Case study: City reduces liability and cost by pre-funding Post Employment Benefit Trust

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By Charles Hodge | 26 September 2011

A city prefunded their Post Employment Benefit Trust (PEB Trust) to reduce the Annual Required Contribution (ARC) total liability and begin securing the benefits.

Issue: A city with a PEB trust wanted to secure benefits and reduce cost

A city had a Post Employment Benefit liability for retiree healthcare. Based on new requirements under GASB 45, beginning in 2006 they were required to calculate the actuarial accrued liability of these future benefits. Although they were calculating the value of that liability, they had not yet set aside assets to fund the future expense. Without a strategy for funding, the actuarial valuation was based on the expected return on assets expected to fund the benefit. For most governmental organizations this is the return expected on their general assets. General assets tend to be invested in short term, high grade investment vehicles such as treasuries, commercial paper, bankers acceptances, money market funds and CDs. This interest rate, or expected return on this type of investment, is low compared to a diversified portfolio of equity and fixed income assets. If they were to create a trust and develop an investment strategy they would be allowed under GASB to assume a higher expected return on assets and thus a higher discount rate. This higher discount rate would contribute to a lower accrued liability and a lower ARC. In addition, the city was worried that if they did not begin funding this rising liability it might adversely affect their credit rating and thus increase their interest cost in future debt issues. Their challenges were to establish a trust to prefund the liability and create an investment strategy to earn a higher rate of return and justify a higher discount rate.

Solution: Begin funding and invest for growth

By establishing a funding schedule and segregating assets, they could expect to earn a higher return on their asset to fund the liability as well as use a higher return assumption for the actuarial valuation (to lower the liability.) In order to use a higher return assumption on the assets, the portfolio had to be structured to earn a higher rate of return. Milliman worked with the city’s finance department to evaluate the governance of such a strategy and build a team of stakeholders to assist with the decisions related to funding the Post Employment Benefit Liability. Current benefits were set-up for “pay-as-you-go” so the trust was for those liabilities with a longer time horizon. The city established a trust and Milliman worked with the finance committee to establish an asset allocation strategy that will help them meet their goals over the long term. The plan was funded with assets (cash) set aside for this purpose. The final asset allocation was one of five considered, covering the range from low risk-low expected return (low equity as a percentage) to higher risk-higher expected return (higher equity allocation.) These portfolios included broad asset classes like intermediate fixed income, large-cap and small-cap equity as well as international equity. In addition, Milliman assisted with the selection of investment managers in each of the new asset classes. Milliman also assisted in the construction of an Investment Policy Statement that codified the process. Ongoing, Milliman will assist with the review of the asset allocation as well as reviewing the investment managers for risk and return.

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Outcome: Created discipline for investing and reduced liability by 54%

Without funding the trust, the expected return on the assets was equal to the city’s expected return on the short-term general fund assets. By funding the trust and building a diversified portfolio of equity and fixed income investments, the client now expects to earn a higher rate of return over the long-term, 7.5% compared to 4%. This higher expected return, along with a disciplined funding approach, reduced the present value of the future payouts by around 50%. The city is now confident they are addressing the Post Employment Benefit liability in a prudent manner that protects the employees who will receive the benefit as well as the city taxpayers who will ultimately fund it.