Accounting Changes for Post-Retirement Health Benefits The Impact on Schools

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1 Route to: For more information about our education resources, go to thompson.com and click on Education Accounting Changes for Post-Retirement Health Benefits The Impact on Schools Special Report Recent changes in accounting for post-retirement health benefits are presenting dramatic problems for school systems. This special report looks at the new GASB accounting requirements for these benefits and what they will mean for school district budgets especially since funding benefit costs in advance will likely cut into funds available for program activities. The changes will also affect the federal grants that school systems receive.

2 Thompson Publishing Group, Inc. Thompson Publishing Group is a trusted name in providing education professionals with authoritative analysis of laws and regulations that help them develop regulatory compliance strategies. Since 1972, thousands of professionals in education, business, government, law and academia have relied on Thompson Publishing Group for the most authoritative, timely and practical guidance available. Thompson offers loose-leaf services, books, specialty newsletters, audio conferences and online products in a number of subject and regulatory compliance areas. We offer products featuring analysis, practical guidance and real-world solutions to issues facing education professionals, written by our network of experts. For more information, visit us at thompson.com, or see the last page of this special report. Accounting Changes for Post-Retirement Health Benefits The Impact on Schools is published by Thompson Publishing Group, Inc., th St., NW, 3rd Floor, Washington, DC Authors: Cynthia Burrow and Chuck Edwards Desktop Publisher: Brock G. McClung u This information is designed to be accurate and authoritative, but the publisher is not rendering legal, accounting or other professional services. If legal or other expert advice is desired, retain the services of an appropriate professional. Copyright 2007 by Thompson Publishing Group, Inc. All rights reserved. Photocopying without the publisher s consent is strictly prohibited. Consent needs to be granted to reproduce individual items for personal or internal use by the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA Accounting Changes for Post-Retirement Health Benefits The Impact on Schools

3 Accounting Changes for Post- Retirement Health Benefits The Impact on Schools Cynthia Burrow and Chuck Edwards A recent pronouncement by the Government Accounting Standards Board (GASB) is shaking up public agencies of all sizes. At issue is how these agencies should report post-retirement health benefits in their budgets and GASB s method could dramatically worsen the public perception of school districts financial health. The new GASB standard requires public agencies to report the costs of all accrued post-retirement nonpension benefits up front as a current liability. This can lead to an immediate, and visible, hit to the balance sheet. By far the largest component of these benefits is for retiree health care. When districts initially gave these benefits, they were relatively inexpensive, said Suzi Rader, director of District and Financial Services for the California School Boards Association. But as health care costs are going up in double-digit increases every year, they got more expensive. Also, we re coming up on the baby boom retirees and there are going to be more of them leaving the system. If public agencies decide to fund the accrued costs in advance the likely solution for many the increased fringe benefit charges will drain money from regular program activities. Agencies will also have responsibility for investing the money to pay for expenses payable years down the road. State and local financial managers now face a host of accounting issues as a result of the GASB statement, and these are not confined to state and local money: Grant-funded agencies like school districts face additional accounting complications when determining how to assign an appropriate share of these benefit costs to federal grants. These complications are heightened by the federal government s unique financial rules (see p. 6). GASB 45 GASB was established in 1984 to set high standards for government accounting operations a kind of compendium of best practices for managing public agency funds. Failing to meet the standards can result in negative audit findings and poor credit ratings. GASB Standard 45 was issued in 2004, but only recently is becoming effective. It focuses on how public agencies report post-retirement benefits other than pensions due to their employees. These benefits may include health, dental, vision, hearing, long-term care, long-term disability and life insurance, but are commonly lumped together as post-retirement health benefits, or PRHBs. At present, most public agencies use a pay as you go accounting method in other words, they only report actual cash paid out for accrued benefits in a given year s budget. Yet the ultimate cost to the employer of already-earned employee benefits may be significantly higher. GASB 45 says that in order to accurately account for post-retirement benefit costs, governmental agencies should be using an actuarial estimate, which assigns a yearly budget expense to take account of the promised and actual benefits associated with that year s activities. This yearly expense is determined based on a variety of factors, Accounting Changes for Post-Retirement Health Benefits The Impact on Schools 3

4 such as the number of agency employees who have earned benefits, how long the employees are expected to live after retirement, expected health care cost increases, and the return the agency expects on its investments. For example, while a school district may lay out only $5 million in cash in a given year to pay for the PRHBs of its retired teachers, it may also have promised its current employees PRHBs at a significantly higher rate than the agency is currently paying. Moreover, benefit costs for current retirees may continue to climb with medical cost inflation. By only reporting actual cash outlay for the year, without considering the future costs of its accrued employee benefits, the district is painting an inaccurate picture of its longterm financial health and is inhibiting its ability to plan for a future higher payout. It should be emphasized that GASB 45 does not require agencies to actually fund these future benefit payouts. GASB merely requires them to report the future payouts on their annual financial statements. That year s actuarial accrued liabilities for current employees must be reported as an expense each year. (GASB 45 does not require agencies to project future costs associated with future work done by employees; it is simply concerned with the future costs of benefits already earned by current and past employees.) If an agency doesn t set aside the money to fund its accrued PRHB obligations in any given year, those liabilities will be added to the agency s unfunded PRHB liability both for the current year and for past years which will be reported in its financial notes. As the gap between an agency s liabilities and investments grows, bonding agencies will adjust their ratings accordingly. Hence, education agencies are likely to start pre-funding these liabilities. In some states, they will have no choice, due to state laws that require full funding for public liabilities. Timeline for Implementation GASB 45 provides a rolling timeline for converting from a pay-as-you-go model to an actuarial model in calculating PHRB liabilities. Beginning in December 2006, governments with total annual revenues of $100 million or more were expected to begin using an actuarial model. Governments with total annual revenues of between $10 million and $100 million will follow beginning Dec. 15, 2007, and governments with total annual revenues of less than $10 million will begin Dec. 15, With the first deadline already passed, several large state governments that have taken a first, hard look at their long-term liabilities face tremendous sticker shock. In a December 2006 press release, California Gov. Arnold Schwarzenegger announced the formation of a commission to address unfunded liabilities for retiree health care benefits estimated by California s Legislative Analyst Office at between $40 billion and $70 billion. These figures, notes the press release, do not include additional liabilities that may be held by local governmental agencies with a later deadline for compliance. Rader confirmed that most of the districts she has worked with have faced similar sobering results: As more and more districts are beginning to get their numbers, it s probably less shocking than the first ones. But I think that for the most part the numbers were bigger than they had anticipated. School Districts Gear Up Some private and public organizations are working now to create GASB 45-compliant funding options to assist agencies in estimating and addressing their unfunded liabilities. For example, anticipating the impact of the new GASB rules on local school districts, the California Schools Boards Association has Accounting Changes for Post-Retirement Health Benefits The Impact on Schools

5 created a GASB 45 Solutions initiative to help local school boards determine their liabilities and plan for funding them over the long haul. We saw that the new GASB rule had been proposed and realized it was going to have a big impact on districts, Rader said. So we pulled together a team and basically designed a program that we thought could assist districts. We created a trust and got an IRS private letter ruling so that districts could have an investment vehicle that met all of the requirements without each district having to create its own. In recent testimony to the New York Assembly s Committee on Ways and Means, Robert Lowry, deputy director of the New York State Council of School Superintendents, urged the committee to give school districts the legal authority to establish irrevocable trusts for the purpose of funding post-retirement benefits. Collective Bargaining Implications In addition, GASB 45 may impact collective bargaining agreements because many state and local agencies will need to reevaluate the benefits they offer their employees upon retirement. In comparing the impact of a similar private-sector standard issued by the Federal Accounting Standards Board in 1991, the California School Boards Association notes that the number of large employers offering retiree medical benefits dropped from 66 percent in 1988 to 36 percent in The association suggests that districts begin discussing options for providing affordable, sustainable benefits with their employees and other stakeholders now. Self-Insured Schools of California, which also offers GASB 45-compliant actuarial evaluations and trusts, advises, Having the initial actuarial valuation at hand during the next round of collective bargaining gives an excellent starting point for talks relative to changes in plan design that a great majority of districts are now finding necessary. Pay Me Now or Pay Me Later As the bill for GASB 45 starts to come due this year, one thing is certain more and more public education agencies of all sizes will face hard decisions about what they can fund and what must be cut. Most states and locals not all are still on a pay-as-you-go situation where they don t really deal with the issue until the bill is called due, said Richard (Ted) Mueller at a federal grants management conference held by education law firm Brustein & Manasevit. Mueller is head of the U.S. Department of Education s Indirect Cost Group. If the agencies pre-fund their PRHB liabilities, the money must come from current budgets. Of course, the benefits must be paid sooner or later, but agencies that pre-fund their obligations will face a painful adjustment immediately. Mueller cited one state that now has a fringe benefit rate of 47 percent. You are seeing an erosion of program dollars to pay for this PRHB, he said. It s a huge monkey out there. Moreover, the short-term adjustments can be a nightmare. Mueller emphasized that converting from a pay-as-you-go system to a pre-funded system is not simply a matter of paying for costs for newly accrued benefits moving forward. Agencies must also play catch up with the prior-service liabilities (PSLs) promised but not yet paid to both retired and current employees. Accounting Changes for Post-Retirement Health Benefits The Impact on Schools 5

6 Impact on Federal Grants On an agency s annual financial report, expenses for newly accrued benefits and for catch-up payments for PSLs (if any) are reported as one lump sum. For the purpose of determining how to pay for these expenses, however, Mueller says PRHB liabilities can be broken down into three categories: 1. Normal, actuarially determined PRHB costs and related liabilities for active employees, going forward 2. PSLs for active employees 3. PSLs for already retired employees State and local agencies may develop their own approaches to funding obligations associated with employees paid with state and local funds. But paying for PRHB obligations associated with federal education grants involves federal cost regulations, and that was the focus of Mueller s presentation to his audience of state and local officials managing federal grants. In general, PRHB benefits, like other benefits associated with employees working on federal grants, may be paid for with federal funds, in conformance with applicable federal cost principles. As with any cost, PRHB costs must be allocable to the grants based on the relevant benefits received by the pertinent federal program. Normally, allocability of these costs would be determined by consulting Office of Management and Budget Circular A-87, which establishes cost principles for federal grants, Mueller said. He pointed out, however, Circular A-87 is way behind these [GASB] pronouncements. As a result, school districts are approaching the Education Department for guidance on the issue. It s in kind of a state of flux, Mueller said. Actuarial Costs vs. Prior-Service Liabilities The easiest case is the actuarial costs for benefits accrued by current employees in the current year. You develop the actuarial costs and you add that on as a fringe benefit, Mueller said. You follow the labor. Most of that cost would be charged as a direct cost to the current program. It s going to translate to a higher fringe benefit rate, [which means] more money will be taken out directly from the award to help pay for that. Unfunded PSLs pose more complex issues, however. Attachment B, Paragraph 8.f.4 of Circular A-87 allows PSLs to be amortized in accordance with generally accepted accounting principles or, if none exists, over another period of time. That is, once the total of all PSLs is determined, the cost can be spread over a number of years to avoid a direct hit during a given budget year. The period is negotiated with the cognizant federal agency. For cost negotiation, federal cognizance Allocating PRHBs to Federal Grants 1. Current Employees a) Past service: Charge as direct costs in proportion to salaries for all current employees, i.e., when making up for the past amounts that should have been set aside, charge each current salary a proportion representing current total salary distribution between federal and nonfederal sources. b) Current service: Charge as direct costs in proportion to the distribution of that particular salary between federal and nonfederal sources. 2. Retirees Charge all costs as indirect, and make sure to comply with restricted indirect rate rules. Source: Leigh Manasevit, Esq., Brustein & Manasevit Accounting Changes for Post-Retirement Health Benefits The Impact on Schools

7 is generally assigned to the federal agency providing the greatest dollar support that is subject to indirect costs rates. Are PSLs Indirect or Direct Costs? A-87 is silent on whether prior service liabilities are allocated as indirect or direct costs, however. In contrast to direct costs, which may be separately identified and charged to a particular project, indirect costs are administrative costs (such as payroll services or heat) that generally benefit the agency and the grant-funded project but can t be easily broken out. These are apportioned to grants by calculating an indirect cost rate for the institution as a whole and then charging the appropriate percentage against specified grant expenditures. Mueller said the process for dealing with PSLs is still being worked out. In negotiations with the state of California, it was decided that the costs for PSLs for current employees should for now be added to the direct fringe benefit costs, with an agreement to revisit the issue at a later date. In particular, he said, there might be a need for some kind of stratification of employees based on their length of service. The conclusion was different for PSLs for retired employees, he said. Because the current cost of active employees is so high, this is what I have worked out with the state of California: The PSL liability for retirees should not be considered as a direct cost; instead, keep it as a pooled cost and continue allocating that indirectly. I negotiated that because we just couldn t tell to what extent it would erode program dollars from current awards to pay for these [unfunded] liabilities, he added. In other words, it would not be a prudent business decision to approve payment of these liabilities as a direct cost. Mueller noted that agencies that decide to use federal grant funds to pay for their allocable share of PSLs for retired employees must consider the implications for the agency s indirect cost rate (see p. 8 for details). Since the Brustein & Manasevit conference, Mueller has also addressed another California funding issue: whether costs associated with issuing bonds to cover PRHBs may be chargeable to federal grants. In a separate interview, Mueller said that Circular A-87 only permits such costs to be charged to federal grants when the debt is used for a hard asset such as a building needed to support a federally funded project. Percentage Method for Current Employees In a separate session at the fall forum, a partner with Brustein & Manasevit elaborated on Mueller s agreement with the state on the issue of PSL costs for current employees. (Brustein & Manasevit represents the California state educational agency and is a contributor to many Thompson education publications.) Leigh Manasevit pointed out that some of an agency s current grant-funded employees might have been funded with nonfederal resources in the past, and vice versa. How can you go back in time and figure out what percentage of the agency s total PSL costs for current employees should be ascribed to federal grants? he asked rhetorically. Accounting Changes for Post-Retirement Health Benefits The Impact on Schools 7

8 PRHB Impact on Indirect Cost Rates As noted on p. 7, the Education Department has decided that prior service liabilities (PSLs) for federal retirees must be treated as an indirect cost for the purpose of allocating funds from a federal grant. Thus, if an education agency wants to fund its PSL obligations for retirees with federal funds, this will have an impact on its restricted and unrestricted indirect cost rates. Grant recipients typically negotiate an indirect cost rate with their cognizant federal agencies. An indirect cost rate is calculated by dividing the agency s indirect costs by its direct costs (less certain unallowable expenditures, such as capital costs and flow-through funds). For example, an agency might have indirect costs of $2 million and modified total direct costs of $20 million, leading to an indirect cost rate of 10% Indirect costs $2,000,000 = Modified total direct costs $20,000,000 = 10% indirect cost rate This means that a grantee could charge as indirect costs 10% of the modified total direct costs incurred under federal grants. But many large federal formula programs have a supplement-not-supplant requirement, which prohibits the use of federal funds to cover costs an agency would normally cover with state and local funds. In particular, costs associated with the superintendent s office and certain other executive officers must be excluded when calculating an agency s indirect cost rate. Using the example above, if these indirect costs amount to $500,000, that would reduce the numerator in the fraction to $1.5 million, resulting in an indirect cost rate of only 7.5%. This is termed the restricted indirect cost rate. Indirect costs $1,500,000 = Modified total direct costs $20,000,000 = 7.5% restricted indirect cost rate A major component of these unallowable indirect costs say, $300,000 will be salaries. If these salaries are unallowable, so are the fringe benefits, including PHRB costs. This requires another calculation to determine how much of these costs must be excluded when calculating the indirect cost rate. Assume that the total agency salaries are $15 million and PRHB costs are $1 million. To calculate the share of PRHB costs that must be excluded, first divide the amount of unallowable salaries by the agency total salaries. This yields a ratio of 2% of unallowable to allowable salaries. Unallowable salaries $300,000 = Agency total salaries $15,000,000 Then apply the same ratio to the PRHB costs. = 2% ratio of unallowable to allowable salaries PRHB costs ($1 million) x 2% = $20,000 Thus, the total indirect costs used to calculate the restricted indirect cost rate will be reduced by $20,000. Using the example above, this amount would be deducted from $1.5 million, further reducing the numerator in the indirect cost rate calculation to $1.48 million. This results in an indirect cost rate of only 7.4%. Indirect costs $1,480,000 = Modified total direct costs $20,000,000 = 7.4% restricted indirect cost rate 8 Accounting Changes for Post-Retirement Health Benefits The Impact on Schools

9 It is effectively impossible, said Manasevit. So, Ted, in his role as director of the Indirect Cost Group, negotiated a percentage methodology where the agency bases the percentage on the current payroll. For example, if the current payroll is 10 percent federal and 90 percent nonfederal, the agency would apply 10 percent of its obligation for allocable costs of previously earned PRHBs to its current federal grants. Cross-Agency Coordination Needed Mueller has emphasized that development of federal grant policy for PRHBs is in its early stages. In fact, he said, the U.S. Department of Education is the only federal agency that has attempted to develop guidelines for grantees. This is the case even though the relentless march of GASB deadlines is forcing state and local governments to develop approaches to funding their PRHB costs now. OMB probably should convene an interagency working group to construct consistent guidelines across the government, he concluded. For More Information Suzi Rader, Director, District and Financial Services, California School Board Association, (800) , srader@csba.org GASB45 Solutions, California School Board Association, Self-Insured Schools of California GASB 45, Summary of Statement No. 45: Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions (Issued 6/04), Accounting Changes for Post-Retirement Health Benefits The Impact on Schools 9

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