OPEB's Silver Lining

Unlike with pension fund investments, nothing ventured means nothing lost.
March 5, 2009 AT 3:00 AM
Girard Miller
By Girard Miller  |  Finance Columnist
The finance columnist for Governing.

Here's an ironic result of the way state and local governments have procrastinated over their mounting obligations to pay for retiree medical benefits: By failing to properly fund their "other post-employment benefits " (OPEB) plans like pension funds, they have avoided the trillion-dollar market meltdown. Although their liabilities will likely swell from $1.5 trillion to $2 trillion before the economy recovers, most of these OPEB plans have not suffered asset losses because they had no money to invest.

Usually, financial ostriches suffer from their failure to take decisive actions. But the ongoing mega-bear market in stocks is now perversely rewarding public employers for doing nothing. Had these OPEB plans been properly funded over the past decade, they would have suffered investment losses just like their sibling pension funds.

Now what? So, now that the stock market has lost half of its market value in the past 18 months, what should public agencies do about their unfunded OPEB liabilities? Delay yet further? Start funding? Avoid stocks or favor them as investments? Sell OPEB bonds? These are the critical strategic questions that each public employer must now begin to ask and answer in the coming months.

Financial triage. Most public agencies today have little or no money available to begin funding their OPEB liabilities on a proper actuarial basis. As a first step, many of them should first begin to trim back their promises to employees by reformulating their retiree medical benefits plan. This requires them to develop a strategic plan for their overall retirement benefits program that takes into account the growing financial claims their pension funds will demand as they seek to amortize their investment losses of the past two years. As mandatory pension contributions increase, employers will be forced to cut back elsewhere, and retiree medical plans may be one of several areas that require a scalpel.

Taking a long-term view. For those employers that have already put aside some money for OPEB plans, and those who can begin to make actuarial contributions, the big question this year is how to approach the investment markets. Bond yields are pathetically low and cash pays almost nothing, so an investment policy focused on those two asset classes will result in a low discount rate (the expected portfolio rate of return) that greatly inflates the actuarial liability. This almost compels plan sponsors to consider equities, and actually encourages many plans to consider an initial equity-tilt strategy.

If you think of a start-up OPEB plan like a young college graduate just starting her career and making her first contributions to a 401(k) plan, the investment wisdom of most financial planners would be that the asset allocation should be more aggressive than a midlife business executive who has already accumulated substantial assets and has a lot to lose. The youngster knows that she will be making 30 years of future contributions that will greatly outweigh this year's initial savings, so the investment risk of this small dab of money today is relatively meaningless in the context of the long-term plan.

The same logic applies to start-up OPEB plans, with one exception. An actuarially funded OPEB plan must make payments to existing retirees, and it is imprudent to buy stocks with money needed imminently for benefits payments. A cash buffer is needed for anticipated disbursements.

Equity-tilt inception strategy. An equity-tilt strategy for a start-up OPEB plan has several advantages, once the aforementioned cash buffer is established. First, the plan can begin to make a dollar-cost-averaging investment into the stock market for a decade following the worst stock-market meltdown in 75 years. Over the next 30 years, that long-term view should be rewarded with superior returns from bargain-basement purchases if history is any guide. Second, there is no reason to buy bonds today in light of widespread expectations that interest rates will ultimately turn higher once this devastating recession has ended. Third, the actuary can take the stock-heavy asset allocation into account in setting the discount rate, especially if the investment advisor provides a long-term plan with long-term investment expectations based on both historical research and professional perspectives on future opportunities. For some plans, this could reduce the required employer contribution.

OPEB bonds. A second strategy that will likely arise later this year is the use of taxable municipal bonds to borrow part of the OPEB liability to invest in stocks, explained in my previous column on benefits bonds. As noted in that column, I generally advise most employers to fund no more than 1/3 of their OPEB liabilities with bond proceeds in any one year, just to avoid taking oversized market-entry risks. However, the odds would seem to eventually favor a "benefits bonds window" later this year or early next. Financial professionals should begin their planning now, as these windows typically do not last forever. Once the economy begins to visibly recover, the opportunity to deploy this strategy will pass.

One size does not fit all. If there is one obvious conclusion to be drawn from these observations, it is that OPEB plans and investment strategies must be custom-designed. One size clearly does not fit all. Asset-liability considerations, cash-flow characteristics and risk tolerances vary widely from one OPEB plan to another. Custom solutions are needed for almost all plans, except for a handful of plain-vanilla plans that coincidentally happen to be "average" in each of these dimensions.

A strategic roadmap -- I'll talk about that in a forthcoming column -- will be helpful to those searching for optimal approaches to these challenges. For more information about such maps, public officials and managers may e-mail me.

Girard Miller
Girard Miller | Finance Columnist | millergirard@yahoo.com