Postal Pension Funding Reform: Issues Related to the Postal	 
Service's Proposed Use of Pension Savings (26-NOV-03,		 
GAO-04-238).							 
                                                                 
In April 2003, Congress enacted the Postal Civil Service	 
Retirement System (CSRS) Funding Reform Act of 2003 (P.L.	 
108-18), which\ lowered the Postal Service's (Service) annual	 
payment for its CSRS obligation by over $2.5 billion beginning in
fiscal year 2003. P.L. 108-18 includes requiring (1) the Service 
to begin making payments into an escrow account in fiscal year	 
2006, (2) the Service to issue a report on its proposed use of	 
"savings" resulting from the lower CSRS payments, and (3) GAO to 
evaluate the Service's report and present its findings to	 
Congress. GAO evaluated whether the Service's proposals were	 
consistent with P.L. 108-18; the impact of the escrow account;	 
and whether the proposals were fair to current and future	 
ratepayers, affordable, and helped achieve transformation goals. 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-238 					        
    ACCNO:   A08944						        
  TITLE:     Postal Pension Funding Reform: Issues Related to the     
Postal Service's Proposed Use of Pension Savings		 
     DATE:   11/26/2003 
  SUBJECT:   Comparative analysis				 
	     Escrow accounts					 
	     Evaluation criteria				 
	     Federal funds					 
	     Federal legislation				 
	     Financial analysis 				 
	     Financial management				 
	     Funds management					 
	     Reporting requirements				 
	     Retirement pensions				 
	     Strategic planning 				 
	     Civil Service Retirement and Disability		 
	     Fund						 
                                                                 
	     Civil Service Retirement System			 

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GAO-04-238

United States General Accounting Office

GAO

                       Report to Congressional Committees

November 2003

POSTAL PENSION FUNDING REFORM

     Issues Related to the Postal Service's Proposed Use of Pension Savings

                                       a

GAO-04-238

Highlights of GAO-04-238, a report to congressional committees

In April 2003, Congress enacted the Postal Civil Service Retirement System
(CSRS) Funding Reform Act of 2003 (P.L. 108-18), which lowered the Postal
Service's (Service) annual payment for its CSRS obligation by over $2.5
billion beginning in fiscal year 2003. P.L. 108-18 includes requiring (1)
the Service to begin making payments into an escrow account in fiscal year
2006, (2) the Service to issue a report on its proposed use of "savings"
resulting from the lower CSRS payments, and (3) GAO to evaluate the
Service's report and present its findings to Congress. GAO evaluated
whether the Service's proposals were consistent with P.L. 108-18; the
impact of the escrow account; and whether the proposals were fair to
current and future ratepayers, affordable, and helped achieve
transformation goals.

To ensure continuing progress in addressing the Service's financial
challenges, Congress should consider repealing the escrow requirement
after it receives an acceptable plan on rationalizing the Service's
infrastructure and workforce. Absent an acceptable plan, Congress could
direct the Service to fund specific purposes, such as prefunding its
retiree health benefits obligation or supporting the Service's
transformation. GAO makes additional matters for Congress to consider in
the report.

www.gao.gov/cgi-bin/getrpt?GAO-04-238.

To view the full product, including the scope and methodology, click on
the link above. For more information, contact Bernard L. Ungar at (202)
512-2834 or [email protected].

November 2003

POSTAL PENSION FUNDING REFORM

Issues Related to the Postal Service's Proposed Use of Pension Savings

The Service's report presented two proposals for how it would use the
"savings," and GAO found both to be generally consistent with P.L. 108-18.
The first proposal assumes that responsibility for military service
pension costs shifts to the Treasury Department and proposes prefunding
retiree health benefits for retirees and current employees. The second
proposal assumes that the Service retains responsibility for military
service pension costs and proposes prefunding retiree health benefits only
for new employees. Both proposals assume that the Service would pay down
debt and fund capital investment through inflation-based rate increases.

Under both proposals, the Service proposes that the escrow requirement be
eliminated, so that the Service would not have to include $3 billion as a
mandated incremental operating expense beginning in fiscal year 2006. The
Service cannot use the escrow funds unless Congress eliminates the escrow
requirement or specifies by law how these funds may be used. If no action
is taken, the Service believes that it would have to raise rates higher
than would otherwise be necessary. The escrow requirement provides
Congress an opportunity to review how the Postal Service will address a
number of long-term challenges, such as progress toward transformation and
funding its retiree health benefits obligation. Once Congress is
satisfied, it could repeal the escrow requirement so that an escrow
account is not needed.

GAO assessed the Service's two proposals according to their fairness,
affordability, and the ability to achieve transformation goals, as
follows:

Fairness: Proposal I strikes a more equitable balance of allocating costs
between current and future ratepayers, because benefits earned by today's
employees will be built into the current rate base. Under Proposal II,
much of the retiree health benefits obligation would remain unfunded,
thereby placing the burden of the benefits being earned today on future
ratepayers.

Affordability: The Service's proposals attempt to balance short-term rate
mitigation with some level of prefunding to address its long-term
obligations. The first proposal would require a larger postal rate
increase than the second proposal and would prefund more of the retiree
health benefits. The second proposal focuses more on rate mitigation.
Given the Service's uncertain financial future, its ability to raise
revenues, reduce costs, and improve productivity and efficiency is
critical to affordability.

Transformation goals: Although the Service believes it can pay down debt
and fund the capital investments associated with its transformation
initiatives, this is not clear because the Service has not yet presented a
comprehensive, integrated infrastructure and workforce rationalization
plan. GAO has previously recommended that the Service provide Congress
with such a plan and periodic reports on its transformation progress. The
Service disagrees with GAO that the escrow repeal should be tied to a
plan.

Contents

  Letter

Results in Brief
Background
Both Proposals Are Generally Consistent with P.L. 108-18
Escrow Requirement Places Pressure on Rates
Key Issues Used to Assess the Postal Service's Proposals
Issues Related to the Implementation of Proposals I and II
Conclusions
Matters for Congressional Consideration
Agency Comments and Our Evaluation

                                                                  1 4 9 10 12

14 24 29 30 31

  Appendixes

Appendix I: Objectives, Scope, and Methodology 34

Appendix II: Comments from the U.S. Postal Service 36

Appendix III:	GAO Contact and Staff Acknowledgments 38
GAO Contact 38
Staff Acknowledgments 38

Table Table 1:	Estimated Debt Repayment and Capital Investment under
Proposal II

Figures Figure 1: Additional Expense Generated from Proposal I 19
Figure 2: Comparison of Retiree Health Premiums and "Savings"
under Proposal II 20

Contents

Abbreviations

CBO Congressional Budget Office
CSRS Civil Service Retirement System
CSRDF Civil Service Retirement and Disability Fund
FASB Financial Accounting Standards Board
OPM Office of Personnel Management
PRC Postal Rate Commission

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separately.

Comptroller General of the United States

United States General Accounting Office Washington, D.C. 20548

November 26, 2003

The Honorable Susan M. Collins
Chairman
The Honorable Joseph I. Lieberman
Ranking Minority Member
Committee on Governmental Affairs
United States Senate

The Honorable Tom Davis
Chairman
The Honorable Henry A. Waxman
Ranking Minority Member
Committee on Government Reform
House of Representatives

The Postal Service (Service) faces significant financial challenges,
including declining mail volume, the need to fund productivity
improvement and cost saving initiatives necessary to transform itself into
a
more efficient organization, and a growing obligation for retiree health
benefits that the Service estimated will reach $54 billion by the end of
fiscal
year 2003. In April 2003, Congress enacted the Postal Civil Service
Retirement System (CSRS) Funding Reform Act of 2003 (P.L. 108-18),
which afforded the Service the opportunity to address some of these
challenges by lowering the annual payment the Service is required to make
into the Civil Service Retirement & Disability Fund (CSRDF) by over $2.5
billion annually beginning in fiscal year 2003. The legislation specified
how
these savings were to be used for fiscal years 2003-2005. It also required
the
Service to begin making payments into an escrow account beginning in
fiscal year 2006 in an amount equal to the difference between the
estimated
CSRS payments prior to, and after, enactment of the legislation. The
amount of the payments into the escrow account would have to be
included in the Service's rate base. Under the legislation, the Service
cannot use the funds in the escrow account unless Congress eliminates the
escrow requirement or specifies by law how the escrow funds may be used.
In our view, this escrow requirement provides Congress an opportunity to
review how the Service will address a number of long-term challenges,
including debt repayment, capital projects, and its unfunded retiree
health
benefits obligation. The legislation also required the Service to report
by
September 30, 2003, on how it proposes to use these pension savings and
required GAO to evaluate the Service's submission and present our findings

to the appropriate oversight committees.1 The legislation states that not
later than 180 days after receiving our report, the Congress shall revisit
the issue of how the savings accruing to the Service as a result of
enactment of the legislation should be used.

P.L. 108-18 also transferred responsibility for CSRS pension benefits
attributable to military service in the amount of $27 billion from the
Department of the Treasury (Treasury) to the Postal Service. The law
required the Service, the Office of Personnel Management (OPM), and the
Treasury to prepare reports by September 30, 2003, articulating who should
be responsible for these costs in the future.2 The Postal Service's report
on this issue recommended that the responsibility for military service
costs be transferred back to the Treasury. However, the joint report of
Treasury and OPM recommended that the Postal Service should be responsible
(1) for all pension costs related to military service for its employees
that were hired after the Service's reorganization in 1971 and (2) for a
portion of the military service costs for employees hired before 1971.
Further, the legislation required GAO to review these reports and submit
our findings to the appropriate oversight committees, which we are
providing in a separate report (GAO-04-281) also issued on this date.3

To guide the Service in its proposed use of pension-related savings
beginning in fiscal year 2006, the legislation included specific "Matters
to Consider" and a "Sense of Congress." The "Matters to Consider" included
the following matters: (i) debt repayment; (ii) prefunding of
postretirement health care benefits for current and former postal
employees; (iii) productivity and cost-saving capital investments; (iv)
delaying or moderating increases in postal rates; and (v) any other
matter. The "Sense of Congress" stated that

1U.S. Postal Service, Postal Service Proposal: Use of Savings for Fiscal
Years after 2005, P.L. 108-18, Sept. 30, 2003.

2U.S. Postal Service, Postal Service Proposal: Military Service Payments
Requirements, P.L. 108-18, Sept. 30, 2003. Joint report by the Office of
Personnel Management and the Department of the Treasury, Report to
Congress on the Financing of Benefits Attributable to the Military Service
of Current and Former Employees of the Postal Service, Sept. 30, 2003.

3U.S. General Accounting Office, Postal Pension Funding Reform: Review of
Military Service Funding Proposals, GAO-04-281 (Washington, D.C.: Nov. 26,
2003).

o 	"the savings accruing to the Postal Service as a result of the
enactment of this act will be sufficient to allow the Postal Service to
fulfill its commitment to hold postage rates unchanged until at least
2006;

o 	because the Postal Service still faces substantial obligations related
to postretirement health benefits for its current and former employees,
some portion of the savings . . . should be used to address those unfunded
obligations; and

o 	none of the savings . . . should be used in the computation of any
bonuses for Postal Service executives."

In addition, the legislation stated that the Service should also consider
the work of the President's Commission on the United States Postal Service
(the Commission), whose report, issued in July 2003, identified the need
for the Service to operate more efficiently.4 The Commission's report
recommended, among other things, that

o 	"the Service should review its current policy relating to the
accounting treatment of retiree health care benefits, and work with its
independent auditor to determine the most appropriate treatment of such
costs in accordance with applicable accounting standards and in
consideration of the Postal Service's need for complete transparency in
the reporting of future liabilities;

o 	the Postal Service should consider funding a reserve account for
unfunded retiree health care obligations to the extent that its financial
condition allows; and

o 	responsibility for funding Civil Service Retirement System pension
benefits relating to the military service of Postal Service retirees
should be returned to the Department of the Treasury."

The Service's report on the use of the savings contained two proposals
that are linked to the outcome of the military service issue. The first
proposal (Proposal I) is predicated on the assumption that the Service is
relieved of responsibility for military service costs and proposes that
the Service

4President's Commission on the United States Postal Service, Embracing the
Future: Making the Tough Choices to Preserve Universal Mail Service,
(Washington, D.C.: July 31, 2003).

would prefund retiree health benefits for retirees and current employees.
In its second proposal (Proposal II), the Service assumes that it retains
responsibility for the military costs and proposes that it would prefund
retiree health benefits only for new employees, pay down debt, and finance
selected capital investments. The Service also stated that this proposal
would have what the Service characterized as an "indirect benefit" of
mitigating rate increases. By using most of the pension savings to fund
normal operating expenses, the only additional rate increase needed would
be a 0.3 percent increase over the rate of inflation to cover the
prefunding for its new employees.

This report addresses four objectives. First, it evaluates whether the
Postal Service's report on the use of the pension savings is consistent
with P.L. 108-18. Second, it evaluates the issues surrounding the impact
of the escrow requirement that the Service identified in its report.
Third, it assesses the Service's two proposals according to the following
questions, which are based upon our previous work:

o 	Are these proposals fair and balanced between current and future
ratepayers and taxpayers?

o 	Can the Service afford to do as it proposes in light of its financial
challenges?

o 	Do these proposals help promote and accelerate the Service's
transformation efforts, including related cost savings and productivity
improvement efforts?

Finally, our report discusses other pertinent issues, such as how the
proposals might be implemented, that we identified in the course of our
review. Our work is based on our review of Postal Service documents, the
report of the President's Commission on the United States Postal Service,
our prior reports, and interviews with officials at the Postal Service and
the Congressional Budget Office (CBO). A more detailed discussion of our
objectives, scope, and methodology is included in appendix I. We requested
comments on a draft of this report from the Postal Service, and its
comments are discussed later in this report and reproduced in appendix II.

Results in Brief	Both proposals are generally consistent with the Sense of
Congress expressed in P.L. 108-18 because they address, to varying
degrees, prefunding the retiree health benefits obligation. They also
address some of

the Matters to Consider outlined in P.L. 108-18, including rate mitigation
and, to a lesser degree, debt repayment and productivity and cost-saving
capital investments. In addition, the proposals are generally consistent
with the Commission's recommendations and our previous work. In
considering the Service's proposals, we note that this legislation, by
significantly reducing the Service's pension costs, has provided an
opportunity for the Service to address some of its long-standing
challenges, including prefunding its retiree health obligations and
accelerating its transformation to a more efficient and viable
organization. While the Service's proposals addressed the prefunding
obligation, and the Service has indicated that it can support its
transformation initiatives through normal rate increases, the extent to
which it would be able to support or accelerate its transformation was not
clear. Consequently, careful monitoring of the Service's financial
situation and the pace of its progress in implementing its transformation
initiatives will be necessary.

One of the issues we considered in evaluating these proposals was the
impact of the escrow requirement. The Service's report proposes that the
escrow requirement be eliminated, because the Service cannot use these
funds unless Congress eliminates the escrow requirement or specifies by
law how the escrow funds may be used. If no action were taken, the Service
would not realize a reduction in its annual operating expense of over $3
billion beginning in fiscal year 2006. Consequently, the Service believes
it would have to raise rates higher than would otherwise be necessary. In
our view, the escrow requirement could be one means to direct funding for
specific purposes that Congress may believe to be especially important.
Once Congress is satisfied, it could repeal the escrow requirement so that
an escrow account is not needed, or it could indicate its preferences
through means other than an escrow requirement.

Moreover, it is critical to the Service's future viability that it
continue to make progress on addressing its financial challenges, such as
prefunding retiree health obligations, repaying debt, and financing
capital needed to implement its transformation initiatives. We believe
that Congress will need to have sufficient information to determine that
the Service is making or accelerating progress in achieving its
transformation goals. In this regard, we have already recommended that the
Service provide periodic reports on the status of its transformation
initiatives and other Commission recommendations, which the Service
recently provided to its congressional oversight committees. In addition,
the Chairman of the Senate Committee on Governmental Affairs and Senator
Carper sent a letter to the Postmaster General dated November 19, 2003,
asking for a comprehensive plan by

early April 2004 that lays out how the Postal Service intends to optimize
its infrastructure and workforce.

We also assessed Proposals I and II according to their fairness,
affordability, and how they address the Service's transformation efforts,
including its cost saving and productivity improvement initiatives, as
follows:

o 	Fairness: Proposal I strikes a more equitable balance of allocating
costs between current and future ratepayers because benefits being earned
by today's employees would be built into the current postal rate base.
Under Proposal II, a substantial portion of the retiree health benefits
obligation would remain unfunded, thereby placing the burden of the
retiree health benefits being earned today on future ratepayers. Fairness
between ratepayers and taxpayers is also an issue, because P.L. 108-18
transferred $27 billion in pension costs related to military service from
the Treasury Department to the Postal Service-or in effect, from taxpayers
to ratepayers-but required further study of who should be responsible for
these costs. This issue is discussed in more detail in GAO's related
report.

o 	Affordability: The Service's proposals attempt to balance both
shortterm rate mitigation and some level of prefunding to address its
longterm obligations. Given the Service's uncertain financial future, the
affordability of these proposals is tied to the Service's ability to raise
revenue, cut costs, and improve productivity and efficiency. In recent
years, the Service has made some progress in cutting its costs and
improving productivity but has had trouble raising sufficient revenue to
offset declines in First-Class Mail volume. Under both proposals, the
Service assumes that it can pay down debt and fund capital investment
needs through periodic rate increases within normal inflationary trends.
The Service's proposals for prefunding some level of its retiree health
benefits obligation would require modest additional rate increases over
the amount needed to cover inflationary cost increases. The Service
estimated that Proposal I would require an additional rate increase in
fiscal year 2006 of 2 percent over the rate of inflation, while Proposal
II would require only an additional increase of 0.3 percent over the rate
of inflation since it is funding a smaller portion of the retiree health
benefits obligation. The Service did not estimate the impact of either
proposal on postal rates beyond fiscal year 2006. Furthermore, the Service
did not propose to fully fund its retiree health benefits obligation in a
specified time period under either proposal. However,

even moderate rate increases to prefund some portion of the retiree health
benefits obligation now could help the Service avoid more dramatic postal
rate increases later.

o 	Transformation: In passing P.L. 108-18, several Members of Congress
expressed the need for the Service to continue its modernization efforts
to transform itself into a more efficient and effective organization.
Further, the Commission and GAO have reported on the need for the Service
to enhance its efficiency through such efforts as standardization of its
mail processing operations, improving retail access, and rationalizing its
infrastructure and workforce. The Service has begun implementing a number
of its transformation initiatives to improve its efficiency and has made
meaningful progress in a number of areas, including reducing its
workforce, cutting costs, and improving productivity. To achieve
additional results, sufficient capital investment will need to be made.
Both proposals assume that the Service can raise sufficient capital
through inflation-based rate increases. Although the Service has provided
some information to us showing what capital investments it plans to make
related to its transformation goals, it has not yet prepared a
comprehensive, integrated plan showing how it plans to rationalize its
infrastructure and workforce and the funding that would be needed to
implement such a plan, as well as the savings or additional revenue the
plan would be expected to generate. Without such a plan, and periodic
updates on the status of transformation initiatives as we have previously
recommended, as well as their cost and funding, it is not clear whether
the Service's planned funding would be sufficient.5

Under both proposals, we also identified technical issues related to
implementation of prefunding retiree health benefits obligation, including
whether the Service should explore the implications of fully funding its
retiree health benefits obligation over a specific time period; the proper
demographic and economic assumptions to employ in estimating the
obligation; and what agency should be responsible for making these
decisions.

To ensure continuing progress in addressing the Service's financial
challenges, we suggest that Congress consider the following:

5U.S. General Accounting Office, U.S. Postal Service: Bold Action Needed
to Continue Progress on Postal Transformation, GAO-04-108T (Washington,
D.C.: Nov. 5, 2003).

o 	Repealing the escrow requirement after receiving an acceptable plan
from the Service describing how it intends to rationalize its
infrastructure and workforce and is confident that the Service is making
satisfactory progress on transforming itself into a more efficient
organization and implementing its transformation goals.

o 	Directing the Service to fund specific purposes that Congress believes
are especially important-such as prefunding the retiree health benefits
obligation or supporting and possibly accelerating the Service's
transformation efforts-if the Service does not provide an acceptable plan
for rationalizing its infrastructure and workforce, or show satisfactory
progress in implementing transformation, or if Congress wants greater
assurance that the Service will spend funds in a particular manner. In
this regard, we have already recommended that the Service provide periodic
reports on the status of its transformation initiatives and other
Commission recommendations.

o 	Addressing implementation issues related to prefunding the retiree
health benefits obligation. For example, one key issue that would need to
be further explored is what options may be available that would allow the
Service to amortize its unfunded retiree health benefits obligation over a
specified time period (e.g., 20-40 years) and prefund the retiree health
benefits obligation for future retirees.

In commenting on a draft of our report, the Service disagreed with our
Matters for Congressional Consideration that repeal of the escrow
requirement should be tied to an acceptable plan. We agree that
establishing an escrow account without allowing the Service to use the
funds would not be a desirable outcome and that is one of the reasons why
we suggested that Congress consider repealing the escrow requirement. On
the other hand, contrary to the Service's view, we believe the escrow
requirement is an opportunity for Congress to review how the Service plans
to address a number of long-term challenges, including debt repayment,
capital projects, its unfunded retiree health benefits obligation, and its
progress toward transformation. If the Service provides Congress with an
acceptable plan in the next several months and Congress finds the plan and
the Service's transformation progress satisfactory, we believe Congress
should have sufficient time to repeal the escrow requirement so that an
escrow account would not be needed. Thus, the Service would not have to
include the operating expense associated with the escrow requirement in
its rate base for the next rate case filing.

Background	In April 2003, Congress enacted P.L. 108-18, which reduced the
Service's annual payment into the CSRS pension fund, in part, to reflect a
reduction in the Service's estimated unfunded obligation for prior years'
service from about $30 billion to about $5 billion. The difference between
the Service's CSRS payment required prior to enactment of P.L. 108-18 and
the payment after enactment is labeled the "savings" in the legislation.
However, P.L. 108-18 requires the Service to use the savings in fiscal
years 2003 and 2004 to pay down outstanding debt and in fiscal year 2005
to extend the current rate cycle. Therefore, according to the Service, all
of the overfunding generated by current rates will be completely consumed
by the end of fiscal year 2005. In fiscal year 2006, the Service is
required to begin making payments into an escrow account that it cannot
use until otherwise provided for by law. The amount of the payments into
the escrow account would have to be included in the Service's rate base.
The Service's report recommended that the escrow requirement be repealed,
and provided two proposals for use of the "savings." A brief description
of each proposal is given below.

Proposal I	Transferring the military costs from the Service to the
Treasury, as detailed in Proposal I, increases the projected overfunding
of the postal CSRS pension fund from $78 billion to $105 billion. This
would result in an overall cost reassignment of $27 billion and a $10
billion overfunding of the postal CSRS pension fund as of the end of
fiscal year 2002. The Service proposes that the $10 billion in overfunding
would remain in the pension fund, in a separate account designated as the
"Postal Service Retiree Health Benefit Fund (Retiree Health Fund)." The
Service made a payment of about $1.3 billion for its pension obligation
into the CSRS pension fund in fiscal year 2003. Under current legislation,
it would continue to make payments of $2.2 billion in fiscal year 2004 and
$2.1 billion in fiscal year 2005. If responsibility for all military
service costs is transferred back to the Treasury, the resulting
overfunded status would negate the need for further Postal Service annual
CSRS payments.6 The Service proposes that the CSRS payments it made in
fiscal year 2003, and will make in fiscal years 2004 and 2005, remain in
the CSRDF in the newly designated Retiree Health Fund. Beginning in fiscal
year 2006, the Service proposes to make annual

6Postal employees would continue to make their contributions to the CSRS
fund, which are currently 7 percent of pay.

payments into the Retiree Health Fund. This new fund would be used to pay
retiree health insurance premiums in the future.

This proposal assumes that the escrow requirement would be eliminated.
However, the Service estimates that the expense for prefunding retiree
health obligations would add $1.2 billion to its expenses in fiscal year
2006. The Service estimates that this expense would require a rate
increase that would be 2 percent higher than would be necessary to cover
inflationary expense growth. Otherwise, the Service believes it can pay
down debt and finance its capital investment needs through its normal
cycle of inflationbased rate increases.

Proposal II	Proposal II, other than funding a small amount of the retiree
health benefits obligation, results primarily in rate mitigation. This
proposal is based on the assumption that the escrow requirement would be
repealed and that the Service would remain responsible for military
service costs. Under this scenario, the Service proposes to prefund the
retiree health benefits cost for employees hired after fiscal year 2002.
It would not fund the retiree health benefits cost already incurred for
current and former employees, which comprises most of the obligation. The
Service estimates that the expense created to prefund retiree health
benefit costs for new employees would require a rate increase in fiscal
year 2006 that would be 0.3 percent higher than necessary to cover normal
inflationary expense growth. Although the Service's proposal stated that
some funds would be used to pay down debt and fund capital investments,
postal officials have told us that the proposed debt repayment and capital
investment costs are equal to what they had planned to spend regardless of
enactment of P.L. 108-18. Consequently, the Service believes that, absent
the escrow requirement, it would be able to continue to pay the retiree
health premium costs for current and former employees on a pay-as-you-go
basis, pay down debt, and finance its capital investment needs through
normal rate increases that would correspond with general inflation trends.

Both Proposals Are We believe that both proposals are generally consistent
with the "Sense of

Congress" expressed in P.L. 108-18, that some portion of the savings
shouldGenerally Consistent be used to address the Service's unfunded
obligations. However, Proposal I with P.L. 108-18 goes much further in
this area because it proposes prefunding a substantial

portion of retiree health benefits for all current and former employees,
while Proposal II would prefund these costs only for employees hired after

fiscal year 2002. Both proposals also address, to varying degrees, the
Matters to Consider, outlined in P.L. 108-18. Proposal I addresses, almost
exclusively, matter (ii)-prefunding of postretirement health benefits for
current and former employees. Proposal II addresses matter (ii) to a
limited extent, and matter (iv)-delaying or moderating increases in postal
rates. Under both proposals, the Service believes that it can address
matter (i)-debt repayment-and matter (iii)-productivity and cost saving
capital investments-through inflation-based rate increases.

The legislation also directed the Postal Service to consider the work of
the Commission. The Commission recommendations, like our previous work,
stressed the significance of funding the retiree health benefits cost to
the extent that the Service's finances permit. The Commission pointed out
that the pension obligation is funded as benefits are earned and recovered
through rates, but the retiree health benefits obligation is funded as the
benefits are paid and not as they are earned. The Commission strongly
urged the Service to consider funding a reserve account to begin paying
down the retiree health benefits obligation so future ratepayers are not
forced to pay for costs associated with postal services delivered today.
The Commission also stated that raising rates should be the last recourse,
not the first, to cover rising costs. In our November 2003 testimony
before the Senate Committee on Governmental Affairs, we also raised
concerns about rate increases, stating that raising rates may provide an
immediate boost to the Service's revenues but would likely accelerate the
transition of mailed communications to electronic alternatives.7 In
addition, the Commission expressed concern regarding the Service's ability
to repay its debt and stressed the importance of the Service improving its
operational efficiency. Another important recommendation of the Commission
was that the Service should review its current policy relating to the
accounting treatment of retiree health care benefits, and work with its
independent auditor to determine the most appropriate treatment of such
costs in accordance with applicable accounting standards and in
consideration of the Postal Service's need for complete transparency in
the reporting of future liabilities. We have also discussed these issues
in our previous work.8 Proposal I addresses the issue of funding retiree
health benefits to a

7GAO-04-108T.

8U.S. General Accounting Office, Major Management Challenges and Program
Risks: U.S. Postal Service, GAO-03-118 (Washington, D.C.: January 2003);
and U.S. Postal Service: Deteriorating Financial Outlook Increases Need
for Transformation, GAO-02-355 (Washington, D.C.: Feb. 28, 2002).

greater extent than Proposal II, while Proposal II addresses the matter of
mitigating rates to a greater extent than Proposal I.9 Both proposals
address the issue of debt repayment and capital investment through
inflation-based rate increases.

  Escrow Requirement Places Pressure on Rates

The Service recommended in its report that Congress eliminate the escrow
requirement, because of its negative impact on postage rates and the
mailing industry, the general public, and the economy as a whole. The
Service estimates that it would need an additional rate increase of 5.4
percent, including 2 cents on the 37-cent First-Class stamp, in order to
generate the $3.2 billion required to be placed in an escrow account in
fiscal year 2006. This is because P.L. 108-18 requires all "savings"
attributable to fiscal years after 2005 to be considered an "operating
expense" and placed into an account that the Service cannot use until
Congress specifies how the funds may be used. All of the "savings"
accruing under current rates would likely be expended or absorbed by
inflationary cost increases by the end of fiscal year 2005. Thus, in order
to pay this "operating expense" the Service would need to include the $3.2
billion in its rate base in fiscal year 2006 and collect the money from
its ratepayers or lower expenses by a corresponding amount. The Service
has taken steps to reduce its total expenses over the past 2 fiscal years,
and we believe it is important for the Service to continue its
cost-cutting efforts. However, setting aside unused funds in an escrow
account that must be considered an "operating expense" would serve to
lessen the financial benefits of the Service's cost-cutting efforts.

For fiscal years after 2006, an increasing amount-estimated to eventually
reach a peak of $8.7 billion-would have to be placed annually in the
escrow account. This would be in addition to its operating expenses, such
as compensation and retiree health premiums, as well as any amounts needed
to pay down debt or fund capital investments. The Service estimates that
it would require additional biannual rate increases between 1 percent and
1.5 percent to cover the required escrow amount. Frequent rate increases
of this magnitude would likely hasten the decline in First

9It should be noted that Proposal I, by funding retiree health benefits
for current and former employees only if it is relieved of responsibility
for military service costs, also addresses rate mitigation because funding
this obligation for current and former employees, while retaining
responsibility for military service costs, would result in even higher
rate increases.

Class Mail volume and increase the risk of volume declines in other mail
classes.

In our view, the escrow requirement could be viewed as one means to direct
funding for specific purposes that Congress may believe to be especially
important. We also believe it is critical to the Service's future
viability that it continue to make progress on addressing its financial
challenges, such as prefunding retiree health obligations, repaying debt,
and financing capital needed to implement its transformation initiatives.
Several options include (1) tying the repeal of the escrow requirement to
congressional review of the Service's progress on transformation, which
could include the Service providing Congress with an acceptable plan for
realigning its infrastructure and workforce; (2) repealing the escrow
requirement but specifying the use of funds; or (3) repealing the escrow
requirement and allowing the Service to fund activities as specified in
its proposals. Another option would be to retain the escrow requirement
and direct funding for specific purposes, which would likely require
Congress to periodically revisit the use of funds. We believe this option
could be problematic if an impasse arose, which could make the funds
unavailable to the Service to spend on specific purposes.

If Congress does not want to specify by law the purposes and amounts that
should be funded, but rather permit the Service to decide which activities
to fund, we believe that Congress would need to have sufficient
information to determine that the Service is making or accelerating
progress in achieving its transformation goals. In this regard, we have
already recommended that the Service provide periodic reports on the
status of its transformation initiatives and other Commission
recommendations that fall within the scope of its existing authority. The
Chairman of the Senate Committee on Governmental Affairs, along with
Senator Carper, requested in a letter to the Postmaster General dated
November 19, 2003, that the Service provide the Committee with a
comprehensive plan that lays out how the Service intends to optimize its
infrastructure and workforce. Further, the letter requested biannual
updates on the status of implementing transformation initiatives and
recommendations of the Presidential Commission. In November 2003, the
Service provided the congressional oversight committees with a progress
report on its transformation initiatives.

  Key Issues Used to Assess the Postal Service's Proposals

We also assessed the Service's two proposals in the context of three key
issues emerging from our previous work and the Commission's
recommendations. The first issue is whether the proposals are fair and
balanced between current and future ratepayers regarding who pays for
employee benefits earned today. Another aspect of this issue is fairness
between ratepayers and taxpayers regarding responsibility for military
service costs and the effect of the proposals on the federal budget. The
second issue is whether the proposals are affordable in light of the
Service's current financial situation. Given declining First-Class Mail
volume, rising compensation costs, and a significant retiree health
benefits obligation, if the Service's proposals greatly exacerbate these
financial challenges, affordable universal service could be jeopardized.
The third issue is how these proposals assist the Service in achieving or
accelerating its transformation initiatives. The importance of this issue
lies in the need for the Service to become a more efficient and effective
organization in order to remain financially viable.

Fairness Issues	One factor that should be kept in mind when evaluating
these proposals is the issue of maintaining an equitable balance between
the postal costs paid for by current and future ratepayers and the impact
of these proposals on taxpayers. As we noted in our November 2003
testimony, under the Service's current accounting and rate-setting
methods, current ratepayers have not fully covered the total costs of the
postal services they have received.10 Further, future ratepayers are
likely to face more significant and frequent rate increases to cover the
cost of benefits being earned by current employees. The equity of this
arrangement should be considered in evaluating these proposals. Likewise,
the effects of these proposals on the federal budget-which specifies the
spending and financing of the federal government-and whether these effects
are equitable to both ratepayers and taxpayers, should also be considered.

Proposal I strikes a better balance between current and future ratepayers
by prefunding the retiree health benefits obligation for both retirees and
current employees and providing a mechanism for better aligning current
expenses with current revenues. Therefore, benefits being earned by
today's employees would be built into the current rate base.

10GAO-04-108T.

While Proposal II does partially address the issue of striking a balance
between current and future ratepayers in regard to the retiree health
benefits obligation, it does not go as far as Proposal I in this area. By
only prefunding the retiree health benefits cost for new employees, it
leaves a sizable portion of this obligation unfunded. This means that
future ratepayers will still be required to pay for most of the retiree
health benefits earned by today's workforce. In addition, mailers argue
that prior to enactment of P.L. 108-18, they were paying too much for the
CSRS obligation; therefore, mitigating rate increases now is merely
recompense. However, while mailers may have been paying more than
necessary to fund the pension obligation, they were paying less than
necessary to fund the retiree health benefits obligation.

    Fairness between Ratepayers and Taxpayers

Another important consideration is the effect these proposals would have
on the federal budget and, therefore, the taxpayer. An issue currently
before Congress is who should be responsible for paying the military
service pension costs of postal employees covered by CSRS. Proposal II is
predicated on the assumption that current ratepayers pay for pension costs
related to military service, much of which was vested prior to creation of
the Postal Service and had already been paid by Treasury. If Congress
decides that the Service should retain responsibility for these costs, the
postal ratepayers would bear the costs. If Congress determines that the
Treasury should be responsible for these costs, then the costs would be
borne by taxpayers. The Service has stated that the impact on the federal
budget of transferring these costs under Proposal I would likely be
minimal. The budgetary effects of the Service's proposals have not been
scored by CBO. However, based on its scoring of the Postal Civil Service
Retirement System Funding Reform Act, we believe that Proposal I might be
scored as having little effect on the deficit in the short term. In the
long term, it could have an effect when the Service's cash flow changes in
later years as the prefunded benefits are paid. However, insufficient
detail has been provided on both proposals to determine their overall
budget effects.

The CBO is required to "score," or estimate, the budgetary effects of
legislation reported out of committees, so it has not scored the Service's
proposals. However, the CBO scoring report on the bill that resulted in
the pension legislation provides some insight into how this proposal might
be scored.

CBO scoring considers both on-budget and off-budget effects of legislative
proposals. As an off-budget entity, any payments that the Service makes to

the retirement trust fund (an on-budget entity) are considered offsetting
receipts; reducing those payments would reduce on-budget receipts. Under
P.L. 108-18, after fiscal year 2005, savings resulting from the act are to
be considered operating expenses of the Service. Therefore, these expenses
would be included in rate setting, even though the Service's actual
expenses would decline by the amount placed in escrow. As a result, net
off-budget outlays of the Postal Service would decline by the same amount
as the savings from lower pension payments, beginning in fiscal year 2006.
This is reflected in the CBO scoring report. These lower off-budget
outlays would offset the on-budget impact of lower payments to CSRS. Thus,
any proposal that uses the escrowed savings could affect the overall
federal budget deficit.

Scoring of the Service's proposals hinges on what the Service would do
with the escrowed savings. Proposal I, in shifting the cost of military
service back to the Treasury, would result in a reduction in on-budget
receipts. But Proposal I, in using most of the savings to prefund retiree
health benefits, would also keep those amounts in a separate CSRS account.
11 The combined impact might be scored as having little effect on the
deficit in the short term. However, in the long term, it could have an
effect because at some point, the prefunded benefits would be paid out,
resulting in changes in cash flows in later years. In addition, Proposal I
would use a small amount of the savings for debt reduction, which would
cause on-budget interest receipts to be lower.

Under Proposal II, which assumes that the Service would retain
responsibility for the military service costs, the Service said it would
fund its retiree health benefits obligation only for its employees hired
after fiscal year 2002 and then fund, in priority sequence, debt repayment
and capital investments to improve productivity and cost-savings. This
proposal also raises issues related to the federal budget. The
continuation of payments for military service costs would mean that there
would be no reduction in on-budget receipts. In the short term, prefunding
some retiree health benefits could have a small positive effect on the
budget, because the Service would be collecting revenue that would not be
immediately paid out. In general, any reduction in the Service's debt
would reduce on-budget interest receipts. Any additional capital
investments would increase offbudget outlays. However, if the Service can
provide credible support that

11Proposal I specifies that any overfunding not be withdrawn from the
separate account. If it were withdrawn, there would also be on-budget
outlays.

the investments would result in cost savings, the scoring may show
increased outlays initially and savings subsequently.

    Affordability of Proposals Is Unclear

The Service believes that its proposals are affordable, meaning they would
not cause rate increases that irreparably harm volume, or hinder the
Service's ability to sustain current operations and implement
transformation initiatives. We are concerned that the Service may not be
able to achieve all of these goals if its financial situation worsens.
Therefore, we believe it is imperative for the Service to continue
addressing its key financial challenges-long-term obligations and debt,
difficulty raising revenue, and aggressive cost-cutting measures-to the
extent that it is able. The Service faces a difficult challenge in trying
to balance all of these issues. The Service's proposals attempt to balance
both short-term rate mitigation and some level of prefunding of retiree
health obligations to address its long-term obligations, while also
providing for debt repayment and capital investment. However, the Service
did not present an analysis of how its proposals would affect the overall
financial condition of the Postal Service. Consequently, it is difficult
to assess which, if either, of these proposals would improve the long-term
financial situation of the Postal Service or ensure its future financial
viability. Therefore, we believe that the Service's financial situation
will need to be closely monitored to ensure that its proposals are indeed
affordable.

The affordability of these proposals to ratepayers is also a
consideration, as is the effect of rate increases on volume because, as we
have previously reported, the Service faces uncertainty regarding its
future revenue stream.12 Since fiscal year 2000, the Service's total mail
volume has declined by almost 6 billion pieces and is estimated to
continue declining. In a report for the Commission, the Institute for the
Future developed a mail volume estimate that shows a gradual 10 percent
decline from 202.8 billion pieces in fiscal year 2002 to 181.7 billion
pieces in 2017. Also, First-Class Mail volume, which provides the bulk of
the Service's revenue, has been declining and shows no sign of rebounding.
Declines in First-Class Mail are particularly troublesome to the Service,
because First-Class Mail pays almost 70 percent of the Service's
institutional costs. These costs, which are approximately 40 percent of
all postal expenses, include some administrative, facility, postmaster,
and supervisor costs, and a large

12GAO-04-108T.

portion of the expanding delivery network costs. Therefore, if First-Class
Mail volume continues to decline, it would become more difficult for the
Service to fund its institutional costs without raising postal rates.

Historically, when the Service has raised postal rates, mail volume growth
declined in the fiscal year immediately following the rate increase but
rebounded in the next fiscal year. However, over the last 3 years this has
not been the case. The Service raised rates twice in fiscal year 2001 and
once in fiscal year 2002. Total estimated mail volume at the end of fiscal
year 2003 was almost 6 billion pieces lower than total mail volume was in
fiscal year 2000. In this climate, rate increases may lead to further
volume declines, which in turn would necessitate additional rate increases
and begin a cycle often referred to as the "death spiral."

The Service's first proposal would require a larger rate increase than the
second proposal. Under Proposal I, the Service estimates that prefunding
retiree health benefits would add $1.2 billion to its expenses in fiscal
year 2006 compared with its expenses in that year under the current law,
assuming the escrow requirement were eliminated. According to the Service,
this additional expense would require a rate increase in fiscal year 2006
that is 2 percent higher than the increase that would be necessary due to
inflationary expense growth alone. In fiscal years after 2006, the Service
would continue to make these additional payments and future rate increases
would likely be marginally higher than would be necessary to reflect
inflationary pressures alone.13 Figure 1 shows the annual additional
amount the Service proposes to spend on prefunding under Proposal I.

13It is important to note, however, that rate increases would not be
higher than they would have been if P.L. 108-18 had not lowered the
Service's annual CSRS pension payments.

Figure 1: Additional Expense Generated from Proposal I

If the Service's mail volume continues to decline and the Service is
unable to cut costs accordingly, or if the Service is faced with higher
retiree health premium costs than estimated, the Service may not be able
to afford to continue prefunding the retiree health benefits obligation.
Therefore, the Service's financial condition must be carefully monitored
under this proposal.

Proposal II would require a lower rate increase than Proposal I in fiscal
year 2006, and thus would likely have less of an impact on postal volumes
in the short term. However, in the long-term it may require larger rate
increases that could have a negative impact on future volumes. As seen in
figure 2, the estimated retiree health premium expense will eventually
outpace the estimated difference between the CSRS payment prior to
enactment of P.L. 108-18 and the payment required under the legislation.
Consequently, in order to pay the retiree health premiums in the future,
the

Service would need to raise additional revenue through rate increases or
lower its operating expenses.

Figure 2: Comparison of Retiree Health Premiums and "Savings" under
Proposal II

The Postal Service is required to pay the retiree health premiums
regardless of whether it prefunds some or all of these costs, and the
annual costs are expected to increase over the next 20 years. If
prefunding retiree health benefits for new employees proves to be more
costly than estimated, or if the premiums for current retirees continue to
grow rapidly, the Service could find itself facing a significant
obligation at a time when revenues are shrinking. It seems prudent to set
aside funds now, while they are available, to address escalating future
costs rather than waiting until costs are higher and adequate revenue may
not be forthcoming. Because Proposal II would result in a smaller rate
increase in fiscal year 2006 than Proposal I, it raises the question of
whether it would be possible for the Service to increase its proposed
level of prefunding retiree health benefits under Proposal II. By setting
aside an additional $1 billion in funding for this obligation, the Service
would need an additional rate increase of 2 percent, the same increase the
Service proposes under Proposal I. The Service has stated that the
decision to prefund only retiree health benefits for new employees arose
from the desire to have a logical basis for its funding proposal. Because
the legislation was enacted in fiscal year 2003, the Service decided to
begin prefunding with a corresponding time period. While this may provide
a baseline, we agree with the Commission that the Service should address
its retiree health benefits obligation to the extent that its financial
situation allows. Again, we believe the Service's financial situation will
have to be carefully monitored to ensure that this option remains
affordable.

Another factor associated with the affordability of the proposals concerns
how they address the Service's outstanding debt level, which in fiscal
year 2002 was close to statutory limits and was threatening the Service's
ability to fund capital improvements. The Service made significant
progress in reducing its outstanding debt in fiscal year 2003, from $11.1
billion to an estimated $7.3 billion, and plans to continue paying down
its debt in fiscal years 2004 and 2005. The Service has estimated that
debt outstanding as of the end of fiscal year 2005 will be $3 billion.
Under both proposals, the Service proposes to repay the same amount of
debt in fiscal years 20062010. As seen in table 1, the Service estimates
that its outstanding debt will be paid off by 2010. These estimates assume
that the Service would raise rates when necessary to break even for each
of the fiscal years 2006 through 2010. If this break-even assumption is
not correct, or if the Service faces unforeseen financial problems, the
Service may not be able to pay down the amount of debt it proposes, and
may, in fact, have to borrow more.

Table 1: Estimated Debt Repayment and Capital Investment under Proposal II

Dollars in millions

                        Beginning debt   Estimated debt 
          Fiscal year          balance          payment   Ending debt balance 
                 2006           $3,000             $776                $2,224 
                 2007            2,224              540                 1,684 
                 2008            1,684              612                 1,073 
                 2009            1,073              521                   552 
                 2010              552              559                   (7) 

Source: U.S. Postal Service.

The affordability of these proposals is also tied to a separate matter
currently before Congress-who should bear responsibility for military
service pension costs and how these costs should be determined. If
Congress determines that the Treasury should bear responsibility for
military service costs, then the Service believes that it can afford to
prefund retiree health care costs for all of its current and former
employees. If Congress determines that the Service should retain
responsibility for the military service costs, then the Service believes
that it can only afford to prefund the retiree health benefits cost for
employees hired after fiscal year 2002, which would leave the obligation
for current and former employees unfunded.

As both the Commission and we have noted, the Service has had limited
success in its pursuit of new revenue streams. Therefore, to counter the
loss in revenue due to declining mail volume without resorting to frequent
rate increases, the Service must aggressively cut costs. To its credit,
the Service has decreased work hours, reduced its workforce, and closed
some facilities. However, we do not believe that these incremental savings
will be enough to ensure a financially viable Postal Service over the
longer term, especially if mail volumes continue to decline. For this
reason, we believe the Service must continue to make progress in
implementing its transformation goals.

Transformation Issues	In assessing these proposals, we also considered how
the Service would be able to fund cost saving and productivity initiatives
needed to successfully transform itself into a viable organization for the
21st century. In April 2002, in response to a GAO recommendation14 and a
request by the Senate Committee on Governmental Affairs, the Postal
Service prepared a Transformation Plan that outlined strategies for
transforming the organization into an efficient and performance-based
entity. Among those initiatives were plans to standardize operations,
increase customer access, and realign the processing and distribution
network. The Commission's report also made suggestions for improving
postal efficiency. We agree with the Commission that the Service must
continue to pursue aggressive costcutting strategies and productivity
gains in an effort to become more efficient. We also believe that the
mandate for the Service to report on the potential use of savings from
P.L. 108-18 was an opportunity for the Service to present its plans in
this area, and the Service's proposals must be evaluated with the need for
cost-cutting and productivity gains in mind.

Under both proposals, the Service believes it can finance capital
investments related to upgrading existing assets and the investment needed
to implement transformation initiatives through inflation-based rate
increases. We are concerned that the Service's financing plan may not be
adequate to provide for its capital investment needs, because
historically, the Service has found it problematic to finance its capital
needs with operating revenues. Thus, it has often resorted to borrowing to
finance its capital needs. In contrast, under both proposals, the Service
would finance its capital needs while continuing to pay down debt through
inflation-based rate increases. Another possible source of capital funds
could be the proceeds from the sale of excess property. However, the
Service did not discuss this issue in its report.

We are also concerned with the Service's lack of specifics on capital
investments under both proposals. While the Service stated that its
capital investments for productivity gains and cost saving initiatives
were related to its Transformation Plan, it has provided little detail on
any of these initiatives in its pension savings report, its Five-Year
Strategic Plan FY 20042008, or its Five-Year Strategic Capital Investment
Plan 2004-2008. The Service did provide a breakdown of some capital
investments related to its Transformation Plan initiatives, but did not
provide sufficient back-up data

14GAO-01-598T.

or description to enable us to determine to what transformation
initiatives these investments were related or to what extent they would
meet transformation goals.

In our November 2003 testimony, we also noted our concern that since the
Service issued its Transformation Plan in April 2002, it has not provided
adequate transparency on its plans to rationalize its infrastructure and
workforce; the status of initiatives included in its Transformation Plan;
and how it plans to integrate the strategies, timing, and funding
necessary to implement its plans.15 While the Postal Service is moving
forward with its Transformation Plan initiatives, and has made meaningful
progress in a number of areas, it is not clear how it will be able to
finance these initiatives within inflation-based rate increases,
especially if mail volume continues to decline. Therefore, we recommended
in our November testimony that the Postmaster General develop a
comprehensive and integrated plan to optimize the Service's infrastructure
and workforce, in collaboration with its key stakeholders, and make it
available to Congress and the general public. We also recommended that the
Postmaster General provide periodic reports to Congress and the public on
the status of implementing its transformation initiatives and other
Commission recommendations that fall within the scope of its existing
authority. Postal officials have agreed to develop a comprehensive and
integrated plan to optimize its infrastructure and provide periodic
reports on the implementation of its transformation initiatives and make
them available to Congress and the public. As previously mentioned, the
Service provided its congressional oversight committees with a progress
report on its transformation initiatives in November 2003. The
infrastructure and workforce plan and the periodic reports on the status
of transformation initiatives will be critical to oversight in this area.

Issues Related to the During our review, we identified implementation
issues that Congress may

want to consider if it determines that the Service should prefund some
orImplementation of all of its retiree health benefits obligation. Under
Proposal I, Proposals I and II implementation issues involve the method
that would be used to fund the

retiree health benefits, and the demographic and economic assumptions that
would be used to determine the amount of the total obligation as well as
the annual funding amount. Under Proposal II, the question arises as to

15GAO-04-108T.

how the annual cost of retiree health benefits for employees hired after
fiscal year 2002 would be calculated. In addition, neither proposal
ensures that the Service would continue to prefund the retiree health
benefits obligation. Additional questions arise about the Service's
accounting treatment for retiree health benefits under both proposals.

If Congress decides to accept one of the proposals, technical issues
related to implementing the proposal would need to be addressed. Under
Proposal I, the Service would fund the retiree health benefits obligation
by making payments into a fund currently maintained by OPM. Postal
officials raised questions about which agency-the Service or OPM-should
determine the amount of the obligation, and what economic and demographic
assumptions should be used. In addition, we have questions about the
Service's proposed funding mechanism, because it does not amortize the
obligation over a specific time period. In Proposal II, the Service would
maintain control of the retiree health benefits fund. Under both
proposals, the Service would continue to make payments into the respective
funds after 2010; however, under P.L. 108-18, the Service would be under
no obligation to prefund the retiree health benefits obligation.

    Technical Issues Related to Proposal I

One issue pertains to the assumptions used by the Service to estimate its
retiree health benefits obligation. If these assumptions change, then the
future funded status of the obligation would also change. This estimated
obligation is based on several assumptions, such as premium costs,
retirement rates, termination rates, mortality assumptions, disability
assumptions, plan enrollment, and coverage election that could change
annually and may differ between the Postal Service and other agencies.
These assumptions materially affect the future funded status of the
obligation. An illustration of the practical effect of using different
assumptions can be seen in the estimate of the Service's total retiree
health benefits obligation. A postal estimate of its retiree health
benefits obligation as of the end of fiscal year 2003 differs from an
estimate for the same period prepared by OPM by about 4 percent, or $2.2
billion. According to the Service, the difference in these two estimates
is primarily due to differences in the measurement date, the discount
rate, the health care trend rate, the cost basis, and the attribution
method used. The Service's estimate was actuarially certified as
reasonable. However, a different set of results could also be considered
reasonable actuarial results, because the actuarial standards describe a
"best-estimate range" for each assumption rather than a single
best-estimate value.

In addition, the Service said it would not amortize the retiree health
benefits obligation within a specified time frame. Instead, the proposed
funding that the Service calculates to address its retiree health benefits
obligation is the amount that would be required to fund the annual retiree
premium cost plus the estimated future cost of retiree health premiums for
current employees (service costs), and interest expense on both the
outstanding obligation and the new service cost. According to the Postal
Service, while it is the Service's intention to eventually fully fund its
retiree health benefits obligation under Proposal I, this proposal does
not fully fund all prior years' service costs-the $54 billion
obligation-within a specified time period. In fact, because the proposed
funding under Proposal I includes a beginning asset balance of $10
billion, but does not amortize any of the retiree health benefits
obligation, approximately $45 billion of the obligation would not be
funded. The Service's proposed funding for the retiree health benefits
obligation is modeled after the funding method used by some utilities to
prefund their retiree health benefits. However, other options might allow
the Service to amortize its existing obligation and prefund the retiree
health benefits obligation for future retirees. While postal officials
indicated that under these proposals the Service intends to make annual
payments for prefunding, the Service would be under no obligation to do
so. Consequently, if Congress wanted to ensure that the Service prefunds
its retiree health benefits, legislative action would be required.

In considering Proposal I, we identified the following unresolved
questions:

o 	Should prefunding Postal Service retiree health benefits be mandated by
Congress, or left to the Service's discretion?

o 	Should the Postal Service, OPM, or another entity determine the amount
of the Service's total retiree health benefits obligation?

o 	Who should determine the proper funding mechanism for the retiree
health benefits obligation?

o 	Should the Postal Service be required to amortize its prior years'
service obligation within a set time frame? If so, what is the appropriate
time frame?

o 	What economic and demographic assumptions should be used to determine
the current obligation, service costs, and asset balance, and future
estimates of these amounts? Furthermore, how often should

these assumptions be updated, and what process should be used to update
future estimates?

o 	What recourse, if any, should parties have if they disagree with this
funding mechanism?

o  What oversight, if any, is needed in this area?

    Technical Issues Related to Proposal II

According to postal officials, unlike Proposal I, in Proposal II the
Service would maintain control of the funds used to prefund the retiree
health benefits cost for new employees. These officials have also stated
that the Service would be responsible for determining the proper economic
and demographic assumptions to be used in calculating the annual fund
amount. However, questions arise about how the Service estimated these
costs for fiscal years 2006-2010. For example, the Service provided us
with estimates of these costs that ranged from $214 million in fiscal year
2006 to $687 million in fiscal year 2010. The Service then adjusted these
numbers downward to $100 million for fiscal year 2006 and to $300 million
for fiscal year 2010. According to postal officials, this downward
adjustment was made to reflect attrition. Although we attempted to verify
the method used to lower these estimated costs, we were unable to obtain
the necessary data in the time available to complete our work. As with
Proposal I, while the Service has said that it intends to fund this
obligation for employees hired after fiscal year 2002, it is not currently
required to prefund. Questions similar to those raised in Proposal I would
also relate to consideration of this proposal, including the following:

o 	Should prefunding retiree health benefits for new employees be
voluntary or legislatively mandated?

o  How should the annual funding amount be determined?

o  What oversight, if any, is needed in this area?

Questions Remain about the Regardless of which proposal is adopted,
questions remain about how the Accounting Treatment of retiree health
benefits obligation should be reflected in the Service's the Retiree
Health Benefits financial statements. The Service currently uses a
pay-as-you go basis of

accounting for its retiree health benefits obligation. We previously
reportedObligation that we believe the Service should consider whether the
accrual basis of accounting is both the acceptable and appropriate method
for this

obligation, especially considering the importance of giving full
consideration to economic realities as the Service attempts to transform
itself in order to respond to major operational and financial
challenges.16 Postal Service management and the Board of Governors, the
Postal Rate Commission, Congress, and other stakeholders need to have a
clear understanding of the Service's true financial condition as difficult
transformation decisions are being considered.

It is our understanding that the Service would not adopt the accrual basis
of accounting under either of the proposals presented, but would disclose
the amount of its retiree health benefits obligation in the footnotes to
its financial statements. While enhanced disclosure would be a positive
step, we continue to believe that accrual accounting is needed in order to
provide all stakeholders with the soundest and most transparent basis for
decisionmaking. In our view, the enactment of P.L. 108-18 could be viewed
as a significant event that triggers the need to reassess the accounting
treatment currently used by the Service with respect to these obligations,
and even more strongly reinforces our view that full accrual accounting
should be adopted for financial statement reporting purposes. Given the
unique nature of the Postal Service retiree health benefits obligation and
the impact of P.L. 108-18, it may be prudent for the Service and its
auditors to consult with the Financial Accounting Standards Board (FASB)
on the appropriate accounting treatment for this obligation for financial
statement reporting purposes.

A postal official has expressed concern that accrual accounting for this
obligation would result in immediate rate increases of significant
magnitude. We recognize that such an approach may initially result in
higher rate increases than would otherwise be the case under a
pay-as-yougo basis; however, rate increases would likely be more moderate
in the longer term. Various options may exist for addressing the effect of
recognizing this obligation, including possible amortization of any
current unfunded obligation over a reasonable time period, such as 20-40
years. To further explore these options, we believe that the Service
should work with the Postal Rate Commission and other appropriate
stakeholders to determine options for phasing in any potential effect on
postal rates.

16See U.S. General Accounting Office, U.S. Postal Service: Accounting for
Postretirement Benefits, GAO-02-916R (Washington, D.C.: Sept. 12, 2002).

We will be assessing the impact of the accounting treatment for the
retiree health benefits obligation for whichever proposal is adopted, as
well as for the Service's pension obligation, as part of our ongoing work.

Conclusions	The Service faces an uncertain future. First-Class Mail volume
continues to decline, and new revenue sources are not apparent. The
Service faces significant unfunded obligations, the largest of which is
for retirees, which must be addressed. Further, decisions must be made as
to whether current or future ratepayers, or taxpayers, should be
responsible for paying these obligations. The Service has acknowledged
that it needs to reduce its operating costs to deal with the decline in
First-Class Mail volume and meet its obligations. The most direct way for
the Service to do this is to become more efficient by standardizing its
operations and reducing excess capacity in its network as part of an
integrated strategy to rationalize its infrastructure and workforce. The
Service has stated that it plans to reduce its debt and finance capital
investment necessary to transform itself from rate increases within the
rate of inflation. It also proposes to prefund at least some of its
retiree health benefits obligation. However, it is not clear based upon
available information from the Postal Service whether it can accomplish
these goals. If sufficient funding for transformation initiatives is not
available, or if it does not achieve additional cost savings, significant
additional efficiency gains may not be achieved. In addition, if larger
postal rate increases are needed, further declines in mail volume could
result. These scenarios could thereby threaten the Service's future
financial viability.

It is against this backdrop of fairness to current and future ratepayers
and taxpayers, affordability, and the ability of the Service to achieve
its transformation goals that the Service's proposal to eliminate the
escrow requirement and its two funding proposals must be weighed. We
believe that the continuation of the escrow requirement after fiscal year
2005 without allowing the Service to use the funds has the potential for
significantly raising postal rates unnecessarily. Rate increases of the
magnitude necessary to fund this escrow requirement in the future may
precipitate further declines in mail volume and could hinder the Service's
ability to achieve other financial goals. Furthermore, Congress has other
means by which it can direct or guide the Service in its use of funds if
it chooses to do so.

Both funding proposals presented by the Service are generally consistent
with the provisions of P.L. 108-18. Proposal I, which is preferred by the

Service, hinges on transferring the responsibility for military service
pension costs from the Service to the Treasury. Proposal I would result in
a greater postal rate increase and would shift more of the responsibility
for the retiree health benefits obligation to current ratepayers. Proposal
II, on the other hand, would require less of a postal rate increase, focus
more on rate mitigation, and shift less of the responsibility for the
retiree health benefits obligation to current ratepayers than Proposal I.
This would leave future postal ratepayers with more of the burden of
paying for costs unrelated to products and services they receive.

Under both proposals, a portion of the retiree health benefits obligation
would remain unfunded, and the Service currently does not intend to
account for or report on its retiree health benefits obligation on an
accrual basis under either proposal. Thus, the full extent of the
Service's obligation would not be recognized on its financial statements.
Finally, the Service anticipates that it will be able to pay down debt and
fund capital investments through inflation-based rate increases under both
proposals. In our view, the Service needs to begin addressing its retiree
health benefits obligation as soon as it can afford to do so, and to the
extent it can. The most substantive way it will be able to do this, as
well as enhance its overall financial viability, is by effectively
implementing the transformation goals it and the President's Commission
set forth, particularly by becoming more efficient and rationalizing its
infrastructure and workforce. It is therefore critical for the Service to
have the capital funding needed for transformation. Although the Service
believes it would be able to generate enough funds, this is not clear
because the Service has not yet presented a comprehensive integrated
infrastructure and workforce rationalization plan. However, the Service
has agreed to do so, as well as report periodically on its progress in
implementing its Transformation Plan. Finally, a number of technical
issues need to be considered that are associated with the Service's two
funding proposals, including the implementation of any prefunding of the
Service's retiree health benefits obligation and the manner in which the
Service should amortize and report on its obligation.

Matters for To ensure continuing progress in addressing the Service's
financial Congressional challenges, we suggest that Congress consider the
following:

Consideration  o 	Repealing the escrow requirement after receiving an
acceptable plan from the Service describing how it intends to rationalize
its infrastructure and workforce and is confident that the Service is
making

satisfactory progress on transforming itself into a more efficient
organization and implementing its transformation goals.

o 	Directing the Service to fund specific purposes that Congress believes
are especially important-such as prefunding the retiree health benefits
obligation or supporting and possibly accelerating the Service's
transformation efforts-if the Service does not provide an acceptable plan
for rationalizing its infrastructure and workforce, or show satisfactory
progress in implementing transformation, or if Congress wants greater
assurance that the Service will spend funds in a particular manner. In
this regard, we have already recommended that the Service provide periodic
reports on the status of its transformation initiatives and other
Commission recommendations.

o 	Addressing implementation issues related to the retiree health benefits
obligation. For example, one key issue that would need to be further
explored is what options may be available that will allow the Service to
amortize its unfunded retiree health benefits obligation over a specified
time period (e.g., 20-40 years) and prefund the retiree health benefits
obligation for future retirees.

  Agency Comments and Our Evaluation

The Postal Service provided comments on a draft of this report in a letter
from the Chief Financial Officer dated November 21, 2003. These comments
are summarized below and reproduced in appendix II. The Service's letter
stated the following:

o 	It was pleased that our report found its proposals to be consistent
with P.L. 108-18, and that its preferred proposal presented a more
equitable balance of costs between current and future ratepayers.

o 	It would have to raise rates to generate funds for the escrow
requirement.

o 	The issue of the affordability of the proposals should be viewed as a
question of whether the ratepayers can afford them.

o 	It was concerned with our recommendation that Congress repeal the
escrow requirement after it receives an acceptable plan from the Service
concerning rationalization of its infrastructure and workforce, and if
Congress believes that the Service is making satisfactory progress on its
transformation goals.

o 	The Service believes that it already provides adequate information to
Congress for reviewing its plans and progress on transformation. Thus, the
Service believes that using the escrow as an oversight mechanism is not
necessary and will result in forcing the Service to raise rates.

o 	It believes that its Proposal I is in the best interest of the
taxpayers and postal stakeholders.

In response to the Service's comment regarding the affordability issue, we
agree that affordability to ratepayers is an important consideration and
discuss the impact of these proposals on rate increases and volume. We
have also added language to our report to clarify this point.

Regarding the Service's concern about tying the escrow requirement to an
acceptable infrastructure and workforce rationalization plan, we
understand the Service's concern that if the escrow requirement is not
repealed, it would have to raise rates unnecessarily. We agree that
establishing an escrow account without allowing the Service to use the
funds would not be a desirable outcome, and that is one of the reasons why
we suggested that Congress consider repealing the escrow requirement. On
the other hand, contrary to the Service's view, we believe the escrow
requirement is an opportunity for Congress to review how the Service plans
to address a number of long-term challenges, including debt repayment,
capital projects, an unfunded retiree health benefits obligation, and its
progress toward transformation. If the Service provides Congress with an
acceptable plan in the next several months and Congress finds the plan and
the Service's transformation progress satisfactory, we believe Congress
should have sufficient time to repeal the escrow requirement so that an
escrow account would not be needed. Thus, the Service would not have to
include the operating expense associated with the escrow requirement in
its rate base for the next rate case filing. Alternatively, if Congress is
not satisfied, it could direct the Service to fund specific activities or
purposes through means other than an escrow requirement.

Finally, the Service believes that using the escrow requirement for
additional oversight is not needed, because it has provided Congress with
adequate information on its plans and progress toward transformation.
While we agree that the Service provides a variety of reports and plans to
Congress, including its November 2003 Transformation Plan Progress Report,
the Service has not provided Congress with a comprehensive and integrated
infrastructure and workforce rationalization plan. We believe such a plan
is needed because the Service's rationalization of its

infrastructure and workforce is among the most important initiatives in
the Service's Transformation Plan since it will significantly affect the
Service as well as so many employees, mailers, and communities.
Recognizing the widespread interest and potential controversy associated
with any changes in this area, it is critical that the Service inform
Congress and the public about its rationalization strategies and plans.
We, as well as the President's Commission, believe that these initiatives
are also key to the Service's efforts to cut costs and become more
efficient. Accordingly, we believe oversight in this area is necessary,
and that information related to the cost of these initiatives and the
Service's ability to fund them will be needed to assure Congress that the
Service is continuing to make progress in implementing its Transformation
Plan.

We will send copies of this report to the Chairmen and Ranking Minority
Members of the House and Senate Committees on Appropriations, as well
as Representative John M. McHugh, Chairman of the House Special Panel
on Postal Reform and Oversight; Representative Danny K. Davis, Senator
Daniel K. Akaka, Senator Thomas R. Carper, the Postmaster General, the
Secretary of the Treasury, the Director of the Office of Personnel
Management, the Director of the Office of Management and Budget, the
Chairman of the Postal Rate Commission, and other interested parties. We
will also make copies available to others on request. In addition, this
report
will be available at no charge on GAO's Web site at http://www.gao.gov.

Staff acknowledgments are included in appendix III. If you have any
questions about this report, please contact Bernard L. Ungar, Director,
Physical Infrastructure Issues, at (202) 512-2834 or at [email protected].

David M. Walker
Comptroller General of the United States

Appendix I

                       Objectives, Scope, and Methodology

Our objectives for this report were to fulfill our legislative mandate to
evaluate the Postal Service's proposal for use of the savings accruing to
the Service from enactment of pension reform legislation. We evaluated the
report based on its consistency with P.L. 108-18. We also addressed the
escrow requirement that the Service identified as an issue in its report,
and identified issues based upon our previous work that Congress may want
to consider in assessing the Service's proposals, including the fairness
and affordability of the proposals, and the ability of the proposals to
help the Service achieve its transformation goals. Finally, we discussed
other pertinent issues that we identified in the course of our review.

To assess whether the proposals were consistent with the provisions of
P.L. 108-18, we reviewed the legislative history of P.L. 108-18. We then
assessed how well each of these proposals addressed the Sense of Congress
and the Matters to Consider expressed in that legislation. We also
reviewed the Commission recommendations to determine if the proposals were
consistent with this work.

To assess the escrow requirement, we reviewed the Service's report,
interviewed postal officials, and analyzed the Postal Service's financial
data to assess the impact of the escrow requirement on the Service's
financial situation. We also interviewed congressional staff to discuss
the purpose of this account.

To identify issues we had previously reported on, we reviewed our previous
work. To assess how well each proposal addressed fairness issues, we
reviewed Postal Service documents and interviewed Postal Service
officials. We also assessed the affordability of each proposal by
obtaining and analyzing Postal Service documents, including the Five-Year
Strategic Plan FY 2004-2008, the Integrated Financial Plan for Fiscal Year
2004, the Five-Year Strategic Capital Investment Plan 2004-2008, annual
reports, and materials provided by the Service in support of its
proposals. We did not independently verify any of the financial data
provided by the Postal Service. We also reviewed actuarial reports
regarding the retiree health benefits obligation, and analyzed the
Service's proposed funding mechanism. We did not independently verify any
of the actuarial reports. We also reviewed the Service's April 2002
Transformation Plan to assess progress in this area. To assess the impact
on the federal budget, we reviewed the federal budget and documents
prepared by the Congressional Budget Office related to the effect of P.L.
108-18 on the federal budget, and we conducted interviews with officials
from the Congressional Budget Office.

Appendix I
Objectives, Scope, and Methodology

To identify other pertinent issues that Congress may want to consider, we
reviewed Postal Service documents, the Commission's report, and our
previous work. We also conducted interviews with congressional staff, OPM,
and Postal Service officials.

The Service raised another issue in its report that was not within the
scope of our review. The Service has expressed concern with the method
that OPM used to determine the amount of the postal CSRS fund. The Service
believes that OPM's methodology assigns an unreasonably low portion of the
retirement benefit to the federal government, so it provided OPM with two
alternatives to consider. OPM did not agree with the first alternative and
did not respond to the second alternative. P.L. 108-18 required OPM, in
consultation with the Postal Service, to develop the methodology used to
determine the amount of the postal CSRS fund. The law also afforded the
Service the opportunity to appeal OPM's methodology to the Board of
Actuaries of the Civil Service Retirement System, which the Service is
currently considering. Thus, we did not include this issue in the scope of
our review.

We conducted our review at Postal Service headquarters in Washington,
D.C., from October 1, 2003, through November 25, 2003, in accordance with
generally accepted government auditing standards.

                                  Appendix II

                     Comments from the U.S. Postal Service

Appendix II
Comments from the U.S. Postal Service

Appendix III

                     GAO Contact and Staff Acknowledgments

GAO Contact Bernard L. Ungar, (202) 512-2834.

Staff 	Teresa L. Anderson, Alan N. Belkin, Christine Bonham, Margaret
Cigno, Nikki Clowers, Kathy Gilhooly, and Kenneth E. John made key

  Acknowledgments contributions to this report.

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