OPEB IN PERSPECTIVE - Government Finance Officers Association

STEPHEN J. GAUTHIER
OPEB IN PERSPECTIVE
GASB Statement No. 45 Four Years Later

Typically, a new accounting standard generates limited
interest,at best,from those outside the accounting and
auditing profession. Even the introduction of a new
governmental financial reporting model in 1999 seems to
have elicited only passing interest from those not directly
involved in its implementation. Such was certainly not the
case,however,when the Governmental Accounting Standards
Board (GASB) issued Statement No. 45, Accounting and
Financial Reporting by Employers for Postemployment Benefits
Other Than Pensions in July 2004. It seems safe to say that no
other public-sector financial reporting standard in recent
memory has evoked more interest (and passion!) on the part
of those not otherwise professionally involved with accounting
and auditing. Moreover, in the four years since the standard
was issued, the level of interest seems to have increased
rather than diminished.
The release of GASB Statement No. 45 was met with considerable
misunderstanding. Happily, much of the confusion
appears to be dissipating as governments approach the deadline
for implementation (from the fiscal year ending
December 31, 2007, for the largest governments to the fiscal
year ending December 31, 2009, for the smallest).Accordingly,
now appears a good time to reconsider GASB Statement No.45
in the light of all that has been learned over the past four years.
PENSIONS V. OPEB:
A TALE OF TWO BENEFITS
Other postemployment benefits (OPEB) such as retirement
health care are essentially similar to pensions in that both
constitute a form of compensation to employees for services
rendered. All the same, there are important practical differences
between these two types of postemployment benefits.
Defined benefit pension benefits are provided to employees
pursuant to a formal contractual arrangement between
employer and employees that cannot be unilaterally altered.
OPEB, on the other hand, typically allow for considerable
employer flexibility. Indeed, employers often are free, in principle,
to drop OPEB altogether, at their sole discretion. Also,
there has long been a consensus that pensions should be prefunded,
whereas OPEB have historically been financed
almost universally on a pay-as-you-go basis.
These differences undoubtedly explain,at least in part,why
accounting for OPEB has historically differed from accounting
for pensions, even though both are forms of employee
compensation. Employers in both the private and the public
sectors have long been required to accrue expense for the
cost of pension benefits as employees earn those benefits
(i.e., over employees’ active service life). However, it was only
in the early 1990s that the Financial Accounting Standards
Board (FASB) prescribed this same treatment for OPEB in
FASB Statement No.106,Employers’Accounting for Postretirement
Benefits Other Than Pensions. GASB Statement No. 45 is now
doing for the public sector what FASB Statement No. 106 did
for the private sector well over a decade ago.
HOW THE ACCOUNTING WORKS
Accounting and financial reporting for OPEB under GASB
Statement No.45 is virtually identical to accounting and financial
reporting for pensions under GASB Statement No. 27,
Accounting for Pensions by State and Local Governmental
Employers. In the case of defined benefits, the approach might
be summarized as follows:
■ The goal is to systematically and rationally allocate the
present value of the ultimate (i.e.,“projected”) cost of benefits
over the working life of benefiting employees (much
like depreciation expense allocates the cost of a capital
asset over its useful life).
■ This allocation is accomplished by means of an actuarial
valuation.
■ The amount the actuary allocates to a given year is
known as the annual required contribution (ARC), which
serves as the basic measure of expense.
■ The present value of benefits earned to date by employees
is known as the actuarial accrued liability.The difference
between this amount and any resources placed in
trust is known as the unfunded actuarial accrued liability.In
the case of OPEB, this latter amount will include the cost
of OPEB benefits earned by employees, but not funded,
prior to the implementation of GASB Statement No. 45.
■ Neither the actuarial accrued liability nor the unfunded
actuarial accrued liability is ever reported on the face of
the financial statements. Rather, the actuary, as part of the
calculation of the ARC, includes an amount intended to
amortize the unfunded actuarial accrued liability over a
period not to exceed 30 years.
■ If an employer pays the full amount of the ARC each year,
no liability is reported on the face of the financial statements
(although the unfunded actuarial accrued liability is
disclosed in the notes to the financial statements).
■ If an employer does not fully fund the ARC each year,the
aggregate difference is reported as a liability on the face of
the government-wide financial statements (net pension liabili-
February 2008 | Government Finance Review 9

ty/net OPEB liability),but not on the face of governmental fund
financial statements.Thus,an employer’s failure to fund the cost
of OPEB has no effect on fund balance in the general fund.
As a rule, the cost of health care will increase with age.Thus,
age-adjusted health-care premiums for active employees can
normally be expected to be less than age-adjusted premiums
for retirees. Employers, however, commonly ignore this cost differential
and establish a single premium for both active employees
and retirees that falls somewhere between the two ageadjusted
premium rates. They then permit retirees to purchase
coverage for themselves at what,for them,amounts to a reduced
rate. GASB Statement No. 45 describes such an arrangement as
an implicit rate subsidy and mandates that any retiree savings be
treated as OPEB,even though the employer makes no payments
directly on behalf of retirees.
As already mentioned,many employers legally retain the right
to unilaterally lower the level of OPEB benefits or to eliminate
those benefits altogether. In practice, however, employers rarely
exercise this right.Accounting in both the public and private sectors
emphasizes economic substance over legal form.Therefore,
GASB Statement No.45 mandates that employers accrue the cost
of OPEB as expense whenever there is a substantive plan,including
situations like the one just described.That is, so long as both
employer and employees share a mutual understanding that
OPEB will be provided,the cost of those benefits must be recognized
as expense as earned by employees.
FEARS REAL AND IMAGINED
As the discussion thus far should have made clear, some of
the fears initially raised by GASB Statement No. 45 are groundless.
For example, neither the actuarial accrued liability nor the
unfunded actuarial accrued liability will appear on the face of the
financial statements.Thus, financial statements will not report a
liability “overnight” for the cost of OPEB earned prior to the
implementation of GASB Statement No. 45. In addition, governmental
funds are unaffected by the recognition of OPEB
expense in the government-wide financial statements.Thus,fund
balance in the general fund will continue to be reported just as
it has been in the past, even once GASB Statement No. 45 has
been implemented.
Conversely,some employers appear to be proceeding under the
misapprehension that they have no OPEB to report,when,in fact,
they do offer OPEB as defined by GASB Statement No.45.
■ An employer must normally report OPEB expense even if
the entire health-care premium is paid by retirees, assuming
that a single rate is used for both active employees and
retirees (i.e., implicit rate subsidy = OPEB).
■ The fact that employers may unilaterally change benefit levels
or eliminate benefits altogether does not mean that they
do not have to report OPEB (focus on substantive plan
rather than legal form).
■ The fact that an employer is statutorily prohibited from
entering into a binding promise to pay benefits in future
years does not mean there is no OPEB (focus on substantive
plan rather than legal form).
THE PROBLEM IS THE FEVER—
NOT THE THERMOMETER!
GASB Statement No. 45 has provoked strong negative reactions
in some quarters. However, it seems only fair to observe
that the statement does not so much create a problem as disclose
one that has been around for a long time, just under the
surface.The real challenge is not so much accounting for OPEB
as dealing with their budgetary implications,especially as baby
boomers begin to retire in an environment of spiraling healthcare
costs. At least such appears to be the conclusion reached
by more and more governments as they prepare to implement
GASB Statement No. 45.
KEEP ON KEEPING ON
The most important consideration, of course, is ensuring that
whatever benefits are offered are financially sustainable. As
already noted, OPEB historically have been financed on a payas-you-go
basis, which has tended to give the false impression
that OPEB are less costly than they actually are (much like a 30-
year mortgage might easily appear less costly to the unsuspecting
eye than a 15-year mortgage, based on monthly payments
alone). In fact, preliminary estimates indicate that the true cost
of OPEB (as represented by OPEB expense calculated on an
actuarial basis in accordance with GASB Statement No. 45) is
likely to exceed payments made on a pay-as-you-go basis by a
multiple of no less than three to one! In the face of this prospect,
governments will likely wish to evaluate their plan design for
OPEB.Specific aspects of plan design to be considered include
the following:
■ Health-care cost containment. Has every reasonable step
possible been taken to keep current benefit levels affordable
by containing health-care costs?
■ Benefit levels. Are benefit levels appropriate, in light of
their true cost? If not, is some modification appropriate or
necessary? How can any needed adjustments be made with-
10 Government Finance Review | February 2008

Exhibit 1: OPEB Decision Points 1
Establish Governance Structure
Initial Actuarial Valuation
and Financial Reporting
Health-care 2 Policy
Decision
And
Funding Strategy
Decision
Plan Design
Communicating with Stakeholders
Benefit Levels
Implicit Rate
Subsidy
Health-care Cost
Containment
Prefund
Funding
Mechanism
Decision
Partial Prefund
Pay-as-you-go
Irrevocable Trust
Revocable Trust
Earmark
Cash
Bond
Cash
Bond
401(h)
VEBA
Section
115
Cash
Bond
Cash Bond Cash Bond
Notes
1. GFOA extends its appreciation to the GFOA Committee on Retirement Benefits Administration and its advisor. Leslie Thompson
of Gabriel, Roeder, Smith and Company, who developed the initial version of this decision tree.
2.While OPEB decisions do not necessarily focus on health care, this decision tree focuses on this particular benefit as the majority
of the OPEB emphasis and cost is related to health-care benefits.
February 2008 | Government Finance Review 11

out breaking faith with long-time employees? Should different
benefit levels be offered to new employees?
■ Implicit rate subsidy. Should retirees continue to be
allowed to purchase health-care coverage at the same rates
as active employees? Should they pay at least some part of
the differential?
PAY NOW, PAY LATER
Although many employers will likely make important
changes in how they offer OPEB in the future because of GASB
Statement No. 45, it appears highly unlikely that many employers
will opt to eliminate OPEB entirely. Accordingly, employers
still face the challenge of funding OPEB.
The first funding decision,of course,is whether to attempt to
budget for OPEB expense as calculated under GASB Statement
No. 45, or to continue to finance benefits on a pay-as-you-go
basis. The latter approach, as explained earlier, would require
the employer to report a liability in its government-wide financial
statements in the amount of the aggregate underfunding.
Many have expressed concern at the potential impact such a
liability might have on a government’s credit rating.
If a government does elect to prefund OPEB, it must then
consider the appropriate level of funding. Should the government
attempt to fund the entire amount of OPEB expense each
period,or just a portion (which would result in a liability being
reported in the financial statements for the underfunding)?
Some fear that partial funding may be the only realistic option
in their specific circumstances, given budgetary constraints.
Others generally favor prefunding OPEB, but balk at the
prospect of prefunding OPEB resulting from an implicit rate
subsidy. Furthermore, governments that offer federally reimbursable
prescription drug benefits under Medicare Part D
may be resistant to prefunding the full amount of OPEB
expense, given that future federal reimbursements are excluded
from the calculation.
WHICH COOKIE JAR?
Once an employer has decided to prefund OPEB, at whatever
level, a decision needs to be made regarding how the accumulated
resources are to be managed. Should the employer
use an irrevocable trust fund (or equivalent arrangement) for
the purpose? What about a revocable trust? Or is it satisfactory
simply to earmark the resources (e.g., in an internal service
fund or as a designated fund balance in the general fund)? A
key consideration in making any decision is the accounting
implications.For instance,if a government’s OPEB expense was
$100 and it made a $100 payment to an irrevocable trust fund
(or equivalent arrangement), no liability would be reported
because the expense would be considered fully funded.
Conversely, if the $100 were placed in a revocable trust or otherwise
earmarked, the employer would be required to report a
$100 liability for underfunding because only amounts placed
in irrevocable trust qualify as contributions for accounting purposes.Furthermore,employers
who elect to use an irrevocable
trust fund must choose which legal vehicle to use for this purpose,
such as Internal Revenue Code (IRC) Section 401(h)
accounts,Voluntary Employee Benefit Association accounts,or
IRC Section 115 trusts.
YOU’VE GOT A FRIEND
This issue of Government Finance Review features articles on
a number of topics currently generating high levels of interest
as governments seek to cope with the challenge of OPEB.
Specific topics addressed include health-care cost containment,
the use of defined contribution plans, the pros and cons
of specific trust fund alternatives, and the use of alternative
investments.The GFOA is also offering a new online “toolkit”of
resources designed to facilitate the decision-making process for
OPEB (for more information, go to www.gfoa.org/opebtoolkit/).
The GFOA also is reviewing its existing recommended practices
and considering new ones to address the challenge of
OPEB.Two recommended practices specifically devoted to the
topic have already been issued: Ensuring the Sustainability of
Other Postemployment Benefits and Need for Considerable
Caution in Regard to OPEB Bonds.The GFOA has also released
Accounting for Pensions and Other Postemployment Benefits in
its popular “Elected Official’s Guide”series.
FINAL THOUGHTS
If a key objective of GASB Statement No.45 was to draw attention
to the financial implications of OPEB, there can be little
doubt as to its effectiveness! The entire topic of OPEB has by
now reached well beyond the world of accountants and auditors.
This development is a welcome one, as sound decision
making for OPEB demands the active and concerted involvement
of professionals from a range of disciplines within public
finance. The GFOA is committed to providing every possible
assistance to facilitate this effort. ❙
STEPHEN J. GAUTHIER is director of the GFOA’s Technical Services
Center in Chicago, Illinois.
12 Government Finance Review | February 2008

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