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Before the FASB's OPEB ruling: the first steps to take.

Before the FASB's OPEB ruling: the first steps to take

As the FASB releases its exposure draft on other postemployment benefits, companies are finding that the Board is serious about recognizing OPEB obligations on a firm's financial statements. But is a "best guess" of the obligation figure good enough? Two accounting practitioners offer their six steps for responding to the FASB proposal. In the face of increasing controversy, the FASB's project on accounting for postemployment benefits other than pensions continues to forge ahead. An important step in this process is the issuance of the FASB's exposure draft (expected in December of 1988 as this article went to press). If adopted as proposed, the new accounting rules for other postemployment benefits will have a dramatic effect on future financial statements and possibly on the amount of retirement benefits companies promise to employees.

The different estimates of costs associated with providing postemployment benefits are staggering. In 1986, the House Select Committee on Aging reported that providing medical benefits to the existing work force would cost $2 trillion. A Department of Labor study estimated the liability for benefits promised to existing workers over the age of 40 at $98 billion. Given the total net worth of the Fortune 500 companies of almost $700 billion, it is easy to understand why many corporate executives believe the issue is a financial time bomb.

Statement 87 as a model

The FASB's project on other postemployment benefits (referred to as OPEBs) is an offshoot of its earlier project dealing with pension plans. The fundamental approach taken by the FASB to resolve the issues relating to OPEB has been to use the accounting model embodied in FASB Statement 87, Employers' Accounting for Pensions. The FASB has concluded that, to the extent that similarities exist between the benefits provided under defined benefit pension plans and the benefits provided to retiring employees under various other plans, the accounting treatment in terms of both recognition and measurement should be the same.

As with pensions, the FASB has decided that, not-withstanding legal liability questions, the corporate promise to provide other postemployment benefits constitutes a liability for accounting purposes. The benefits are viewed as a form of deferred compensation that should be recognized as the employee renders service.

The FASB's approach requires estimates of the total costs of providing benefits to employees after they retire. The cost would be recognized in the financial statements as an expense over the employee's service period. For expense recognition purposes, the employee service period would extend only to the date the employee first becomes eligible for benefits, rather than the expected retirement date.

However, certain obligations would not be recognized immediately in the financial statements. For example, recognition of OPEB obligations attributed to prior service at the date the new rules go into effect would be deferred, off the balance sheet, and recognized over the greater of the period of employee service or 15 years. The effect of future plan amendments on prior service cost would be recognized over the period of employee service. In certain circumstances, however, a minimum liability for benefits promised to employees who already have retired and employees who are eligible for benefits would be recorded in the financial statements.

Since the FASB has concluded that the promise to provide such benefits constitutes a liability, the question of measuring those benefits becomes paramount. The proposed approach would necessitate detailed and complex actuarial calculations of the present value at retirement of the estimated costs to provide the benefits promised employees. The result of these calculations, referred to as the "expected benefit obligation," involves using the best estimate of the underlying assumptions, such as retirement age, employee turnover, mortality, the frequency and cost of future medical services, and an appropriate discount rate.

While the requirement to use the best estimate of each of the underlying assumptions is consistent with the approach taken by Statement 87 for pension plans, it will prove to be more difficult to implement because of the variables unique to other postemployment plans, namely the expectations about the future use and costs of health care.

Assumptions about Medicare levels, incurred claim costs, and the somewhat elusive health care cost trend rate also will be required. The last assumption is a function of the general level of price increases in health care costs, the frequency and use of health care services and, finally, the impact of future technological advances in health care services.

Concerns about the reliability of such measurements for financial reporting have been raised by the members of the FASB task force on this project. Acknowledging this concern, the FASB is proposing that companies disclose in their financial statements the effect of a 1 percent change in the health care trend rate assumption on the benefit obligation and cost. It is hoped that this type of disclosure will illustrate the sensitivity and uncertainty of the obligation estimate.

Other aspects of the FASB proposal, such as the effect of plan amendments on prior service obligations, gains and losses, and other disclosures, are expected to be similar to those required for pensions by Statement 87.

Because of the financial implications--reductions in reported net income and increased liabilities--and the complexities associated with the recognition and measurement issues, the FASB is allowing a comment period of at least six months. Public hearings are scheduled during the summer of 1989, and present plans target the issuance of a final statement in 1990. Current plans are for the final statement to be effective for years beginning after December 15, 1991, with certain provisions, such as those pertaining to the recognition of the minimum liability, taking effect five years later.

Six steps toward responding to the FASB

Because of the controversial nature of the project, companies are encouraged to give careful consideration to the provisions of the exposure draft, especially as they relate to the costs that will be incurred to implement any new standard as well as those relating to a host of implementation issues that likely will be identified. In this regard, a field test sponsored by the Financial Executives Research Foundation will analyze the impact of the exposure draft on the financial statements of 25 companies. Results will be made available to the FASB and should provide useful information during the comment period.

In the meantime, companies can evaluate the impact of the proposal and prepare to respond to the FASB by taking these six measures: * Determine benefits promised. Determining what benefits have been promised to employees may be more complicated than it appears because, in some cases, those determinations will involve legal interpretations of the promises made. Recently, some employers have attempted to reduce or even eliminate retiree medical and other nonpension benefits. Legal actions initiated by unions and retirees have resulted in court decisions that employers could not unilaterally reduce or terminate benefits previously promised to retirees.

The sources of employer promises have extended beyond plan documents and include other communications, such as employee newsletters, company meetings, letters, and memoranda, and even verbal exit interviews. Accordingly, companies should involve appropriate legal and human resource personnel in determining the nature and extent of promises that have been made. * Gather the data required for actuarial measurements. For some companies, obtaining the necessary information will be a difficult task because the data required for the complex actuarial calculations might not be readily available. Projecting the costs of providing postemployment benefits will require information about annual incurred claims costs for retirees by age category.

Because an employer's cost is significantly higher for medical benefits provided to retirees under age 65 who are not yet eligible for Medicare, this type of information will be critical to the actuarial calculations. Some companies may find, however, that retiree medical costs are combined with costs for active employees or that the required cost information will not be categorized by age groups.

Even companies with relatively few retired employees will need to accumulate information regarding their active employees. For example, information such as age, sex, number of covered dependents, and expected retirement age information must be gathered to make the necessary projections. In some cases, information systems will need to be modified to provide this data. In other cases, insurance carriers or claims processors might be able to help. * Obtain actuarial estimates of your obligation. The next step is to "run the numbers" and estimate the potential obligation. Again, this may be difficult. While the use of actuarial estimates also is required for pensions, the methodology for estimating OPEBs is not as well developed. This is compounded by the fact that presently the number of actuaries specializing in health care projections is far fewer than the number of actuaries versed in pension matters.

Also, there is a significant degree of uncertainty in the assumptions needed to estimate these obligations, particularly the health care cost trend rate. It is important to work closely with actuaries in developing assumptions that reflect the best estimates of the obligations under the plans. * Assess the funding and accounting impact of the estimated obligation. In connection with obtaining actuarial estimates of the obligation, projected cash flows and funding alternatives should be considered. Unlike pensions, almost all companies now fund these benefits on a pay-as-you-go basis as opposed to prefunding. To date, prefunding postemployment plans has been unattractive because very limited tax incentives presently are available under existing tax law. And while there is some interest in Congress in providing additional tax incentives for prefunding, no substantial legislation appears close to enactment, particularly in light of the current emphasis on reducing the budget deficit. * Plan modifications. Cost containment options and "capping" liabilities for benefits through changes in plan design also should be considered. This, of course, must be balanced with corporate objectives for providing retiree benefits and with existing commitments. A possible strategy could be reducing lifetime liability limits, raising or indexing deductibles, or utilizing a defined contribution approach for medical benefits. Because of the legal implications of modifying plan benefits, companies should obtain legal advice about any plan modifications. * Monitor future legislative and legal developments. The issues surrounding postemployment benefits transcend financial reporting matters. In addition to the FASB's activities, some believe ERISA-type legislation addressing vesting, eligibility, and funding could be enacted. In addition, significant court decisions might provide precedents on legal liability issues that will be important. A coordinated effort by legal, actuarial, human resource, and financial personnel to monitor developments in these areas should be undertaken.

Even deeper concerns

The FASB's decision that the corporate promise to provide postemployment benefits constitutes a liability for accounting purposes reflects, in part, the Board's belief that recognizing some number is better than no number at all. This conclusion would toll the death knell to the pay-as-you-go method of accounting for OPEBs, which presently is used by the vast majority of companies providing benefits to retired employees.

Already, some companies are examining the benefits offered to retirees and many have been unpleasantly surprised at the magnitude of the costs involved and the difficulty of estimating them. It is important that companies take action now to evaluate the effects of the possible new accounting rules and to respond to the FASB in a timely fashion.

But the accounting issues related to postemployment benefits are just one aspect of this pervasive issue. Significant societal issues regarding the extent to which health care benefits should be provided to retired employees, questions about who should have the ultimate responsibility for those benefits, and the extent to which federal fiscal policy should promote private-sector funding through tax incentives are just a few of the issues that ultimately must be resolved.

Robert K. Herdman and Robert D. Neary The authors are partners in the national office of Ernst & Whinney. They thank their colleagues Alex T. Arcady and Jan J. Meder for their assistance.
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Title Annotation:Other Postemployment Benefits; Financial Accounting Standards Board
Author:Neary, Robert D.
Publication:Financial Executive
Date:Jan 1, 1989
Previous Article:Underfunded pension plans now mean more company liability.
Next Article:The FASB, guidance, and Statement 96.

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