Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. How Consultants Determine Local Government Liability for OPEB Public Employee Forum on GASB Statement #45 February 7, 2007 J. Richard Johnson Senior Vice President Public Sector Health Practice Leader The Segal Company

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 1 What’s Different in GASB Financial Statement Disclosure?  In the past…  Annual outlay for retiree health premiums or benefit costs  Only took current retirees into account  Usually handled as a footnote  Going forward…  Actuarial valuation of retiree health liabilities  Reporting incorporated into financial statements –Annual Required Contribution (ARC) –Net OPEB Obligation (NOO) –Required Supplementary Information  Takes into account both active employees and retirees

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 2 Financial Statement Disclosure  Income Statement  Annual Required Contribution (ARC) –The Actuarial Accrued Liability (AAL) is the portion of the actuarial present value of total projected benefits allocated to years of employment prior to the measurement date –The Normal Cost is the portion of the actuarial present value of total projected benefits allocated to the year following the measurement date –The ARC is equal to the normal cost and the amortization of the unfunded accrued liability. –There is no requirement that the ARC is funded  Balance Sheet  Net OPEB Obligation (NOO) –The NOO is the cumulative difference between the ARC and the actual contributions made (if any). –At transition the NOO may be set at zero  Notes to Financial Statements  Generally similar to Retirement Supplement Information

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 3 What Benefits Are Included in OPEB Valuations?  Medical benefits  Dental  Vision  Prescription drugs  Life insurance  Legal services

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 4 What Goes Into the GASB OPEB Valuation? Employee and Retiree Data Actuarial Cost Method Funding and Financial Data Plan Provisions Actuarial Assumptions Actuarial Valuation Results Claims and Premium Cost

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 5 Calculation Begins with Starting Costs  Monthly claims and enrollment information for recent period of time (one to three years)  Includes active employees and retirees  Consider plan changes during the claim/enrollment period  Determine initial average cost – actives and retirees  True cost increases with age. Project starting costs to reflect “cost curve”  “Starting costs” are the true costs at age 65 for the following:  Male, pre-65  Female, pre-65  Male, post-65 (post-Medicare)  Female, post-65 (post-Medicare)

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 6 What’s Different in Rate Calculations? Traditional Rate Setting GASB Rate Determination POOL: Actives Retirees Medicare Retirees $500/mo RATES:Total Active$500 Pre-65 Retiree$500 Medicare Retiree$300 Active Employees Pre-65 Retirees Medicare Retirees ActualIMPLICIT RATES:TotalSUBSIDY Active$375$125 Pre-65 Retiree$675($175) Medicare Retiree$325($25)

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 7 Establish Methods and Assumptions  Funding methods  Allocate costs between normal cost and accrued liability  Methods vary in stability and funding pattern  6 methods available for GASB valuation  Actuarial assumptions  Need to match related DB retirement plan assumptions  Investment return assumption (discount rate) is dependent on funding –No pre-funding – use employer’s rate of return on assets (3%-4%) –Pre-funding – use rate of return on funded assets (7%-8%)  Healthcare cost trend assumptions –Based on experience of covered group –Reflects expected long-term future trends –Can differ by benefit –Typically starts at 10%-12%, then decreases 1% each year until ultimate level is reached (typically 5%)

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 8 What Issues are Public Employers Facing?  Health benefit costs are increasing much faster than general inflation  Health costs increase as an employee/retiree gets older  Limited ability to fund liability out of current revenue flow – will OPEB destroy the budget?  Large OPEB liability can impair jurisdiction’s ability to issue bonds  How to explain large retiree health liability to stakeholders and general public  To fund or not to fund?  How to balance competing revenue interests

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 9 ACTIVES AND RETIREES UNDER AGE 65 Source: 2007 Segal Health Plan Cost Trend Survey and U.S. Bureau of Labor Statistics. U.S. Projected Medical Trends (with Rx) Gap

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 10 What are Employers Doing to Address the OPEB Liability?  Getting an early handle on the GASB OPEB liability  Rethinking the programs  Eligibility and entitlement for retiree health benefits  Plan design changes  Looking at different subsidy approaches - separate for actives and retirees  Investigating pre-funding options  Retiree health trust options  Redeploying existing fund balances  Surcharging current employee and employer rates to build reserves  Using retirement plan assets for funding retiree health benefits  Balancing retiree health against other revenue sources and uses  Reviewing total pay and the balance between pay and benefits

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 11 June 30, 2009 GASB Timeline/Implementation Plan June 30, 2006June 30, 2007June 30, 2008June 30, 2010 FY2010 Deliver Final GASB Valuation & Financial Reporting Budget Estimate for FY2010 Data Collection Assumptions & Valuation FY2009 Deliver Final GASB Valuation & Financial Reporting Budget Estimate for FY2009 Data Collection Assumptions & Valuation FY2008 Planning & Analysis Initial GASB Liability Estimate Deliver Final GASB Valuation & Financial Reporting Budget Estimate for FY2008 Data Collection Assumptions & Valuation

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 12 Benefit Design Strategy to Manage Liabilities The Three “R”s of Cost Containment:  Redefining Eligibility Requirements  Tie retiree health eligibility to service levels  Consider institutional goals for work force planning  Review spouse coverage rules  Eliminate retiree health benefits to get rid of OPEB liability?

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 13 Benefit Design Strategy to Manage Liabilities continued The Three “R”s of Cost Containment:  Restructuring Benefits  Create new tier for new hires  Reduce benefits for future retirees  Review Medicare Coordination Method  Review Prescription Drugs –Leverage Medicare Part D –PDP vs. Subsidy –Eliminate Rx plan  Establish benefit caps  Look at underlying health plan to manage utilization and claim costs

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 14 Benefit Design Strategy to Manage Liabilities continued The Three “R”s of Cost Containment:  Rethinking Cost Sharing  Move to a flat dollar employer share  Increase retiree contribution  Tie benefit levels to service levels  Defined Contribution approach –Fund while employees are active

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 15 Key Decision: Pre-funding OPEB Requires Disclosure – NOT Funding Experience already shows moving from pay-go to pre-funding increases annual costs 3–6 times. 1 Debt Financing 3 2 Options Pre-funding Pay-As-You-Go 4 Combination

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 16 To Pre-fund or Not to Pre-fund?  No simple solution for all jurisdictions  Opportunity trade-offs  Pre-funding –Lower liabilities, better rating, lower cost of capital, higher current year costs  Pay-Go –Higher liabilities, potential lower rating, higher cost of capital, lower current year costs  Pre-funding requires clear set aside from jurisdiction accounts  Separate retiree health trust  Irrevocable trust within an existing health fund trust

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 17 Pre-funding Trade-offs Level of Pre-funding  Proportion of benefits pre-funded will dictate discount rate  Pay-go (no pre-funding) is risk-free rate – can base on internal ROI  Pre-funding can use a market rate used in similar retirement trusts Irrevocable or Not?  If funding vehicle is not irrevocable, jurisdiction cannot count assets as OPEB assets in the financial statement  However, full disclosure and discussions with rating agencies may help mitigate rating risk

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 18 Debt Financing OPEB Obligation Bonds  Taxable municipal “arbitrage” bonds  Trading soft debt for hard debt  First one—Gainesville, Florida  Does long term debt for retiree health make sense with future of nationalized health care unknown?  Insurance approaches paired with OPEB bonds  Life insurance policy purchase for active employees  Perception issues among elected officials re betting people will die as a way to fund retiree health  Complex, multi-tiered funding approach is difficult for taxpayer to understand

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 19 Pre-Funding VehicleMeritsShortcomings Employer General Asset Accounts  Simple set-up  Considerable flexibility in funding and plan design  Employee contributions only permitted on an after-tax basis  Use of account assets not restricted to plan purposes  Assets subject to the claims of general creditors.  Subject to certain nondiscrimination requirements State-Law Grantor Trusts (Integral IRC Section 115 Trusts)  Considerable flexibility in funding and plan design  Use of trust assets may be limited to the exclusive benefits of the covered employees and their families  Employee contributions only permitted on an after-tax basis  Varying state laws for establishment and governance of trusts  Subject to certain nondiscrimination requirements Voluntary Employees’ Beneficiary Association Trusts (VEBAs) **  VEBA assets and earnings specifically earmarked for the sole purpose of providing the intended benefits ( e.g., life, sickness, accident or other benefits) to members of the association or their dependents or designated beneficiaries  Considerable flexibility in funding and plan design  Employee contributions only permitted on an after-tax basis  Funding limits differ for bargained and non-bargained employees  Limits on types of benefits offered  Subject to certain nondiscrimination requirements Section 401(h) Retiree Medical Accounts within a Pension Plan***  Use of assets restricted to medical purposes  Pre-tax employee contributions permitted through a mandatory “pickup” arrangement in which all eligible employees must participate  On plan termination, excess assets revert to the employer  Possible employee dissatisfaction stemming from mandatory and irrevocable “pickup” arrangement  Additional administration required: separate funding and accounting for pension and medical benefits  Contributions limited to 33 1/3% of total retirement contributions. Sponsors of well- funded pension plans may not be able to make contributions because of this limit. Health Reimbursement Arrangements (HRAs)  Allows year-to-year carry-over of unused value  Encourages careful consumption of health care services  May discourage employee or dependent from seeking needed medical care now, resulting in potentially greater insured costs later  Additional administration required  Coordination of HRAs with Medicare may be problematic Health Savings Accounts (HSAs)  Vehicle for active employees to save for retiree health premiums  Account balance carries over and is portable if employee leaves  Employer may contribute to savings account to fund part of the high deductible  Employee/employer contributions are limited (Archer IRA limits)  Must be paired with a high deductible health plan ($1, 000 single/$2,000 family), retiree savings vehicle not available by itself  Low paid participants with significant health claims may not be able to have money left in account to carry over for retiree health premiums later  May discourage employee or dependent from seeking needed medical care now, resulting in potentially greater insured costs later  Additional administration required for savings and investment component Pre-Funding Options

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 20 How Does Retiree Health Fit Into Total Rewards? Employee Value Proposition Direct Financial Affiliation Work Content Career Indirect Financial  Organization commitment  Organization support  Work environment  Organization citizenship  Title  Base salary  Incentives  Ownership  Cash recognition  Premium pay  Pay process  Benefits  Non-cash recognition  Perquisites  Advancement  Personal Growth  Training  Employment security  Variety  Challenge  Autonomy  Meaningfulness  Feedback

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. 21 Looking Ahead – New Themes in Retiree Health Benefits  What can/should be done to ensure that health benefit promises made to retirees are kept?  What are acceptable trade-offs between generations?  Is it better to have pressure on bond ratings or pressure on current year budget?  How to balance among pay increases, pension benefits and retiree health benefits?  How important are retiree health benefits in light of total compensation?

Copyright © 2007 by The Segal Group, Inc., the parent of The Segal Company. All rights reserved. Questions? J. Richard Johnson