Under GASB 45 accounting rules, there are many technical terms. One of these is the Annual Required Contribution (ARC). I often get questions from clients regarding the “meaning” of the ARC, so I thought that I’d give a quick and simplified explanation.
Background: GASB 45 rules create a method for public employers to accrue OPEB liabilities (like retiree health insurance) on their balance sheets. The value of these benefits must be recognized as they accrue over each participant’s career instead of when they are actually paid in retirement. Many OPEB benefits have been accruing silently (i.e., without balance sheet recognition) for decades, but fortunately the GASB 45 rules don’t require employers to recognize the entire liability right away. Instead it is done via the ARC.
The ARC consists of two main components:
- Normal Cost: this is the value of benefits that employees are expected to earn during the current year, and
- UAAL Amortization: this is a portion of the unfunded benefits earned in prior years (i.e., the Unfunded Actuarial Accrued Liability, or UAAL) that have not been recognized on the balance sheet yet.
The intent of the ARC is to encourage employers to recognize the value of any new benefits as they are earned (so that they don’t dig a deeper liability hole) and also recognize a piece of the large liability that was accrued prior to the implementation of GASB 45 accounting rules.
Realize that there is no requirement to fund the ARC each year; it is just a measure of how well an employer has funded their plan compared to the GASB’s recommended policy. In a later post, I’ll go through the effects of contributing more or less than the ARC on a consistent basis.
Simplified Example: A City or School District has a prior accrued liability (UAAL) of $1,000 and expects the value of retirement benefits “earned” by its employees during the year to be $100. If we assume that the amortization (i.e., the allocation over time) of the UAAL is $40 per year, then the ARC for the current year is $140. If the normal cost in the following year is $150 and the UAAL amortization remains unchanged, then the ARC next year will be $190 ($150 + $40). After 25 years, the entire UAAL will have been recognized on the balance sheet (1000 = 40 x 25) and the value of any new benefit accruals will also have been accounted for. Note that this example ignores the effect of interest.