Posted July 12, 2007

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Bonus columns:
· Pension Divestment and Fiscal Sanity
· A Possible Benefits Crackdown

Funding OPEB With Pension Profits

Optimizing the taxpayers’ money

In last month's column on pension overfunding, I pledged to return with another column explaining how public agencies could convert pension fund surpluses into seed money for underfunded retiree medical benefits plans. These "other post-employment benefits" (OPEB) have become highly visible ever since the Governmental Accounting Standards Board issued its Statement 45, which requires disclosure of OPEB liabilities and prescribes the financial methodology for reporting retiree medical plans with defined benefits. These liabilities are estimated to exceed $1 trillion nationwide and very few governments have put away any money to defray their obligations for past employee service.

Meanwhile, bullish financial markets are pushing the assets of some well-run public pension funds above their liabilities. Last month's column addressed this.

At the June 2007 annual conference of the Government Finance Officers Association (GFOA), I joined a panel of industry experts providing funding alternatives and solutions for OPEB financing. Copies of the "OPEB II" session slides can be found at their Web site by clicking the speakers' names.

In a nutshell, the choices are:

—continue business-as-usual and run out of money eventually
—continue benefits and start pre-funding them like a pension fund so investment income pays most of the long-term costs
—freeze the current defined benefit plan and do something less costly in the future, such as a defined contribution plan
—cap benefits for retirees
—require employees and retirees to share more costs
—establish individual health funding accounts
—install a hybrid plan that combines several of these options.

For employers with fully funded pension plans (assets exceed actuarial plan liabilities) an additional strategy is to exploit surplus pension plan assets to provide seed capital for a properly pre-funded OPEB trust fund. It's not a perfect solution and it works only when there is a pension surplus, but it helps launch politicians on the path of proper actuarial funding for OPEB. The economic result would be a reduction of the pension plan's surplus and a simultaneous, equal reduction of the OPEB trust fund's deficit.

First, let's be clear about what you cannot do. Pension funds cannot be used to provide tax-free retirement medical benefits to employees. Uncle Sam would likely impose a tax and penalties on such a scheme. So the most viable way to accomplish the same objective is to indirectly return a pension surplus to its rightful owner — the governmental unit that sponsors the plan — by temporarily reducing its annual contributions. From there, the public agency must then independently re-appropriate the funds to the OPEB trust fund as a capital infusion to pay off part of the unfunded liability for past service, or as a supplemental contribution toward pre-funding the OPEB plan on a proper actuarial basis.

Any such arrangements should be in addition to, not in lieu of, a normal annual OPEB contribution determined actuarially. This strategy is a booster shot, not a placebo.

That sounds simple enough, but there are some technical high hurdles to clear. First, the reversion of pension plan assets to the employer must be permissible under law and clear of federal tax entanglements. The employer reduces annual pension contributions despite an actuarial rate that is higher, which may require approval by the pension trustees as well as the plan sponsor. Some states' laws may require amendment before such a strategy could be deployed. These are matters best left to the actuaries and pension fund attorneys to resolve, and special care must be taken to avoid federal tax complications. The accountants must also prepare new financial statement disclosures.

If a recessionary bear market with declining asset values subsequently evaporates the pension plan's surplus, the employer could again face an unfunded liability for its pension plan and would be required to make supplemental contributions to regain full funding. But that would be no worse than suffering an even larger deficit in the OPEB fund, so the taxpayers would be no worse off. And as I've suggested before (in my April Bonding with OPEB column), the right time to issue OPEB and pension obligation bonds would be when the investment markets are weak — at the bottom of a recession — at which time both plans could be funded fully through bond proceeds.

Ideally, both the pension plan and the OPEB trust fund should be fully funded at precisely 100 percent forever. But in today's imperfect world, it is far more likely that well-funded pension plans will run a surplus in periods of exuberant financial markets, while OPEB funds will remain pathetically underfunded. Until permanent financing is put into place, this intermediate strategy might be worth considering. Just be sure to cover all your bases and obtain competent, qualified professional assistance with a sharp focus on tax and legal considerations. Even if you reject this strategy, you will learn more about your options, in the process.

Last month:
· ‘Over-funded’ Pensions? Hardly!
· ‘Target-Date’ Funds Miss the Bull's-Eye
· Hounding the Fat Cats

Index of recent columns

Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net.
More biographical information.

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