This year is the OPEB deadline. For the first time, state and local governments will be required to disclose massive liabilities for amounts owed to retired employees for health care and other post-employment benefits (OPEB). For many local governments – though not all – the numbers are large. $10 billion for South Carolina. Somewhere in the range of $40 billion to $70 billion for California. New York City measured its OPEB obligation as $53.5 billion.

Cities and states remain in the early stages of this accounting-driven change in the municipal bond market. Thornburg is tightly monitoring OPEB disclosures to manage this risk in bond portfolios.

But from a bond investor’s perspective, three favorable trends have emerged in the last year: first, establishment of dedicated OPEB trust funds; second, reductions in the benefits promised made to retired employees; and third, the emergence of scattered local governments with very small OPEB liabilities.

Background

For decades, cities and states have promised retirement benefits in addition to pensions to retired employees, without measuring the cost. The principal liability is free health care, but prescription drugs, vision, life and long-term care insurance are also significant. Until this year, it was an unmeasured, unaccounted liability of staggering size – approximately $1.5 trillion nationwide according to a Credit Suisse report.

Until 2007, governments did not measure OPEB liabilities or report them in the annual financial statements. They simply reported cash payments to existing retirees as expenses on the income statement – pay-as-you-go accounting. There was no accrual accounting for this huge liability.

2007 is the first year that local and state governments are required to record this liability in their financial footnotes. The new disclosure is dubbed “the OPEB footnote.” Like unfunded pension obligations, OPEB liabilities will appear only in the footnotes – not on the balance sheet itself. OPEBs are considered a “soft liability” because the liability can only be roughly estimated and is subject to broad swings year to year.

The new accounting rule, GASB 45, was issued in 2004. It requires OPEBs to be measured and reported in footnotes to the financial statements in the same manner as pensions. There is no requirement to reserve cash or prefund the liabilities. Governments have a choice of continuing with the current pay-as-you-go system, or making an annual contribution, known as the Annually Required Contribution (ARC), to a trust fund.

What are governments doing to fix the problem?

Our view is that governments with strong fiscal management will address the OPEB problem by:

• Taking a proactive approach to measuring and lowering the liability.
• Establishing dedicated OPEB trust funds.
• Lowering benefits, altering eligibility thresholds, increasing co-payments, deductibles and health care premiums, requiring current employees to contribute to funding, requiring retirees to pay a portion of insurance premiums, and switching to defined-contribution plans.
• Working jointly with employee associations and unions to find politically workable solutions.

To date, governments that have established OPEB trusts include the state of Ohio, Oakland County, MI., Gainesville, FL., and Waukesha, WI. OPEB trust funds have been proposed and are under consideration in many locations, including Carroll County, MD and the states of Nevada and Delaware.

For now, we believe the primary risk is rating downgrades and the resulting increase in borrowing rates. But so far, rating agencies are not threatening downgrades. The bond raters are monitoring developments to see how much of a cash drain these liabilities become.

State and cities can issue OPEB bonds, like pension obligation bonds, a new sector in the municipal bond market that developed over the last decade. OPEB bonds would likely be taxable municipal bonds, as are pension obligation bonds. The city of Gainesville, FL issued OPEB bonds in 2005 to fund its $30.6 million liability.

For newly hired employees, governments can reduce or stop paying retiree benefits, just as corporations have done in the private sector. Aside from auto companies, few corporations pay retiree health benefits. The city of San Diego, CA, does not offer retiree health benefits to employees hired after July 1, 2005, making the program a closed system. The city of Arlington, TX, made the identical move for employees hired after 2006.

For current employees, governments can shift costs to the retirees by requiring them to pay part of their own insurance premium or imposing co-payments. Or they could replace standard health insurance by establishing private health savings accounts and high-deductible insurance plans, as Alaska did in 2005. And of course, governments can raise taxes.

Exactly what employers are affected?

GASB 45 applies to all city, county, and state governments, as well as public entities such as school districts, hospitals, community colleges, and other specialized districts.

The new GASB reporting and disclosure requirements became effective in 2007 for governments with annual revenues in excess of $100 million, and will begin in 2008 for those with annual revenues of $10 to $100 million, and in 2009 for those with revenues of less than $10 million.

In addition to these reporting deadlines for financial statements, the SEC has stated that if tax-exempt bond issuers can estimate OPEB liabilities earlier, they should report the liabilities in bond offering documents, or else risk being charged with withholding material information from investors.

What are the specific problems?

Projecting future health care costs requires estimating a medical inflation rate for the next 30 years. Since no one knows that number, determining OPEB liabilities necessarily involves guessing. It also requires actuarial data such as retirement ages, lifespan projections, claims data, and Medicare eligibility. Public employee labor unions are a major factor also.

GASB does not currently require funding of OPEB liabilities. GASB 45 does not create a cash cost, other than the cost of paying actuarials to estimate the liability.

What does OPEB mean for investors?

OPEB liabilities add to a government’s debt burden, which elevates credit risk. For governments with very low OPEB liabilities, e.g. Orange County, Florida, the risk is negligible. OPEB risk is worse for long-term bonds than for short- and intermediate-term bonds. In the short term, the cash costs are affordable and liabilities can be estimated with some accuracy. But in the long term, the cash costs are huge, the number of retirees will be bigger, and cost estimates are flimsy. OPEB is not so large a problem that municipal bond investors need to flee the sector. We believe the impact of OPEB can be minimized and managed by sticking to the fundamentals:

• Monitor financial disclosures to gauge how large the OPEB liability is for specific issuers.
• Keep maturities short or intermediate. These bonds will mature before OPEBs cause a cash crunch.
• Stay well diversified. We feel the simplest way to do this is to invest in a well-managed municipal bond fund.
• When considering new bonds, investors should read the bond offering statement in case the OPEB disclosure is material. This has already occurred in at least once case: a GO bond issued by the District of Columbia in 2005. The district estimated its OPEB liability as $562 million with assets of $153 million, for an unfunded accrued liability of $409 million.

About the Author
Josh Gonze is a managing director and co-portfolio manager for Thornburg municipal bond portfolios.  He is responsible for credit analysis for new bond transactions, monitoring credit quality within the portfolios, and evaluation of sector-wide credit trends. His scope of activity includes assessment of industry, business, and financial risk, including calculation of financial and operating ratios. He also assists in trading bonds for both the mutual funds and private accounts.

Josh joined Thornburg Investment Management in 1999, and was named managing director in 2003. He was promoted to co-manager in 2007. Prior to joining Thornburg, Josh served as an associate director at Standard and Poor’s, where he set credit ratings for corporate bonds. Prior to Standard and Poor’s, Josh worked in corporate banking at the Toronto-Dominion Bank in New York. Josh holds a BA in economics from Oberlin College and an MBA in finance from the New York University School of Business.

The views expressed by a Portfolio Manager reflect his professional opinions and should not be considered buy or sell recommendations. These views are subject to change.

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