Question: Can you explain to me why our retiree benefits will cause us to make severe budget cuts and eventually could bankrupt our district?

Response: The costs involved with retiree benefits are normally not understood to be as costly as they really are. And since there are not any Education Code or other statutes specifically requiring that dollars be set aside instead of paying year to year, it is an area that has been severely ignored by many agencies until it is basically too late to keep up with the fiscal obligation. The Education Code sections that DO cover aspects of this subject include:

Section 42850: Gives the authority to establish a fund for retiree health benefits.

Section 42140: *Requires that districts shall certify annually to the governing board the costs of any unfunded benefits for retirees after the age of 65;

*Requires that the unfunded costs of retiree health benefits shall be based on an actuarial report that shall be conducted every three years;

*Requires reports to the county superintendent and other specific disclosures.

Funding retiree health and welfare benefits has been a major issue for many employers in both the private and public sectors. Because few employers are able to fund these benefits in advance, many have been using the "pay-as-you-go" method.

New Governmental Accounting Standards Board (GASB) standards 43 and 45 direct how state and local governments account for and report other post-employment benefits (OPEB) that are separate from pension benefits. The most common OPEB is retiree health benefits.

GASB is a not-for-profit agency that develops and issues financial and accounting standards for state and local government agencies. These standards are consistent with standards established by the Generally Accepted Accounting Principles (GAAP), which cover non-state and local government agencies.

Districts that fail to fund the new GASB requirement could experience reduced bond ratings when rating agencies review their financial statements, as these statements will have to account for an unfunded liability. Reduced bond ratings will result in higher issuance costs and interest rates. Financial statements will weaken over time unless the liability is reduced. A district’s ability to borrow and incur additional debt also could be affected. Failure to implement GASB 45 could result in an adverse opinion by a district auditor. Although the pay-as-you-go method is permissible, using it means that the growing liability will be unmatched by a reserve of equal value. While professional accounting standards do not require public agencies to set aside the funding, failure to do so will have fiscal and reporting consequences. Post-employment benefit costs continue to rise and incurring this type of debt should be avoided, if possible.

GASB 43, Financial Reporting for Post-employment Benefit Plans Other Than Pension Plans, provides financial reporting procedures (in the district’s annual audit report) for these benefits. GASB 45, Accounting and Financial Reporting by Employers for Post-employment Benefits, provides accounting procedures. The two statements are closely related are considered together in this report.

The two standards are phased in over three years, based on the governmental unit’s size. This is similar to the implementation for GASB 34. The phase in period for these new standards would span three fiscal years—2006-07, 2007-08 and 2008-09, with the larger districts/agencies phased in first, determined by ADA. The reporting standard is implemented before the accounting standard, so financial statement footnote disclosure will occur one year before the actual accounting changes are necessary. As with many new accounting standards, early implementation is encouraged.

The new reporting and accounting requirements were created to help districts realize how past negotiated retiree benefit commitments affect current and future budgets. The requirements also help districts accurately reflect the cost of those commitments in the years the costs are incurred (the years the employees work for the district). GASB 45 requires OPEB to be recognized as an expense and obligation, if applicable, on the LEA’s financial statements reported on the full accrual basis of accounting. This is for districts with any benefit structure for retirees, whether for a lifetime or some shorter time frame.

Future benefits result in a liability. Because most educational agencies have funded this liability on a pay-as-you-go basis, these new GASB reporting and accounting requirements will substantially affect financial statements. One of the requirements of these new standards is an actuarial determination of the liability and expense, which will be reflected in the district’s financial statements.

The new standards also require an amortization of the existing unfunded retiree benefit liability. This unfunded liability does not have to be booked in the first year of implementation. The amortization can occur over a period of time as long as 30 years. Statement 45 also establishes disclosure requirements for information about the plans in which an employer participates, the funding policy followed, the actuarial valuation process and assumptions, and, for certain employers, the extent to which the plan has been funded over time.

The actuarial valuation involves using the following to make certain calculations related to the plan:

     · Actuarial cost method – Several acceptable actuarial cost methods are available. The district will need to discuss these with its actuary to determine whether there are inherent advantages or disadvantages in the method used.

     · Actuarial assumptions – These include demographic information (such as employee life spans, marriage status and termination status) and economic data (such as current and future investment returns and cost trends).

     · Plan assets – These must be transferred to an irrevocable trust to be counted as part of the funding available to pay the plan liability. Plan assets are reported based on market values (either at a specific date, or an average over the reporting period).

     · Employer census data – These consist of demographic data related to eligible plan members.

The actuarial report will result in the district’s annual required contribution (ARC), which is the district’s accrued expense (and related liability) in its current year financial statements. Although labeled as a contribution, the district may choose not to fund the ARC, resulting in an unfunded liability. The ARC has two components:

     · The normal cost – The current actuarial cost of the retiree benefits earned by employees in the current year.

     · Amortization of the unfunded prior liability – The amortization of the prior unfunded employee benefits liability for a period of up to 30 years.

After the prior unfunded liability has been totally recognized, the ARC will consist solely of the current year’s actuarially determined costs of the benefits. Contributions toward the annual cost are made through premiums paid to the insuring agency and through contributions to an irrevocable trust (Fund 71), whose assets are held for future premium payments. One advantage of establishing an irrevocable trust is that the annual actual costs (normal costs) of the retiree benefits can be charged equitably to all programs, including categorical programs. Under the pay-as-you-go funding method, the unfunded liability unfairly burdens the unrestricted general fund. This method also drastically understates the actual cost of each district employee. The cost lags considerably because expenses are not recognized until the employee actually retires. All other employee costs are expensed during their employment lifetime.

As a result of these new accounting standards, educational agencies will need to make several decisions and take actions as follows:

     · Discuss the various actuarial methods with its actuary to determine which will best meet the district’s needs.

     · Determine whether categorical funds will be charged an equitable portion of the ongoing cost as well as the amortization of the prior unfunded liability.

     · Review the current unfunded OPEB liability and determine the period of amortization. The standards allow up to 30 years. The amortized liability and expense will be reflected in the entity wide audited financial statements and will reduce net assets.

     · Determine the actual funding level of the ARC. The current method will result in a cumulatively larger unfunded liability. This is an important cash flow issue, but it will not affect the actual expenditure level.

     · Establish an irrevocable trust if it is decided that funding levels will be established to at least partially address the annual cost exceeding the annual premiums. If an irrevocable trust is not established, any amounts set aside to fund the liability will not reduce the reported liability.

     · Communicate the results of these new standards to interested parties, including board members, the public, financing institutions, employees, and unions.

     · Determine whether the district can afford retiree benefits at the current level. Although any changes must be negotiated with employee unions, the discussion must occur at some point due to the significant effect on the district.

According to the Office of Management and Budget, Circular A-87, Cost Principles for State, Local, and Indian Tribal Governments, post-retirement health benefits may be equitably charged to federal categorical funds based either on the pay-as-you-go method or on the actuarially determined GAAP compliant expense as long as an irrevocable trust is in place. Specifically, the circular states that to be allowable in the current year, the PRHB (post-retirement health benefit) costs must be paid to one of the following:

     · An insurer or other benefit provider as current year costs or premiums, or

     · An insurer or trustee to maintain a trust fund or reserve for the sole purpose of providing post retirement benefits to retirees and other beneficiaries.

This circular goes on to state that an equitable portion of the prior unfunded liability also may be charged to federal funds, as follows:

     When a governmental unit converts to an acceptable actuarial cost method and funds PRHB costs in accordance with this method, the initial unfunded liability attributable to prior years shall be allowable if amortized over a period of years in accordance with GAAP, or, if no such GAAP period exists, over a period negotiated with the cognizant agency.

Educational agencies, therefore, could charge a pro-rata share of the cost of these benefits, including amortization of the prior unfunded liability, to categorical programs, as long as all amounts that exceed the pay-as-you-go level are deposited to an irrevocable trust. Although no such guidance exists for state categorical funds, the state often follows the same guidelines set forth for federal grants.

The circular does not provide specific details on how categorical programs can be charged for retiree liabilities, so the district may generate its own method. The most acceptable methodology found across the state is basing the pro-rata rate on all relevant salaries. Based on GASB 45, it seems permissible to charge a rate on current costs as well as a phase-in (amortization) of the prior liability (which will probably be amortized over 30 years by most districts). The amortized liability and expense will be reflected in the entity-wide audited financial statements and may reduce net assets.

The chosen methodology should be fair and equitable to both categorical and unrestricted funds and should be consistently and uniformly applied to all district operations. It will be charged just as other payroll costs are charged based on a rate on relevant payroll (i.e., lifetime benefits should be based only on teachers’ salaries if only teachers have lifetime benefits). Whatever method the district chooses, it should be fully documented and the records retained indefinitely. In addition, the rate should be recalculated each time a new actuarial report is received. Documentation is crucial because these new requirements will receive much attention in the near future. Also, as more districts implement the new standards, it will be possible to see what different methodologies other districts are using.

Costs for retiree health and welfare benefits increase based on both the number of new retirees and the annual increases in health and welfare benefit costs. The annual cost increase can be enormous. If a district does not set aside the future costs of those benefits at the time an employee retires, the costs will encroach significantly on future district revenues. Unfortunately, some districts have accrued-but-unfunded costs for prior retirees to an amount that exceeds even the total annual revenues of the local agency. Some of those districts are funding "pay as you go" costs for retiree benefits--retirees from dozens of years earlier--that are equal to 5% of the district's current-year income. It is absolutely appropriate that you cover the future costs for retirees with funds in the Retiree Benefit Fund. If you now collapse that fund and spend the one-time amount on today’s settlement, how are you going to cover tomorrow’s costs for the benefits you have already granted?