Health benefits for retirees - surviving with OPEB.

After years of controversy, the FASB statment on postretirement benefits other than pensions is now a reality. Here's help in implementing its provisions.

Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, will for the first time require employers to begin to accrue the cost of retiree health and other postretirement benefits over the working careers of active employees. Statement 106 is generally effective for fiscal years beginning after December 15, 1992 (i.e., the first quarter of fiscal 1993).

Management is now faced with the challenge of balancing the health benefit needs of current and future retirees with financial, business, and accounting constraints. There are certain steps that employers can incorporate into an action plan to understand more fully the significant financial reporting and business issues related to their retiree health programs. These steps are as follows:

* Understand the basic accounting requirements under Statement 106.

* Measure obligations and expense under the new accounting rules.

* Evaluate plan design changes and their impact.

* Assess financing and advance funding alternatives.

* Select transition approach and adoption date.

Management should develop an overall strategy that deals with these issues, integrating each of the steps in the action plan.

This article discusses the key accounting and measurement issues under Statement 106. In a second article in the March/April issue of Financial Executive, we will highlight the important plan design, cost control, financing, and funding issues that management will need to consider before adopting the new accounting rules.

Understanding statement 106:

Management needs to start with a good understanding of the new rules and their general impact. Based on the comprehensive field test of the FASB's exposure draft (ED) that Coopers & Lybrand conducted last year for Financial Executives Research Foundation and on other actuarial valuations performed by our firm that consider the changes the FASB is making to the ED, the FASB's new rules will generally result in significantly higher expense, increased recorded liabilities, and reduced net worth.

The amount of the increase in expense will vary from company to company, based on specific company demographics and plan terms, and on the assumptions used to determine expense. For those companies that participated in the field test and that had a significant number of retirees, expense under accrual accounting generally ranged from two to six times their current pay-as-you-go costs. For companies with fewer retirees, current pay-as-you-go costs were minimal, and therefore the expense as a multiple of the pay-as-you-go costs was much higher.

In finalizing the requirements under Statement 106, the FASB has made some important changes to the ED but has retained several key elements. (See the comparison of the ED with the final statement on pages 36 and 37.)

Measuring obligations and expense:

With Statement 106 in mind, management needs to examine the company's current health benefits program. Although many employers have rough estimates of their retiree health obligations, relatively few have had thorough actuarial valuations to assess current and future costs. These valuations will help management be strategically positioned to make informed, effective benefit planning decisions, as well as comply with the new accounting rules.

The six steps normally performed in a retiree health actuarial valuation are as follows:

Step 1: Examine the current benefit program to understand each plan provision that affects cost (see discussion of "substantive plan" below).

Step 2: Obtain and analyze demographic data to identify retirees (and their dependents) and active employees who currently are or will be eligible for benefits.

Step 3: Obtain and analyze claims data for use in assessing the company's current retiree health costs.

Step 4: Estimate average per capita (baseline) costs using plan, demographic, and claims data as starting points for projecting future costs.

Step 5: Select actuarial assumptions to provide the basis for estimates of future cash flows and the present value of the obligation. At a minimum, these assumptions should include health care cost trend, discount rate, and demographic assumptions (e.g., mortality, turnover, and retirement age).

Step 6: Calculate estimates of obligation and expense under present plan and under alternative plan designs being considered. Develop a range of results using alternative actuarial assumptions.

How Statement 106 works:

In the FASB's view, the present value of postretirement benefit costs should be fully accrued by the date the employee is eligible to receive full benefits based on the terms of the plan (the "full eligibility date"), since the employee need not perform additional service to receive full benefits. Typically, full eligibility is completed when an employee reaches a specific age and works a specified period of service for the employer (for example, age 55 with 10 years of service).

An employer should focus separately on the following groups (and their dependents):

* Retirees currently receiving benefits.

* Active employees fully eligible for retiree health benefits.

* Active employees not yet fully eligible.

Defining the obligation:

The FASB standard contains two measurements of the employer's postretirement benefit obligation (illustrated for two hypothetical employers in Figure 1 on page 34) as follows:

* Expected post retirement benefit obligation (EPBO). The EPBO is the actuarial present value of the postretirement benefits expected to be paid after retirement to the employee and the employee's dependents. The EPBO is not recorded or disclosed in the financial statements, but is referred to in the measurement process.

* Accumulated postretirement benefit obligation (APBO). The APBO is the actuarial present value of all future benefits based on employees' service rendered up to the measurement date. The APBO is equal to the EPBO for retirees and active employees fully eligible for benefits. Prior to the date an employee attains full eligibility, the APBO is a portion of the EPBO.

Estimating the impact of expense:

Assuming that the employer elects to amortize the transition obligation (see discussion of alternative transition approaches below), the components of expense under Statement 106 in the year of adoption include service cost, interest cost, and transition amortization (less expected return on plan assets if the plan is funded). In subsequent years, additional components of expense may be needed for amortizations of actuarial gains and losses and prior service costs arising from plan amendments.

Figure 2 represents the components of expense for the hypothetical employers illustrated in Figure 1. Understanding the substantive plan In what may be the most important departure from the ED, Statement 106 bases the accounting on the "substantive plan," not just on the terms of the written plan. Under the new approach, employers may be able to assume that the cost-sharing provisions of the written plan (e.g., deductibles, retiree contributions, plan maximums'.) will be changed in the future. Applying this concept is likely to have a significant impact on obligations and expense under Statement 106.

The FASB's requirements are very complex and-include a number of conditions that an employer must examine to determine whether changes to the written plan can be anticipated. Employers should begin now to assess how to deal with the "substantive plan" approach. (For more information and a definition of "substantive plan," refer to the final statement.) At a minimum, employers should:

* Analyze prior changes to the plan to assess if the company has a consistent: practice of changes in cost sharing.

* Review past communications to employees and retirees to determine the extent to which the employer has announced its intent to modify plan terms.

* Consider whether to make appropriate plan changes before 1993 and to communicate these changes to employees and retirees to establish the basis for anticipating future plan changes.

Selecting a transition approach:

While Statement 106 requires all employers to follow a single measurement approach, it does allow greater flexibility in accounting for the transition to accrual accounting than did the ED. First, employers can select the date of adoption, but in no event can it be later than the beginning of fiscal 1993 (fiscal 1995 for nonpublic employers with under 500 plan participants). Employers also have the choice of immediately recognizing the obligation at that date, or of amortizing the obligation to expense over future years.

Immediate recognition will be permitted only at the adoption date, and the entire past service obligation at that date must be charged to expense as a cumulative catch-up adjustment. Because these obligations are so large, many employers may not select the immediate recognition option. However, some may like the idea of getting the "bad news" behind them, such as might occur in a year in which the employer has a large unusual gain. The primary benefit of immediate recognition is that income in future years will not be reduced by the portion of expense relating to amortization of the transition obligation. In the field test, immediate recognition of the transition obligation reduced ongoing retiree health expense by, on average, 25 to 35 percent.

What's next?:

Developing a strategy to manage retiree health benefit plans effectively is a broad business issue for which there are no easy solutions. Considering the need to implement the FASB's new accounting rules while ensuring that your program is manageable, efficient, and cost-effective requires the same management strategies commonly applied to other key business planning issues.

Messrs. Dankner and Akresh and Ms. Bald are coauthors, with John M. Bertko and Jean M. Wodarczyk, of the 1989 research study conducted by Coopers & Lybrand for Financial Executives Research Foundation (FERF), Retiree Health Benefits: Field Test of the FASB Proposal.

Editor's note: As this article went to press, the FASB bad voted to issue Statement 106 but bad not yet released it. This overview is based on the authors' attendance at public FASB meetings, the FASB Action Alert publications, and the authors' detailed understanding of the issues. Readers should review the final Statement 106 before implementing any programs relevant to it.