NASACT Conference Presentation to: August 14, 2007 Case Studies in OPEB Financing Elizabeth Yee, Vice President.

NASACT Conference

Presentation to:

August 14, 2007

Case Studies in OPEB Financing

Elizabeth Yee, Vice President

Public Sector OPEB Obligations are “The Norm”

___________________________Source: Mercer National Survey of Employer-Sponsored Health Plans, 2005.

88%

28%

81%

31%

0%10%20%30%40%50%60%70%80%90%

100%

Pre-Medicare Eligible Medicare-Eligible RetireesPublic Private

Public vs. Private Sector OPEB Liabilities

The public sector offers retiree coverage at almost 3x the rate of the private sector

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Demographics Drive the Agencies’ OPEB Exposure – Sample Municipal OPEB Data

0

100

200

300

400

500

600

1986 1991 1996 2001 2006 2011 2016 2021

# of Retirees

New Retirees Projected Expected Retirees

Annual Number of State Retirees(Historical & Projected)

___________________________Source: Buck Consultants.

Approval of Enhanced Benefits

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

2000 2005 2010 2015 2020 2025

# of Retirees

Total Retirees Total Projected Expected Retirees

Cumulative Number of State Retirees (Historical & Projected)

An aging workforce is leading to retirement rates over next 20 years which is far in excess of historical retirement rates

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What Do Rating Agencies and Other Credit Arbiters Say?

"You can't ignore the problem. You can't let the OPEB number grow to infinity over time. You need to develop a feasible plan to address the liability. Arguing that you only need to continue with the PAY-GO and failure to address the OPEB liability is unacceptable."

Parry Young, Standard & Poor’s

"If you decide you want to continue Retiree Health Benefits as a priority, then make a plan and fund it. If you decide that Retiree Health Benefits are not a priority, then don't make a plan, and you don't have to fund it. But don't maintain Retiree Health Benefits with no plan and no funding."

Ken Kurtz, Moody’s Investor Services

Rating agencies are focused on OPEB given the workforce demographics It is unlikely that they will unleash wholesale downgrades, however they have

incorporated OPEB and pension funding as a consideration in determining ratings

Some have already noted an agency’s OPEB liability in its rating report Insurers and Institutional Investors are also aware of this liability and consider it

as part of their due diligence process Developing a strategy is critical for maintaining market access

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GASB 45 Status Update

All of our “Phase 1” issuer-clients have commenced or finalized their OPEB studies in compliance with GASB 45

– Under SB 1102, Texas municipalities have the option to disclose their OPEB liabilities

– Some “early adopters” have done a disclosure “dry run” in their FY 2006 financials (ex. City of New York and CPS Energy)

Those who have completed their studies are evaluating their plan benefits and funding options

OPEB Studies are underway

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The Range of Potential Plan Benefit Adjustments is Limitless

Proposed adjustments to Plan Benefits include:

– Reducing available benefits/gradually eliminating benefit

– Transitioning to new tiers for new employees

– Freezing benefits at current level

– Tying medical inflation to a quantifiable, hedge-able index

– Transitioning to a specific dollar contribution

– Requiring those with partners/spouses eligible for Medicare to transition out of existing plan

– The “GM approach” – providing an upfront payment to beneficiaries

– Reinstating OPEB benefits!

The OPEB phenomena seems to be significantly more diverse than pensions

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GASB 45 Status Update

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Comparison of State LiabilitiesThe nature of retiree health benefits varies greatly from State to State

Over $10 billion

Between $1 billion and $10 billion

Less than $1 billion

___________________________Source: Credit Suisse Equity Research Report, March 2007.

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Addressing the OPEB Liability – A “Sample” Ohio

– Aggressively pre-funded its OPEB plan, which has accumulated nearly $11 billion in assets against a $30 billion OPEB obligation (37% funded)

– To extend the solvency of the health benefits, Ohio modified its retiree health plan so only employees with at least 30 years of service are eligible for full coverage

– In addition, Ohio mandated increased contributions for active workers and employers

Alabama– Increased the premium payment obligation for certain employees, including smokers and

individuals who retire after a short period of service

– Approved a bill to create a pair of OPEB trusts to help pay health-care costs of retired teachers ($200+ million) and state employees

Maryland– Set aside $200 million for the State Employees and Retirees Health & Welfare Benefits, an

OPEB trust fund

– OPEB benefit payments have jumped 62% from $146 million in 2005 to $236 million in 2006

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Other Approaches to Funding the OPEB Liability

The “Ostrich” approach

– Not recommended Modest annual set-asides

– Right direction; limited investment earnings advantage Commitment of Future Cashflows (freed up debt service, Tobacco) Many states with sizable unfunded pension liabilities already have

begun to review these liabilities to reduce costs and redeploy capital Pre-funding with taxable OPEB Bonds

– There have been 4 local municipal OPEB Bond funding transactions to date

– There have been no OPEB bonding transactions at a State level

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Goals of an OPEB Financing

Ideal: Normal Cost + UAAL Amortization < Pay-As-You GoAttaining this “ideal” can be challenging for some

Isolate and address liability Take advantage of low interest rate environment and explore

reinvestment options

– GASB 45 allows funded plans to use a higher discount rate and reduce the size of the reported liability

Enhance benefit security for current and future retirees Provide a predictable, manageable retiree health cost

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Case Study: Peralta Community College District

District Budget of $100 million Retiree Health Benefit was capped on July

1, 2004 via negotiation with Unions OPEB obligation projected to increase from

$5.2 million in FY 2006 to $10.2 million in FY 2016

Net Present Value of Benefits ranges from $132 million (@ 7%) to $196 million (@ 4.5%)

Debt service structured assuming 2.0% annual growth in General Fund revenues, at 6.7% of projected General Fund revenues

Peralta created an indentured trust in which to deposit its OPEB bond proceeds

OPEB Debt Service vs. General Fund Revenues

District will contribute a constant percentage of General Fund revenues towards debt service

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

2006 2011 2016 2021 2026 2031 2036 2041 2046

$ 000

Estimated Pay-Go CostDebt Service = 6.7% of GF Revenues at 2%

Annual Growth

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Case Study: East Side Union High School District

OPEB Debt Service vs. General Fund Revenues

0

500

1,000

1,500

2,000

2,500

3,000

3,500

2006 2011 2016 2021 2026 2031

$ 000

Debt Service

0.86% of GF Revenues at 2% Annual Growth

District had a $28.1 million OPEB UAAL District issued $32.1 million of taxable OPEB Bonds

with a 30-year maturity and established a GASB 45 compliant Trust to fund UAAL and 2006-07 payment

Debt service was structured to grow at 2% per year, replicating expected General Fund growth

– Debt service is prepaid by September 1st

– Rate Stabilization Fund will hold any voluntary deposits and can be used to pay debt service or retiree costs

District makes monthly pay-go payments, Trust will reimburse District annually

Investments are governed by an Investment Policy and funds are managed by an independent 3rd party

Bond Placement Results – Geographic Distribution

Ireland22%

Germany30%

Canada29%

England19%

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Case Study: County of Oakland, Michigan

Closed VEBA program which was 35% funded as of 2006 with an UAAL of approximately $480 mm

Effective January 1, 2006 County switched from a DB to a DC plan where County pays a fixed cash amount to retirees

Oakland County’s Plan – Fully fund VEBA

– Sell $500 mm in 20-year taxable general obligation bonds at 5.5%

– $42 mm annually vs. paying $55 mm ARC ($12.8 mm savings)

– County will invest $500 mm taxable proceeds through the VEBA Trust fund at 7.5% over 20-year period (net gain of $150 mm NPV)

Transaction structured as Trust Certificates, which are supported by the assets of the trust rather than the full faith and credit of the County

In July 2007, $556,985,000 Taxable COP Series 2007 was issued competitively with a short 7-year par call to fund OPEB UAAL

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Risk / Return Analysis is Key to Asset Allocation Decisions

Past data illustrate volatility vs. return “trade-offs” among asset classes

7

8

9

10

11

12

13

14

5 7 9 11 13 15 17

Volatility (Standard Deviation) %

Ann

uali

zed

Tot

al R

etur

n %

100% Bonds

100% Stocks

20% Stocks / 80% Bonds

50% Stocks / 50% Bonds

80% Stocks / 20% Bonds

U.S. Stock/Bond Portfolios1975-2005

___________________________Source: Callan Associates. Stocks represented by S&P 500. Bonds represented by the Lehman Brothers Intermediate Government/Credit Bond index.

The challenge is to invest an OPEB Trust so that it produces sufficient investment income in the near-term while still generating equity-like returns over the long term

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Twenty-years of Best-Performing Assets Show Variability

No one asset class consistently outperforms

___________________________Source: Lehman Brothers Asset Management.

Year Best-Performing Asset Class (Domestic) Total Return

1986 Long-Term Government Bonds 24.5%1987 U.S. Treasury Bills 5.51988 Small Company Stocks 24.91989 Large Company Stocks 31.51990 Intermediate-term Government Bonds 9.71991 Small Company Stocks 46.11992 Small Company Stocks 18.41993 Small Company Stocks 18.91994 U.S. Treasury Bills 3.91995 Large Company Stocks 37.41996 Large Company Stocks 23.11997 Large Company Stocks 33.41998 Large Company Stocks 28.61999 Small Company Stocks 21.32000 Long-Term Government Bonds 21.52001 Long-Term Government Bonds 10.72002 Long-Term Government Bonds 17.82003 Small Company Stocks 47.32004 Small Company Stocks 18.32005 Large Company Stocks 4.91

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There are Numerous Policy and Fiscal Issues to Discuss “One size does not fits all” It is pretty clear that few entities will have the ability to fund the ARC in the near-term OPEB-Catch 22 – rating agencies say it’s too early to make adjustments and issuers won’t make

adjustments until forced by the rating agencies Valuations are only as good as their assumptions Many agencies are using the State Pension Plans’ retirement rate OPEB benefits are diverse and long-term medflation can produce uneven outcomes What level of “proof” might the market need to accept that these liabilities are not vested? Although benefits are not constitutionally or statutorily protected, they still are subject to meet and

confer with good faith bargaining requirements, few can be unilaterally reduced, and the practical reality is that employees and retirees are voters, too

“Implied subsidy” issue may warrant “bifurcation” from UAAL Bond funding is not a panacea but may offer a useful tool for managing these UAALs

– Benefits = the discounting associated with prefunding and the reshaping opportunities OPEB Bonds present similar benefit/risks as POBs, although reinvestment challenges seem greater

given prevailing near-zero funding ratios

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Lehman Brothers is an Active Participant in the OPEB Discussion

National Federation of Municipal Analysts

May 2006

IMN National Municipal OPEB Conference

May 2006 and April 2007

Bond Buyer OPEB Liability Conference

March 2006 and March 2007

IMN California Public Finance Conference

April 2006

California Debt & Investment Advisory

Commission

September 2006

Peralta Community College District $153,749,832.25

Taxable 2005 Limited Obligation (OPEB) Bonds

December 2005

National Association of State Auditors,

Comptrollers and Treasurers

August 2006

February 2006

State Association of County Retirement Systems

2006 California Association of County Treasurers & Tax

Collectors Annual Conference

June 2006

ACWA

May 2006

Spring Conference

$32,050,000East Side Union High School District

November 2006

Taxable 2006 Limited Obligation (OPEB Bonds)

2006 State Controller’s Annual Conference for County Auditors

April 2006

Standard & Poor s OPEB Conference

September 2005 & September 2006

’

Western Interstate Region Conference

May 2006

New York State Association of Counties

January 2006

IMN New England Public Finance

Conference

October 2006

$556,985,000 County of Oakland, MI

OPEB Financing

July 2007

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Lehman Brothers’ OPEB Contacts

BARBARA LLOYD Senior Vice President

LEHMAN

BROTHERS

Lehman Brothers Inc. 10250 Constellation Blvd 25th Floor Los Angeles, CA 90067 (310) 481-4963 Fax: (646) 758-3082 email: [email protected]

ELIZABETH YEE Vice President

LEHMAN

BROTHERS

Lehman Brothers Inc. 399 Park Avenue, 16th Floor New York, NY 10022 (212) 526-8863 Fax: (212) 520-0857 email: [email protected]

ROBERT LARKINS Managing Director

LEHMAN

BROTHERS

Lehman Brothers Inc. 555 California Street, 41st Floor San Francisco, CA 94014 (415) 274-5355 Fax: (212) 520-0856 email: [email protected]

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