OPEB and GASB 45

From an accounting point of view, the MPSERS and MSERS retiree medical benefits described in Michigan law[12] represent accounting liabilities that must be calculated and included in annually disclosed financial reports as long as the Legislature continues to keep the laws on the books. The development and calculation of OPEB liabilities are conceptually similar to those of pensions from an actuarial and accounting perspective.

However, given a 2005 Michigan Supreme Court ruling, there are grounds to believe OPEB accounting liabilities for Michigan public employees may be unilaterally modified even for current retirees, meaning that they do not represent binding legal liabilities that cannot be altered.[*] For this reason, OPEB accounting liabilities may be considered to represent a significantly different type of liability from those of MPSERS and MSERS pension benefits. In contrast, modifying pension benefits that employees have already earned would likely present considerable constitutional difficulties.[†] Hence, the law may treat the two liabilities differently, allowing the Legislature to modify commitments on OPEB[‡] and not on pensions.

Effective Sept. 15, 2006, important accounting changes were made to large government retiree medical plans under Government Accounting Standards Board Statement 45 (known as “GASB 45”), which now requires accounting recognition of OPEB liabilities. This transition of OPEB accounting from a pay-as-you-go accounting to a more pension-type accounting system serves to better quantify the amount of current and future costs within the retiree medical benefit program. The effect is to make the liabilities of the MPSERS and MSERS retiree health plans more like pension liabilities and more transparent to the public.

Of important note, unlike pension plans, GASB 45 does not require OPEB liabilities to be prefunded, or paid up, by the time employees retire. While the state has adopted the GASB 45 accounting standard, the funding remains on a “pay-as-you-go” basis. In other words, the money placed in MPSERS and MSERS health plans each year is used only to pay health insurance benefits for current MPSERS and MSERS retirees, rather than prefunding benefits for active members who have not yet retired.

This pay-as-you-go approach does produce a lower annual cost at present; to prefund these liabilities would involve a significantly higher budgeted annual contribution level. But pay-as-you-go financing also means that no assets are set aside, and therefore that there is no asset growth to help pay for future benefits. At some point in the future, as the number of retirees climbs, the relationship between annual pay-as-you-go and prefunding payments will be reversed, and pay-as-you-go will become more expensive than prefunding.

Under GASB 45, the state’s decision to use a pay-as-you-go policy for retiree health benefits means that the state must discount these future liabilities using a lower investment return assumption than the 8 percent basis used in pensions. As a result, the state has selected a 4 percent interest rate assumption that results in significantly higher liabilities than under a prefunded approach, such as the one used in MPSERS and MSERS pension plans.

While a pay-as-you go policy creates near-term cash flow relief compared to a prefunded arrangement, GASB rules also require that the difference between the contribution required each year for prefunding (known as the “annual required contribution”) and the pay-as-you-go cost be reflected annually on the balance sheet as a liability. Another assumption that affects the retiree health care liabilities involves the future rate of health care cost increases. While MPSERS and MSERS assumed a 9.0 percent growth in health care costs in fiscal 2010, they also assumed progressively lower annual medical cost growth in subsequent years, reaching an assumed annual rate of increase of 3.5 percent in fiscal 2021 and subsequent years.[13]

It is also difficult to predict the extent to which projected Medicare benefits will offset future retiree health care liabilities, especially given a further and most significant variable: the potential impact of federal health care legislation passed in 2010[14] on GASB 45 liabilities for MPSERS and MSERS retiree health plans. Such considerations are relevant at all levels of state and local government where OPEB liabilities may exist.

Financial engineering of pension and GASB liabilities will prove to be of limited short-term value. The proper balance between short- and long-term costs can be debated, but the need to establish affordable short- and long-term costs is fundamental. While superior MPSERS and MSERS asset growth — in other words, achieving or surpassing the 8 percent assumed annual rate of return — will help pay future pension costs to an extent, such gains will prove insignificant in retiree medical benefits, given that almost no assets have been set aside to grow and help finance future benefits.

While the pay-as-you-go cost approach provides some short-term budgetary relief, it fails to account for future costs implicit in increased longevity, rising annual health care costs and a growing number of retirees and their eligible dependents. The combined impact of these factors on future retiree medical costs should be better disclosed by policymakers and better understood by legislators and taxpayers as a whole.

As funding requirements increase, the resulting impact on taxpayers will become evident unless legislators decide to borrow or otherwise further defer these costs. This is significant given the funding requirements that already exist for current taxpayers. Without successfully managing these costs, the resulting increases in taxes will create disincentives for individuals and businesses to live, work or invest in Michigan.

The following summary, reported by the Office of Retirement Services, shows MPSERS’ and MSERS’ unfunded liabilities as of Sept. 30, 2009, the date calculated in the most recent annual actuarial valuation reports, which were released in May and June of this year. Of significant note is that the pensions’ unfunded liabilities are not scheduled to be paid off for another 27 years.[15] The pattern of increasing future costs, the likelihood of actuarial losses (which will increase the unfunded liability) and the prospects of a lower assumed rate of return on assets will make it likely that even the current unfunded liability will not be fully amortized over this period.

Graphic 1: Unfunded Liabilities of MPSERS and MSERS Pension and Retiree Medical Benefits (Billions of Dollars)

Graphic 1: Unfunded Liabilities of MPSERS and MSERS Pension and Retiree Medical Benefits (Billions of Dollars) - click to enlarge

Source: Computations based on “Michigan Public School Employees’ Retirement System 2009 Annual Actuarial Valuation Report” (Gabriel Roeder Smith & Company, 2010), B-1; “Michigan State Employees’ Retirement System 2009 Annual Actuarial Valuation Report” (Gabriel Roeder Smith & Company, 2010), B-1; “Michigan Public School Employees’ Retiree Health Benefits 2009 Annual Actuarial Valuation Report” (Gabriel Roeder Smith & Company, 2010), A-2; “Michigan State Employees’ Retiree Health Benefits 2009 Annual Actuarial Valuation Report” (Gabriel Roeder Smith & Company, 2010), A-2. As noted elsewhere in the text, the unfunded liabilities for MPSERS and MSERS retiree medical care (or OPEB) may be subject to modification by the state Legislature. The range of figures reported for OPEB liabilities is based on whether a 4 percent or 8 percent interest rate is assumed. 

[*] Studier v Michigan Public School Employees’ Retirement Board, 472 Mich 642 (2005). Public Act 75 of 2010, however, may have created an unalterable, though limited, OPEB legal liability. As noted earlier, the act requires MPSERS employees to contribute 3 percent of their compensation to an irrevocable trust for MPSERS retiree health care, and the money in this trust may have to be spent on those health care benefits (see, for instance, Patrick J. Wright, “MEA Lawsuit on Retiree Health Benefits Misguided” (Mackinac Center for Public Policy, 2010), http://www.mackinac.org/archives/ 2010/v2010-22.pdf (accessed Aug. 31, 2010)). Also as noted earlier, the money is temporarily being placed in an escrow account pending an MEA lawsuit against the 3 percent requirement. (Public Act 185 may have created a similar legal liability.)

[†] See Patrick J. Wright, “MEA Lawsuit on Retiree Health Benefits Misguided” (Mackinac Center for Public Policy, 2010), http://www.mackinac.org/archives/2010/v2010-22.pdf (accessed Aug. 31, 2010). Wright concludes that modifying pension liabilities would be unconstitutional under a 2005 Michigan Supreme Court decision (see previous footnote).

[‡] Gov. Jennifer Granholm, for instance, proposed eliminating retiree dental and vision insurance subsidies for all MPSERS members retiring after Sept. 30, 2010. See “Executive Budget Fiscal Year 2011” (Michigan Office of the Budget, 2010), A-6, http://mi.gov/documents/budget/2_310743_7.pdf (accessed Sept. 3, 2010); “Overview of Governor Granholm’s FY 2010-11 Budget” (Michigan Senate Fiscal Agency, 2010), 36-37, 39-40, http://www.senate.michigan.gov/sfa/Publications/BudUpdates/ OverviewGovsRecFY11.pdf (accessed Sept. 3, 2010).