How to meet your OPEB obligation.

In the wake of Statement 106, seven panelists examine the value of Prefunding retiree medical benefits and discuss the techniques that have worked for them.

How effectively are companies today addressing the need to set aside funds to pay for future health benefits? How much is their approach driven by financial considerations?

What funding vehicles do they use? Given certain limitations these vehicles have, can help be expected from a Congress reluctant to cut revenue sources?

These were among the issues on the agenda of a recent panel discussion organized by Actuarial Sciences Associates (ASA). Sharing a broad range of practical experiences, the seven panelists agreed the decision to pre-fund is an allocation of resources issue, but noted that pre-funding is viewed differently by retirees and current employees and must be handled differently for union employees and management employees.

The panelists' overall objective: Make funding tax-efficient. Their overall consensus: Business should make do with the vehicles it has now.

The roundtable participants were: Donald D. Cameron, senior vice president, Large Corporate Market Division, Massachusetts Mutual Life Insurance Company; John Erlenborn, partner, Seyfarth, Shaw, Fairweather & Geraldson, and one of the authors of ERISA; Neela K. Ranade, vice president of Welfare Benefits Consulting, Actuarial Sciences Associates; Frederick W. Ruebeck, director of Investment Administration, Eli Lilly; Dallas Salisbury, president, Employee Benefits Research Institute; and J. E. (Jack) Stair, Jr., senior consultant, DuPont. The moderator for the panel was Michael J. Gulotta, president and CEO, Actuarial Sciences Associates.

The following is an edited version of their discussion.

GULOTTA: Now that the FASB has issued Statement 106 on Accounting for Postretirement Health Benefits, corporations are addressing two questions: whether or not to pre-fund their obligation and, if they do pre-fund, how to do it. Is there a greater need to pre-fund, now that income statements and balance sheets will show the current and accrued expense for postretirement benefits? Companies are also concerned about identifying the size of their liability and how they can change it by changing either the plan design or their assumptions. And, of course, some are asking if they should provide the benefits at all.

RUEBECK: Ideally, companies will identify what their liabilities are, then look at alternatives for funding. But what often happens is that companies look first at the design of their plans, and then think about the funding.

ERLENBORN: Well, before FAS 106, a number of companies began to look at VEBAs for pre-funding. Congress responded by amending the law, making it much more difficult to use a VEBA. That's why many companies are looking at plan design changes to limit the liability.

STAIR: I have a more basic question. Is it fundamentally sound to take money away from the business and put it in trust funds? This raises the issue of allocation of resources. And do employees really feel better by having these liabilities pre-funded? I'm not convinced that there's been a hue and cry across the land that the benefits need to be pre-funded.

SALISBURY: Clearly, retirees would feel a lot better if they knew the liability was pre-funded, but active employees would rather have that money in their paychecks. In a recent EBRIGallup survey, 68 percent of active employees said their decision to take a job would be affected by whether or not there was a health benefit. But only 29 percent said a pension plan is vital. The number who placed first priority on a retiree health plan didn't even register. Employees first want economic security today; then they worry about tomorrow. And they don't look primarily to their employers for retiree health benefits; they look to Medicare.

RANADE: But there is concern that Medicare benefits are being cut back.

GULOTTA: With the emergence of baby-boomer retirees and the pressures on Medicare, there is also concern that the burden is being turned over to the next generation of taxpayers. The public policy analysis of pre-funding has to start from understanding the ramifications of a lack of funding, the trend to defined contributions plans, and the evident fact that people are not saving money.

CAMERON: I don't think you're going to get government action until you have a groundswell of public opinion that voices a concern about the viability of the system to take care of them, be it a government plan or employer-sponsored plans. Until then, the tendency to push the problem off to the next generation will continue.

GULOTTA: in looking at pre-funding, to what extent will corporations attempt to achieve a balance between the financial perspective and the human resources/ employee relations perspective?

RUEBECK: The decision to fund will ultimately be a financial decision-whether you can show an attractive return for pre-funding and have that return reflected in the current operations of the company. A tax-deductible contribution, with earnings that are compounding tax free, is the only way that a pre-funding investment can compete with the corporate cost of capital.

ERLENBORN: But I don't see Congress allowing tax benefits or tax breaks at this time, given the nation's budgetary problems. Assuming they will be willing at some time to provide a funding vehicle on a tax-preferred basis, I think they will demand minimum standards for vesting, participation, and funding at the same time. SALISBURY: What is technically possible under existing law may have absolutely nothing to do with legislative intent. So to the degree that companies decide to approach retiree medical benefits through 401 (h), through some defined benefit or defined contribution plan, or through another type of qualified arrangement, they're clearly saying that these vehicles have had the blessing of the Congress for decades and that they take care of the issue of non-forfeitability.

ERLENBORN: The vesting of defined benefits is a difficult issue. After five years, you may be vested, but vested in what? Up until now, if you stayed in one company until you retired, you might or might not be vested. But if vesting of health benefits was required, then after being vested, if you move to another company, you would have partial vesting in each company. In a defined contribution plan, that's manageable; in a defined benefit plan, it's not.

GULOTTA: Yes, vesting is a sensitive issue, and, in considering tax-favored funding, Congress may be affected by whether or not there is individual vesting of benefits. It's a lot easier to lobby the issue if you're going to Capitol Hill with a halo.

Also, in the long run, we may be better off with minimum funding standards, for when you look at the unfunded pension benefits versus the unfunded health benefits, you have a much bigger problem on the health side than you do on the pension side. And yet we have minimum standards on the pension side but not on the health side.

RUEBECK: What about a trade-off? What if tax-advantaged funding is made available to corporations, but the medical benefits themselves become taxable to the individuals receiving the benefits?

ERLENBORN: I see that happening with current employees, if it happens at all. Passing the tax burden to present retirees is politically unacceptable.

RUEBECK: There's also the issue of whether the benefits themselves should be taxed, or whether the taxable income would be based on some imputed actuarial value of the benefit.

ERLENBORN: As a matter of fact, some limitation on the value of tax-free health benefits could happen soon for current employees. Senator John Chafee (R-RI) recently stated that the Senate Republican task force on health insurance reform was considering limiting the tax deduction for companies for the cost of providing health insurance and taxing employee insurance benefits above a certain level. He noted that the current tax preferences for health insurance cost the federal government $40 billion annually. The task force proposal has the double value of providing additional revenue for the federal government and being a substitute for non-discrimination rules. You put a cap on the tax-free portion of health benefits and you don't have to worry about the highly compensated getting preferential treatment. This has a great deal of appeal to Congress. SALISBURY: Five years ago, corporations probably could have obtained that kind of trade-off-the ability to create funding in return for so-called ERISAfication. I don't think Congress will go along with that today. Any change will have to be revenue-neutral. So companies should assume that current public policy will be the public policy for the balance of this century; they should not expect Congress to do anything to make pre-funding easier. And if pre-funding becomes widespread and is perceived to be a significant revenue loser, Congress will probably cut back on existing vehicles, as they have previously cut back on VEBAS, corporate life insurance, and employee stock ownership. Therefore, if companies want to prefund, they probably should be doing it aggressively, taking advantage of the law as it currently exists. STAIR: As long as Congress talks about changing the way we deliver health care in this country, some companies will be reluctant to put money into the system. They'll need reasonable assurance that things aren't going to change in any significant way.

GULOTTA: I think both of those points are important. It seems reasonable that companies that are going to pre-fund should do it quickly in order to enjoy, if possible, the "grandfathering" of current legislation. But, as Jack pointed out, such action is not entirely without risk.

CAMERON: When the postretirement benefit obligation was first brought up, Business Week said: "This is going to cost $2 trillion. Let's shoot the accountants." The emphasis was on finding some mechanism for negating or ameliorating the liability.

We haven't discussed this yet. Is earnings an issue?

STAIR: A lot of companies in the early days were concerned that the adoption of the accounting standard could have a devastating effect on stock prices. But the cause for concern wasn't real. The rating agencies were among the first to say, "No big deal. Put the numbers on the balance sheet." Now the basic question is, "Does it affect cash flow?" When you say, no," they're satisfied.

RUEBECK: I don't think the story's over on that one. Companies have different mixes of retirees and active employees, and are at different stages in their corporate life cycles. It's the difference among companies that will interest analysts and the rating agencies. The American Enterprise Institute did a study last year that looked at various groups of employees. The obligation ranged from a ratio of five times the pay-as-you-go to maybe two times the pay-as-you-go.

GULOTTA: The fact that one company takes steps to mitigate the impact on earnings per share of its postretirement benefit program and another company does not will, in my mind, affect the way investors view how each is managing expenses and obligations. From an investor's point of view, pre-funding is certainly not negative. In fact, it may be very positive, especially if you've taken steps to control your obligations and change your plan design, and are doing so with an employee relations and labor relations perspective.

I'd like to go back to the considerations in the decision to pre-fund. I agree that companies look at the financials before anything else. Can they get a net present value cash flow advantage by pre-funding? And what are the most effective funding vehicles, and under what scenarios will they get the present value advantage? But when they move beyond that, another question arises: Will it be a positive action from a moral perspective or a labor relations perspective?

RUEBECK: In my company, human resources are extremely important. But the human resource question is part of a broader public policy question, which asks, "What are you going to do when the well runs dry?" Corporate America may decide to fund aggressively because of financial incentives to do so, but it also needs to raise the broader issue of benefit security before Congress. We don't need another Studebaker bankruptcy to make Congress aware.

RANADE: I think that employees are concerned about the security of the benefits promised to them. And I think employees will increasingly demand pre-funding of postretirement health benefits. Without pre-funding, the employer's promise to provide retiree medical benefits might turn out to be a very empty promise.

GULOTTA: I have personally seen these types of employee concerns emerge in the past. To reduce its financial obligations, one of our clients proposed a defined dollar plan for its postretirement health benefits. But union leadership didn't want to make this decision without the shop stewards understanding its ramifications. The shop stewards asked, since there is no fund, how could they be sure these benefits would be paid? They wanted to talk about the funding of the postretirement benefit obligations. In the end, the company set up a collectively bargained 501 (c) (9) trust.

SALISBURY: What we're seeing on the pension side, the capital accumulation side, and the health side, is a movement by senior management to ask not only how should we pay for this, but do we want to be doing any of this? We're seeing a zero-based reevaluation of the role companies are going to play in these economic security programs, a reevaluation of the whole ball of wax.

GULOTTA: Is Congress likely to react to cut backs in retirement benefits and to the absence of pre-funding? Might it require companies to prefund a minimum level of postretirement benefits?

ERLENBORN: I think it's unlikely. There will be more concentration on the active employee population and the health care delivery system.

SALISBURY: If companies simply modify their programs, there is likely to be little Congressional reaction in terms of legislation-probably none. You'll see Congressional reaction only if companies yank away from existing retirees the entire retiree medical benefit promised.

GULOTTA: For those companies considering pre-funding, a key question is, "What are the available options, and what are the advantages and disadvantages of each option?"

RANADE: The tendency seems to be for companies to move toward taking advantage of the current law to fund a collectively bargained VEBA or to use trust-owned life insurance in a 501 (c) (9) trust.

Where it can be used, the collectively bargained VEBA is especially valuable because it allows tax-deductible contributions, tax-free asset accumulation, and the ability to fund the entire retiree medical liability, including the medical inflation component. Another attractive vehicle is the 401 (h) account, but contributions to the 401 (h) can be severely limited.

As we said earlier, if there's a rampant use of these vehicles, then perhaps there will be restrictions. But I can see Congress being criticized for pulling the carpet out from under companies that want to fund. And I think Congress is aware that unions want greater benefits and greater benefit security for their members. You can see this in the difference between funding for management employees under a 501 (c) (9) trust and the more tax-advantaged funding vehicles for collectively bargained employees.

RUEBECK: My company started with funding a VEBA, and then added a 401 (h) account. By actuarially dividing it-the inflation portion basically funded by the 401 (h)-we have funded a significant portion of the liability.

STAIR: We are using surplus pension assets to fund current obligations. The alternatives are relatively expensive. In fact, we might continue to use these surplus assets for the next five years. If we assume that the provision will be extended, and the surplus continues, then we have already fully funded our retiree health care obligations. We don't have to take any additional dollars away from our businesses.

RUEBECK: But overfunding is cyclical. The stock markets of the 1980s have been fabulous. How overfunded are you going to be in the year 2000?

GULOTTA: I'd like to describe the experience of another company with whom we've been involved. It has a well-funded pension plan, and considered transferring excess pension funds as well as pre-funding its postretirement medical benefits. The company looked at the issues first from a financial point of view, but then got other disciplines involved, including investor relations, treasury, human resources, and labor relations. It broke the study into two parts: union employees and the management group. The decision was to transfer excess pension assets and to pre-fund using a collectively bargained

VEBA. This approach will serve to fund a significant portion of the liability over time, because about two-thirds of the company's employees are in the collectively bargained group.

For management, the company assumed that future inflation for purposes of computing the tax-deductible contribution would be zero, as required by legislation, and that trust earnings would be subject to Unrelated Business Income Tax. It was then determined that the use of trust-owned life insurance (TOLI) moved the net present value of future cash flows from negative just into positive. So it began pre-funding using that vehicle in a non-collectively bargained 501 (c) (9) trust.

CAMERON: To our knowledge, relatively few companies have established any pre-funding vehicle. Mass Mutual got involved when a company came to us in 1986 and said it was going to pre-fund using leveraged COLI. Then came FAS 106, which brought TOLI as a solution. We did a nine-month research project to find out if TOLI could cut it, and reached the conclusion that it was viable.

At the two companies with which we have been involved in funding with TOLI, people have difficulty understanding the role life insurance plays in the TOLI structure. But now that competitive pressures have driven the policy loadings to a level low enough to make the financials work, the decision-makers are able to accept life insurance as a viable method of accumulating funds to pay benefits.

Having said that, one of the other major considerations goes back to the cost of funding. Clients say, "I've got my pay-as-you-go costs, and now you're going to ask me to put my qualified asset account limit on top of that in order to pre-fund. \Were does that money come from? Do we raise prices to pay for it? How do we adjust our business practices to pay for it?" These questions are critical in determining whether pre-funding makes sense.

RANADE: We've found with many companies there's confusion between TOLI and COLI, and there are some unpleasant memories of COLI.

CAMERON: There is confusion between COLI and TOLI. COLI is generally highly leveraged and often considered to be a very aggressive financial vehicle. As a result, some people have a very negative impression of COLI. The facts are that TOLI is not the same thing. The intent of TOLI is to fund an obligation on an actuarially sound basis, in a manner very similar to pension funding.

SALISBURY: There is another issue which should be raised. That is, are companies using tax-advantaged funding creating the equivalent of a non-forfeitable benefit in the process? Has anybody promised the equivalent of vesting even though it's not legally required?

I raise the point because it's the only caveat that I see coming up in the public policy debate. John Erlenborn's earlier comment on the quid pro quo reflects a concern that these assets are being set aside on a tax-advantaged basis without any nonforfeitable rights for current retirees or for active workers. I think any debate over cutting back the currently available vehicles would revolve around this issue of non-forfeitability, and whether the government wants to be involved in a partnership where there is no absolute certainty of benefit delivery to the participant.

RUEBECK: The funds actually put into the trust cannot revert to the company. They are dedicated to retiree medical care. In fact, for both the VEBA and the 401 (h), it's not only the IRS that prohibits reversion. FASB rules require that the funds be dedicated to retiree medical use. So, both tax law and accounting rules call for a trust structure that requires funds be dedicated to providing these benefits.

GULOTTA: If the concern is that the contributions and the tax-free income will be used for some purpose other than employee benefits, I think the 100-percent excise tax on the reversion of assets from a 501 (c) (9) trust is a tremendous safeguard.

ERLENBORN: I don't think that's the problem, though. I don't think employees are worried about funds being taken out of the trust. Since you are pre-funding a benefit that they expect to get in the future, they see a moral, if not a legal, vesting.

SALISBURY: But what about companies that aren't ready to say, "This is forever"? For those companies that want to take care of the liability on the books today, and separate that from what they may want to do for people in the future, the long-term implications are far different.

RANADE: What about some of the other funding vehicles we have read about, such as attaching a 401 (h) to a money purchase plan?

STAIR: There are serious questions about whether anybody can really do this. Furthermore, to the extent companies come forward with these types of aggressive pre-funding programs, causing revenue losses to the government, they're inviting Congress to come in and put a stop to it.

SALISBURY: It's also a question of whether Congress thinks there's some gimmick at work. Few members of Congress, and for that matter few CEOs, could describe what trust-owned life insurance is. But if you ask on Capitol Hill what a defined contribution savings plan is, they'll all know. And so will the CEOS. So if companies aggressively started using defined contribution plans and called them retiree medical savings plans, I doubt that Congress would shut them down, even if it meant a mounting revenue loss. Congress remembers very well the 1986 Tax Reform Act debate over 401 (k) plans and limits.

RUEBECK: I hear you saying that the forms of tax-favored funding that exist today carry with them some risks. But are the risks so terrible when they have the effect of getting retiree health benefits on the public agenda? It certainly isn't there now.

ERLENBORN: But how will retiree health benefits balance against health care for the general nonretired population? Since retirees are already covered by Medicare, employer-provided retiree health care is the frosting on the cake. When Congress looks at the large segment of non-elderly, non-retired people who have no access to health care at all, which side do you think it's going to put its dollars on?

SALISBURY: The clearest answer is evident in Rostenkowski's proposal to reduce Medicare eligibility from age 65 to age 60. And there's nothing in his bill that relates to the pre-funding of employer-provided retiree medical benefits. judging from the Congressional hearings over the past four or five years, it is unlikely Congress will provide any new vehicle which will allow companies to pre-fund these programs on a tax-advantaged basis. And if existing vehicles come to the fore, they're likely to be cut back.

GULOTTA: Let's create a scenario. You're a corporation, and you've negotiated with your unions a certain level of postretirement benefits. You find that from a financial point of view it's beneficial to take advantage of the collectively bargained VEBA. Why wouldn't you aggressively fund the collectively bargained postretirement benefits? And if your financial analysis indicated there would be some advantage in using a VEBA with TOLI for funding the management retiree medical benefits, why would you not similarly fund the management benefits?

RUEBECK: Dallas, what percentage of the American workforce that would be covered by postretirement promises are in fact unionized?

SALISBURY: About 20 percent in the for-profit sector.

CAMERON: For the union employees, the collectively bargained 501 (c) (9) trust is very favorable. I believe most companies who have that option should take advantage of it. STAIR: So, for 20 percent of the people out there, there is in place a perfectly fine vehicle-the collectively bargained VEBA-that could be used, but is not being used.

CAMERON: That's right, because American business hasn't yet made a strong commitment to stand behind its postretirement benefits promises.

SALISBURY: There's a second issue here, too. Organized labor has no consensus that this is where it wants limited dollars allocated. At their bargaining cycle, some unions have been negotiating less total compensation in real terms. Along with pension contributions, cash wages, and active worker health care, they've factored in the pre-funding of retiree medical promises. But in a number of industries, unions have given a categorical: "No way. We don't have to do it; we won't do it."

STAIR: In the scenario Mike Gulotta outlined, I'm more persuaded by the employee/human resource side of the issue than by the financial side. It doesn't make any sense when twothirds of your work force (the union employees) have pre-funding for their retiree medical benefits, and the other one-third does not. This is especially true if they have the same benefits. That's an untenable situation, and I don't think we, or any other company like mine, would permit a situation like that to exist.

GULOTTA: In that case, would you go ahead and use TOLI for pre-funding the management benefits?

STAIR: Of all the alternatives, that's the most attractive one on the market today. That doesn't make it ideal, of course, for it does have its problems. For example, it's not the most cost effective.

GULOTTA: But in a non-collectively bargained situation, is it the most tax effective vehicle available today?

SALISBURY: I think we have consensus regarding tax-efficient financing. If you have a collectively bargained workforce, your best option is to use a collectively bargained VEBA. With non-union employees, the best available option is trust-owned life insurance. There are not many other options.

ERLENBORN: Does the present problem in the insurance industry make it a little more nerve-racking to get into that kind of vehicle?

GULOTTA: Yes, the current concern about the financial strength of the insurance industry is a factor. However, TOLI assets would be in a separate account, and, therefore, under most state's insurance laws, not reachable for purposes of satisfying the insurer's other obligations.

ERLENBORN: You know, that gets back to how Congress looks at these things. It's not beyond reason that Congress would look at these insurance policies as investments rather than true life insurance performing the function for which it was intended by making the inside build-up tax free. So, this kind of investment might not be free from Congressional scrutiny and limitation.

RUEBECK: There is another implication we haven't examined, and it may be worthy of some discussion on another day. That is the issue of public-policy support of programs that contribute to capital formation in this country, including the role large corporations play in those programs. The rate of asset growth in pension funds is declining. In the past, these funds have contributed greatly to our level of savings, but they are likely to have much less impact in the future. And considering what has been happening recently with banks and insurance companies, as well as economic forces which seem to adversely affect the savings rate, shouldn't new funding arrangements-such as retiree medical benefits funding-be encouraged?

GULOTTA: I agree. Both business and Congress will no doubt be taking a look at the capital formation issue, since it has both short- and long-term implications.

Today's discussion has highlighted the number of different concerns and varying viewpoints regarding the funding of postretirement medical benefits. Not too long ago, decisions in this area might have been driven primarily by human resources considerations. But in today's economic environment, while there is still a strong concern for individuals, it's obvious that financial considerations often sway corporate decisions.

Companies that want to fund will need to make efficient use of the vehicles that now exist. But although there are several favorable vehicles, each has its limitations.

So the subject is still wide open. And while we have come up with some interesting approaches that make sense for today, we by no means believe we have all the answers. We do, however, share the same concerns, and, as I hear it, seem to be asking the right questions.

FUNDING VEHICLES FOR RETIREE MEDICAL BENEFITS

IDEAL

* Tax-deductible contributions

* Ability to recognize entire liability in determining funding contributions (including inflation component)

* Tax-free investment earnings

* No additional taxable income to employees when contribution is made or when funds are ultimately used to provide benefits

* Assets offset FAS 106 liability MOST COMMONLY USED 401 (H) ACCOUNT

* Tax-deductible contribution to pension plan's 401 (h) account for postretirement medical benefits

* Transfer of excess pension assets from pension fund to 401 (h) account also permitted

* Separate account must be maintained

* Contributions must be determined under acceptable actuarial method and must be reasonable; contribution limited to 25 percent of actual contributions to pension fund full funding of postretirement medical liability impractical for well-funded pension plans)

Tax-free investment earnings

* No additional employee or retiree taxation

* 401 (h) account assets should offset FAS 106 liability

VEBA, OR A 501 C)(9) TRUST

Collectively Bargained VEBA

* VEBA must be maintained pursuant to a collective bargaining agreement 

* Benefits to be funded through VEBA must be collectively bargained

* Deductible employer contribution (liability may be fully funded, including recognition of future medical inflation)

* Tax-free investment earnings

* No additional employee or retiree taxation

* VEBA assets should offset FAS 106 liability

Non-bargained VEBA

* Deductible contributions may not recognize future medical inflation or increased utilization of medical services

* Investment earnings subject to Unrelated Business Income Tax (UBIT); taxable income of trust can be reduced through use of tax-favored investments such as Municipal Bonds or Trust-Owned Life Insurance (TOLI)

For a brief discussion of other funding vehicles, refer to Financial Executive, March/April 1991, pp. 52 and 53.