Presented by: Michael Schionning Jacqueline Farren Finance Committee Presentation on Governmental Accounting Standards Board Statement No. 45 Presented by: Michael Schionning Jacqueline Farren May 4, 2006

Finance Committee Presentation Outline Results of the analysis by Buck Consultants, LLC Overview of GASB 45 and its requirements Methodology used to calculate GASB 45 costs Initial assessment of the County’s GASB 45 costs Management Considerations Options available to the County to manage the cost Additional unresolved issues requiring further investigation Recommended direction to County staff May 4, 2006

Overview of GASB 45 Accounting and financial reporting for Postemployment Benefits other than Pensions (OPEB) GASB 45 applies to governmental employers Mandates uniform accrual-based accounting For the County it is effective for the fiscal year beginning July 1, 2007 Objectives of GASB 45 Report OPEB the same way pensions are currently reported Recognize cost of OPEB systematically over employees’ years of service May 4, 2006

Overview of GASB 45 OPEB stands for Other Postemployment Benefits OPEBs are all benefits other than pension benefits and include medical, prescription drugs, dental, vision, hearing and Medicare Part B or Part D premiums OPEBs can also include other postemployment benefits when provided separately from a pension plan Life insurance Long-term care Long-term disability For Contra Costa County OPEBs include medical, prescription drug, dental and self-funded long term disability May 4, 2006

Overview of GASB 45 Currently, most governmental employers use a Pay-As-You-Go (PAYGO) method to report OPEB costs Financial statements only report the OPEB benefits being paid in the current year as the expense Since OPEB is reported in this manner, there has been little or no pre-funding of OPEB benefits CURRENT REPORTING Typically, OPEB costs have been and are reported as pay as you go…. Which means that only the current cost of benefits are shown on the financial statements There has been little or no pre-funding of OPEB benefits. Those employers or Systems (few and far between) who have pre-funded have done so through a 401h account. Employers will not be forced to pre-fund. What will change is that even if you pay benefits “as you go” you will have to record expenses and liabilities in financial statements. May 4, 2006

Overview of GASB 45 Why is GASB Requiring this Reporting? OPEB benefits are part of the compensation for services rendered by employees Benefits are “earned,” and obligations accrue or accumulate, during employment Entities are not properly accounting for the future benefits that are promised and/or expected by employees Analysts will be able to evaluate OPEB obligations in the same way they currently evaluate pension obligations GASB has consistently made the effort to follow the private sector lead which follows FASB (the financial accounting standards board). In the early ‘90s, FAS 106 was implemented which is similar to GASB 43/45 for private sector employers. GASB also wishes to improve financial statement transparency and to align public accounting more closely with the private sector. Benefits are earned during employment and so should be recognized as a cost during the working lifetime. The argument goes that the “true” cost of these benefits should not be deferred and passed on to a future generation of taxpayers. READ QUOTE “Standard & Poor’s will analyze any OPEB obligations in the same way we currently evaluate pension obligations and will weigh the effect these obligations may have on an employer’s willingness to pay debt service on its bonds.”Yet, it is interesting when we discuss parallels with the private sector, these two GASB OPEB statements are quite a bit different than the FASB OPEB approach, beyond the commonality of “let’s account in advance rather than use pay as you go.” May 4, 2006

Overview of GASB 45 The new standard requires the measurement of two items: The value of premium payments made on behalf of the retiree and his or her covered dependents The value of the “subsidy” that occurs if the retiree rates are lower than the actual cost of the benefits The “subsidy” results if an employer: uses the same rates for active and retired employees does not set the retiree rates to be equal to the actual cost of providing coverage May 4, 2006

Overview of GASB 45 The new standard requires the disclosure of two key items: The Unfunded Accrued Actuarial Liability (UAAL). The Annual Required Contribution (ARC) This is made up of the normal cost – the amount that the active employees earn for their service in the year And a not greater that 30 year amortization of the UAAL The standard does not require that the ARC be funded However, the credit rating agencies will look at how an entity is handling the liability – including whether the liability is being funded – in determining ratings May 4, 2006

Overview of GASB 45 The likely credit implications of GASB 45 include: Lack of funding along with recent rapid health-care cost increases will result in significant OPEB obligations (primarily health care) These obligations may adversely impact credit rating Reporting OPEB could reveal: Funding could strain operation Employers may be unable to fulfill obligation Unfunded liabilities will be considered in rating process Obligations are significant. Full liabilities and costs will become more transparent True financial responsibility that must be paid Mature governmental entities with large percent of union employees will have largest liability (northeast and Midwest) Fitch has stated publicly that GASB 45 – if not addressed – will result in a downgrade of credit rating. May 4, 2006

Methodology Used to Calculate GASB 45 Costs The measurement of the liability can broadly be determined by: Projecting employer cash outflows for benefits Discounting projected benefits to the current date (or the Present Value (PV)) Allocating the PV of projected benefits to periods using an acceptable actuarial cost method This measurement includes the use of demographic and economic assumptions (including the healthcare cost trend rate) May 4, 2006

Methodology Used to Calculate GASB 45 Costs Substantive Plan – The plan as understood by the employer and plan members Need to consider: Eligibility, underlying benefits and cost sharing arrangements Historical patterns of changes Written documents and communications to participants Other plan features Caps on Employer’s share of benefits Potential implicit rate subsidies Medicare Part B or Part D premium reimbursement Take you on a tour through the typical ER process in addressing these new standards… …b/c all facets of the plan are not always well documented, is the written plan up-to-date?, Cost sharing provisions have often been modified, is the current arrangement clearly documented? How about eligibility provisions, deductibles, co-pays? What has been communicated to employees? That material is very important. Basis for the GASB calculations is the substantive plan… #1Implicit rate subsidies – arise when ER determines contributions for <65 retirees based on a premium that reflects active as well as retiree experience. I know of situations where an employer told me “we don’t do anything but offer coverage” to retirees. But, the program is self-insured and the amount charged to retirees is a rate based on the entire group of active and retired covered—that’s a subsidy. Interestingly, FASB has always required a measurement of liability for this type of subsidy, but the exposure draft for GASB did not. The final version is clear—unless the retirees are paying a “true” cost for their group, you have GASB 45 measurements. May 4, 2006

Methodology Used to Calculate GASB 45 Costs Substantive Plan Retired and Active Employee Census Data Assumptions and Methods Actuarial Present Value (PV) of Total Projected Benefits Actuarial Cost Method Assets MEASURING THE COSTS Once the ER has defined the SP it can begin thinking about measuring the accounting costs. On this slide we try to visually show an overview of the valuation process… SP is basis for the valuation. Census data for covered participants needs to be provided…. Assumptions & methods will need to be selected. ACMthd is used to allocate the TPV to past and future service  normal cost & AAL. This info and the assets if any are used to determine the ARC Note—”required” is a funny word for the statement to use. There is no watchdog agency that imposes a penalty on failing to make this so-called “required” contribution, as happens in the private pension sector. However, failing to make this ARC may be noted by users of the financial statements. Annual Required Contribution (ARC) May 4, 2006

Methodology Used to Calculate GASB 45 Costs Census Data Demographic Assumptions Participation & dependent coverage assumptions I N P U T Base year per capita costs Trend and Aging Assumptions Substantive plan Now let’s drill down a little deeper and examine how the TPV of benefits is determined. First step is to calculate the projected employer-provided benefit payments. The equation at the bottom of this slide shows the elements… The projected covered population is applied to the projected per capita costs to determine the total proj benefits. The expected future ret contributions are subtracted from this amount to determine the expected future ER provided benefits. Covd pop – using similar demographic assumptions as used in pension vals, if you have one. Use a few other assumptions unique to OPEB calcs such as the part & dependent covg are used. In contrib plans the part assump is used to estimate how many retirees will waive covg in the future. In addtn we have to est how many retiree will elect to cover other dependents, if the plan design permits. Will benefits stop at 65 when Medicare is available? Will post-age 65 retirees have coverage. What portion of the cost is the retiree paying? Per caps – proj base year per capita costs into future using the trend and aging assmptns Finally, use the SP to determine the expected ret contrib. Projected Covered Population X Projected Per Capita Costs Projected Retiree Contributions = Total Projected Benefits - Projected Employer Provided Benefits = O U T P U T May 4, 2006

Methodology Used to Calculate GASB 45 Costs Total PV of Benefits is discounted value of projected benefit payments Year Projected Employer Provided Benefits Total Present Value of Benefits 2007 $3,000,000 2008 $3,300,000 2009 $3,600,000 2010 $3,900,000 2011 $4,300,000 ASSUMPS & METHODS We then use the Discount Rate to calculate the TPV of these future benefits In other words, DR is used to bring each future payment back to today’s $ For example, assuming a 5% DR, the $3m 2007 expected benefits have a value the year earlier of $2.86m. At 4%, 2.89m, at 10% 2.73m. So, you can see how even in one year the DR has an impact. That impact compounds dramatically over time. Sum of these discounted values gives you the TPV Discount Rate May 4, 2006

Methodology Used to Calculate GASB 45 Costs Discount rate – Expected long-term investment yield on investments expected to be used to finance payment of benefits. Investments could include: Plan assets — for a funded plan (where assets are accumulated in a trust) Employer assets — for an unfunded plan A combination of plan and employer assets — for a partially funded plan Let’s cover a few critical assumptions in a little more detail. First look at the DISCOUNT RATE… For unfunded plans, we anticipate the discount rate could be in the 4% range—the expected LT ROR on investments used to finance the OPEB—since there are no assets set aside, that means the general employer assets, probably short-term fixed investments. For funded plans the DR could be in the 7% to 8% range and the DR for partially funded plans likely to fall somewhere b/w these rates. Clearly, funding policy will have a dramatic impact on the accounting costs. For example, the ARC calculated assuming no advanced funding could be 40% to 50% higher than the ARC in a fully funded scenario. While GASB not mandated advanced funding, there will be an incentive for Ers to consider it b/c of its impact on obligations. It fits with earlier argument that the employer ought to be paying for the value of these benefits “now.” May 4, 2006

Initial Assessment of the County’s GASB 45 Costs As of January 1, 2006, Buck estimates than the Actuarial Liability for the current benefit plan is: $2.57 billion under the assumption that the County continues to fund the OPEB benefits on a PAYGO basis $1.43 billion under the assumption that the County elects to fully fund the Annual Required Cost (ARC) each year May 4, 2006

Initial Assessment of the County’s GASB 45 Costs As of January 1, 2006, Buck estimates than the Annual Required Cost (ARC) for the first year is: $216.33 million under the assumption that the County continues to fund the OPEB benefits on a PAYGO basis $102.70 million under the assumption that the County elects to fully fund the Annual Required Cost (ARC) each year This compares to the expected PAYGO cost of $33.15 million for the first year May 4, 2006

Initial Assessment of the County’s GASB 45 Costs If the County elects to fully fund the ARC, then the net OPEB obligation – or the liability that is shown on the balance sheet – is $0 If the County elects to continue to only fund the PAYGO costs, then the difference between the ARC and the PAYGO cost is reflected as the net OPEB obligation This would be $216.33 million less the $33.15 million PAYGO cost or $183.18 million This OPEB obligation would continue to increase over time until it is equal to the actuarial liability May 4, 2006

Initial Assessment of the County’s GASB 45 Costs The chart on the next page provides a 30-year projection of: The ARC under the assumption that the ARC is fully funded each year The ARC under the assumption that the PAYGO cost is funded each year The expected PAYGO costs for each year May 4, 2006

Initial Assessment of the County’s GASB 45 Costs $ in Millions May 4, 2006

Management Considerations May 4, 2006

Options Available to the County Option 1 - Continue to fund the PAYGO costs Option 2 – Modify the existing OPEB plan Option 3 - Pre-fund all or portion of liability Option 4 - A combination of the above options May 4, 2006

Option 1: Continue PAYGO Funding Under this option the County would leave the current OPEB plan unchanged It would not fund the ARC above the required PAYGO funding Essentially, this Option is keeping the status quo May 4, 2006

Option 1: Continue PAYGO Funding Pros: Minimizes short-term budget impact No change from current process May 4, 2006

Option 1: Continue PAYGO Funding Cons: Large long-term budget impact as the costs continue to grow Net OPEB obligation continues to grow on balance sheet and will reach a level consistent with the $2.57 billion actuarial liability Estimate that in 5 to 6 years, the County’s total liabilities will exceed total assets Risk of credit rating downgrade May 4, 2006

Option 2: Modify the Existing OPEB Program Under this option, the County would look at changes in the existing OPEB programs. Although the County has not initiated any analysis on any options, the changes could include: Changing the eligibility requirements for the benefit Changing the coverage amounts (deductibles, copays, coinsurance, etc.) Changing the amount the County contributes towards coverage Unblending the active and retiree rates May 4, 2006

Option 2: Modify the Existing OPEB Program Pros: Reduced liability and PAYGO costs Produce an ARC that may be within the County’s ability to fund May 4, 2006

Option 2: Modify the Existing OPEB Program Cons: May affect competitiveness with other employers A portion of the employees are covered under CalPERS, where the County has little or no control on program design May 4, 2006

Option 3: Pre-funding in an Irrevocable Trust Under this option the County would pre-fund some portion of the ARC up to the full amount through a Trust By pre-funding the obligation through an irrevocable trust or equivalent arrangement, the County can use a higher discount rate – which by itself lowers the liability and ARC The investment earnings will help reduce the long term cost commitment from the County general fund for the OPEB benefits May 4, 2006

Option 3: Pre-funding in an Irrevocable Trust Pros: Reduces liability by allowing higher discount rate assumption (higher assumption only applies to the portion pre-funded) Reduces risk of credit rating downgrade Reduces budget volatility by establishing funding plan not tied to annual premium cost increases May 4, 2006

Option 3: Pre-funding in an Irrevocable Trust Cons: Full pre-funding is likely not affordable Uncertainty as to whether the State/Federal Government will reimburse pre-funded amounts Risk that pre-funding will be unnecessary if liability is reduced by unforeseen events such as major assumption changes or nationalized health care Risk of investment losses in the trust fund May 4, 2006

Option 4 – A Combination of Options The county may wish to consider a combination of approaches to manage its OPEB liability, which may include: Modifications to the current OPEB plan Partial pre-funding through an irrevocable trust or equivalent arrangement May 4, 2006

Additional Unresolved Issues Requiring Further Investigation Research competitive level of current OPEB benefits Research State and Federal positions on reimbursement of OPEB expenses Identify steps to establish a trust for accumulating pre-funding assets Identify options for managing investment of trust assets May 4, 2006

Recommended Direction to County Staff Prepare an analysis of liability reductions that could be produced through changes to healthcare benefits and present in closed session Prepare an analysis of the cost associated with funding varying levels of the liability and make recommendations concerning the portion of the liability that should be pre-funded and present at a future meeting of the Finance Committee May 4, 2006

Recommended Direction to County Staff Investigate unresolved questions concerning State/Fed cost reimbursement, establishment of an irrevocable trust for pre-funding assets, and investment options for pre-funding assets and report back at a future meeting of the Finance Committee Work with California State Association of Counties (CSAC) and other public sector partners to gather data and develop statewide strategies for managing this issue May 4, 2006