TO: Roger L. Stancil, Town Manager
FROM: Kay Johnson, Finance Director
SUBJECT: Retiree Health Insurance Liability
DATE: March 26, 2007
This report presents information on how the Town will need to report and fund retiree health benefits beginning in 2007-08.
In the past, the Town of Chapel Hill has reported the annual cost of retiree health insurance as the actual cash paid out in a given year for retirees, commonly known as the “pay-as-you-go” method. The Town has reported no liability for future years’ benefits and, like many governments, has no funding set aside to meet future obligations to retirees. The annual cost has been around $623,000.
Beginning in 2007-08, changes in governmental accounting standards require the Town to report both the estimated future liability and the funds set aside to meet the liability. The Town is required to have an actuary develop the estimate for the Town.
Actuarial Calculation
Chapel Hill contracted with Cavanaugh Macdonald Consulting, LLC to prepare the required calculation. Cavanaugh was contracted by the League of Municipalities to prepare the calculation for local governments in North Carolina.
Based on its assumptions, Cavanaugh Macdonald has calculated the current year expense for retiree health as $5,637,660 for all funds, with a total liability of $45 million for all funds, based on a total of 803 current and retired employees. Beginning in 2007-08, the Town is required to show the calculated current year expense of $5.6 million as an annual cost, but the Town is not required to fund the $5.6 million. The total estimated liability of $45 million is reported in financial statement notes, but is not shown as part of current year costs.
On a “pay-as-you-go” basis, the Town would pay $623,000 for retiree medical insurance in 2006-07.
Chapel Hill’s annual cost under the new calculation is almost nine times greater than the cost as calculated under the “pay-as-you-go” method. Raleigh has a similar ratio, but most local governments have much smaller liabilities, proportionally. With 803 employees and a total liability of $45 million, Chapel Hill’s liability and annual expense are high in comparison with similar-sized communities. For example, the Town of Hickory has a total liability of $11.9 million with 700 eligible employees. Iredell County, with 856 employees has a total liability of $23 million; Cabarrus County with 800 employees has a total liability of $19.5 million, and Cary with 1,028 employees has a total liability of $57.8 million. Each of these employers intends to continue to fund the liability on a “pay-as-you-go” basis and record the balance of the amount owed each year as an outstanding liability.
DISCUSSION
The calculation shows the Town with a high liability relative to the number of employees. We plan to continue discussions with Cavanaugh Macdonald Consulting, LLC to review their estimates.
Bond rating agencies will expect governmental units to develop a plan for addressing the retiree health benefit liability. At one end of the spectrum, the Council could choose to continue the practice of funding only the amount needed for current retirees, that is, the “pay-as-you-go” method. At the other end of the spectrum, the Town could choose to borrow to cover the cost of the liability. While this has been done by some local governments in other states, no local government in North Carolina has elected to fund the liability by borrowing, nor is borrowing recommended by the major rating agencies.
One strategy that is popular for addressing retiree health care costs is to set up a trust fund. A trust fund meets the new accounting standard requirement that an irrevocable source is identified to meet retiree health care obligations. It also has the advantage of allowing governments more flexibility in the use of investment options. Like pension funds, retiree health care trust funds would permit investments in equities and other potentially higher yielding investment vehicles.
The League of Municipalities is working with the State to create a trust fund for local governments to use to fund the future liability in excess of the pay-as-you-go cash requirements. The League anticipates that it will take two years to put such a trust fund in place. Such a trust would be useful to the Town, since funds in such an instrument could be invested in instruments similar to those used for the State retirement system. These instruments generally yield a higher return than that available to local governments.
Bond rating agencies want governments to develop a plan for addressing the retiree medical insurance liability. Since preserving Chapel Hill’s bond rating helps reduce the interest costs for borrowing, it is important the Town develop such a plan.
While we continue our discussions with the actuary, the Council could consider establishing a fund balance reserve to begin to address the liability. We recommend an amount equal to 10 percent of the estimated annual cost, $560,000 in 2007-08, based on current estimates. The reserved funds could still be used for other purposes if the need arose. We would have another actuarial study competed in two years, at about the time that the State trust fund would be established.
Investment in the trust fund would earn a higher rate of return than we can otherwise earn, because of legal restrictions on local government investments in North Carolina. However, once funds are invested in a trust fund, those funds cannot be reclaimed for other purposes. At that time the Council could reasonably transfer funds to the trust fund and reconsider the amount that the Town would contribute towards funding the liability.
CONCLUSION
The Town needs to develop a plan for addressing the retiree health insurance liability. While we continue discussions with the Town’s actuary and with our peers, we recommend that the Council consider setting aside a portion of fund balance equal to 10 percent of the annual cost of the liability and that the Council consider investing any reserved funds in the State trust fund, once that fund is established.
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