United States: The City of Gainesville Issues the First Other Post Employment Benefits Bonds (OPEB) in the Country

The City of Gainesville’s Taxable Other Post Employment Benefit Bonds, issued in July 2005, are believed to be the first bonds in the U.S. sold to fund an unfunded actuarial accrued liability for a local government’s retiree medical plan. The city’s sale was prompted at least in part in response to new requirements released last year by the Governmental Accounting Standards Board (GASB) under Statement No. 45 (GASB 45) which are being phased in through 2008. Under GASB 45 local governments will be required to account for retiree health care benefits and other post employment benefits (OPEB) in a similar manner to that already required for pension benefits. Once phased in, GASB 45 will require, for the first time, local governments to show on their financial statements the accrued liabilities of their retiree medical plans and OPEB that are provided. GASB 45 will establish standards for the measurement, recognition, and display of retiree medical plans and OPEB, related expenses/expenditures and related liabilities, note disclosures and required supplementary information, when applicable, in the financial reports of local governments’ financial statements.

Currently, most local governments fund their retiree medical plans on a pay-as-you- go basis as a current operating expense, and reflect such expenses on their financial statements in the fiscal year in which payments related thereto are made. Therefore, most local governments have not deposited enough (or any) moneys to pay for the unfunded liabilities. Under GASB 45, local governments who provide other post employment benefits, which include retiree health insurance, will be required to begin showing the accrued liabilities associated with OPEB on their financial statements and whether, and to what extent, progress is being made in funding the liability. (Plans with less than 100 plan members will be allowed to use a simplified alternative measurement method instead of obtaining actuarial valuations.) A contribution by a local government into a retiree medical plan which is less than the annual required contribution will result in a net OPEB cost, which will now be required to be recorded as a liability in the local government’s financial statements. Depending on the type of plan, the footnotes to the financial statements may be required to include, among other things, the funding policy, contributions made in comparison to the OPEB cost, changes in the net OPEB obligation, the funded status of the plan, a schedule of funding progress, and methods and assumptions of the actuarial valuation. GASB 45 is being phased in beginning in fiscal years commencing after December 15, 2006 for governments with annual revenues greater than $100 million, in fiscal years commencing after December 15, 2007 for governments with annual revenues between $10 million and $100 million and in fiscal years commencing after December 15, 2008 for governments with total annual revenues of less than $10 million. However, GASB is encouraging governments to undertake early implementation.

Many governments have already been required under state law to have actuarial valuations performed on their retiree medical plans. For instance, under Florida law, local governments who want to self insure their retiree medical plan must demonstrate to the Office of Insurance Regulation the actuarial soundness of the plan. In seeking approval of its plan, a local government must show a plan to amortize any unfunded liabilities and a description of actions taken to reduce unfunded liabilities (Section 112.08(2)(b), Florida Statutes). What is new is that under GASB 45, local governments’ will now be required to show the unfunded liabilities on their financial statements. According to the report issued by Standard & Poor’s, it is expected that the magnitude of unfunded OPEB liabilities could be quite large with some issuers totaling in the billions of dollar.

Although GASB cannot require compliance by local governments, doing nothing is not a viable alternative for local governments. For starters, auditors will not issue clean opinions if GASB 45 is not complied with. Furthermore, rating agencies have recently begun scrutinizing the unfunded liability of retiree medical plans. The Standard & Poor’s report notes that there is great concern over how quickly OPEB costs have increased. FitchRatings reports that over time, failure to plan for funding might have a negative impact on an issuer’s credit rating. Conversely, Fitch assigned the City of Gainesville an AA- implied GO Rating, citing in part the proactive approach the city has taken in addressing their OPEB unfunded liability. Inaction by local governments could impact the overall credit rating of the issuer and hamper their ability to access the financial markets.

Another option for local governments is to make their minimum annual required contribution. Some local governments who have been paying retiree medical expenses on a pay-as-you-go basis may not have the revenues to make the annual required contributions. The annual required contribution for many local governments with large unfunded liabilities may be substantially higher than current plan expenses. Furthermore, local governments risk that the unfunded liability will continue to grow, thereby putting increased pressure on those governments to make larger annual required contributions.

Reducing benefits for current retirees is often not a viable option for local governments, due to legal and political constraints. Many local governments’ medical plans provide that benefits may be unilaterally changed by the plan sponsor. But unlike pensions, the law pertaining to retiree medical plans is not well defined. For example, Florida courts have routinely held in regard to pensions that once a plan’s member retires that the plan may not thereafter be adversely amended. Therefore, assuming the courts found that a retiree medical plan is comparable to a pension plan, local governments would be prohibited from reducing or eliminating benefits currently provided to retirees in an effort to avoid or reduce its liability. Furthermore, reducing benefits to current or future retirees may be limited by labor agreements, state law, and not to mention, the political risk to politicians who propose such a course of action.

Local governments who are authorized under their state and local laws can issue taxable OPEB bonds to fund all or a portion of the unfunded liability, in a manner similar to the issuance of pension bonds to fund the unfunded liability of a pension plan. But the future liabilities of retiree medical plans are dependant on factors not present in pension valuations, and which are more difficult to accurately predict, such as the cost of medical care more than four decades away and changes to federal medical benefits.

Local governments issuing OPEB bonds to fund all or a portion of their plan’s unfunded liability may recognize several benefits. First, issuers may expect that in today’s low-interest environment that the total debt service payments on their OPEB bonds and the annual required contributions will over the long term, be lower than the annual required contributions that would have been required had the issuer not issued bonds. The lower debt service payments would free up general revenues of the issuer for other governmental uses and/or provide an option for governments who would otherwise have insufficient revenues to make their annual required contributions.

Second, issuers may expect that the investment returns on the retiree medical plan trust funds, funded in part with bond proceeds, will exceed the interest expense on the bonds. Issuing bonds will, however, result in the unfunded liability (which would increase or decrease in future actuarial valuations), becoming a fixed cost. To some issuers, this leveling of future payments may be an additional benefit by facilitating future budgeting. However, as noted by Fitch, OPEB or pension funding bonds create a true debt, one which must be paid pursuant to a fixed schedule, rather than a liability that could be adjusted during periods of fiscal stress.

Issuing bonds does not remove the risk that future unfunded liabilities will exist. New unfunded liabilities may surface if the investment returns on the retiree medical plan’s trust fund are lower than the actuarially estimated returns and/or if any other underlying actuarial estimates are not met (i.e. future plan expenses are higher than actuarial estimates).

In light of the recent scrutiny of unfunded pension liabilities, it is not surprising that attention has now turned to the potentially large unfunded liabilities of retiree medical plans and OPEB. Investors’ concerns over the large unfunded liabilities of retiree medical plans and local governments ability to pay for these liabilities could negatively impact local governments’ access to the financial markets through either higher interest rates or more restrictive requirements being imposed by investors. Without a plan to fund the unfunded liability, the liability may balloon due to increasing medical costs, longer life spans, changes in federal medical benefits, and lower than expected investment returns. Rating agencies will continue to scrutinize local governments’ plans to deal with the ballooning costs of retiree medical plans and other post employment benefits. An option for many local governments faced with large unfunded liabilities may be to fund all or a portion of this liability through the issuance of OPEB bonds.

Holland & Knight acted as Bond Counsel to the City of Gainesville’s Taxable Other Post Employment Benefit Bonds, issued in July 2005.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.