California State Auditor's Report: High Speed Rail (HSR) Becoming Increasingly Risky (2011)

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High-Risk UpdateOther

Postemployment Benefts:Signifcant Financial Risk Exists i the State Does Not ActivelyManage the Costs o State Retirees Health and Dental Benefts

April 2009 Letter Report 2008-607

C A L I F O R N I A

S T A T E A U D I T O R


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Te rst ve copies o each Caliornia State Auditor report are ree. Additional copies are $3 each, payable by

check or money order. You can obtain reports by contacting the Bureau o State Audits at the ollowing address:

California State Auditor

Bureau of State Audits

555 Capitol Mall, Suite 300

Sacramento, California 95814

916.445.0255 or TTY 916.445.0033

OR

Tis report is also available on the World Wide Web http://www.bsa.ca.gov

Te Caliornia State Auditor is pleased to announce the availability o an on-line subscription service. Forinormation on how to subscribe, please contact the Inormation echnology Unit at 916.445.0255, ext. 456,

or visit our Web site at www.bsa.ca.gov.

Alternate ormat reports available upon request.

Permission is granted to reproduce reports.

For questions regarding the contents o this report,

please contact Margarita Fernndez, Chie o Public Aairs, at 916.445.0255.


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CALIFORNIA STATE AUDITORB u r e a u o f S t a t e A u d i t s

Doug Cordiner

Chief Deputy

Elaine M. Howle

State Auditor

555 C a pit o l Ma l l , Su i t e 3 Sa c ra m ent o , C A 514 1 . 4 4 5 . 5 5 1 . 3 . 1 a x www.bs a .c a .go v

April 30, 2009 2008-607

Te Governor o CaliorniaPresident pro empore o the SenateSpeaker o the AssemblyState CapitolSacramento, Caliornia 95814

Dear Governor and Legislative Leaders:

Tis letter report presents a review conducted by the Bureau o State Audits (bureau)concerning the States eorts to manage the nancial risks associated with the costs o otherpostemployment beneftsor benets in addition to pensions. Commonly reerred to as OPEB,other postemployment benets encompass primarily medical and dental insurance provided toretired state employees. Tis review ollows up on the discussion o these risks in our May 2007report titledHigh Risk: Te Caliornia State Auditors Initial Assessment o HighRisk Issues theState and Select State Agencies Face (2006-601).

New accounting rules that the State must ollow have spotlighted the cost o medical anddental benets or retired state employees. Under the new accounting rules, beginning inscal year 200708, the State must have an actuary estimate the amount the State needs to payeach year or health insurance premiums or retirees, as well as the amount it would need to setaside now to und benets it is obligated to pay in the uture. In addition, the new accountingrules require the State to record the dierence between the actuarys yearly estimate knownas the annual required contributionand the amount o the States cash payments as a liabilityin the States nancial statements. According to the States most recent actuarial study, its totalestimated OPEB liability or retirees was $48 billion. In todays dollars this amount represents thecost o retiree OPEB that state employees have already earned.

Historically, state and local governments have treated the uture costs o retirees health andother nonpension benets dierently rom the uture costs o pensions. Most governmentsusually preund the uture costs o pensionsthat is, most state and local governments haveestablished dedicated trust unds in which they deposit money to nance the anticipated costs

o pensions or current and past employees. Te State contributes to these pension trust undsto ully or partially cover the amount needed to pay or current and past employees pensioncosts. In contrast, the State and many other governments have not chosen historically to preundOPEB costs through deposits to a trust und. Rather, the State appropriates only enough moneyin its annual budget to pay the yearly premiums or retiree health (medical and dental) insurance.Known aspay as you go, this method o unding OPEB costs addresses only the current yearscosts and does not set aside unds to cover any uture costs to the State. For example, in scalyear 200708, the State paid only $1.25 billion o the $3.59 billion annual required contributionor OPEB costs. Consequently, the State recorded an OPEB liability o $2.34 billion in itsnancial statements. Further, the State expects to only pay $1.36 billion o the $3.72 billionrequired contribution or scal year 200809, which is projected to increase the States


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Caliornia State Auditor Letter Report 2008-607

April 2009

2

OPEB liability to $4.71 billion. At that rate o growth, the OPEBliability reported by the State could likely begin to overshadow

other liabilities in the States nancial statements and aect theStates credit rating.

OPEB will continue to be a high-risk area or the State as long as itcontinues to use the pay-as-you-go method o unding these costs.However, the State could reduce its short-term and long-termOPEB costs by beginning to set aside some money to und thesecosts. Te interest that could be earned rom these unds couldbe used to help pay or OPEB costs. Specically, any interestearned rom these unds would lower the States annual requiredcontribution and its total estimated OPEB liability, dependingon how much money the State sets aside. For example, i the

State committed to pay the ull amount o the annual requiredcontribution or scal year 200809, and subsequent scal years,it would have reduced its cost by an estimated $1.04 billion in thatscal year. In addition, the State would achieve similar annualsavings in uture years, which would reduce its total estimatedOPEB liability by about $17.05 billion. Even partially preundingthese costs would also result in signicant savings.

In act, investing money now to help pay or OPEB is one othe main recommendations o the governors Public EmployeePost-Employment Benets Commission (commission).Although the governor publicly endorsed the commissionsrecommendations, the Legislature has yet to earmark any undsto be set aside or OPEB in the scal year 200910 budget. Tegovernor and Legislature will continue considering OPEB undingand other budgetary issues or scal year 200910 as part o theMay revision o the budget. As a result, it remains unclear whetherthe State will begin preunding OPEB obligations and how theState will manage the risks associated with its large and growingOPEB liability.

Background

Legislation that became eective in January 2005 authorizes thebureau to develop a risk assessment process or the State andto identiy, audit, and issue status reports or high-risk areas.Te bureaus May 2007 report identied other postemploymentbeneftsor benets in addition to pensionsas a statewidehigh-risk area because o the increasing cost to the State oproviding these benets to retired state employees. Commonlyreerred to as OPEB, other postemployment benets encompassmedical and dental insurance primarily. Additionally, ourreport indicated that on an actuarial basis as o June 30, 2007,Caliornias total OPEB liability was estimated to be $48 billion.


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April 2009

Furthermore, the report highlighted that the State aces risk inat least two areas: Providing the level o benets promised to

its employees and at the same time protecting its credit rating.Reporting OPEB inormation in accordance with the GovernmentalAccounting Standards Boards (GASB) requirements will,among other things, provide readers o nancial statements withinormation useul in assessing potential demands on the Statesuture cash ows. Bond-rating agencies have already made itclear that they will look with disavor on governments that do notsufciently plan or managing such liabilities. o protect its creditrating and ensure that it can borrow at the lowest available interestrates, the State will need to demonstrate that it is adequatelymanaging the long-term costs o its OPEB. Tis letter reportassesses the States progress in managing this liability.

Overview o the States Other Postemployment Benets or Retirees

New accounting rules issued by GASB spotlighted the cost omedical and dental benets or retired state employees. In exchangeor their services, state employees receive compensation in variousorms. In addition to the salaries and benets that employeesreceive, they also earn benets that they will not receive until atertheir employment with the State ends. Te most recognized typeo these postemployment benets is a pension. In addition, theState, like many other government employers, provides retiredemployees with OPEB, or health (medical and prescription drug)and dental benets. Te State generally pays 100 percent o thehealth insurance costs or retirees and 90 percent o the additionalinsurance premiums or retirees amily members. In addition, theState generally pays all or a portion o retirees dental insurancecosts, depending on the retirees years o state service at retirement.As o June 30, 2008, approximately 138,300 retirees were receivinghealth benets, and 112,600 retirees were receiving dental benets.

For nancial reporting purposes, Te University o Caliornia and58 county superior courts (trial courts) are considered separate

employers. As separate employers, these entities determine theirown benets, benet levels, and unding policies. Te benet plansor the University o Caliornia and the trial courts currently coverabout 32,900 and 2,700 retirees, respectively. Because these entitieshave separate actuarial surveys to determine their OPEB costs,we have generally excluded them rom our analysis. In addition,most Caliornia cities, counties, and other local governmental

1 GASB is the entity that establishes accounting standards that governments must ollow whenproviding audited nancial statements.

2 The State also oers lie insurance, longterm care, and vision benets to retirees; however,because these benets are completely paid or by retirees, there is no OPEB liability to the State.


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April 2009

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entities have OPEB liabilities. However, the State is not directlyresponsible or these entities OPEB liabilities, so we omitted them

rom most o our analyses.

Accounting or OPEB Costs Has Been Diferent Than Accountingor Pensions

Historically, state and local governments have treated the uturecosts o retirees health and other nonpension benets dierentlyrom the uture costs o pensions. Most governments usuallypreund the uture costs o pensionsthat is, most state and localgovernments have established dedicated trust unds in whichthey deposit money to nance the anticipated costs o pensions

or current and past employees. Te State contributes to thesepension trust unds to ully or partially cover the amount neededto pay or current and past employeespension costs. Variousactuaries prepare periodic reports indicating the amount o moneythe State needs to deposit into pension trust unds each yearto meet both current and uture pension costs. In addition, theamount that each trust und pays or current retirees each yearappears on und records as a reduction o assets in the trust undsnancial statements. Moreover, to comply with generally acceptedaccounting principles, the State must also calculate and thendisclose in its annual nancial statements an estimate o the uturecosts o employee pension benets.

In contrast, the State and many other governments have not chosenhistorically to preund OPEB costs through deposits to a trust und.Rather, the State appropriates only enough money in its annualbudget to pay the yearly premiums or retiree health (medical anddental) insurance. Known aspay as you go, this method o undingOPEB costs addresses only the current years costs and does not setaside unds to cover any uture costs to the State. One o the mainreasons or the dierence in the treatment o pension costs andOPEB costs is that GASB has not previously required state and localgovernments to calculate and report the uture cost o the retiree

benets beyond pensions that the governments promised to currentand past employees. Pensions generally provide retirees with xedbenets, and actuaries use ormulas that include such actors as theination rate, investment returns, and retiree lie span to calculatetotal pension costs. Tereore, these ormulas can reasonablypredict how much the State needs to set aside each year to unduture pension costs. However, retirees health insurance costs havetypically grown aster than ination, making the uture costs moredifcult to predict.

3 Most current state employees participating in the Caliornia Public Employees Retirement Systemalso make contributions toward their pension benets during each pay period.


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April 2009

The State Must Now Estimate and Disclose FutureOPEB Costs

itledAccounting and Financial Reporting byEmployers or Postemployment Benefts OtherTan Pensions, GASB Statement No. 45 (GASB 45)required the State to begin recognizing in itsnancial statements or scal year 200708 thecurrent and uture cost o state retirees healthbenets. For previous scal years, GASB hadrequired governments to provide basic inormationabout their OPEB plans and the amount o benetspaid in a particular scal year. Te GASBs newreporting requirements or OPEB costs are now

similar to those or pensions. Specically, it requiresthat state and local governments move rom a cashbasis method o accounting or OPEB costs to onethat recognizes both the current and uture costo these benets. In other words, instead o simplyshowing the amount that the State is paying orcurrent retirees medical insurance each year, theState must now estimate and show the total amountthat it will owe to all o its employeesboth currentand pastwhen they retire. Te State must alsoreport the extent to which it is unding this amount.Tis new requirement applies only to the way inwhich OPEB costs are accounted orthat is, howeach governments nancial statements show thecosts. Te new requirement does not mandatethat the government pay or these costs, nor doesit require governments to set aside money to undthese uture payments. However, the requirementto disclose the ull extent o these costs hashighlighted the existence o a large liability acingthe State that will continue to grow unless the Statebegins to preund OPEB costs.

Because the State needs to calculate its total OPEBamount owed and the amount that it would need topay each year to ully und this liabilitythe annualrequired contributionGASB now requires theState to have an actuarial study perormed at leastevery two years. See the text box or denitions okey terms related to OPEB.

According to its second and most recent actuarialstudy, as o June 30, 2008, the States total estimated OPEB liabilitywas $48.22 billion. In todays dollars this gure represents theuture cost o retiree health benets that state employees have

Denition o Key Terms Related to Other

Postemployment Benets

Annual required contributionAn amount actuarially

determined in accordance with the parameters o

Governmental Accounting Standards Board Statement

No. 45 (GASB 45). This contribution represents a level o

unding that, i paid on an ongoing basis, is projected to

cover the cost o benefts earned during the current year

and a portion o the cost or benefts earned in prior years.

Employer contributionsThe payments an employer

makes (1) directly to or on behal o a retiree or benefciary,

(2) to insurers or medical insurance premiums, or (3) to a

trust (or equivalent arrangement), which is dedicated toproviding benefts to retirees and is legally protected rom

creditors o the employer and plan administrator.

Annual other postemployment benets (OPEB)

expenseThe annual required contribution plus

(1) one years interest on any existing OPEB liability at the

beginning o the year and (2) an actuarial adjustment or

past contribution excesses or defciencies.

Recognized OPEB liabilityThe liability that the employer

reports in its fnancial statements is the annual OPEB

expense less the employers contributions plus any existing

OPEB liability at the beginning o the year. It is also known

as the net OPEB obligation.

Total estimated OPEB liabilityThe uture cost in

todays dollars (or present value) o retiree health benefts

attributable to employee benefts previously earned, also

known as the actuarial accrued liability.

Total ununded OPEB liabilityThe excess o the total

estimated OPEB liability over the value o any assets set

aside to pay or OPEB expenses, also known as the unfunded

actuarial accrued liability. GASB 45 does not require the

employer to record this liability in its fnancial statements;

instead this liability is gradually recognized i the employer

does not ully und the annual required contribution.

Sources: GASB Statement No. 45 Accounting and FinancialReporting by Employers or Postemployment Benefts Other ThanPensions; Other Postemployment Benefts: A PlainLanguageSummary o GASB Statements No. 43 and No. 45 ; and Stateo Caliornia Retiree Health Benefts Program: GASB Nos. 43and 45 Actuarial Valuation Report As o June 30, 2008 (datedSeptember 15, 2008).


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April 2009

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already earned. Because the State has not established a trust orset aside any money to pay or these benets, this entire liability

is currently ununded. GASB does not require that the Stateshow this entire ununded amount as a liability in its nancialstatements. Instead, the State is allowed to recognize a portion othis liability each year, over a period o up to 30 years. Te Stateincludes this annual portion, along with amounts to cover the costso benets earned during the current year, in the calculation oits annual required contribution. Essentially, the annual requiredcontribution is the amount that the State would need to contributeeach year to ully und the estimated benets that state employeeshave earned but that the State will not pay until sometime in theuture. According to GASB, as long as an employer sets asideunds each year that are sufcient to cover the annual required

contribution, the employer does not need to record a liability in itsnancial statements.

However, in scal year 200708, the State paid only $1.25 billiontoward the annual required contribution o $3.59 billion. Tereore,it reported in its nancial statements a $2.34 billion liability oruture OPEB costs as o June 30, 2008. Tis underunding occurredbecause the State was using the pay-as-you-go unding approachand paying only or current retirees medical and dental insurancepremiums as they occurred.

For scal year 200809, the States annual required contribution is$3.72 billion, o which the State expects to pay $1.36 billion or thecurrent cost o retirees medical and dental insurance premiums underthe pay-as-you-go unding method. able 1 lists the components othe calculation o the projected OPEB liability or scal year 200809,which is a projection based on the actuarial report since scal year200809 has not yet ended. Because the State did not pay enougho its annual required contribution in scal year 200708, it mustinclude interest on the $2.34 billion liability rom that year, as well asan actuarial adjustment, in its calculation o the annual OPEB expenseor scal year 200809. Based on this calculation, the ull OPEBexpense or scal year 200809 will be $3.73 billion. However, because

the State expects to pay only $1.36 billion, it projects that its liabilityin the current year will increase by $2.37 billion. Te State must addthis increase to the $2.34 billion liability recognized in scal year200708, or a total recognized OPEB liability o $4.71 billion that theState will need to disclose in its nancial statements or the scal yearending June 30, 2009.


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Table 1

Projected Calculation o the States Liability or Other

Postemployment BenetsFiscal Year 200809

(In Thousands)

Amount

Annual required contribution $3,715,201

Interest and actuarial adjustments* 12,810

Annual Other Postemployment Benets (OPEB) Expense $3,728,011

Expected employer cash payments (1,360,672)

Increase in Projected Liability $2,367,339

Recognized OPEB LiabilityJuly 1, 2008 $2,340,886

Projected OPEB LiabilityJune 30, 2009 $4,708,225

Source: State o Caliornia Retiree Health Benefts Program: GASB Nos. 43 and 45 Actuarial ValuationReport As o June 30, 2008 (dated September 15, 2008).

Notes: This table does not include the University o Caliornia or the trial courts.

Because scal year 200809 has not yet ended and because the States actual contributions or thisscal year are currently unknown, this calculation is a projection based on the actuarial report.

* This amount is the net o interest on the July 1, 2008, OPEB liability and an actuarial adjustmentresulting rom the scal year 200708 contribution deciency.

Signicant Financial Risks Exist i Governments Do Not ActivelyManage OPEB Liabilities

OPEB will continue to be a high-risk area or many governments aslong as they continue to use the pay-as-you-go method o undingOPEB costs without setting aside additional unds or taking otheractions to address OPEB liabilities. In uture years, the OPEBliability reported by the State, i the State has not substantiallyunded those costs, could grow so rapidly that it could begin toovershadow other liabilities on its nancial statements and aect theStates credit rating. In act, in its April 2009 ofcial statement orgeneral obligation bonds, the State acknowledged, Te long-termcosts or other post-employment benets may negatively aect the

states nancial reports and impact its credit rating i the State doesnot adequately manage such costs. A weaker credit rating couldcompound the States budget problems by increasing the costs oborrowing money when it issues bonds. As previously described,the projected $4.71 billion liability or scal year 200809 is aboutdouble the $2.34 billion liability as o June 30, 2008. In addition,the initial OPEB liability o $2.34 billion represented 1.6 percent othe States total liabilities o $147.8 billion as reported in its nancialstatements or scal year 200708. I total liabilities remained thesame, this percentage could increase to 3.2 percent in the Statesscal year 200809 nancial statements as the reported OPEBliability grows rom $2.34 billion to $4.71 billion. Furthermore,


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according to the States second actuarial survey, its total unundedOPEB liability grew to $48.22 billion as o June 30, 2008, which is

an increase o approximately $340 million rom the $47.88 billionestimated in May 2007 in its rst actuarial survey. I the Statecontinues to use its pay-as-you-go unding method, the Statessecond actuarial study concludes that the annual OPEB costs couldrange rom three to ve times the pay-as-you-go costs and thebalance sheet liability could grow exponentially.

A majority o other public agencies within Caliornia ace thesame risks that exist at the state level according to data compiledby the commission. In December 2006 the governor created thecommission to report on how the State and Caliornias localgovernments were addressing their OPEB liabilities. Released in

January 2008, the commissions report included the results o asurvey that took place in May and June 2007 at public agenciesthroughout Caliornia in part to identiy the agencies practicesor addressing OPEB liabilities. In addition to evaluating the Stateand the University o Caliornia, the commission surveyed cities,counties, special districts, school districts, and community collegedistricts. With the exception o trial courts, which the commissionsreport did not include, almost 1,200 entities responded. Surveyrespondents included all counties and more than two-thirds oCaliornias cities, special districts, school districts, and communitycolleges as measured by their total revenues. As able 2 shows,approximately 78 percent o the survey respondents reported thatthey are using the pay-as-you-go method o unding OPEB, whileonly 22 percent partially or ully preund their OPEB obligations.

In addition, as able 2 indicates, these public agencies reporteda combined ununded OPEB liability o more than $71 billionaccording to their most recent actuarial valuations at the timeo the survey. Moreover, the commissions report acknowledgedthat the combined OPEB liability is probably understated becauseonly 37 percent o the agencies that reported oering OPEB alsoincluded data on their OPEB liability. Te commission indicatedthat this low response rate most likely reected the act that at

the time o the survey, many agencies were still in the process ocomplying with the new OPEB accounting standards and may nothave released their actuarial valuations publicly.


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Table 2

The Funding Policies and Total Ununded Liability or the Other Postemployment Benets

o Public Entities in Caliornia

C Al ifor ni A Gov er nme ntA l en ti ti es fu nd in G P oli Ci estotAl unfunded

liAbility

for other

PostemPloyment

benefits

(in billions)

totAl

ContACted

for survey

totAl

resPonded

to survey

PerCentAGe

resPondinG

PerCentAGe

usinG

PAyAsyouGo

method

PerCentAGe

usinG

PArtiAl

or full

fundinG

Counties 58 58 100% 77% 23% $28.0

School districts 1,036 475 46 79 21 15.9

University o Caliornia 1 1 100 100 0 11.5

Cities 478 231 48 80 20 8.8

Special districts 2,052 374 18 78 22 3.5

Community colleges 72 39 54 51 49 2.5

Trial courts* 1.3

Totals 3,697 1,178 32% 78% 22% $71.5

Source: Funding Pensions & Retiree Health Care or Public Employees: A Report o the Public Employee PostEmployment Benefts Commission (commission).

* We obtained trial court data rom separate actuarial surveys dated July 1, 2007, because the commissions survey did not include trial courts. As aresult, we include only the total ununded liability or trial courts. However, all 58 trial courts use the payasyougo method.

As noted on page 8, because many agencies were still in the process o complying with Governmental Accounting Standards Board requirements atthe time o the commissions survey, only 37 percent o the agencies that reported oering other postemployment benets (OPEB) also includeddata on their OPEB liability. Consequently, this amount is understated.

Like Caliornia, most other states use the pay-as-you-gomethod to und OPEB and thus underund their OPEB liability.According to a report released in December 2007 by the PewCharitable rusts Center on the States (Pew Center), only six states(Arizona, Ohio, Oregon, North Dakota, Utah, and Wisconsin) hada policy o ully unding their annual required contribution, andonly three states (Wisconsin, Arizona, and Alaska) had undedmore than 50 percent o their total estimated OPEB liability. Sincethe reports publication, some states have begun to move towardpartial or ull unding o OPEB. However, states like Caliornia thatcontinue to allow their OPEB liability to grow unchecked may seenegative eects on their credit ratings.

Preunding OPEB Could Result in Potentially Signicant Savings

Te State has three basic options or unding its estimated OPEBliability: the current pay-as-you-go method, partial-undingmethod, or ull-unding method. able 3 on the ollowing pageshows the advantages and disadvantages o each unding method.Te pay-as-you-go approach, which the State currently uses, meansthat it pays only or medical and dental insurance or employeesalready retired when the insurance premiums are due. Tepay-as-you-go method requires the smallest annual employer cashpayment o the three unding methodsa situation that benets the


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States short-term cash-ow situation. However, the approach alsoresults in the largest annual OPEB expense and the astest-growing

OPEB liability recognized in the States nancial statementsbecause the State is not setting aside any unds to pay or retireesuture health benets. Te partial-unding method entails settingaside some cash reserves each year to pay or uture OPEB costsin addition to paying or the medical and dental premiums oemployees already retired. Under this unding approach, the annualcash payment that an employer makes is less than the requiredcontribution, and this circumstance means that the OPEB liabilityreported in the employers nancial statements will continue togrow; however, the liability will grow at a slower rate than under thepay-as-you-go method. As able 3 shows, the ull-unding methodrequires the largest cash payment by the employer, and it means

that the employer is making the ull amount o the annual requiredcontribution every year and thereore does not need to recognizean OPEB liability in its nancial statements as long as the employerhas always ully unded OPEB. Moreover, the ull-unding methodresults in the lowest annual OPEB expense, as compared to thepay-as-you-go or partial-unding approaches.

Table 3

Advantages and Disadvantages o Diferent Methods o Funding Other Postemployment Benets

APProACh emPloyer Contributions

AnnuAl other PostemPloyment benefits

(oPeb) exPense

reCoGnized oPeb (finAnCiAl

stAtement) liAbility

Payasyougo Smallest cash payment amount (only

actual health and dental premiums or

retired employees). Improves shortterm

cashfow situation.

Largest annual OPEB expense reported

in the nancial statements and highest

longterm cost.

Largest and astestgrowing

liability reported in the

nancial statements.

Partialunding Cash payment o more than the actual

health and dental premiums or retired

employees but less than the ull actuarially

required amount. Allows plan assets to

start accumulating or uture benets, but

it may reduce shortterm cash fows.

Annual OPEB expense between

that o the payasyougo and the

ullunding approach.

Smaller and slowergrowing

liability than the

payasyougo unding

method, but larger than the

ullunding approach.

Fullunding Largest cash payment required (ull

actuarially required amount). Negatively

aects shortterm cash fows.

Smallest annual OPEB expense

reported in the nancial statements

and lowest longterm cost.

No liability reported in

the nancial statements

i ully unded rom the

year o implementation oGovernmental Accounting

Standards Board (GASB)

Statement No. 45.

Source: State o Caliornia Retiree Health Benefts Program: GASB Nos. 43 and 45 Actuarial Valuation Report As o June 30, 2008 (dated September 15, 2008).

Partial or ull unding o OPEB results in lower costs andliabilities than does pay-as-you-go unding because the partial- orull-unding methods allow the employer to use a higher assumedrate o return in its actuarial calculations. Te assumed rate oreturn is a primary variable inuencing the calculation o the


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April 2009

annual required contribution and total OPEB liability, and actuariesdetermine this rate using a long-term perspective. Te States

second actuarial study rom September 2008 explains this process:

Te interest discount rate is based on the assets available to paybenets. Plan sponsors that nance benets on a pay-as-you-gobasis typically pay retiree health care benets rom the generalund. Because an employers general und is primarily investedin short-term securities, a low investment return assumption,such as our percent to ve percent, is typically used to developthe present value o uture benets. However, plan sponsorsthat ully-und retiree health care benets in a separate trustmay be able to construct a diversied investment portoliothat generates much higher returns such as seven percent to

eight percent. Using a higher discount rate such as eight percentwill produce a lower [annual required contribution] whencompared to a discount rate o our percent. Also, as assets inthe trust accumulate, investment income will also grow thuslowering the overall costs to the employer.

able 4 on the ollowing page provides a practical illustration romthe States second actuarial study that shows how the States undingpolicy aects the assumed rate o return and, by extension, theannual required contribution and the recognized OPEB liability orscal year 200809. Although preunding has clear advantages,the budget crisis precipitated by the economic downturn has ledto a shortall in revenues or the State, and this shortall hascreated cash-ow difculties and made the States ability to ullyund OPEB less easible in light o competing scal priorities andlimited resources.

As able 4 on the ollowing page indicates, i the State were tocommit to ully unding OPEB in scal year 200809 and in utureyears, it would save an estimated $1.04 billion by reducing theStates annual required contribution in that scal year. It wouldachieve similar savings in subsequent scal years, which wouldlower by about $17.05 billion the total estimated OPEB liability.

Even by committing to partially preunding OPEB at 50 percent, asshown in able 4, the State would save an estimated $630 million byreducing the annual required contribution that scal year and, overtime, would lower by about $9.92 billion the total estimated OPEBliability. Tus, in both the short term and long term, preundingwould provide signicant savings to the State.

A comparison o the unding methods used by the city oLos Angeles (Los Angeles) and the city and county o San Francisco(San Francisco), using inormation rom the commissions report,urther illustrates the benets o preunding. able 5 on page 13provides this comparison. Although these public entities dier in the


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Table 4

Comparison o the Efects on Liabilities o Caliornias Contributing Diferent

Levels o Cash Payments or Other Postemployment BenetsFiscal Year 200809

(Dollars in Billions)

fundinG method

PAyAsyouGo

fundinG PoliCy

PArtiAlfundinG

PoliCy

(50 PerCent)

fullfundinG

PoliCy

(100 PerCent)

Ass umed rate o ret urn on inve stments* 4.50% 6.125% 7.75%

Total Estimated Liability or Other

Postemployment Benets (OPEB) as o

June 30, 2008 $48.22 $38.30 $31.17

Savings over payasyougo unding policy 9.92 17.05

Annual Required Contribution $3.72 $3.09 $2.68

Savings over payasyougo unding policy 0.63 1.04

Expected Employer Cash Payments $1.36 $2.02 $2.68

Projected OPEB Liability or Fiscal

Year 200809 $4.71 $3.44 $2.39

Source: State o Caliornia Retiree Health Benefts Program: GASB Nos. 43 and 45 Actuarial ValuationReport As o June 30, 2008 (dated September 15, 2008).

Note: The University o Caliornia and trial courts had separate actuarial studies perormed so theamounts in this table excluded these public entities.

* Governmental Accounting Standards Board Statement No. 45 requires that employers use the

longterm assumed rate o return on the investments that employers expect to use to pay OPEBbenets as they come due.

Although the actuarial study based this 4.5 percent or the States pooled money investmentaccount on a longterm perspective, the actual rate o return on these underlyinginvestments will vary and was only 1.8 percent in March 2009.

Under the ullunding policy, this amount is any previously recognized OPEB liability or priorscal years (in this case, only scal year 200708), with interest and actuarial adjustments.

exact benets and plans they oer to their retirees, the entitiesare similar in terms o revenue and the total number o activeand retired employees that they reported in response to thecommissions survey. An important distinction between their plansis that Los Angeles requires an employee to reach a minimum age

o 55 and to have 10 years o service beore an individual can receivehealth benets, and it bases its contribution on the employees yearso service. San Francisco provides retired employees with healthbenets at a minimum age o 50 i the employees retire with ve ormore years o service. Tis distinction is signicant and could, byitsel, result in a higher OPEB liability or San Francisco. However,the approaches that both public entities use to und uture OPEBcosts also aect OPEB expenses and liabilities.

Los Angeles ully preunds the estimated OPEB liability or theretirees o its largest retirement system, while San Franciscouses a pay-as-you-go unding policy. As previously discussed, a


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preunded plan can use a relatively higher assumed rate o returnthan can a plan using the pay-as-you-go method. As a result,

Los Angeles used an 8 percent rate o return in its actuarialstudy, while San Francisco used a 4.5 percent rate. Further,San Franciscos annual OPEB expense and total estimated OPEBliability were $409 million and $4.04 billion, respectively, whilethe same amounts or Los Angeless were only $109 million and$585 million. Los Angeless much smaller annual OPEB expenseand total estimated OPEB liability illustrate the benets o aull-unding policy.

Table 5

Comparison o Similar Entities Use o Diferent Methods to Fund Their

Retirees Other Postemployment Benets

(Dollars in Millions)

City of los AnGeles*

City And County

of sAn frAnCisCo

Similar Characteristics

Total number o active and retired employees 45,011 49,359

Total revenues $5,300 $5,700

Policy Choices

Other postemployment benets (OPEB)

unding method Fullunding Payasyougo

Benet vesting policy Minimum age

o 55 and 10 yearso service

Minimum age

o 50 and 5 yearso service

Impact on OPEB

Assumed rate o return on investments 8.0% 4.5%

Annual OPEB expense $109 $409

Total estimated OPEB liability $585 $4,036

Sources: Funding Pensions & Retiree Health Care or Public Employees: A Report o the Public EmployeePostEmployment Benefts Commission, and Los Angeless and San Franciscos consolidated annualnancial reports or scal year 200708.

* Los Angeles City Employees Postemployment Healthcare Plan.

San Francisco Health Services System.

The State Is Exploring Preunding Options, but It Has Yet to Set AsideAny Funds

For all o the reasons discussed previously, one o the commissionskey recommendations is that the State establish preunding oOPEB as a policy and budget priority. Te governor endorsedthe commissions recommendations in May 2008. Te governordirected the Department o Finance (Finance) and the Departmento Personnel Administration (Personnel) to research options


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14

that would allow the State to begin preunding OPEB obligationswithout raising taxes or using General Fund money. Finance and

Personnels complete analysis o these options was not publiclyavailable at the time o our report. However, in its April 2009general obligation bond ofcial statement, the State indicatesthe two agencies have identied our general approaches: (1) uselower-cost health-plan options, (2) direct contributions to anOPEB trust und by active employees, (3) increase the vestingperiod or retiree health care benets, and (4) use incentives topromote longer careers among state employees. In response to therst option, the scal year 200910 Governors Budget anticipatespartially preunding OPEB beginning in scal year 201011 byusing savings expected rom contracting or lower-cost healthcare coverage. According to the Governors Budget, the savings

would be about $180 million, which the State presumably wouldhave put into a trust und. However, the budget initially approvedby the Legislature did not incorporate this proposal. Te governorand Legislature will continue considering OPEB unding and otherbudgetary issues ollowing an update o revenues and expendituresrom Finance as part o the May revision o the budget. As a result,it remains unclear whether the State will begin preunding OPEBobligations and how the State will manage the risks associated withits large and growing OPEB liability.

We prepared this letter report under the authority vested in the Caliornia State Auditor by Section8546.5 o the Caliornia Government Code.

Respectully submitted,

ELAINE M. HOWLE, CPAState Auditor

Sta: John Baier, CPA, Audit PrincipalMichael ilden, CPANick Lange, CPA, CIA

For questions regarding the contents o this report, please contactMargarita Fernndez, Chie o Public Aairs, at 916.445.0255.


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April 2009

cc: Members o the LegislatureOfce o the Lieutenant Governor

Milton Marks Commission on Caliornia StateGovernment Organization and Economy

Department o FinanceAttorney GeneralState ControllerState reasurerLegislative AnalystSenate Ofce o ResearchCaliornia Research BureauCapitol Press

California State Auditor's Report: High Speed Rail (HSR) Becoming Increasingly Risky (2011)

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