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February 17, 2006

OPEB: The 800 Pound Gorilla in the Room

Rick Mattoon, Senior Economist and Economic Advisor
Federal Reserve Bank of Chicago

State and local governments are facing other retirement-related issues as well as the problem of funding pensions. The Government Accounting Standards Board (GASB) has established new guidelines that require governments to account for their “other post employment pension” (OPEB) obligations (GASB no.35 and no.45). Large state and local governments will be required to begin accounting for these obligations on December 15, 2006. OPEB obligations are primarily for retiree health care costs but also can include other benefits such as insurance. Currently OPEB obligations are paid for out of current revenues on a pay-as-you-go method. The annual cost of OPEB is what it costs to cover specific retirees in that year without regard to how this obligation might change as the number of retirees changes or the cost of providing the benefits changes in the future.

The new GASB regulations are intended to improve transparency in government accounts by making it easier to know what the future liability for OPEB expenses will be for a given government and to assess whether they have a strategy for meeting these requirements. The GASB regulations are patterned after similar requirements that FASB placed on private firms in 1992 (SFAS 106). As was the case for private firms, this new accounting standard for governments raises many challenges. For example:

• estimating the total OPEB liability is an accounting nightmare. Unlike pensions where actuarial estimates can be at least somewhat understood, OPEB requires making guesses about things like health care and prescription drug inflation and utilization. One estimate suggests the unfunded liability is around $700 billion, but this is a back of the envelope guess. Other estimates suggest that OPEB exposure could range from five to ten times current outlays for retiree health care.

• managing OPEB costs is tricky. In most cases, retiree health care is not a contractual responsibility like pensions. It is a voluntary benefit offered by the employer. However where it is a contractual responsibility, the ability to require retiree contributions, increase co-pays or cut benefit coverage is limited. Where retiree health insurance can be modified, a concern is that when these liabilities are reported, some governments may choose to abandon or significantly reduce coverage, forcing the federal government to serve as the health care insurer of last resort.

• There are strategies for managing OPEB costs. Efforts to contain health care costs and slow increases in health insurance premium costs can help. Shifting more costs to retirees can be an option, along with trying to limit future OPEB obligations by changing benefit packages for new employees. One strategy that is popular (and essentially required) for addressing OPEB costs is to set up a trust fund. A trust fund meets the new accounting standard requirement that an irrevocable source is identified for meeting OPEB obligations. It also has the advantage of allowing governments more flexibility in the use of investment options. Like pension funds, OPEB trust funds would permit investments in equities and other potentially higher yielding investment vehicles. A potentially attractive option that a trust fund may allow is the ability to issue OPEB bonds to cover part or even all of a government’s OPEB liability. Like pension bonds, these are essentially an arbitrage strategy, where the bond issuer anticipates that the investment yield they will receive from the bond assets will exceed the interest that will be paid to bond holders. Also like pension bonds, the OPEB bonds are not free from federal taxes so they must carry slightly higher interest rates than tax-free investments.

• The impact on credit ratings for governments is another real concern. Once this liability is recognized, some governments’ finances might appear more fragile. To date, several of the major rating agencies have indicated that they will judge the creditworthiness of these governments based on whether their plan for meeting OPEB liabilities appears prudent rather than on the size of the liability on the balance sheet when it is first recognized. Credit agencies do expect OPEB liabilities to be largest in the Northeast and Midwest, where government entities have large unionized work forces and slightly older workers on average than in other areas.

• Finally, OPEB is still a major concern for the private sector. It is estimated that for the 337 companies in the S&P 500 that have OPEB obligations, the funding ratio is around 27% (versus 88% for pensions). For the 282 companies with the most complete financial records, the unfunded liability in 2005 was estimated at $292 billion versus an unfunded pension liability of $149 billion. OPEB liability is concentrated in Ford and GM. Their unfunded liability alone is $94 billion, representing 32% of the S&P 500’s total. (These two companies also have 13% of the total pension underfunding.) Telecom is the other industry where OPEB is a significant issue.

In the end, dealing with OPEB will require considerable skill, particularly if governments are intent on trying to reduce retiree benefits or increase retiree contributions. Neither option will be politically popular, and both have the potential for reducing the appeal of public service to potential workers. OPEB will also further squeeze state and local budgets, making reductions in discretionary programs such as economic development and higher education more likely. For the U.S. economy as a whole, a concern is that any reduction in public sector health care coverage will place further burdens on the Medicare system. What is clear is that the combination of pension and OPEB liabilities will be the source of much discussion in state capitols and town halls for some time to come.

Suggested reading on OPEB:
The GASB 43 and 45 Reporting Guidelines For Other Post Employment Benefits: A Civic Federation Issue Brief

The Economist, “Clearly Unhealthy”, 7/2/2005, Vo. 376, Issue 8433, pp 65-66.

Standard & Poor’s, “Funding OPEB Liabilities: Assessing the Options”, December, 14, 2005.

Fitch Ratings, “The Not So Golden Years: Credit Implications of GASB Statement No. 45.”

Posted by Mattoon at February 17, 2006 3:42 PM

Comments

I'd like to see more literature on the growing OPEB situation. I'm particularly interested in how companies can reneg on OPEB promises to those with 30 years at a company while still awarding large benefits to top executives with only 5 years. . . . America has never faced this type of issue. . .how will judges handle suits (if any) against compaies? What will be public policy re: companies that can't keep promises made 30+ years ago? How will America take care of the aging the population with the costs of care and living skyrocketing?

Posted by: Jeff Koblenz at July 17, 2006 4:46 PM

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