Preparing for the OPEB Tsunami

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National Association of State Auditors,
Comptrollers, and Treasurers

• Preparing for the OPEB Tsunami

August 22, 2006
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What You Need to Know
Under GASB 45, States will be required to account
for the cost of OPEB liabilities beginning with
financials for FY 2007-08

• GASB standard aims to recognize the true
  financial cost of benefits
• GASB 45 requires public sector entities to
  quantify and disclose but not fund their OPEB
  liabilities
• Under GASB, liability calculated using discount
  rate commensurate with funding approach
• Pay-Go plans use cash discount rate (3-4)
• Funded plans can use higher rate reflecting
  term/asset allocation (6-8)
• Higher discount rate ? lower unfunded liability
  (UAAL)

Effective Dates
Annual Effective for Fiscal Revenue
Years Beginning after gt 100mm December
15, 2006 10-100mm December 15, 2007 lt10mm
December 15, 2008
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OPEB Funding Has Moved to the Forefront

• Aggregate OPEB UAAL of the U.S. Public Sector
  estimated at 1 trillion
• Aggregate OPEB UAAL for the SP 500 292
  billion
• As the baby boomers retire, many issuers Pay-Go
  expense will double or triple over the next 10-15
  years
• ARC funding may be 3-10x the Pay-Go amount

Putting the OPEB UAAL in Perspective
4.3 Trillion Total U.S. Treasury Debt Outstanding
1.9 Trillion Total U.S. Municipal Debt
Outstanding
1 Trillion Estimated U.S. Public Sector OPEB UAAL
292 Billion Estimated SP 500 OPEB UAAL
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What is Driving the Tsunami?

• Demographics Typical average age of U.S.
  municipal workforce is 43-45 years of age
• GASBs rules compress a lifespan of benefits into
  employees remaining workspan

Typical Pay-Go Cashflow Forecast vs. ARC Funding
Remaining Career
Retirement
OPEB is fundamentally a cashflow issue
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Though GASB 45 is not Effective Until 2008
the Market is becoming an early adopter

• OPEB exposure/funding status is evolving as a
  critical credit metric.
• SEC has announced that issuers with actuarial
  knowledge must disclose now.
• Investors are beginning to talk about credit
  differentials.

Investors
The SEC
Issuers should include material information
about OPEB in disclosure documents as soon as it
is known, even if final numbers are not yet
available, Martha Mahan Haines, Chief of the
SECs Office of Municipal Securities, said this
week. GASBs effective dates for inclusion in
financial statements do not justify withholding
material information from investors.
As the new accounting rules are phased in,
localities disclosing especially high liabilities
could become vulnerable to downgrades of their
credit ratings, says Joe Mason of Fitch Ratings.
John Mousseau, a portfolio manager and tax-exempt
bond expert at Cumberland Advisors of Vineland,
N.J., thinks that yields on bonds from issuers
with heavy retiree health costs could rise
noticeably, compared to those on other bonds, as
prices fall.
The Bond Buyer, March 2, 2006
Barrons, March 13, 2006
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Developing a Credible Plan is Essential to
Protecting Your Ratings

• Rating agencies have generally acknowledged that
  immediate budgetary shift from Pay-Go to ARC is
  not tenable
• Transitioning to full ARC funding over 5-10 years
  seems to be a viable and ratings-neutral strategy
• Failure to adopt and implement a credible funding
  plan is likely to exert downward pressure on
  ratings

Standard Poor's
As part of Standard Poors rating analysis,
the status of an employers pension plans is an
important factor. Any competing obligations that
could weaken the ability of the employer to meet
bond debt service requirements may be a negative
credit issue . . . Thus, pension liabilities,
which include ongoing, annual servicing
requirements in the form of contributions from
employers, must be managed so as to not adversely
affect the employers credit profile. To the
extent that pension funding problems act to
decrease an issuers financial position or
flexibility, and these issues are not addressed,
they could exert downward pressure on
creditworthiness at least over the intermediate
term.
Standard Poors, February 22, 2006
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The Rating Agencies Are Increasingly Focused on
OPEB
Failure to confront OPEB liability may impair
credit ratings

• tantamount to bonded debt (SP)
• (may) constrain the credit quality of their
  sponsors (SP)
• will exacerbate fiscal pressure (Moodys)
• (we) will weigh the effect these obligations
  have on an employers ability and willingness to
  payits bonds (SP)
• their relative magnitude (may) adversely affect
  creditworthiness (SP)
• steady progress towards reaching the
  actuarially determined annual contribution level
  will be critical to sound credit quality (Fitch)
• Fitch will view OPEB liabilities like pensions
  indefinite deferrals are damaging to credit
  quality. While not debt, pension and OPEB
  accumulated costs are legal or practical
  contractual commitments that form a portion of
  fixed costs. Long-term deferral of such
  oblgiations is a sign of fiscal stress that will
  be reflected in ratings (Fitch)
• an absence of action taken to fund OPEB
  liabilities or otherwise manage them will be
  viewed as a negative rating factor (Fitch)

The light at the end of the OPEB tunnel is a
train SP
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Developing an OPEB Strategy
Bonds are the tail of the OPEB dog
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How Can OPEB Bonds Facilitate a Transition To ARC
Funding?

• Isolate and address OPEB liability, demonstrating
  pro-active financial management
• Pay true annual cost of providing OPEB
• Avoid negative ratings action
• Create Trust Fund from which benefits can be paid
• Funding legacy liability may provide
  constructive tool to facilitate transition to 2nd
  tier of benefits
• Take advantage of low interest rate environment
  and GASBs discounting rules to refinance
  liability in public market
• Reduce budget impact

Ideal Normal Cost UAAL Amortization lt
Pay-As-You Go Attaining this ideal can be
challenging for some agencies
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OPEB Bonds Whats the Right Metric?

• Solve against Pay-Go cashflow?
• The most real world scenario
• Solve against the ARC?
• Benchmarking against the ARCs time compressed
  cashflow may present significant budget
  challenges
• ARC forces a lifespan of benefits into much
  shorter funding window
• Solve in context of States macro-financial
  picture?
• Level of Budget
• Sculpted debt service

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Transitioning to ARC FundingNo Bonding
Example is for a state with a general fund budget
of 16.7 billion and a gross (Pay-Go) UAAL of
1.2 billion
Example Pay-Go Cost vs. Normal Cost UAAL
Amortization

• Absent OPEB Bond funding, ARC would be 2x greater
  than net Pay-Go cashflow in near-term

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Scenario 1 Level Savings vs. UAAL Amortization
Pay-Go Cost vs. Normal Cost Pro-Forma OPEB Bond
DS

• Assuming State funded its OPEB liability with
  OPEB Bonds, annual savings versus its UAAL of
  1.2 billion would be 30.6 million annually
• Bonds cost less than UAAL amortization, but Debt
  Service and Normal Cost payments exceed Pay-Go
  costs through Bond maturity (same period as UAAL
  amortization).

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Scenario 2 Level Savings vs. Pay-Go Cashflow
Pay-Go Cost vs. Normal Cost Pro-Forma OPEB Bond
DS

• Normal Cost OPEB Bond debt service could be
  structured to mirror Pay-Go cashflow, which would
  reduce the States annual cost by 3.9 million
  annually

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Scenario 3 POBs Structured at Level Percentage
of Budget
Pay-Go Cost vs. Normal Cost Pro-Forma OPEB Bond
DS

• Assuming ARC funding levels, State would pay
  0.63 of General Fund revenues (with 4 annual
  revenue growth assumed).

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OPEB Case Study Peralta Community College
District
Districts OPEB financing enables it to address
its liability and restructure its obligation on a
more budget-friendly basis.
Projected Pay-as-You-Go Annual Costs

• District Budget of 100 million
• Retiree Health Benefit was capped on July 1, 2004
  via negotiation with Unions
• Districts OPEB exposure is finite
• OPEB obligation projected to increase from 5.2
  million in FY 2006 to 10.2 million in FY 2016
• Net Present Value of Benefits ranges from 132
  million (_at_ 7) to 196 million (_at_ 4.5)

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Peralta Bond Structure Creates Manageable Annual
Cost
District will contribute a constant percentage of
General Fund Revenues towards debt service.
Debt Service Pay-Go as a of General Fund
Revenues1

• Structure enables District to
• Fund its OPEB liability
• Maintain contributions at a constant and
  reasonable percentage of General Fund Revenues
• Retain future callability
• Debt service structured assuming 2.5 annual
  growth in General Fund Revenues
• 20MM of Current Interest Bonds and 133.7MM of
  Convertible Auction Rate Securities (CARSSM)
• 6 series of CARSSM minimizes interest rate risk

OPEB Debt Service is a constant 7 of GF Revenues
at 2.5 Annual Growth
________________ 1. General Fund Revenues grown
at 2.5 annually.
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Conclusion

• OPEB is the next financial tidal wave facing the
  public sector
• Although GASB does not require governments to
  fund these liabilities, the market will be the
  enforcer, requiring plan sponsors to develop
  viable funding plans
• OPEB bonds can be a constructive component of a
  funding plan, but bonds are a tool, not a
  strategy

Given effective dates of GASB 45, prevailing
workload of actuaries, and complexity of
valuation process, the time to start is NOW.
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Contact Information

• Robert Larkins
• Managing Director
• Phone [phone]
• Email robert.larkins_at_lehman.com
• Barbara A. Lloyd
• Senior Vice President
• Phone [phone]
• Email barbara.lloyd_at_lehman.com
• Elizabeth Yee
• Vice President
• Phone [phone]
• Email elizabeth.yee_at_lehman.com

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