryan Holeywell is the Senior Editor at Rice University’s Kinder Institute for Urban Research.

How Pension Standards Can Help Cities Chart Their Future Path

The Government Accounting Standards Board’s (GASB) recent changes to pension and retiree healthcare liability disclosure shine a light on the long-term fiscal burden of these benefits – even when they are not controlled by the city.

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A recent study by the Pew Charitable Trusts put the unfunded liabilities for retiree healthcare benefits for the 30 largest cities at more than $100 billion. (Getty Images)

This is a guest post by David A. Vaudt. This post is the second in NLC’s Public Sector Retirement Initiative blog series.

I’m very pleased to be a part of the National League of Cities’ Public Sector Retirement Initiative to help raise awareness in the city government community about the significant obligations related to postretirement benefits and what can be done to manage them.

The GASB pension standards – which are now fully in effect – and the other post-employment benefit (OPEB) standards for retiree healthcare benefits – which take full effect in 2018 – are bringing dramatic improvements to the disclosures around the postemployment benefits governments provide.

Why is this important? Imagine having bad eyesight and trying to drive a car without your glasses on. You can’t see where you are going very well, and you might end up in a ditch before you realize it. These new disclosures are akin to putting your glasses on. Now, cities and their stakeholders have a much clearer view of the road ahead – and how to navigate it successfully.

The Numbers

There is no question that the road ahead has challenges. A recent study by the Pew Charitable Trusts put the unfunded liabilities for retiree healthcare benefits for the 30 largest cities at more than $100 billion. Meanwhile, unfunded OPEB liabilities for the 50 states exceed $500 billion, according to Standard & Poor’s. Keep in mind, these obligations do not reflect unfunded liabilities for pension benefits, which Pew pegged at an even higher number – $900 billion – back in 2014.

Figures like these underscore the need to get down to work – together – and start to think about how to make sure we can honor the promises that have been made to city employees.

Managing the Liabilities

The GASB pension standards help to clarify the challenge, but of course do not provide answers. How to fund these obligations is a policy matter for elected officials to resolve.  In the simplest terms, city officials will need to focus on managing these liabilities and setting aside the right level of assets to meet the postemployment benefit promises that have been made. Different cities will come to different conclusions about the best way to proceed, based on legal, local economic, political and social considerations.

With the net pension liability now appearing on the face of the financial statements, it will be much easier to assess choices than in the past. Over time, as the net pension liability shrinks, that will be a sign that the government is on the right track. But if that net liability grows, that may indicate the government is pushing current costs down the road to be dealt with in the future – and may be putting the city on an unsustainable course.

The issue of whether the net liability is growing or shrinking is key because it speaks to how well the liabilities are being managed. If pension and OPEB liabilities aren’t well managed, it could have a negative impact on the city’s credit rating and drive up its borrowing costs.

The Economics

It is important to know that the economics of pension promises don’t change because of the GASB’s pension standards. The economics are the same. It’s the level of attention pensions are receiving that is changing. The focus is on how large these promises are and how well governments are managing for those promises.

To help get the word out and answer questions, I’m pleased to tell you that NLC and GASB are partnering later this year on a webinar that will address these and other postemployment benefit issues.

GASB is also working to put an OPEB Communications Resource Group together to help communicate with elected officials and others in the state and local government community about many of these same issues from an OPEB perspective.

No Easy Fixes

There are no easy fixes here; these issues are going to be with us for some time into the future. But we’re now in a better position than ever to talk about what the future looks like and work out what needs to be done.

With so much talent, knowledge, and passion assembled in this group, it is critical to make sure each of our organizations are heard. Great solutions can come from any quarter, for the benefit of all.

Working together, we can’t help but made a difference – it’s deciding how much of a difference that will be our challenge.

About the Author: David A. Vaudt is the Chairman of the Government Accounting Standards Board (GASB). Mr. Vaudt has served as president of the National State Auditors Association, chair of the National Association of State Boards of Accountancy, and chair of the Iowa Accountancy Examining Board. He also served on the boards of numerous nonprofit service organizations in Iowa.

Six Questions Every Elected Official Should Ask About Their City’s Retirement Benefits

NLC recently announced the Public Sector Retirement Initiative, designed to provide timely research and educational resources to help elected officials navigate the retirement landscape, solve local government retirement challenges, and help cities achieve greater fiscal sustainability. This post is the first in NLC’s Public Sector Retirement Initiative blog series.

For city leaders, navigating the waters of public sector retirement can be tricky. Nlc recently launched a new initiative to help identify trends, challenges and solutions to local government retirement issues. (Getty Images)

For city leaders, navigating the waters of public sector retirement can be tricky. NLC recently launched a new initiative to help identify trends, challenges and solutions to local government retirement issues. (Getty Images)

In 2009, the city of Atlanta pensions were only 53 percent funded, facing a $1.5 billion shortfall. Mayor Kasim Reed knew that he needed to act. Focused on an inclusive and transparent reform process, the city established a panel with representatives from unions, elected officials and local businesses leaders to find a solution. The 18-month process ended with a plan unanimously approved by the Atlanta City Council requiring existing employees to make a larger contribution out of their own payroll to the pension, and placing all new employees in a so-called “hybrid” system with a reduced defined benefit plan tied to a 401(k)-type defined contribution benefit with mandatory participation. The reform package also reduced the city’s long-term pension liabilities by over $500 million.

City leaders across the country are faced with rising retiree-related costs, and a responsibility to ensure that the municipal workforce has secure retirement and healthcare. These priorities can at times seem conflicting, and the complexities of managing retirement and other post-employment benefits (OPEB) can be daunting. What options are available and what role can city leaders play?

NLC wants to educate municipal leaders

The National League of Cities (NLC) recently announced the Public Sector Retirement Initiative, designed to provide timely research and educational resources to help elected officials navigate these issues.

The initiative will explore questions every elected official needs to ask, including:

  1. What are the best practices for providing retirement benefits?
  2. What is my city spending to provide retirement and healthcare benefits? Is this a larger proportion of the budget than it was a few years ago?
  3. Do the benefits my municipality provides allow me to recruit and retain the workforce my city needs?
  4. How is my municipality fiscally responsible for the retirement benefits offered to employees?
  5. How will recently enacted Government Accounting Standards Board (GASB) changes affect my municipality’s finances and cost of borrowing?
  6. How do employees use retiree health benefits between their retirement and Medicare eligibility?

Understanding the role of the state

The Public Sector Retirement Initiative will also explore and help city leaders understand the key elements of the city-state relationship affecting the management of retirement and OPEB. For example, many states allow or require some cities to participate in statewide pension systems; this requirement has many benefits, like reducing costs for participating cities. In some cases, state statute sets required pension contributions, limiting a city’s ability to address its liability – even when the city manages its own plans. And no matter how your plan is managed, GASB changes have made it abundantly clear that these liabilities are a part of your city’s fiscal health.

This is the first post in our new blog series on public sector retirement. In the coming weeks, we will have postings from members of NLC’s Public Sector Retirement Advisory Council, a group representing perspectives from the private sector, state municipal leagues, city leadership, academia and nonprofits to provide guidance and advice to the initiative. We hope you find this information useful as you think about your own city’s finances and workforce needs.

About the Author: Josh Hart is the Senior Fellow for Public Finance at the National League of Cities. Contact Josh at Hart@nlc.org.