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Implementation of GASB 45 in North Carolina:

Keeping the Powder Dry

By

Charles K. Coe

School of Public and International Affairs

North CarolinaStateUniversity

Campus Box 8102

Raleigh, NC27695

William Rivenbark

UNCSchool of Government

UNC Chapel Hill

Campus Box 3330, Knapp-SandersBuilding

20 the Annual Conference of the

Association for Budgeting and Financial Management

October 23-25

Chicago
Implementation of GASB 45 in North Carolina:

Keeping the Powder Dry

State and local governments can offer a range of other postemployment benefits (OPEB) in addition to retirement pensions, including dental, vision, life insurance, disability insurance, and health care coverage. In 2004 the Governmental Accounting Standards Board (GASB) issued Statement No. 45—Accounting for Financial Reporting by Employees for Postemployment Benefits (GASB 45). Before GASB 45, most governments paid OPEB costs on an annual, pay-as-you-go (PAYGO) basis. This approach, however, does not disclose the accrued costs of promised OPEB, which can be substantial. To make OPEB commitments transparent, GASB 45 requires governments to make an actuarial evaluation to calculate the actuarially accrued liability (AAL) for OPEB. If a government does not fund the OPEB liability, it must disclose the actuarially required contribution (ARC), which includes the normal cost for the year plus an amortized portion of the total AAL of the plan. The total amortization period cannot exceed 30 years. GASB 45 implementation is staggered in three phases. Phase I local units (annual revenues over $100 million) implemented in FY 2008. Medium-sized units (revenues between $10 and $100 million) will implement in FY 2009 and the others in FY 2010.

The amount of states’ liabilities varies widely. The unfunded actuarial liability (UAAL) ranges from 140% of New Jersey’s budget in New Jersey to less than 1 percent of North Dakota’s (Clark 2008a: 6). The amount of liability in local units will not be known until after GASB 45 is fully implemented, but should range in small and midsized municipalities from $39 to $210 per capita (Marlowe 2007: 106).

Among the GASB 45 policy decisions faced are (1) whether to fund all or part of the ARC, (2) how to fund the liability, (3) whether to increase employee contributions, and (4) whether to reduced OPEB benefits. As yet, research on these and other questions is relatively. A national survey asked how local officials plan to implement the standard (Daley, Clark, Coggburn, and Kearney). [1] Berman and Keating discussed how four localities addressed some implementation questions (2006). Sanford examined how 15 heavily populated counties throughout the county implemented the standard (2007).[2] This paper adds to this literature, discussing how Phase I local units in North Carolina implemented GASB 45.

Methodology

A survey, including a cover section, was sent via email in August 2008 to the 30 Phase I county and municipalities in North Carolina. A follow-up survey was sent to non-respondents, followed by telephone calls. Twenty-five of 30 local governments responded to the survey for a response rate of 83 percent. The survey asked how the local units conducted the actuarial valuation, what preliminary information was gathered to inform policy decision, and the decisions made by governing board members and staff.

Actuarial Valuation

GASB requires that local units calculate their OPEB liability. The frequency of the valuation depends on the number of eligible employees:

  • 200 or more plan participants—at least every two years
  • Less than 200 participants—at least every three years (GASB 2004)

To avoid making an actuarial valuation, GASB permits local units with less than 100 plan participants to use its simplified alternative measurement method. The North Carolina Local Government Commission (LGC), a division of the State Treasurer’s Office, offers an Excel spreadsheet to make the simplified alternative measurement analysis. In testing the program’s usefulness, the LGC found that most small local units were not sufficiently familiar with GASB 45 to use it initially (Edmundson 2008a). The LGC thus recommends that an actuary conduct the first valuation and that the spreadsheet be used for future valuations (Edmundson 2008a).

Conduct the Valuation Early

If the amount of OPEB liability is unknown, local governments are well-served to have a valuation conducted sufficiently ahead of the GASB 45 implementation date to give the governing board enough time to weigh its policy options (Sanford, 2007: 11). For instance, the town of Cary conducted a GASB 45 valuation in 2003 to determine its OPEB liability; another in 2005 to prepare for implementation; and in 2007 to guide the implementation. All but three of respondents conducted a valuation at least one-year ahead of the FY 2008 implementation date. Considerably ahead of the curve, a progressive finance director in Winston-Salem had a valuation conducted in 1991 and persuaded the governing board to prefund its OPEB liability in 1992.[3]

Select an Experienced Actuary

The actuary makes informed assumptions about the likely life span of retirees, investment returns, retirement rates, inflation rates, employee turnover rates, future salary increases, and future medical costs. An OPEB valuation is more complex than a pension valuation. While pension benefits are relatively stable and predictable, OPEB liabilities are less certain because of unpredictably rising health care costs. To find an actuary, staff of the North Carolina League of Municipalities (NCLM)and North Carolina Association of County Commissioners (NCACC) jointly issued a request for proposals (RFP) to which three firms responded.[4] The selection criteria included staffing capacity, price, and especially GASB 45 experience. The NCLM and NCACC awarded the contract to Cavanaugh MacDonald, whose services counties and municipalities could engage if they wished. Cavanaugh MacDonald was already the actuary for the statewide North Carolina Local Government Employees Retirement System (NCLGERS), in which most local units participate. Cavanaugh MacDonald also submitted a very competitive price, which, as shown in Appendix A, is based a local unit’s relative number of active and retired participants and whether a local unit participates in NCLGERS. The units that participated in NCLGERS paid a lower price as the actuary was already familiar with, and had background information on, their plan. Twenty-one respondents contracted with Cavanaugh MacDonald. The four other local units contracted with an experienced actuary as well.[5]

Following the North Carolina’s example, the Georgia Association of County Commissioners, the Alabama League of Municipalities, and the South Carolina Association of Counties likewise selected an actuary with which their local units could contract (Shepard 2008).

RFP Provisions

A model RFP, available from the Government Finance Officers Association (GFOA), specifies the desired scope of work (SOW), information needed about the firm, the process to be used, information provided by the local unit, the implementation schedule, and the cost and terms of agreement (2006).[6] To reduce the cost of the valuation, the local unit should gather and provide the background information needed to make the valuation. Supplying this information can also increase staff’s understanding of GASB 45 (Sanford 2007: 11). Among the data supplied are:

  • Demographic. Name of retirees, their gender, date of birth, date of hire, retirement date, years and months of service, employment group, medical plan.
  • Plan Provisions. The health care benefits policy for retirees and future retirees.
  • Medical Coverage. Medical coverage provisions and costs.
  • Premium Rate Information. Fully-insured premium rates for at least the last two years.
  • Aggregate Claims, Experience, Administration and Other Fixed Fees. Monthly head counts, claims paid for the last two years, stop loss rates, monthly administrative expenses.

The units that contracted with Cavanaugh MacDonald had already provided the data by virtue of participating in NCLGERS. The other four respondents also furnished these data to their actuary.

The RFP should specify that the local unit can negotiate with the actuary to pay extra for costing out alternative funding scenarios. For instance, the governing board may want to know the cost of changing particular benefits or the cost of the liability if funds are invested at different interest rates. The Cavanaugh MacDonald contract provides that the local unit can negotiate an extra fee at an hourly rate ranging $100 to $360. Six units exercised the option: two asked for two funding scenarios; one for three scenarios; and three for four scenarios. The RFP should also specify that the valuation be completed in a timely fashion. The contract with Cavanaugh McDonald specified a timely 10-12 week completion period.

In its first valuation, the actuary incurs start-up costs to be familiar with a local government’s conditions that can be amortized in future valuations. Moreover, a multi-year contract ensures consistency over multiple valuations. The contract with Cavanaugh McDonald is for five years. Of the other four respondents, two entered into a one-year contract and two into a three-year contract.

Apply a Realistic Discount Rate

The discount rate is the interest rate likely earned on invested OPEB funds. The actuary should apply a discount rate consistent with the return on the investments expected to finance the payment of benefits (GASB 2004). A higher rate of return lowers the liability. To minimize the OPEB liability, some governments ill-advisedly shop for an actuary that will apply an unrealistically high discount rate (Sanford 2007: 12).

The discount same rate applied to retiree health trust funds is normally the same as used in OPEB funds. The General Accountability Office found in 2006 that 70 percent of state and local pension trust funds used a rate between 8.0 and 8.5 percent, while the remaining 30 percent used a rate of 7 percent (2008). Cavanaugh MacDonald applied a standard discount rate of 4 percent for the 21 units using PAYGO financing and 7 percent for Raleigh, which fully funded its liability. Of the four units using another actuary, the two that used PAYGO had a rate applied of 4 percent; the two that fully funded, Winston-Salem and Charlotte, had a rate applied of 8 percent and 7.5%, respectively.

Gather Background Information

GFOA recommends that governments undertake a deliberative process, developing principles to guide GASB 45 policy decisions regarding benefits and funding (GFOA 2007). Governing board members may need supporting information as shown in Table 1 and discussed below.

(Table 1 here)

Employees’ Priorities

The governing board may wish to sound out their employees’ priorities with respect to OPEB benefits. For instance, employees may favor a greater salary increase now than benefits like dental and vision coverage when they are retired. To get feedback, employee preferences can be surveyed. None of the respondents conducted a survey, however; perhaps because none of the OPEB benefits of current employees was reduced or their costs increased.

Advice of a Healthcare Consultant

Governing boards, weighing whether to change health care benefits, may engage the services of a specialized health care consultant. Seven of 25 respondents (28%) contracted with such an expert to analyze alternative health care benefits.

Bond Raters Views

Concerned that the OPEB liability may adversely affect their bond rating, local governments may want to sound out the bond rating agencies. Marlowe predicts that local governments that allow OPEB liabilities to weaken their fiscal capacity will likely experience a bond rating downgrade (2007: 108).[7] Indeed, Fitch Ratings avers that OPEB liabilities, if indefinitely ignored, will damage credit quality (Mason 2005). To sound out the bond rating agencies, 15 of 25 respondents (60%) discussed their GASB 45 situation with bond rating agencies in conjunction with a bond issue rating presentation.

Policy Decisions

The overriding policy decision is whether to fund all or part of the ARC. There are three options (1) prefund the entire amount, (2) partially prefund the ARC or (3) stay on a PAYGO basis, funding none of the ARC. The governing board should carefully weigh the pros and cons of prefunding (GFOA 2008):

Pros

  • The benefits promises made to retirees will be kept
  • No loss of financial flexibility in the future if OPEB costs increase
  • Current employees pay for their future benefits, which is more equitable.[8]
  • Funds can be invested in higher-yielding instruments

Cons

  • If the amount of the OPEB liability is very high, too much stress will be placed on current finances
  • National health care insurance may make the funding OPEB moot.

Twenty-two units (88%) stayed with the PAYGO funding approach. The three (12%) that prefunded their liability have a AAA bond rating and keeping the rating factored into their decision.

Create an Irrevocable Trust

GASB recommends that governments, which prefund the ARC, should place the funds in an irrevocable trust where moneys remain in perpetuity. Since a trust is long-term, funds can be invested in equities and other high-yielding instruments. The disadvantage, however, is that funds must forever remain in the trust and cannot be used should a financial emergency occur. However, if a revocable trust is used, OPEB funds can used for other purposes upon the trust’s termination. The three units that prefunded their OPEB liability created an irrevocable trust. Because creating such a trust is technically complex and an uncommon practice, the three units engaged outside counsel to draw up the trust.

Invest in the State OPEB Trust Fund

The state of North Carolina has created an OPEB trust fund in which fully funded local units can invest OPEB funds. The state also permits a local unit to create its own investment fund that includes most investment instruments included in the state OPEB trust fund (Edmundson 2008b). Charlotte created such a own fund; Raleigh and Winston-Salem utilize the state-managed fund (Edmundson 2008b).

Allocate Costs Among All funds

The annual OPEB cost can be paid solely by the general fund or by all funds. The latter is recommended because employees, regardless of where budgeted, will receive and should therefore pay for the cost of OPEB benefits. Costs can be allocated to each fund based on the relative number of employees or the amount of the total payroll in each fund. Ten respondents (50%) charged all funds; 10 did not; and five did not answer the question.

Reduce the ARC

To reduce the ARC, the governing board can reduce the benefits or increase the costs of current employees, retirees, and future retirees. A myth is that retirement benefits are protected by state laws and constitutional provisions (Clark 2008). Yet preliminary evidence indicates some reservation to take such actions. For instance, none of the 15 counties studied by Sanford reduced retirees’ benefits (2007). In some cases, state law may be a factor. For instance, Florida law (Florida Statute 112.0801) requires that retirees have the same health benefit plan as active employees (Sanford 2007: 44).

The courts in North Carolina have not addressed whether a local unit can reduce or eliminate retirees’ benefits (Juffras 2004: 17). The North Carolina Supreme Court did, however, rule in Bailey v. State of North Carolina that the state cannot change its pension benefits terms (Juffras 2004: 17). Regarding current employees, the Fourth Circuit Court of Appeals (whose jurisdiction includes North Carolina) held in Baltimore Teachers Union v. Mayor and City Council of Baltimore that teachers’ benefits can be reduced if basic services are threatened and the reduction is temporary.

If legally permitted, local governments have a range of ways to reduce OPEB benefits or increase costs including:

Retirees

  • Increase retirees’ and dependents’ premiums and deductible amounts
  • Increase retirees’ coinsurance rates
  • Increase retirees’ copayments for medical services
  • Increase the cap on retirees’ out-of-pocket expenses
  • Increase the age at which retiree healthcare is available.

Current Employee

  • Increase the years needed to vest
  • Required employees to enroll in Medicare when eligible
  • Increase the age at which health care benefits are available
  • Limit or terminate subsidies
  • Eliminate health care and/or drug prescription coverage
  • Change to a defined benefit plan

Perhaps because of the specter of the Bailey decision, none of the respondents reduced the benefits or increased the costs of retirees or current employees. Six of 24 local units (25%) did, though, increase the number of years that new employees would need to vest.[9] The vesting period among the respondents varies widely, ranging from 5 to 30 years as shown in Table 2.

(Table 2 here)

Adopt a GASB 45 Policy

A governing board may adopt a stand-alone GASB 45 policy or incorporate GASB 45 provisions into an overall strategic plan. For instance, FairfaxCounty adopted an overarching health care strategic plan that includes OPEB policy provisions (Sanford 2007: 14). None of the respondents, however, adopted a stand-alone policy or integrated OPEB policy decisions into an overall strategic plan.