What it means
When an organisation agrees to pay part of a retiree's medical costs, it takes on a cost that will be paid years after the work is done. Accounting rules require the employer to estimate the present value of those future payments and record them as a liability.
This is sometimes called the total OPEB liability. Unlike pensions, which usually have to be funded through a separate trust, many OPEB promises have historically been paid as they arise, with no money set aside.
That means the liability can be large while the assets set aside against it are small. The gap between the two is the net OPEB liability, and it shows how much is unfunded.
Estimating the liability requires assumptions about how long retirees will live, how fast health costs will rise, how many employees will stay until retirement and what discount rate to use. Small changes in these assumptions can swing the number a lot.
Health care cost inflation in particular is hard to predict. In the United States, state and local governments follow standards issued by the Governmental Accounting Standards Board, while companies follow accounting rules for retirement benefits in their own reporting framework.
International reporting standards treat these benefits under their rules for employee benefits. The details differ, but the principle of recognising the promise earlier is the same.
For managers and creditors, OPEB matters because it is a debt-like claim. Credit rating agencies and lenders include it when assessing financial strength, and changes to benefits can be sensitive politically and legally.
Employers sometimes reduce the promise for new hires or move to a defined contribution approach to limit risk. Good governance means reviewing the liability on a regular schedule.
Actuaries update the estimate each year or every two years, and the board should see how much of any change comes from new assumptions rather than from new promises. A simple one-page summary of the liability, the assets held and the annual cash cost helps non-specialists keep track.
In practice
Real-world examples.
Example
A large manufacturer promises health cover to retired factory workers. Its finance team estimates a liability of $300 million, which appears in the financial statements. The company debates whether to move retirees to a fixed monthly contribution.
Example
A city council has always paid retirees' health bills out of annual budgets. A new accounting standard requires it to report the promised future cost, and the balance sheet shows a liability of $90 million. Bond investors ask how the city plans to pay.
Example
A university sets up a trust and contributes $5 million a year to pre-fund retiree benefits. The funded ratio rises each year, and the credit rating agency treats it positively. The contributions reduce cash for other uses in the short term.
Formula
Calculation
Net OPEB liability = total OPEB liability - plan assets set aside
Funded ratio = plan assets / total OPEB liability
Suppose a city estimates the present value of promised retiree health benefits at $48,000,000 and has set aside $12,000,000 in a trust.
Net OPEB liability = 48,000,000 - 12,000,000 = $36,000,000.
Funded ratio = 12,000,000 / 48,000,000 = 0.25, or 25%.
If the discount rate assumption were lowered, the total liability might rise to $54,000,000, and the net liability would become 54,000,000 - 12,000,000 = $42,000,000, an increase of $6,000,000 with no change in the benefits promised.Case study
Seen in the real world.
Riverton County is an illustrative, fictional local government that had never counted the cost of promised retiree health cover. A new reporting rule required it to record the liability for the first time.
The finance director calculated a total liability of $120 million against assets of nothing. Her report showed that paying benefits as they arose would cost $6 million a year and rise over time, while creating a trust and contributing $4 million a year extra would reduce future pressure.
The county council agreed to start the trust, and also to limit the benefit for new hires. The illustrative lesson is that OPEB liabilities exist whether or not they are recorded, and facing them early gives more choice than waiting.
Watch out
Common mistakes.
- Treating OPEB as the same as pension obligations, when it often has no funding and faces uncertain health cost trends.
- Using a single assumption for health cost growth, when small changes can move the liability sharply.
- Ignoring OPEB when assessing a borrower's debt, even though it behaves like debt owed to retirees.
Questions
People also ask.
What does OPEB include?
It covers benefits other than pensions that are paid after employment ends, mainly retiree health care, dental and life insurance.
Why is OPEB often underfunded?
Many employers paid benefits as they came due and did not set aside money in advance, so the assets are small compared with the promise.
Can employers change OPEB benefits?
Often they can for future hires or in some cases for current staff, but legal, contract and political limits apply, so changes need careful review.
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