Critical crossroads for retiree health benefits.

Not long ago, companies enthusiastically adopted and expanded retiree health programs with seemingly little concern for the long-term financial implications. The programs were relatively inexpensive, there was not an excessive number of retirees or older workers close to eligibility, no advance funding was required and financial disclosures were few or nonexistent.

Retiree health programs were a great vehicle for achieving favorable relations with unions and union workers, as well as for generating career commitment by salaried workers. Unfortunately for both employers and employees, this situation has changed dramatically: today, the benefit to retirees and the financial burdens to employers are intersecting at a critical crossroads.

The Problems ... and Opportunities

Healthcare programs in general are very expensive, and costs continue to rise dramatically. Many companies and industries that previously adopted generous programs now have more retirees than active employees, and this ratio and associated costs continue to grow. The financial disclosures are significant and burdensome, the expense often imposes a drag on the stock price and the current cash outlay for retiree health benefits has saddled many companies with unsustainable and noncompetitive costs. Also, investors, lenders and others are now looking closely at companies' pension and retiree health obligations.

Although the general picture may seem relatively bleak, many companies have undertaken initiatives to manage their programs with creativity, discipline and sensitivity. Moreover, many companies, industries and trade associations are lobbying hard to encourage Congress to adopt a Medicare drug benefit that includes favorable provisions for coordinating with employer-sponsored retiree health plans, and thus ameliorating some cost increases.

Since the adoption of FAS 106, plan sponsors have become increasingly sensitive to the financial implications of these programs. Now, financial input into and oversight concerning the management of and decision-making regarding these plans has become critical.

Evaluating Possible Plan Changes

Taking stock of the present landscape--the financial, legal, design, operational and demographic aspects of a company's present plan--is critical to analyzing its options, limiting long-term financial burdens and planning for the future.

Such an evaluation includes several elements. Perhaps most critical for plan sponsors is the flexibility to modify or curtail plans, the funding regimen (if any) adopted by the sponsor and the financial liabilities and related disclosures regarding the plans" expenses and liabilities. Addressing the specific issues and setting an overall strategy has become a financial issue as much as--or perhaps more than--a human resource one.

Employers are addressing their current cash costs and future liability pressures through two basic approaches: plan design changes resulting in reductions or curtailments of the benefits and, to a lesser extent, efficient and effective funding arrangements.

Legal Concerns

Many plan sponsors have implemented significant plan design and administrative changes to limit costs and liabilities. Many of the changes have been applied to existing retirees, increasing participant costs, sometimes significantly; some employers have terminated plans. Companies are relatively free to modify or terminate plans for future retirees, subject to applicable collective bargaining.

Although limiting changes and curtailments to future retirees can bolster the balance sheet, many employers have implemented major changes applicable to existing retirees in order to manage near-term cash costs and financial obligations. This has generated much controversy and litigation.

The courts have generally evaluated the issues regarding company-initiated changes under an Employee Retirement Income Security Act (ERISA) common law standard because health and welfare benefits are not subject to ERISA vesting standards or other provisions applicable to qualified pension plans.

ERISA is virtually silent on the issue of health and welfare benefit plan termination or modification, and thus, plans may be changed or terminated at any time unless the company does something to impair or waive that right. However, this does not mean that the courts have consistently found that employers are necessarily free to amend or curtail their plans for existing retirees.

Companies reviewing their legal obligations should start with an evaluation of prior and existing plan and communication documents that were in effect when former employees retired. For retirees covered by a union agreement at the time of their retirement, reviewing critical contract terms and bargaining history is also important. With several notable exceptions, recent case law has generally found in favor of employers who have terminated or cut back programs, providing some encouragement that companies can improve their financial situation related to the plans through design, premium and other changes.

The courts that have sided with employers have generally done so on the basis of strong plan language (which was communicated to participants) reserving the right to modify or terminate the plan. Companies such as General Motors Corp., McDonnell-Douglas Corp. (now part of The Boeing Co.), NCR Corp. and Xerox Corp. have successfully litigated their changes for salaried retirees.

Design Changes

Critical plan design changes are focused on better allocating the cost of healthcare between the company and the retirees. Naturally, the most obvious change is to hike retiree premiums, and many companies have done so by capping their own contributions or imposing other limitations on company financial support. About half of the major companies with retiree health programs have imposed a dollar cap on employer contributions per retiree. Others have significantly lowered the percentage of company-provided premiums towards total costs of coverage.

Limiting the employer premium commitment to plans will decrease FASB expense and reduce cash outlays. However, without a cap, financial obligations are still subject to medical inflation. Once a cap has been imposed, companies must stick to it; otherwise their accountants could conclude that the plan's substantive obligations are effectively uncapped.

Companies are also implementing internal plan design changes, including higher deductibles, greater retiree co-payments, managed drug programs, higher premiums for spouses and dependents, elimination of dental, and reimbursement of Medicare Part B premiums and strict coordination of benefits with Medicare and other plan coverages. Some companies that have terminated plans or closed eligibility to new entrants have agreed to continue to provide access to group-rated programs fully supported by participants. Moreover, some companies are looking at so-called "consumer driven healthcare" through establishment of high-deductible plans with associated health spending accounts, hoping to positively influence retiree health behavior and purchasing.

Pre-Funding

ERISA does not require any pre-funding of retiree health benefits. However, pre-funding future benefits provides a means for employers to systematically manage the costs and liabilities, as well as to enhance security for participants. Lacking any legal requirement for doing so, many companies have been discouraged from voluntarily funding because of the limitations on tax-effective outlays and the demands for cash elsewhere in the business.

Retiree health benefits can be prefunded through a Code [section] 401(h) account in a defined benefit pension plan. However, the critical flaw here is that the funding of 401(h) accounts must be linked to and limited by pension funding. Thus, many companies that pre-fund do so through VEBAs (voluntary employee beneficiary associations) and not 401(h) accounts. VEBAs are authorized under provisions of the tax code and regulated by ERISA. Contributions to VEBAs are deductible, but (unlike 401(h) accounts) investment earnings are taxable unless the VEBA covers almost exclusively union employees and retirees, or are invested through a tax-sheltered insurance wrapper known as trust owned life insurance (TOLI).

Although somewhat similar to corporate owned life insurance (COLI) policies, TOLI has not been challenged by the Internal Revenue Service (IRS) to date, and seems to have sound statutory support in the tax law.

A few companies have tried to develop means to allow retirees to pay for medical premiums through tax-favored use of 401(k) and pension distributions, but the IRS has indicated this is not permissible. And, contributions to VEBAs by employees are after-tax and often affect the amount of their contributions to 401(k) plans, and can affect discrimination testing of such. Thus, there is no fully tax-effective means for employees to save towards future health costs, although several Congressional proposals are currently addressing the issue.

Finally, some companies are investigating use of so called "health reimbursement accounts" (HRAs) as a vehicle to help individuals save towards retiree health costs and better manage sponsor costs. HRAs are IRS-approved accounts that may accumulate unused amounts during employment for future years, during later employment or after termination.

HRAs must be associated with high-deductible, so-called "catastrophic insurance" and, although there is no guidance from the IRS on funding such, it appears that they can be funded. Failure to fund would presumably result in increased FAS 106 expense and liabilities.

Concerns regarding the future provision for and costs of America's retiree health benefits for current and retired workers is a growing public policy and societal issue. This is essentially a result of the confluence of a number of factors: the aging workforce, the health care cost spiral and the need for companies to manage and reduce their financial burdens. These factors are unlikely to change in the near-term, and appropriate responses are necessary.

Some of these responses include: developing new and innovative plan designs under which individuals more fully share the responsibility for managing costs; implementing reasonable pre-funding arrangements for both employers and employees; and a regulatory environment that encourages employers to maintain these programs in a voluntary benefit system.

There is no single solution to the growing dilemmas of high demand and costs, and limited resources to fund. The key is for companies to closely evaluate their financial, legal, design and operational situation and options for dealing with each, develop an overall strategy consistent with their business and economic objectives, and implement the changes with a sound and comprehensive communications program. Company financial executives can--and should--take a leading role in this effort.

Percentage of Large Private Employers That Made
Changes to Retiree Health Benefits Within the Past
Two Years

Increased Retiree Contributions
to Premiums                              44%

Increased Cost-Sharing                   36%

Increased Dependant Contributions
to Premiums                              29%

Added Coverage or Benefits for
Retirees                                 17%

Offered Medicare + Choice as an
Option                                   14%

Provided Access Only to Health
Benefits With Retiree Paying 100%
of Costs                                 14%

Terminated All Subsidized Health
Benefits for Future Retirees             13%

Shifted to a Defined Contribution
Approach                                 7%

Source: "The Current State of Retiree Health
Benefits", Findings from the Kaiser/Hewitt 2002
Retiree Health Survey. Reprinted with permission from
the Henry J. Kaiser Family Foundation.

Note: Table is made from bar graph.

Scott J. Macey is Senior Vice President of Aon Consulting, an insurance and consulting services company, in Somerset, N.J. He can be reached at scott_macey @aoncons.com or 732.302.2112.