Article Features Robert Locke

How GASB 45 Will Affect Your City or Agency: What You Need to Know

Robert Locke is finance and administrative services director for the City of Mountain View and immediate past president of the League’s Fiscal Officers Department. He can be reached at Mary Bradley, director of finance for the City of Sunnyvale, also contributed to this article; she can be reached at

Many city council members and other government officials have probably heard about new accounting rules that will require all local and state government agencies to recognize and report the actuarial costs of health and other non-pension-related retiree benefits, commonly referred to as “other post-employment benefits” (OPEB).

These new rules have been issued by the Government Accounting Standards Board (GASB) in its Statement 45. While retiree health benefits are the most costly, the cost of all post-employment benefits provided by government employers must be reported.

Accounting and reporting standards addressing pension obligations have been in place for many years. However, in the absence of authoritative accounting and reporting standards for OPEBs, these liabilities have gone unreported. GASB 45 fills this reporting gap as the authoritative accounting and financial reporting standard that public agencies must follow in order to comply with generally accepted accounting principles.

This article explains the basics of the new accounting and reporting requirements, their impact and significance, and the limited alternatives available for managing their impact.


Most jurisdictions provide post-employment benefits to their retirees. The types of benefits, eligibility requirements and costs for these benefits vary widely among public agencies. Health and medical insurance is the most commonly provided and most expensive benefit, with a wide range of coverage and cost sharing variations between agencies.

The nature of retiree health obligations is similar to that of pension benefits. Like a defined benefit pension plan, the employer is obligated to provide the promised benefit regardless of cost. As healthcare costs outstrip the rate of revenue growth in most California cities and the number of retirees increases, the impact of retiree health benefits on budgets throughout the state is becoming more dramatic. In addition, many attorneys specializing in employment and personnel issues believe that benefits being received by retirees are an inescapable obligation of the employer equal to that of pension benefits and debt service obligations.

The main differences between retiree medical and pension benefits are the way they are funded and reported. Pension benefits, such as those provided through the California Public Employees Retirement System (CalPERS), are funded during the working years of employment with contributions from employees and the employer. Contributions and interest earnings accumulate throughout an employee’s career, and the balance is used to pay pension benefits during retirement. An actuarial analysis of each member agency’s funding status is prepared by CalPERS each year, and employer contribution rates are adjusted to meet funding goals. CalPERS provides each member agency with the actuarial information required by accounting standards for each member agency to use in their annual financial report.

OPEB obligations historically have not been funded in advance like pensions. Most cities fund retiree health benefits as a current year cost on a “pay-as-you-go” basis. It may be that when retiree health benefits were first offered, the costs were minimal and the number of retirees was far lower than now. The absence of standards that required disclosing actuarial liabilities may have contributed to ignoring a “silent” liability that public agencies were accruing. With implementation dates for GASB 45 now imminent, large liabilities that have accrued over decades will begin to be recognized with significant but — for now — unclear impacts on public agencies.

What Does GASB 45 Require And When?

Generally accepted accounting standards for governments, schools, hospitals and other types of public agencies are established by GASB, which releases these standards in sequentially numbered statements. In 2004, GASB released Statement 45, which concerns health and other non-pension retiree benefits for public employees. It goes into effect for large cities for their FY 2007–08 annual financial reports; for medium-sized cities in FY 2008–09; and for the smallest cities in FY 2009–10.

GASB 45 requires each public agency to engage a certified actuary to calculate several actuarial measures estimating the current and future costs and liabilities of an agency’s post-employment benefit program. The same actuarial measures are already being used for pension obligations. Public agencies must calculate their:

  • Unfunded Liability. The estimated future cost for benefits being received by retirees and the cost of future retiree benefits that have been “earned” by active employees to date, less any funding amounts that have been put in trust to fund retiree benefits. Depending on the level of benefit an agency offers, the unfunded liability can be a very large — even frighteningly large — number. Agencies can amortize the unfunded liability over a period of no more than 30 years.
  • Normal Cost. The amount of money needed each year to fund future retiree benefits earned by active employees in the current year. The “normal cost” for a pension benefit is calculated by CalPERS each year to determine the employer contribution rate for the coming year.
  • Annual Required Contribution (ARC).The annual amount to be disclosed in an agency’s financial report each year, which is the sum of the annual amortized portion of the unfunded liability and the “normal cost” for the year being reported.

These estimates are used by the agency as the basis for the retiree benefit liabilities included in the annual financial report.

Results Can Be Shocking

As many cities that have begun implementing GASB 45 have discovered, when the actuarial measures used to determine the funding status of retiree pensions are applied to OPEB obligations, the results can be shocking. The actuary assumes that the cost of a retiree health benefit should be fully funded during a working career and prior to each employee’s estimated retirement date, so that no additional employer contributions should be needed to pay benefits for retired employees. However, when a retirement benefit is originally disclosed, additional time is permitted to amortize the original unfunded liability over as long as 30 years, recognizing that it may have taken decades to accrue the liability.

The amount to be included in the annual financial report is the sum of the amortized portion of the unfunded liability for one year plus the normal cost for one year. These two amounts equal the ARC. Many agencies will find the ARC is a very large amount to add to their annual budget.

Should a City Prefund Retiree Medical Benefits?

It is important to note that GASB 45 requires an actuarial determination of the liabilities, annual cost and the annual amount to record as a liability each year. It does not require agencies to actually fund liabilities, just to calculate and report them. Nevertheless, it may behoove an agency to develop a plan for addressing how their OPEB liability will be funded or managed for several reasons:

  1. The liabilities will continue to grow with compounding interest and eventually must be paid.
  2. An increasing liability in a city’s annual financial report could be a red flag for creditors, rating agencies and other interested parties.
  3. Prefunding the liability in a trust is more favorable financially over time because investment earnings on the contributions will compound and reduce the amount of “new money” the city must ultimately pay.

Furthermore, investment strategies and vehicles available for funds held in trust often earn very significant returns over time. The benefits of prefunding OPEBs can be seen in the chart below.

Consider a Trust as One Option

If possible, a city should prefund as much of its OPEB obligation as it can, and some cities are already doing that in phases. One of the options available under GASB 45 is to place funds for OPEB obligations in an irrevocable trust that is not accessible by the city. Trusts may realize investment earnings substantially higher than a municipality can obtain because they can be structured as legally distinct from the city and, therefore, not subject to the legal restrictions placed on investments permitted in city portfolios.

If your agency or city chooses not to set up an irrevocable trust but instead places the money into another fund (such as a reserve fund, for example), GASB 45 does not allow you to offset the liability by that amount. In such a case, your agency would simply report the ARC as a liability, which will grow.

If the likelihood of higher interest earnings can be substantiated, the actuarial liability of the retiree medical cost can be valued at a more favorable interest rate, thereby reducing the size of the liability. For example, a liability valued at the expected CalPERS investment return of 7.75 percent is substantially lower than if it were valued at the city’s own portfolio earnings rate around 5 percent.

A Good Reason to Delay Investment Decisions

While CalPERS has not yet established a trust to hold and invest funds for retiree medical costs, creating such a trust is under consideration. CalPERS is in a unique position to provide trust and investment services to California agencies that would significantly reduce the public costs of GASB 45 statewide. Additionally, several private firms have recently entered this market offering to create trusts and investment services for this purpose. Since any trust established for OPEB obligations will be irrevocable, it is probably prudent for a local agency to delay any investment decision until the OPEB services market is mature and the possibility of CalPERS services has been resolved.

The Consequences of Not Complying With GASB 45

Independent auditors are employed by public agencies to express their opinion as to whether the content of the annual financial report of a city fairly presents its financial condition. Auditors must certify that an annual financial report was prepared in accordance with generally accepted accounting principles. If the auditor’s opinion letter that accompanies the financial report does not identify any qualifications or issues that condition their opinion, the report is considered to have a “clean” audit opinion. Implementation of GASB 45 will be the required generally accepted accounting practice for many local governments starting in FY 2007–08, and those cities that do not comply will receive a qualified opinion. This may be of concern to outside entities that review financial reports, such as rating agencies or bond holders.

Legal Considerations

From a legal perspective, many attorneys believe post-employment benefits should be considered compensation that is earned with each year of service, with payment deferred until retirement is reached and promised benefits are received. In this view of OPEB costs, the employer “owes” the promised retirement benefits that were earned while serving as an active employee. Many attorneys also think that these benefits constitute a vested right that cannot be unilaterally changed, cut off or reduced by an employer. Retirees and the benefits they have been promised have legal protections that must be understood when considering changes. They also present serious impediments to cost-control strategies while at the same time protecting vulnerable retirees relying on employer promises.

Active employees who have met the vesting requirements necessary to receive a retirement benefit may also have certain legal protections. Vesting requirements usually involve some combination of service years and age. To be “vested” means an employee has met the requirements and may have earned a “right” to the benefit. Changes to the retiree benefit must be agreed to by vested employees and cannot be unilaterally modified or reduced.

Some attorneys believe that benefit changes and reductions affecting vested employees must be negotiated by trading off compensation of similar value to the retirement benefit being reduced. Legal assistance is advised if benefit changes are considered. In any case, retiree and active employee vested rights issues severely narrow the available options for future cost control. Non-vested and new employees may bear the brunt of plan changes necessary for long-term cost containment.

Management Considerations

Cities with outstanding debt and credit ratings (or planning to issue debt) should be concerned about GASB 45’s financial impacts. Credit ratings are based on reviews of numerous aspects of a city’s operations and finances, and the effect of GASB 45 may be a negative factor inan overall rating assessment. One rating agency has commented that, depending on its size, an unfunded OPEB liability could eventually change the asset-liability ratio considered by credit analysts and be a negative factor during a rating review. Other analysts have commented that budgetary flexibility is an important rating consideration and, to the extent that funding GASB 45’s annual required contribution reduces that flexibility, it would be considered a negative factor.

Agencies that cannot fund these liabilities in advance may have problems in the future funding the pay-as-you-go costs of retiree benefits. There may be long-term financial damage caused by a large, growing and unfunded liability. The real impact on credit ratings won’t be known for some time.

Things to Remember

The liabilities are huge and the alternatives few. Funding liabilities of such magnitude may not be an option for many cities. What can be done?

The reality is that it’s better to know how much these liabilities are because they are going to be paid sooner or later. If they are not funded in advance and remain pay-as-you-go, they will be paid in the future at a much higher cost. Each year, the number of retirees will increase, as will the cost of healthcare — slowly draining resources from the annual budget with devastating impacts on operating budgets.

The Prospect of New Products And Services

Cities should explore all the alternatives available to address the issues raised by GASB 45 and postpone making decisions as long as possible. A market is developing around the services required to implement GASB 45. This market is not mature and it’s reasonable to expect that new ideas and approaches will be developed and firms will offer products that aren’t currently available. In addition, CalPERS may offer trust fund and investment services in the future.

Some GASB 45 decisions are irrevocable and difficult to reverse. Don’t eliminate possible options in the future by making premature decisions. Take any action, even if it is small, to begin addressing and funding your OPEB obligations.

This article appears in the November 2006 issue of Western City
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