Dear Curious:
Yes! If your town has a retiree medical, or other post-employment benefits (OPEB) plan, it is a good idea to think about prefunding those benefits. Now you may be wondering what we mean by “prefunding” and how that works in practice, so let’s start there.
Many OPEB plans operate on a pay-as-you-go basis with no prefunding, meaning premiums and claims are paid from the municipality’s general assets and the budget reflects just the benefits that need to be paid out that year. There is no dedicated trust with assets set aside specifically to pay these benefits and there is no mechanism in place to reserve funds now to pay benefits in future years.
If you’ve been involved with a defined benefit (DB) pension plan, you’ve seen prefunding in action. With a defined benefit pension plan, the plan’s assets are held in a trust. The assets are invested in various types of investments, benefits are paid from the trust, and the plan sponsor makes contributions to the trust with the goal of having enough money in the fund to pay all of the benefits that have already been earned to date. The plan sponsor works with an actuary to develop a funding policy that would produce the annual contribution needed to reach this goal.
Prefunding your OPEB benefits would look very similar to prefunding pension benefits. Instead of having a cash account with just enough money to pay the plan’s premiums, claims, and expenses as they come due, you would be setting aside funds for benefits to be paid in future years in a systematic manner.
So why would you want to do this? There are a few reasons. The first is to lower your long-term contributions required to provide these benefits. Because the plan’s assets would be invested in the market, they would generate investment income. Plan benefits would then be funded by the investment returns in addition to the town’s contributions. And over the long term, the investment earnings are expected to make up a significant portion of the plan’s assets; a mature plan can expect to have about 60% of benefits paid by investment income.1 And every dollar paid for by earnings is a dollar you save in contributions!
Figure 1: Source of trust assets
The second reason to consider prefunding your OPEB benefits is intergenerational taxpayer equity. Ideally, today’s taxpayers should be paying for the benefits for the folks currently working for and providing services to the taxpayers. Of course, because a retiree medical plan pays benefits only once someone retires, paying for an active employee’s OPEB benefits today means prefunding those benefits. Without prefunding, today’s taxpayers are paying for the benefits of current retirees, who may have worked many years ago and possibly under a different benefit structure.
The third reason you may want to prefund your retiree medical plan is to improve the municipality’s credit rating. Rating agencies view a funded plan more favorably than an unfunded one. And depending on the size of the plan population and the plan provisions, the OPEB plan liability can be substantial. In many instances, it may be even greater than the pension plan’s unfunded liability because no assets have been set aside for OPEB.
The fourth reason prefunding can be attractive is that it provides some protection for the plan members, because there would be assets set aside to pay the promised benefits.
And finally, another positive outcome of a funded OPEB plan is a lower reported liability on the municipality’s financial statements. Without prefunding, governmental accounting standards dictate that liabilities have to be calculated using something like a municipal bond rate, which is currently in the 3.5% range. When a plan is funded, however, liabilities can be discounted based on the long-term expected return of the plan’s assets. That discount rate could range between 5% and 6.5% depending on how the assets are invested. And a higher discount rate means a lower liability—the liability measured at 6% might be half the size of the liability measured at 3%!
You may be wondering if there are any downsides to prefunding OPEB benefits. You should be aware that once you set up an OPEB trust, the money in the trust can only be used to pay plan benefits. You are not required to keep making contributions to the trust, but you cannot decide to use the funds for some other municipal project. And, as you might suspect, your annual contributions for the plan will increase initially from the current pay-as-you-go level. There will be a catch-up period where you will be working to fund all of the benefits that retirees and employees have already earned. You should work with your actuary to develop a sound funding policy and some contribution projections so you can better plan for the future. You can also consider phasing into the new funding policy contribution gradually to lessen the immediate budget impact. And as long as you maintain the annual discipline of making the recommended contributions, you will see the plan’s funding level steadily improve.
It is also worth noting that retiree medical plan liabilities tend to be more volatile than pension liabilities due both to the variability of healthcare costs and to the higher incidence of significant plan changes. If substantial plan changes are made and premiums drop, it is possible for the plan to become overfunded. You should work with your actuary to develop a funding policy that addresses this concern.
Lastly, moving to a funded model will require some effort and expense on your part. You will need to engage an attorney to write the trust document, an investment consultant to manage the investments, and a trustee or custodian to hold the assets. In some jurisdictions, there may be legal barriers to establishing a trust; there are a number of states where OPEB trusts simply aren’t possible. You may need an ordinance or change of statute to put the trust in place and you will need to establish who oversees the governance of the plan, similar to a pension board for a pension plan. Your actuary will calculate your annual contributions and provide you with the necessary reports.
Note that, in the first few years, when the trust does not have a significant amount of assets, you may want to continue to pay costs like claims and premiums on a “pay as you go” basis and to contribute only the excess of the Actuarially Determined Contribution (ADC) over the expected pay-as-you-go costs to the trust. Over time, however, as trust assets grow, you can start to pay all benefits from the trust and contribute the full ADC into the trust, exactly as you would with a pension plan.
Starting to fund a plan from scratch may seem like a daunting task, but as long as you stick with it (and the markets are kind to you!), you can make significant progress in a relatively short time. Figure 2 demonstrates the progress one municipality made on its OPEB funding through following a sound funding policy, controlling costs, and enjoying healthy asset returns.
Figure 2: One municipality’s funding progress
If you are interested in learning more, you should talk things over with your actuary about what the next best step is for your plan.
Your Milliman Actuary
This edition of Dear Actuary was written by Yelena Pelletier, ASA.
For more Dear Actuary articles, see prior letters here.
Do you have a question about your defined benefit pension plan? Write to us at [email protected].
1 NASRA (March 2022). Public Pension Plan Investment Return Assumptions. NASRA Issue Brief. Retrieved August 19, 2022, from https://www.nasra.org/files/Issue%20Briefs/NASRAInvReturnAssumptBrief.pdf.