Accounting change reduces cost of retiree healthcare by $2.1 billion

Connecticut taxpayers owe $2.1 billion less for state retiree healthcare, according to a new report released Thursday, because actuaries changed one number used to calculate the long-term cost of the benefit.

According to the Segal Company in Farmington, taxpayers were on track to owe present and future retirees $31.2 billion in other post-employment benefits as of this year.

A draft report last month showed that number fell to $20 billion, largely because of changes in assumptions and participation in a new program that has accounting advantages over the previous method of delivering prescription drugs to retirees on Medicare.

One of the major assumption changes in the draft report was an increase in the discount rate from 4.5 percent to 5 percent.

In the final version of the report, the actuaries increased the discount rate again – at the state’s request – this time to 5.7 percent. This simple change of .7 percent reduces the stated cost of the benefits by $2.1 billion.

The discount rate is important because it puts a price on time. The higher your discount rate, the more you prefer to have money today over tomorrow.

Put another way, the discount rate is the amount of money you would give up to have a dollar owed to you next year paid today.

The state is increasing its discount rate because of accounting rules often criticized by financial economists that allow it to use a discount rate based on expected investment returns.

Financial economists say the discount rate should be much lower – specifically what is known as the risk-free rate – if the liability has to be paid.

Higher rates of return – and higher discount rates – imply taking on more risk to obtain such returns and shouldn’t be used for guaranteed payments, the argument goes.

Gov. M. Jodi Rell and the State Employees Bargaining Agent Coalition agreed in 2009 to start saving for OPEB costs in a trust fund.

Although the trust fund currently contains about $49.6 million – or one-four-hundredth the long-term healthcare liability – the state is counting on returns from investing this relatively tiny amount to justify increasing the discount rate.

The state expects to earn 8.25 percent on its investments in the trust. The actuaries determined 5.7 percent represents a blend between the 8.25 percent discount on liabilities with offsetting assets and 4.5 percent for other liabilities.

Private sector companies have to use lower discount rates. The Wall Street Journal recently reported that General Electric is using a 4.2 percent discount rate, while Boeing is using a 4.4 percent rate.

As recently as a year ago their discount rates were higher than 5 percent, but private companies are legally required to fully fund their pensions unlike state governments.

Before setting up the trust, the state paid only the cost of benefits incurred each year instead of the cost of the benefits promised. It still doesn’t pay the full cost of the benefits promised, but its annual contribution and the amount contributed by some state employees is greater than the amount being paid in benefits.

Announcing the completion of the report, Gov. Dannel Malloy and Comptroller Kevin Lembo celebrated its findings.

“Today’s announcement is further proof that the tough decisions we’re making are having a real impact on our state’s finances,” Malloy said. “By planning for the long term, we can make sure that future generations won’t find themselves in a situation where they have to choose between critically important services and obligations to state employees.”

“This future savings is extraordinary, resulting from partnership among state agencies and state unions in controlling costs, while maintaining quality services,” Lembo said. “This report reveals that creativity and collaboration, all accomplished in remarkably short time, will save us billions. This is a powerful incentive to continue these efforts to reduce costs for Connecticut.”

The joint release from Lembo and Malloy described the savings differently than actuaries did in their report.

Lembo and Malloy said the $2.12 billion reduction “is due to recently negotiated increases in employee and state contributions, which are expected to accumulate rapidly under this new arrangement.”

According to the actuaries,

A ten-year projection of the OPEB Trust Fund was completed to study whether the discount rate used to value plan obligations could be further increased. Based on our analysis presented in our memo dated May 10, 2012, the State decided to increase the interest rate to 5.7%, which lowered the obligation by an additional $2.12 billion.

Since the report was long overdue, the state had to use stale numbers in its Comprehensive Annual Financial Report, as it did for the two years before that, prompting auditors to mark the reports incomplete.

Under proposed new accounting rules, the state will soon have to add its retiree healthcare liability to its balance sheet instead of reporting it in footnotes.

According to the actuaries, recent retiree healthcare costs came in lower than expected allowing them to reduce future estimates.

The actuaries also changed the prediction for medical inflation from previous reports. At its peak difference from previous estimates three decades from now, the new inflation rate saves the state about 8.5 percent.

Lembo’s adoption of a new method of delivering Medicare prescription drug benefits has accounting advantages that allow the actuaries to use future federal subsidies to decrease the liability on Connecticut’s books.