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Accounting for the Cost of Retiree Health and Other Benefits (GASB 45)

New rules issued by the Governmental Accounting Standards Board (GASB) that change the way states account for the future cost of health and other non-pension benefits for retirees will force states to make some hard choices.

• For the first time, state and local governments must treat the costs of health and other non-pension benefits for retirees the same way they treat pension costs when preparing budgets and financial statements — that is, put the future cost of those benefits in their accounts as they are earned. Moreover, state and local governments must show the liability for those benefits that have already been accrued for past and current employees.
• The new requirements apply only to the way these costs are accounted for — not to how they are paid. However, this rule will likely result in pressure to pre-pay more of these costs because it will require governments to put a number — often for the first time — on a large future liability. In total, this liability is estimated to top $1 trillion.
• State and local governments may respond to this new rule in ways that will affect funding for services; pre-funding retirement benefits could reduce funds available for annual expenditures on education, health or services. They may also respond by reducing the level of post-retirement benefits provided to employees. To date, responses by state and local governments have run the gamut from doing nothing to entirely eliminating retiree health benefits. The opportunities and pitfalls of the options open to states are discussed in this report.

The new GASB rule leaves states between a rock and a hard place. If a state chooses to pre-fund these costs, the combination of funding requirements for current employees, the transition costs and maintaining payments for current retirees are likely to require significant cutbacks in important services in the rest of the state’s budget. Moreover, it is very difficult to accurately predict the future rate of growth in health costs; if the cost projections prove to be overstated, a state could make cuts to future benefits or to their budgets that could later prove unnecessary. If, on the other hand, a state chooses not to pre-fund, this invites future pressure from bond raters. In addition, if current trends in health care and other non-compensation costs do continue, the state risks reaching a point where health benefits for retirees become unaffordable on a pay-as-you-go basis.

Background

The compensation of state and local employees generally includes a pension and a health insurance benefit package. In many cases, coverage of some or all of the cost of health insurance continues after an employee retires from public service. Although the financial responsibility of the government is fairly similar for both pensions and health benefits for their retirees, retiree benefits other than pensions have traditionally been treated differently from pensions in government budgets and financial statements.[1]

Pension Costs are Pre-Paid

Pension costs are usually pre-paid — that is, most state and local governments have established dedicated trust funds where money is deposited to cover the anticipated costs of pensions for current and past employees. A state’s annual budget shows the amount deposited in the trust fund to cover liabilities accrued that year as an expense of the general fund. In addition, the amount that is withdrawn from the trust fund to be spent on pensions for current retirees is shown as an expense of the trust fund rather than of the annual budget. States and local governments are also required to calculate and show an estimate of the future costs of public employee pension benefits in the governments’ annual financial statements in order to meet generally accepted accounting procedures for state and local governments. These also include estimates of the funding ratio — the share of the future liability that is covered by the assets in the pension trust fund. Currently, the assets in state and local pensions are sufficient to cover 87 percent of future liabilities on average.

Financing of Retiree Health and Other Non-pension Benefits is Typically Pay-As-You-Go

Traditionally, the treatment of the future costs of health and other non-pension benefits for retirees has been very different from that of pensions. Rather than pre-paying these benefits through deposits to a trust fund, most state and local governments appropriate money in their annual budgets for the annual premium costs of retiree health insurance or other benefits. This is known as pay-as-you-go.

One of the main reasons for the difference in the treatment of pension costs and retiree health costs is that state and local governments have never been required to calculate and report the future cost of non-pension retiree benefits promised to current and past employees. Very few have done so voluntarily. In contrast, state and local governments have been required to report pension costs for future retirees since the early 1990s. In addition, at least on a legal basis, the obligation of state and local governments to pay retiree health costs is typically less binding than their obligation to pay pension benefits. Public employee pension benefits are often guaranteed in a state’s constitution while health benefits are not. Finally, the amount of pension that will be paid to any retiree is a known amount — determined by formula — while health insurance costs after retirement cannot be predicted with certainty.

GASB Rules Will Change Reporting of Retiree Health

The treatment of retiree benefits other than pensions is changing as the result of a rule issued by the organization that sets accounting standards for the public sector — the Governmental Accounting Standards Board (GASB.) These standards govern the annual financial reports used by bond rating agencies and others to determine the fiscal health of state and local governments.

In June 2004, GASB issued statement number 45 which requires that state and local governments move from a cash (pay-as-you-go) basis for accounting for the costs of benefits other than pensions to an accrual basis. In other words, instead of just showing the amount that the government is paying each year to employees that are already retired, it must estimate and show the total amount that will be owed to all its employees to date — current and past — when they are retired. The most costly retiree benefits are medical insurance including dental, vision and prescription drug benefits. In addition, costs for life insurance, legal, long-term care and disability benefits outside a pension plan are included in the GASB 45 definition. The box on page 5 shows the information required using Maryland as an example.

GASB 45 applies only to the way the costs are accounted for — that is, how they are shown in the government’s financial statement. It does not, in and of itself, mandate how the government pays for these costs. As described below, however, it can have expenditure implications.

The GASB 45 requirements went into effect for all states for fiscal year 2007-2008 budgets. In addition a number of large local governments will be required to report these costs in their upcoming budgets. The requirements are being phased in over the next two years for smaller local governments.

The cost of retiree benefits other than pensions is large. Estimates of the total liability — the present value of future costs — for all state and local governments ranges from $1 trillion to $1.3 trillion over the next 30 years.[2] This compares to the estimated $2.4 trillion in future pension liability.

While the future cost of OPEB (Other Post Employment Benefits) is lower than the future cost of pensions, OPEB’s immediate impact on state fiscal situations has the potential to be greater because it is a new requirement. The reason for this lies in how states have traditionally handled these two retiree benefits. For a long time, most states have routinely set aside money in a trust fund to pay for current and future pension costs. These funds currently contain enough assets to cover 87 percent of expected costs on average.[3] As noted above, benefits other than pensions have traditionally been handled on a pay-as-you-go basis.

State Bond Ratings Are Potentially Affected

Complying with GASB 45 will force state and local governments to put a number on a significant future unfunded liability. State and local governments and bond rating agencies have known for a long time that the costs of retiree health care for public employees are large and growing. However, they generally have not had an estimate of how large the future cost may be. If this liability is large and the state does not have a plan to address it, this could affect a state’s bond rating and the cost of borrowing money (i.e. the interest rate it must pay to lenders).

So far, the bond rating agencies are saying that they won’t consider it a negative if states don’t pre-fund their retiree health liability right away. They do seem to want to see a plan to deal with the liability and trends may matter in the future. For example, it could be a problem if a state has a large and growing liability for retiree health and has not identified a way to pay for it. Or, if several states do start pre-funding some or all of their retiree health liabilities, bond raters may look more favorably on those states compared to pay-as-you-go states in the future.

Other Parts of Budget May Be Squeezed

The way that state and local governments act to address this liability will affect their budgets. Once the dollar amount of these future liabilities has been identified, there may be pressure for state and local governments to begin to set funds aside now to pay future costs — as they do with pension obligations. As noted, government officials may be concerned about the impact on the state’s bond rating if they do not pre-fund. Or, they may simply consider it prudent fiscal policy to reduce future liabilities. Public employees or their unions may want the increased security that a trust fund would bring.

If a state decides to set money aside each year for this liability, it would have to appropriate an amount over and above the cost of paying the state’s share of the health insurance costs for employees who have already retired. This would put a strain on other parts of the state budget as these funds would not be available for other purposes.

Public Employee Benefits May be Cut

Alternatively, a state could decide to reduce the size of its GASB 45 liability by cutting benefits for existing or future employees. In many states, the cost of paying for retiree health benefits on a pay-as-you-go basis has been increasing as health care costs rise and the number of retirees increase as the population ages. States already face pressures to reduce these costs by scaling back benefits. The publication of estimates of the future cost of these benefits may increase these pressures.

What States Can Do

There are a host of possible ways to fund the current and future costs of retiree health and other post-employment benefits.

Continue As Pay-As-You-Go

Some states will decide to continue on a pay-as-you-go basis. This means annually appropriating the money needed to pay the costs of health and other non-pension benefits for current retirees. Most states currently fund non-pension retiree benefits this way. Texas plans to continue with pay-as-you-go funding for the state and has passed legislati

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