Should you fund your retirees' health care?

As FAS 106 steals a march on Corporate America's balance sheets, companies are divided on the best way to guard their bottom lines. Read how two financial executives on different sides of the fence are coping with the specter of retiree medical benefits.

At Upjohn, we wanted to fund our retiree medical liabilities because we were concerned about the increasing impact an unfunded FAS 106 liability would have on our future operating margins. What helped us in managing the new standard was breaking it into its four components--amortization of prior service, normal cost, interest and return on assets.

Like many companies, we wrote off the prior service cost when we adopted FAS 106 because we felt that we could control normal cost going forward through plan design. We knew there was little we could do about the interest component, and we felt we should concentrate on the return component by beginning the funding process as quickly as possible.

In reviewing funding alternatives, we preferred to stick with one funding vehicle that could attain a high level of funding in a reasonable period of time. We were concerned that a patchwork of several vehicles would be difficult to administer, especially if tax legislation were to change, so we decided on trust-owned life insurance (TOLI), operating with a voluntary employee benefits association (VEBA) trust. Both aspects--the tax-deferred buildup of cash in a life insurance contract and the VEBA trust--had long legislative histories.

The mechanics of a TOLI are quite simple. The company makes contributions to the trust that are tax-deductible up to the qualified asset account limit. The contributions are used to purchase life insurance, and the trust uses the resulting death proceeds to help pay the retiree's medical and dental claims.

One of our first steps was setting up the trust. We were fortunate in being a large Michigan employer, because Michigan was one of the first states to codify the idea that a VEBA trust has an insurable interest in its employees.

After setting up a Michigan trust, we needed to select a carrier. We chose to use a consultant to help us work out the detailed negotiations with potential carriers. A major factor in selecting our carrier was the strength of its investment team. Some carriers handled investments externally, some handled them internally and others did both. Plus, the track records of their investment products varied significantly.

Assessing our administrative expenses was another important part of the process. We brought all contribution costs back to a net present value to help us gauge how much we would have to pay our carrier in administrative costs and mortality charges. We've minimized these costs, so we can live with them.

Next, we had to address the human resources issues. Since the life insurance aspect was critical to the success of the funding vehicle, we began working closely with our human resources group. We wondered whether our employees would be willing to insure their lives and name the VEBA trust as beneficiary. We knew convincing them would take some good communication, but we felt confident that if employees understood that a funded plan was more cost-effective, they would help out.

To start the process, we sent out applications, along with a short medical screening survey. We even employed a third party to ensure the confidentiality of our employees' responses. In fact, we don't know which employees applied nor which applications our carrier selected. That information is locked up in confidential files. But we can say that we were pleased with the number of positive responses.

Overall, we think our funding vehicle gave us some tax efficiencies and strong investment returns. Even with the current uncertainty over health-care reform, we're confident that the trust will perform well for us.

RED FLAG

Before you rush out in search of a benefits funding vehicle, you should think about some of the disadvantages of pre-funding. At Chevron, we view retiree health-care as a conditional and uncertain liability. In most funding vehicles, unless they're highly leveraged, the fund returns are below the cost of your equity capital. Plus, this notion of benefit security is subjective. What do we really mean by security? Who's getting security, who's losing it and how do you provide it?

The first point you should consider before you decide to prefund is the nature of the liability. For instance, at Chevron, we still reserve the right to discontinue our retiree benefits. That's why it's tough for me to accept the notion that we ought to prefund and secure benefits when we're not even willing to guarantee that we won't eliminate them. Also, we don't fix our contribution. Each year, we set a per-capita premium, and we expect the employees and retirees to pay the rest. We want to retain that flexibility, but it makes it more difficult to estimate the major liabilities in funding retiree health care.

Unlike pension costs, the present value of the liabilities is very sensitive to long-term medical cost inflation and government cost shifting in terms of which benefits it pays. For example, in calculating our FASB liability for our active employees' post-retirement medical benefits, we wanted to see how our costs stacked up if medical inflation were zero. We found they'd be one-fourth of what we put on our balance sheet as a write-off for FAS 106. According to this calculation, retiree liabilities would be cut in half. With those kinds of numbers, many companies will be unlikely to prefund for unusually high inflationary scenarios. This shows the importance of getting the inflation rate correct, because if you overestimate it, you're likely to end up with a big surplus.

Also, the irrevocable nature of a prefunded trust is incompatible with such an uncertain liability. And it doesn't mesh well with some companies' reluctance to yield control over how much they want to contribute to benefits or whether to even continue them. This is particularly important now that the federal government is seriously talking about changing the rules. Companies should be wary of putting themselves in a straitjacket by prefunding.

Then there's the cost of equity capital. Clearly, if you prefund, the money comes from a draw-down of capital that the company could otherwise use in its own "primary" investments. And if the company didn't want to invest in these primary assets, it could pay it out to the shareholders, because this money comes from shareholder funds. If you're deciding how to allocate your capital, you have to ask yourself if you want to put it in a fund to prefund, pay it out to your shareholders or invest it in your business. The primary assets should, and over the long term do, offer a higher return than returns from secondary assets or securities. If they don't, we should all liquidate our companies and pay the proceeds out to shareholders so they can buy stock and bond portfolios.

Also, the low cost of debt is not a justification to prefund. If you're going to borrow, go ahead and borrow. But pay your shareholders, because they put a higher value on that money than 8 percent or 9 percent. It's the cost of equity that drives the decision, not the average cost of capital.

Finally, when you prefund, you incur additional costs, such as the costs of legal talent and investment management. And then you have to pay for administrative services and staff salaries.

DON'T LOSE YOUR BALANCE

If companies are going to be conservative in estimating how much money they need to prefund, the security must come from earning a high real rate of return on those assets or from the company's assumption of sizable ongoing contributions. If you accept that logic, the return required will drive these funds into a higher equity position than perhaps a pension plan would hold. In that sense, it would be viewed as less secure than a conventional balanced portfolio with a higher bond content. Even though you're prefunding the portfolio, you'll have some higher risk because you'll be moving more toward equity. That won't give your participants more security.

And if you do prefund, you have to hope that the company remains financially healthy, able and willing to pay the additional contributions, because these liabilities are so long-tailed. Does it serve you well to take capital out of the company, which you may need to make those long-term investments, so you can put it in a portfolio of stocks and bonds? To some degree, you may be undermining the viability of the company. You've got to address that issue.

From our shareholders' point of view, we ought to look to the company's investments to provide this long-term security. While this clearly would involve a less diversified portfolio than a pension situation, it puts the beneficiaries on the same risk footing as the shareholders. And since these are shareholder funds, we have to ask ourselves whether the beneficiaries should have a better claim on these assets than the shareholders.

Also, public policy is changing very rapidly, and we don't yet know where it will end up. It's socially accepted that we prefund for pension benefits and get a tax advantage. That hasn't yet been the case for retiree medical benefits. Much of the retiree liability stems from under-65 retirements. At Chevron, we incur 45 percent of the total liability for post-retirement medical benefits before our employees reach 65. President Clinton prefers tax-favored prefunding, which means asking the government to help pay for medical benefits for employees who retire before 65.

This seems counter to the course that the government is pursuing vis-a-vis Social Security, where public policy on the retirement age is going the other way. The government knows it's very expensive to support its citizens' retirement, but it's also a very big expense for those pre-65 years. In general, Congress views retirees' medical care as its responsibility, but some people in Congress believe Medicare is adequate for that. In any case, it's unlikely we'll see broad-based availability of tax-preferred treatment for pre-funding of retiree medical care. The attitude on the Hill is that if the private sector wants to pre-fund, then it ought to pay for it and not ask the taxpayers to foot the bill.

Lastly, remember that the high-equity exposure you'd have with prefunding produces a much larger risk of overfunding your liabilities. Over the years, that situation is certain to attract litigation claims over who controls the surplus -- the shareholders or the beneficiaries. This can only drive up plan sponsors' costs, either because they lose surplus that they could have used for other purposes or because they have to defend themselves against these claims.

I'm not suggesting that not funding is the only answer. In fact, we almost adopted a leveraged employee stock ownership plan, but we had just done a $1-billion ESOP for something else and decided not to double up. We even looked at other vehicles, such as a transfer of pension assets to a 401 (h) account, but it had too many strings attached, especially given our preference not to prefund. Each company has to examine its situation and evaluate its opportunities carefully.