New ways to manage retiree benefits

New ways to manage retiree benefits - Splash

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How Milliman's experienced actuaries reduced a first-year contribution from a budget-busting $19 million to a manageable $1 million.

Right now, municipalities across America are confronting a multimillion-dollar problem. It could be a city or a town, a school district, a police or fire department, or a hospital. With GASB 45 rules in effect now for all public employers, administrators need to measure and disclose their liability for "other postemployment benefits" (OPEB), which is to say, the cost of providing retiree medical, dental, prescription drug, life, and disability coverage.

Avoiding sticker shock

Becky Sielman, principal and consulting actuary in Milliman's Hartford, Connecticut, office, says she frequently encounters scenarios similar to this one: A town solicits bids and hires a local actuarial firm that promises to do the job for the lowest cost. The firm identifies all the liabilities. It presents its findings and—guess what? The municipality has accrued liabilities of $203 million and an annual required contribution of $19 million. If you’re the mayor, you've got GASB 45 sticker shock. Fortunately, that's not the end of the story. As Becky points out, "You can't just stop when you get your first set of numbers because they don't tell the whole story."

Becky and her colleagues at Milliman have extensive experience in employee benefits for public and private entities. She notes that many actuarial firms have sprung up recently, describing themselves as GASB 45 specialists. But a municipality can find itself in a serious situation if its consultant doesn't command the range of strategies needed to set up a smooth transition to a GASB 45 regime. "The biggest hurdle is that first year," says Becky, "and that's exactly what we set out to do with our clients: create a plan to make that first year manageable."

Here's a quick review of the four steps Becky and her team used to reduce one town's first-year contribution from $19.3 million to $1 million.

Step 1. Prefunding cuts liability calculation in half

First, the town listened to Becky's discussion of the benefits of prefunding, as opposed to addressing its OPEB liabilities on a pay-as-you-go basis: Establishing an OPEB trust (comparable to a defined benefit pension fund) would harness long-term investment returns and improve the town’s status in the eyes of credit-rating agencies. And it would provide the immediate benefit of a higher discount rate in calculating the town’s accrued liability. "Normally," says Becky, "the liability gets cut in half." But in this case, by committing to prefunding its OPEB benefits, the town earned a 40% reduction, to $122.4 million—with a corresponding decrease of $5 million in the annual contribution, reducing it to $14.3 million.

Step 2. Choose a more favorable amortization policy

Rather than using "level dollar amortization," which works like a flat-rate mortgage, Becky recommended that the town utilize "level percent of pay funding." This is an amortization technique that starts with smaller payments, which increase over time in step with the cost of other benefits and compensation. Level percent amortization reduced the annual contribution by almost $4 million, down to $10.6 million.

Step 3. Scrutinize the budget

Becky notes that "municipalities are already paying a significant amount for retiree medical benefits out of their current budget. These expenditures may be hard to spot because they are often buried, along with medical costs for active employees. But the municipality is still paying for them, nonetheless." In this example, Milliman identified $5 million in OPEB costs already in the budget, reducing the amount needed in new contributions to $5.6 million.

Step 4. Phase in over several years

The final adjustment comes from understanding the dynamics of the municipal budget process. Basically, it is much more difficult to add a new line item than it is to increase an existing one. That's why Becky and her team recommended a five-year phase-in period. This allowed the town to start with a politically palatable—and otherwise manageable—initial contribution, and then increase it in regular annual increments. The phase-in strategy allowed the town to begin with an annual contribution of $1 million.

Attention will increase as GASB 45 implementation phases in

The current economic situation has pushed GASB 45 to the back burner for many municipalities, as they grapple with the more immediate problems of shrinking revenues and higher demand for services. In this environment, rating agencies may be more lenient with plan sponsors who delay tackling their OPEB costs. But the OPEB benefits are here to stay, and GASB 45 shines a bright light on just how much those benefits cost. Once the economy improves, public employers will face renewed pressure to manage their OPEB costs effectively. As Becky observes, "We don't know yet if there will be credit downgrades as a result of GASB 45. But I expect that is about to start happening; I think we’re going to start hearing about these enormous numbers causing major headaches."