OPEB Trust Structures NAST Treasury Management Conference

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OPEB Trust StructuresNAST Treasury Management
Conference

• December 3-6 2006
• David Rush

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GASB 45 Provides Several Financial Incentives to
Governments

• Pay-as-you go funding will not be a viable
  solution in the long-term
• Plan benefits should allow for a multi-year
  funding plan that results in the ultimate full
  funding of unfunded OPEB liabilities
• Modification of Benefits
• Employee Contributions
• Cap on State Payments
• Defined Benefits to Defined Contributions

Rethink Approach to Health Care Benefits

• Establishing an irrevocable OPEB Trust Fund will
  provide a significant financial benefit to
  governments
• With appropriate structure a higher discount rate
  can be used
• A higher discount rate results in a lower ARC
• Pension type investment alternatives provide for
  expected attractive earnings rates
• Asset swapping can provide for arbitrage
  opportunities

Establish an Irrevocable Trust

• Assuming the ability to invest in debt, equity
  and other pension-type products, funding the
  trust sooner will reduce the ARC
• The sooner funds are invested in the trust, the
  more earnings potential is available
• If funds are not set aside in a timely manner,
  there will be a significant and geometrically
  growing negative impact on the balance sheet

Fund the Trust Sooner Rather Than Later
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With No Trust Assets, Many Governments will
Experience a Significant Increase in Annual OPEB
Costs
Hypothetical OPEB Liability 1,000,000,000 Disco
unt Rate 4.25 Eligibility for Retirement
Rule of 65 OPEB Benefits 80 of Group Health
Care Costs until 65 100 of Medicare Part A, B
and D after age 65
OPEB UAAL Amortization No Trust Fund
Level Dollar Payment56.003 MM
Level of Payroll
Pay-as-you-go (Cash)
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Establishing a Trust will Reduce the Size of the
OPEB Liability

• GASB 45 provides specific guidelines on
  determining the amount of the OPEB liability
• Pay-as-you-go portions of plans or employer
  assets will use a short-term general fund
  investment rate (4 to 6) to discount benefits
  and determine the OPEB liability
• An OPEB plan administered as a dedicated and
  irrevocable Trust and which is invested similar
  to pension plans will use a higher discount rate
  (7.00 to 8.50) that is reflective of long-term
  return on plan assets
• The higher discount rate will significantly
  reduce the OPEB and result in a lower ARC

Note Reduction is dependent on plan structure
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The Trust Structure Significantly Reduces the
Portion of the ARC Associated with Amortization
of an Unfunded Liability
Savings from Using Trust Structure Level Dollar
Payment
Savings from Using Trust Structure Level Percent
of Payroll
Level Dollar Payment - No Trust (56.003 mm)
Level of Payroll - No Trust
Savings
Level Dollar Payment - With Trust (48.025mm)
Savings
Level of Payroll With Trust
Pay-as-you-go (Cash)
Pay-as-you-go (Cash)
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The Appropriate Trust Structure is Dependent on
the Issuers Objectives and Plan Parameters
Objective of Funding Vehicle

• Ability to earn pension fund type returns
• Trust earnings to be tax-exempt
• Employer contributions to the Trust are not
  taxable
• Benefit payments from Trust are not taxable to
  retirees
• Funds protected from creditors of employers and
  employees
• Excess funds applicable to reduce normal cost
  payments

Funding Vehicles Meeting Objectives

• Internal Revenue Code 401(h) accounts
• Voluntary Employee Benefit Association (VEBA)
• Internal Revenue Code 115 Trusts

In many states, new state law will be required to
allow for the establishment of an OPEB Trust
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A 401(h) Trust is a Separate Account within a
Pension Plan

• Set up as a separate subaccount under a defined
  benefit pension plan
• Can be used to pay various non-pension benefits
• Eligible benefit recipients include pension plan
  retirees and their spouses, dependents and
  beneficiaries
• Employer contributions are made with pre-tax
  dollars and it may be possible to incorporate a
  feature (with limitations) to allow employee
  contributions to be made pre-tax
• While, for accounting purposes 401(h) funds are
  separate from pension assets, they can be
  invested on a co-mingled basis
• Funding of 401(h) benefit obligations must be
  subordinate to the funding of retirement plan
  benefit obligations
• Subordination is not met if actual contributions
  for medical benefits and life insurance exceed
  25 of the total actual contributions to the plan
  (other than contributions to fund past service
  credits)
• Any overfunding in the pension plan can be
  transferred to the 401(h) subaccount
• After all benefit obligations are paid, any
  excess 401(h) subaccount funds must be returned
  to the employer

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A VEBA is a Tax-Exempt Organization Which Can
Accumulate Tax-Free, Income Producing Reserves to
Pay Benefits

• Set up as an employee association
• Established under Internal Revenue 501(c)(9)
• Membership determined by common association (can
  be broad)
• Written document establishing the Trust would
  require IRS approval. General parameters include
• Independent Board of Trustees (not controlled by
  employer or employee unions)
• Specification of benefits payable
• Can not be used to pay retirement or deferred
  compensation benefits
• Must meet nondiscrimination tests
• Limitation on ability to transfer assets
• Eligible benefit recipients include members
  determined by common association plus spouses,
  dependents and beneficiaries
• Employer and Employee contributions can be made
  with pre-tax dollars
• Can be established as defined benefit or defined
  contribution program
• If defined benefit, certain IRS limitations apply
  regarding levels of funding
• If defined contribution, no such limitations apply

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A Section 115 Organization Provides Tax-Exemption
for the Provision of an Essential Governmental
Function

• A tax-exempt organization closely affiliated with
  a state or local government
• Income is excluded from federal income tax
• Requirements are similar (but not identical) to
  exemption requirements under Internal Revenue
  Code 501(c)(3)
• Determination as to eligibility of exclusion of
  income from federal taxation is within the
  jurisdiction of the Associate Chief Counsel
  (Tax-Exempt and Governmental Entities) of the
  Internal Revenue Service
• Several IRS Rulings intimate that the
  establishment of a trust or other organization
  for the express purpose of funding OPEBs is an
  essential governmental function
• Private Letter Ruling appears to confirm
• Provides for a very flexible structure for
  funding OPEBS
• No express limitations on eligibility or
  participants
• No restrictions on funding
• No express restrictions on benefits
• Any structure implemented may have limitations
  based on what constitutes an essential
  governmental function

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Each Trust Alternative Has Advantages and
Disadvantages
401 (h) Trust
Advantages
Disadvantages

• Plan administered under existing pension plan
  infrastructure
• Excess pension plan assets may be used as a
  funding source
• While an account separate from the pension plan
  is required, investments can be co-mingled and
  allocated on a percentage basis

• Contributions to plan are limited to no more than
  1/3 of pension plan contributions
• Benefit payments are subordinate to pension
  payments
• Payments limited to retirees eligible for pension
  benefits

Voluntary Employee Benefit Association
Advantages
Disadvantages

• Flexibility to specify benefit paid
• Benefits not limited to retirees
• Administration independent of employer and union
• Contributions do not count against pension plan
  contributions

• Will require new infrastructure
• Requires IRS qualification
• Limitation on expenditures for a defined benefit
  program
• Employee contributions may be difficult to make

Section 115 Plans Can Be Tailored to Specific
Requirements
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Issues to be Addressed Prior to Implementing a
Trust

• Unlike pension costs, it is unclear whether state
  laws will treat OPEBs as an obligation imposed
  by law or as a softer obligation that can be
  changed
• Legal authorization may be required to provide
  the framework for OPEB accrual funding
• Legislation establishing one or more healthcare
  or health insurance trusts to administer OPEBs
  that is GASB 45 compliant may also be required

Legal Authority

• Depending on Current and Future Benefits, More
  than one Trust Structure may be required (Ohio)
• An infrastructure will have to be developed
  (other than 401(h)) to manage the trust and
  implement appropriate investment strategies
• Trust oversight will have several stakeholders
• States
• Local Government
• Beneficiaries
• Board Members

Selection of Trust Structure
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Bottom Line

• GASB 43 and 45 will increase most governments
  first year budget costs by 50 to 250 just to
  amortize the unfunded liability. The addition of
  Normal Costs will increase overall OPEB cost to
  between 300 to 500
• Establishing an appropriately structured trust
  for OPEB liability will reduce first year budget
  costs for the amortization of unfunded liability
  by up to 15
• Legislation may be required to allow the
  flexibility to implement a cost-effective plan
  for managing an OPEB liability
• Governments will be required to make many
  long-term and broad reaching policy decisions as
  they develop and implement their strategies to
  manage their OPEB liabilities