other post-employment benefits (“opeb”) pre-funding opeb prefunding.pdfother post-employment...

© PFM 1© PFM 1© PFM 1

Other Post-Employment Benefits (“OPEB”)

Pre-FundingJohn C. Robinson, CTP

Senior Managing ConsultantMulti-Asset Class Portfolio Strategist

PFM Asset Management LLC. 221 West 6th Street

Suite 1900Austin, Texas 78701

737.600.1269pfm.com

December 4, 2017


Objectives

• What is OPEB?

• Implications of New GASB Rules

• Benefits of Pre-Funding a Trust

• Types of Trusts

• Creating an Investment Program

• Appendix: OPEB and GASB Rules “Cheat Sheet”


I. What is OPEB?


What is an OPEB?

Form of deferred compensation

Promise to provide retiree benefits must now be accrued during the working years of employees

Post-retirement benefit other than pension

• Including:

• Retiree medical, life, vision, dental

• Implicit retiree medical subsidy

• Not Including:

• Early retirement incentives, severance based on unused sick pay, vacation and compensated absences

Multiple funding options


Losing Purchasing Power

Inflation Rate(Core PCE)

Inflation Rate(Core PCE)

Investment Rate(3 month Treasury)

Investment Rate(3 month Treasury)

0.00

0.50

1.00

1.50

2.00

2.50

Jan-2009 Apr-2012 Jul-2015

Perc

ent (

%)

3.00Healthcare

CPIHealthcare

CPI

Source: Bureau of Labor Statistics


OPEB Funded Ratio Distribution

ME

NY

PA

VAWV

NC

SC

GA

FL

ALMS

TN

KY

OHIN

MIWI

IL

MN

IA

MO

AR

LATX

OK

KS

NE

SD

NDMT

WY

CO

NMAZ

UT

ID

NV

CA

OR

WA

AK

HI

Note: Oklahoma does not report implicit subsidy of its retirement plan death and disability benefits as a separate unfunded OPEB. Nebraska and South Dakota do not offer other OPEBs.

Source: Standard & Poor’s 2016

5% - 10%1% - 5%0% - 1%0% Funded 40% - 60%20% - 40%10% - 20% Above 60%


Healthcare inflation rate historically outstrips CPI

Medicare Age increases result in higher liabilities

Affordable Care Act does not relieve employers of liabilities

Many public OPEB liabilities have grown significantly

Government employers are required to comply with GASB

New GASB rules will force governments to recognize liabilities on the

balance sheet

Considerations


II. Implications of New GASB Rules

© PFM 10© PFM 10© PFM 10

In 1994, GASB established standards for public pensions, but not OPEB

benefits

Cash outlays vs. OPEB costs earned by employees

GASB No. 43, No. 45 issued in 2004

Background

© PFM 11© PFM 11© PFM 11

GASB 45 Creation In June 2004, the Governmental Accounting Standards Board (“GASB”) published Statement No.

45 Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than

Pensions Other Post-Employment Benefits (“OPEBs”) are compensation for employee services that are

realized at some point in the future

Why GASB 45? Postemployment healthcare benefits pose significant costs for most governments

Postemployment healthcare benefits are the most common form of OPEBs Current pay-as-you-go financial reporting fails in regard to OPEBs for several reasons, including:

This type of reporting does not recognize the cost of benefits in periods when they were earned, and

Current reporting fails to provide assessment of future cash flow needs and demands.

GASB 45-Regulations

Source: GASB website; www.gasb.org/st/summary/gstsm45.html

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Phase Government Size (by revenue)

Implementation Date

Phase 1 $100 Million December 15, 2006Phase 2 $10 - 100 Million December 15, 2007Phase 3 Less than $10 Million December 15, 2008

Implementation Timeline

What does GASB do?

GASB 45 states that the cost of OPEBs should be associated with the periods when

benefits are paid or provided

GASB requires governments to report annual OPEB costs as well as unfunded actuarial

accrued liabilities for past service costs

This increases accounting reporting transparencies related to the costs associated

for services provided

GASB 45-Regulations


© PFM 13© PFM 13© PFM 13

GASB Statements 74 & 75 replaced GASB 45 in June 2015

Applies same structure and approach to OPEB

Removes Annual Required Contribution (“ARC”) from statement thus divorcing accounting from funding

Updated GASB Accounting and Reporting


Defines more conservative assumptions and variables

Creates broader transparency into total accrued liabilities

Discount rate assumptions will be somewhat more defined

Introduces the concept of ‘depletion’ into the liability discounting process

Significantly increases supplemental information disclosures

Requires participants in multi-employer plans (i.e., school systems that are part of a state-wide pension plan) to report significantly more information, and record a proportional share of the plan

GASB Statement

Required for FY starting after

Generally in Reports for FY

Ending

GASB 74 June 15, 2016 June 30, 2017GASB 75 June 15, 2017 June 30, 2018

© PFM 14© PFM 14© PFM 14

GASB requires that the OPEB valuation be included on a balance sheet as a long-term liability

Given the current ratings environment, an increase in long-term liabilities related to OPEBs may negatively affect bond rating

Cash designated to cover an OPEB liability will not reduce the OPEB liability on the balance sheet unless invested in an irrevocable trust

Investing in equities is one way to increase the actuary’s assumed rate of return and may lower the amount of funds that must be invested

How GASB 74 & 75 Impact Annual Financial Reporting

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GASB 74/75 – Impact on FinancialsGASB Change Expense

VolatilityImpact on Liabilities

Unfunded liability on balance sheet –

Accrued unfunded liability recognized immediately –

Lower discount rate

ARC requirement eliminated ? ?

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OPEB Balance Sheet Change Illustration

Under GASB 74/75 , the Net liability will be reflected in the balance of the CAFR versus being shown in the notes of the CAFR.

Illustrative Purpose Only

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III. Benefits of Pre-Funding a Trust

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Common Funding Strategies

PAYGO (“Pay as you go”)

Internal Service Fund “Reserve”

Advantages Disadvantages• Convenient• Possibly cost effective

• Creates largest liability• Guaranteed loss to inflation• Does not address problem

Advantages Disadvantages• Can match assets with liabilities,

address inflation• Assets revert to General Fund• Can use funds if needed

• Limited solution• No GASB benefits (full liability

remains)

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Common Funding Strategies

Irrevocable Trust

Advantages Disadvantages• GFOA best practice*• Allows investment in higher

return securities• Better mediation against risks of

healthcare inflation and Medicare age increases

• GASB reporting benefits• Minimizes liability on financial

statements

• May require higher budget commitment upfront

• Requires outside assistance• Ongoing budgetary commitment

* http://www.gfoa.org/establishing-and-administering-opeb-trust

© PFM 20© PFM 20© PFM 20

Why Pre-Fund OPEB liabilities? GASB 74 & 75 make OPEB a long term liability, which must be

reported in the annual financial report Multiple outside entities use the annual report to assess the

creditworthiness and financial soundness Auditors Ratings Agencies Investors and Creditors Public Agencies

Funding liabilities now avoids pushing the funding problem onto future generations of boards and administrations Taking advantage of higher discount rate Potential reduction in budgetary appropriation Possible lower funding cost Funding compensation/benefit package for employees

Funding Your OPEB Liabilities

© PFM 21© PFM 21© PFM 21

$7,612,255

$5,427,433

$3,869,684

1,000,000

3,000,000

5,000,000

7,000,000

9,000,000

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Now 5 Years 10 Years

$1 million invested on day 1, assuming an annual return of 7%, will grow to $7.6 million at the end of 30 years*

The difference between investing now and investing in 5 years is $2.2 million in lost earnings Delaying of funding for 10 years could result in $3.8 million in lost earnings

Advantage of Funding Liabilities Now

*Example represents growth of original deposit at an annual earnings rate of 7%, which is an average long-term rate of return for a balanced fixed-income and equity portfolio; assumes no redemptions of funds.

Model returns may not reflect material economic or market factors.

Returns are shown before any fees.

Do not assume that the recommendations made in the future will be profitable or will equal the performance cited.

Growth of Initial $1 million Investment*Invest today vs. 5 years vs. 10 years

Years

© PFM 22© PFM 22© PFM 22

Discount Rates Under GASB 43/45 and GASB 74/75

A blended discount rate that reflects the

proportionate amounts of plan and employer assets

expected to be used to pay benefits as they come

due

“No single approach may fit all situations”

Blend the rate based on funded ratio

Blend the rate based on percentage of the ARC being

contributed

In many cases the actuaries seem to simply apply the investment return rate to the entire liability amount if the plan sponsor is making reasonable progress toward increasing the funded ratio and annual funding of the ARC

The plan and plan sponsor may continue to follow their

previous approach for funding purposes, but the reporting on

the GASB basis will be based on one standard:

The expected rate of return on plan assets, to the extent plan assets

are projected to be available for the payment of future benefits

The yield of 20-year, tax-exempt municipal bonds for the remainder of

future payments – which will be all future payments if there is no Trust

Based on the implementation of the GASB 67/68 standard, plan assets

will be projected to be available for the payment of future benefits if the

plan sponsor has an actual track record of contributing the full ARC

If there is not a track record of contributing the full ARC, as is likely in

the OPEB space, if there are assets the projected cash flows of

benefits, investment returns, employer and employee contributions

based on historical patterns, and the asset levels will be combined to

identify a potential “depletion date”

C u r r e n t S t a n d a r d : G A S B 4 3 / 4 5 N e w S t a n d a r d : G A S B 7 4 / 7 5

The rate is based on facts and circumstances of the client and final determination by the actuary.

We have greater ability to project a depletion date under the new standards, but still require the

particular financial and actuarial data of the client to do so.

© PFM 23© PFM 23© PFM 23

Moody’s State/Local

• Pre-funding of OPEB liabilities “moderately credit positive”

• Does not add OPEB directly to the scorecard; below-the-line adjustment if liabilities appear large relative to

budget and tax base and management has not addressed

S&P State

• Debt and liability scores include a score for OPEB risk assessment based on relative unfunded liability compared

to other states, an assessment of the flexibility to change the benefits, and strategy for cost management

S&P Local

• OPEB evaluation focuses on required contribution rather than unfunded liabilities

• Adds debt, pension, and OPEB contributions together

• To the extent that pre-funding reduces the unfunded liability by building assets and by enabling a lower discount

rate, the rating would be improved

Fitch

• Adds debt, pension and OPEB contributions together

• Pre-funding OPEB adjusts the debt and liability score upward

Rating Agency Treatment of OPEB

The exact benefit to the scorecard is based on the specific financial data of the client. In some cases

we can analyze the scorecard for a specific issuer and estimate an indicative score for that specific

category. In others the rating framework is more qualitative and estimating an indicative score is not

possible.

© PFM 24© PFM 24© PFM 24

Earn a higher rate of return than cash – more efficient use of resources

Reduce the unfunded liability that will be reported on the balance sheet following GASB 74/75 by:

• Dedicating assets to decrease Net OPEB Liability

• Allowing application of the higher discount rate to some portion of the liability

Offset the % growth in costs of the medical benefits by investing in long-term assets

The cost of the benefit is funded when earned, instead of passed to future taxpayers/ ratepayers

Benefits of an Irrevocable Trust

© PFM 25© PFM 25© PFM 25

IV. Types of Trusts

© PFM 26© PFM 26© PFM 26

GASB Rules for an OPEB Trust

Current GASB standards state that to be allowed as a direct balance sheet offset to

the OPEB liability, the OPEB assets must have the following characteristics:1

1. Must be irrevocable;

2. Remote from creditors; and,

3. For the exclusive benefit of participants and beneficiaries.

Remoteness from creditors has been widely viewed as having two components:

The trust is its own legal entity; and,

The employer and its agents do not exert specific control over investment of the

assets.

Employing a discretionary advisor assists in meeting the remoteness standard.

1Current GASB Standards 43 & 45

© PFM 27© PFM 27© PFM 27

Single Employer TrustSponsored by the employer

May be set up to accept:

• OPEB or pension contributions

Offers great customization to employers with unique needs:

• Documents

• Legal terminology and language

• Distributions

Offers an employer greater flexibility and control

© PFM 28© PFM 28© PFM 28

Sponsored by Plan Administrator and a Trustee Bank, or by two or more

governments

May be set up to accept:

• OPEB or Pension contributions

Multiple employers adopt the same trust

• Employer signs an adoption agreement to participate

• Each employer has a unique account (s)

May have lesser ability for customization

Offers an employer simplified, quick access

• e.g., no need to create a new legal documents

Multiple Employer Trust

© PFM 29© PFM 29© PFM 29

Single Employer vs. Multiple Employer TrustSingle Employer Multiple Employer

Governing Board Not required (but an oversight committee is)1 Not required

Set-up Start new (or existing trust) Existing trust

Documents Created new by attorney, or existing template Existing master trust (vetted)2

IRS Private Ruling Not required (IRC 115) Not required

Customization High May be limited

Investment Flexibility High May be limited

Control High May be limited

Fees Depend on level of assets Depend on level of assets1This group would oversee the trust from the employers perspective to ensure it continued to meet the employer’s needs (i.e., was prudent).2An adoption agreement and service agreement may contain customization options for employers.

© PFM 30© PFM 30© PFM 30

V. Creating an Investment Program

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7. Implement Plan and Oversee OPEB Assets

6. Determine the Appropriate Asset Allocation

5. Establish OPEB Trust

4. Evaluate Implications of Funding Choices

3. Designate Oversight Committee

2. Develop an Implementation Plan

1. Complete an Actuarial Study

OPEB Obligation Management Process

© PFM 32© PFM 32© PFM 32

Annual budget appropriation

Strategic funding allocation from the general fund investment portfolio

Appropriation of a funding amount from a one-time revenue source (initial

funding amount)

Some percentage of debt service savings for general fund

OPEB Trust Funding Options

© PFM 33© PFM 33© PFM 33

Develop Investment Policy Statement

Compile written Investment Policy Statement to

provide guidelines on:

• Investment Authority & Objectives

• Incorporate Asset Allocation Targets and Ranges

•Selection of Investment Managers

•Guidelines for Portfolio Holdings

•Performance Standards

•Control Procedures

Annual Investment Policy Review

Investment PolicyStatement

© PFM 34© PFM 34© PFM 34

2017 Capital Market Assumptions

For the intermediate term (up to five years), our capital market assumptions derive from our assessment of current economic conditions, including corporate profits, balance sheets, etc, and current valuations for various asset classes. Our long-term assumptions are derived using an economic building block approach that projects economic and corporate profit growth and takes into consideration the fundamental factors driving long-term real economic growth, our expectation for inflation, productivity and labor force growth.

Expected Return Expected Risk Expected Return Expected Risk

US Equity 7.0% 17% 7.7% 16%

International Developed Equity

6.6% 18% 7.7% 17%

Em erging M arkets Equity

6.1% 24% 7.7% 20%

Core Bonds 1.5% 4% 5.5% 5%

Interm ediate Investm ent G rade

1.9% 6% 6.3% 7%

Em erging M arkets Debt

4.0% 10% 7.3% 10%

High Yield 4.8% 10% 6.8% 10%

Bank Loans 4.5% 6% 5.2% 6%

REITs 5.5% 12% 6.4% 12%

Private Equity Real Estate

6.8% 15% 7.7% 15%

Com m odities 3.9% 16% 5.3% 16%

Hedge Funds 5.9% 15% 7.3% 15%

Private Equity 8.7% 25% 9.6% 25%

Cash 1.9% 1% 3.3% 1%

Interm ediate: Next 5 Years Long Term Projections

© PFM 35© PFM 35© PFM 35

2017 Capital Market Assumptions, Cont.

Please refer to PFM’s 2017 Capital Market Assumptions for a complete description of the methodology used to develop these assumptions and important disclosures.

US Equity



Core Bonds

Interm ediate Investm ent G rade Corp


High Yield

Bank Loans

REITsPrivate

Equity Real Estate

Com m oditiesHedge Funds

Private Equity

Cash

US Equity 1


0.8 1


0.7 0.7 1

Core Bonds 0.3 0.2 0.2 1

Interm ediate Investm ent G rade

0.3 0.2 0.2 0.9 1


0.5 0.5 0.5 0.4 0.4 1

High Yield 0.7 0.5 0.5 0.4 0.4 0.4 1

Bank Loans 0.4 0.3 0.3 0.3 0.3 0.7 0.7 1

REITs 0.5 0.4 0.4 0.3 0.3 0.3 0.4 0.4 1

Private Equity Real Estate

0.4 0.3 0.3 0.3 0.3 0.2 0.4 0.2 0.8 1

Com m odities 0.1 0.1 0.2 0.2 0.2 0.3 0.2 0.2 0.1 0.1 1

Hedge Funds 0.6 0.5 0.5 0.4 0.4 0.3 0.4 0.4 0.4 0.3 0.2 1

Private Equity 0.7 0.6 0.6 0.3 0.3 0.3 0.5 0.2 0.4 0.4 0.1 0.5 1

Cash 0.1 0.1 0.1 0.2 0.2 0.1 0.1 0.2 0.1 0.1 0.1 0.1 0.1 1

Correlations

© PFM 37© PFM 37© PFM 37

Efficient FrontierBased on Long-Term Capital Market Assumptions

Exp

ecte

d R

etur

n

Expected Risk

Domestic Equity

International Equity

Alternatives

Fixed Income100 FI

20/8025/75

30/7035/65

40/60

50/5055/45

60/4065/35

70/3075/25

© PFM 38© PFM 38© PFM 38

Determine the Appropriate Asset Allocation

• Greater return potential (4% to 7%)• Invests in securities with return expectations to more closely match liability growth

• Actuary, Investment Advisor, and Board should determine the asset mix60%

40%

Multi‐Asset Class Portfolio

Stocks Bonds

© PFM 39© PFM 39© PFM 39

Your Board/Committee maintains fiduciary responsibility

Key Items to Update & Monitor:

Investment Policy Development

Portfolio Diversification / Risk

Investment Advisor Fees

Investment Fund Fees

Investment Performance

Implement Plan and Oversee OPEB Assets

Key Parties to Engage:

Finance Department

Actuary

Investment Advisor

Procurement

Custodian/Trustee

© PFM 42© PFM 42© PFM 42

• Pay As You Go (PAYGO)– Current year out of pocket claims and insurance premiums payable

• Actuarial Accrued Liability (AAL)– The existing liability for OPEB

• Unfunded Actuarial Accrued Liability (UAAL)– The existing unfunded liability for OPEB which is amortized over a period of years.

• Normal Cost– The cost of future benefits earned by employees in the current year. Annual Required Contribution

(ARC)

– Amortized Unfunded Actuarial Accrued Liability + Normal Cost.

• Net OPEB Obligation (NOO)– OPEB amount stated on balance sheet, cumulative ARC less qualifying OPEB assets.

Important OPEB Definitions (will change with new standards)

© PFM 43© PFM 43© PFM 43

GASB Rules for OPEB (1 of 4)Feature GASB 45 GASB 74-75 Potential ImpactOPEB Liability

The difference between the actuarial funding requirement (Annual OPEB Cost, AOC) and what was actually funded is recorded on the Statement of Net Position as a liability (or asset). The full liability is addressed in the notes and as supplemental information.

The entire net, or unfunded, portion of the OPEB liability will be recognized in the Statement of Net Position in the government’s financial statements.

Combined with the other changes from pronouncements 67, 68, 74 and 75, many governments that previously had a positive Net Position could be in a negative position following implementation.

Cost Allocation/ Expense Recognition

Six methods allowed including Projected Unit Credit, which is the prevailing standard for private pensions

The present value of projected future benefit payments will be attributed only through the entry age actuarial cost method using level percentage of payroll

The entry age actuarial cost method may result in a higher liability measure than the other measures that were previously allowed

© PFM 44© PFM 44© PFM 44

GASB Rules for OPEB (2 of 4)Feature GASB 45 GASB 74-75 Potential ImpactDiscount rate for Measuring Liability

A policy rate selected based on expected long-term investment returns

A hybrid of the current practice and the more conservative rules for private sector accounting, which are based on the cost of debt/other liabilities. The portion of benefit payments not expected to be funded by trust assets must be discounted using a high-quality tax-exempt 20-year general obligation municipal bond rate.

An increase in reported liability for the majority of plans that continue to fund OPEB as a pay-as-you-go expense, and for plans that are projected to deplete their funds.

Amortization of Accrued Liability

Unfunded liability could be recognized over open or closed periods of up to 30 years

The net unfunded liability accrued to date will be recognized immediately. Issuers and plans may continue to use alternate amortization methods for their funding policy.

The reported liability will increase significantly

© PFM 45© PFM 45© PFM 45

GASB Rules for OPEB (3 of 4)Feature GASB 45 GASB 74-75 Potential ImpactAmortization of Changes in Expense/ Liability

Open or closed periods of up to 30 years

Depending on the cause of the change, either immediate, five years, or a closed period based on the average expected remaining service life for actives and inactives

Increased amount and volatility of expense

Calculation of Expense

The AOC adjusts the ARC, based on normal cost and the amortization of accrued liability on an open or closed period of up to 30 years, for any cumulative unpaid ARC to date

The expense or change in net position is equal to a number of factors (service cost, interest, changes of benefit terms or assumptions, experience, etc.)

The ARC will no longer be a required calculation, and plans will have to set funding on an Actuarial Determined Calculation based on their choice of assumptions.

Annual expense will be more volatile. Funding policy will be separated from accounting, and more responsibility for setting funding policy and reporting funding progress will be placed with the plan and issuer

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GASB Rules for OPEB (4 of 4)Feature GASB 45 GASB 74-75 Potential ImpactReporting for Cost-Sharing Multiple-Employer Plans

Report only the contractual or statutory amount contributed to the OPEB plan as an expense

Will report OPEB expense, net liability, and the supporting actuarial data based on their proportionate share of the collective amounts for all governments in the plan

In conjunction with the similar requirement from GASB 67 and 68 this will be a major change for these employers and will provide information that the bond rating agencies have not been able to consistently incorporate into their ratings previously.

Asset Valuation

OPEB trust fund values can be smoothed over up to a 30-year period

Plan assets must be measured at market value as of the end of the reporting period

Net Liability and expense will be more volatile

Note Disclosures

Information on the plan, benefits, total Unfunded Actuarial Liability, and actuarial assumptions

Significantly expanded detail of actuarial assumptions, as well as sensitivity analyses for projected costs and investment returns, and ten-year historical data on liabilities, expenses, funding.

More extensive information on plan trends and financial position.

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DisclaimersAny investment advice in this document is provided solely by PFM Asset Management LLC. PFM

Asset Management LLC (“PFMAM”) is an investment advisor registered under the Investment

Advisers Act of 1940.

This material is based on information obtained from sources generally believed to be reliable and

available to the public, however PFM Asset Management LLC cannot guarantee its accuracy,

completeness or suitability. This material is for general information purposes only and is not intended

to provide specific advice or a specific recommendation. All statements as to what will or may happen

under certain circumstances are based on assumptions, some but not all of which are noted in the

presentation. Assumptions may or may not be proven correct as actual events occur, and results may

depend on events outside of your or our control. Changes in assumptions may have a material effect

on results. Past performance does not necessarily reflect and is not a guaranty of future results. The

information contained in this presentation is not an offer to purchase or sell any securities.