What business needs in order to meet its OPEB obligations.

What business needs in order to meet its OPEB obligations

Corporations are not expected to make drastic cut-backs in retiree health care benefits because of the proposed FASB standard. But to meet their funding obligations, they need legislation passed that will enable them, first, to use excess pension fund assets and, second, to prefund retiree medical benefits on a pre-tax basis. The proposed FASB standard on accounting for OPEB obligations has created a major issue for corporations because of the magnitude of the expense and liability numbers which will appear on financial statements. These numbers are so large because corporations have promised to pay the bulk of the health care costs incurred by their retirees--over and above the portion picked up by Medicare. In other words, there is an open-ended promise to cover a cost--health care--that is out of control. And projecting these costs at historic rates discounted to present value produces an enormous expense and liability.

How will U.S. corporations react to the severe and adverse financial impact of accruing these retiree health care costs? The impact will be both on their balance sheets (producing increased liabilities and a corresponding reduction in stockholder equity) and on their income statements (producing higher expenses and lower earnings).

Preliminary calculations indicate that income statement charges for providing retiree health care will range from three to six times greater when using accrual accounting than under the current pay-as-you-go method. A General Accounting Office study estimates aggregate accrual costs to be 3-1/2 times the pay-as-you-go cost--which is $34 billion, or one-eight of total pretax company profits.

Moreover, the balance sheet liability for retiree health care will be so large that, for many companies, existing loan covenants will be violated and/or the ability to obtain additional financing will be curtailed or severely reduced. At certain companies, the balance sheet retiree health care liability may exceed net worth.

The initial corporate reaction was that many employers would substitute a defined contribution approach to both retiree and active health care in place of the current "open-ended promise" approach. Thus, as health care costs continued to escalate, employers under a defined contribution approach would be able to control and clearly define the impact of future costs on their financial statements. It was also believed that many other employers would eliminate the retiree health care benefit entirely.

However, further reflection has resulted in a modification of either the drastically-reduce or eliminate-the-benefit approach. First, a series of court decisions seem to say that persons already retired have contractual, or even common law, rights to health benefits. These rights were promised to them at the time of their retirement. Some believe that this applies even if the employer explicitly reserves the right to change the health care commitment--although this is not at all clear. The right to modify the retiree health promise apparently does exist before an employee retires. However, for companies with a high ratio of retirees to actives, the commitment to those already retired constitutes a substantial part of the FASB liability.

Second, even in the absence of such legal constraints, there are public relations, government relations, and employee relations constraints. From a public relations and a moral standpoint, reneging on health care promises to retirees is obviously not the way to go--unless it is the only way to insure the survival of the corporation.

As regards the federal government, LTV discovered that Congress will not permit the elimination of health benefits for those already retired--even in a bankruptcy situation. Finally, such elimination would undoubtedly be a strike issue for labor unions at most companies.

Given all of the above, what will be the corporate response? First, the retiree health benefit will be redesigned for those not yet retired. Co-pays and deductibles will be increased and indexed to health care inflation. Other changes may include substituting a defined contribution approach for the current "open-ended" promise and/or basing the size of the promise on years of service. In other words, those yet to retire will pay a larger portion of their health care costs in retirement than do those already retired.

However, even after this redesigning, there will still be a sizable FASB accrual cost and liability. This will be handled the way business tries to maintain margins in the face of any other labor cost increase. That is, by price and/or productivity increases to the extent possible. Also, business and labor will tend to look at wages and health care costs--including retiree health care costs--as more of a package. The faster health care costs increase, the less room there will be for wage increases.

The legislative front

On another front, business is already working hard in Washington for legislation which will help it to solve the retiree health care problem. Before discussing such legislation, a little background is in order.

An obvious way for business to offset the adverse impact of the FASB standard would be to set funds aside to cover retiree health care benefits as it does for pensions. However, mainly due to revenue considerations, Congress will not permit tax-favored funding for retiree health care. Here the legislators have a dilemma, because they also worry that companies may not be able to keep their health care promises to retirees--since funds have not been set aside.

I believe that, given the proper tax incentives, corporations can go a long way toward resolving the dilemma. That is, we can reduce our future FASB income statement charges and balance sheet liabilities, make our health care promises to our retirees more secure, and continue to provide high quality health care benefits to our future retirees.

Of course, no one can be certain that, given the proper tax incentives, corporations can solve the retiree health benefits problem. However, what can be said with certainty is: first, absent such tax incentives, there is no way that corporations can solve the problem; and second, with such incentives, there is a chance that we can indeed solve the problem. A good chance, I believe.

What are the incentives we need? One suggestion calls for a three-step legislative program. The first step would permit companies to pay their current retiree health benefits directly from excess pension assets. The second step would permit companies to transfer a portion of such excess pension assets to a separate fund which would pay retiree health benefits for current and future retirees. Finally, the third step would be the establishment of the same type of ongoing tax-favored funding for retiree health care that we already have for pensions.

Before discussing these steps, I should point out that the key question is: would business use the vehicles provided by such legislation? Naturally, these decisions would be made by the individual companies--each considering its own situation in regard to cash flow, earnings, alternative investments, etc. However, there is a new, powerful motivator to do so--the forthcoming accounting change.

This proposed FASB standard will have such a severe, and adverse, impact on corporate earnings and liabilities that companies will be faced with a choice of either fully or partially offsetting the FASB liability, or reducing or eliminating the retiree health care benefit. The only way I know to offset the liability is to set assets aside to cover it--either excess assets already set aside for pensions or new assets purchased through an advance tax-favored funding vehicle.

A three-step program

Here is the proposed three-step legislative program:

First, permit companies to pay their current retiree health benefits directly from excess pension assets in their pension funds, rather than from general corporate funds. This provision could be in effect for a limited period of time, say two to five years. It would lead to permitting transfers of excess pension assets into a separate retiree health care fund, and would eventually permit full advance funding of retiree health benefits.

Meanwhile, the proposal would increase tax revenues by $500 million to $1 billion annually. This would occur because payments of retiree health benefits from excess pension assets would not be tax deductible--while current payments on a pay-as-you-go basis from general corporate funds are tax deductible. Moreover, the proposal would make retiree health care promises more secure for retirees without jeopardizing the security of their pension promises. Excess pension assets are now estimated at more than $200 billion, versus an annual corporate pay-out for retiree health care of only $5 to $10 billion. Thus, a cushion could easily be retained in pension funds to provide further protection for pension promises.

The second legislative step would allow employers whose pension plans are overfunded to transfer a portion of the excess assets to a separate fund which would pay retiree health benefits for current and future retirees. This would lead to permitting the full advance funding of retiree health benefits. This second step would also increase tax revenues by almost $6 billion over the next five years--because payments from a retiree health care fund would not be tax deductible, while current payments on a pay-as-you-go basis from general corporate funds are tax deductible. Like the first step, this step would also make retiree health care promises more secure for retirees, because the rules would leave a cushion in the pension fund.

With excess pension assets now estimated at over $200 billion, using some of those assets to fund retiree health costs should go a long way toward minimizing corporate plans to reduce or eliminate retiree health care benefits. In return, however, employers will have to accept a prohibition on reversions of pension assets for any other purpose.

The third legislative step would establish the same type of ongoing funding vehicle for retiree health care as already exists for pensions--in other words, the ongoing ability to prefund post retirement medical benefits on a tax-favored basis. In return, employers must be prepared to accept a "retiree health care ERISA." That is, a company would not only have to advance fund the benefit, it would also have to meet vesting and participation standards--in return for a tax deduction for the contributions and for tax-free accumulation of earnings on the funds contributed.

However, even with ERISA-type rules, the country's budget deficit situation would seem to preclude tax-favored funding in the foreseeable future, since such funding would reduce tax revenues. Therefore, if we are to have a funding vehicle--and we must ultimately have one if we are to solve the problem--business must put some revenue raisers on the table. Such items could be inside or outside the benefits area.

A question of compromises

In summary, it is clear that such a legislative program will require significant give-ups on the part of employers. The problem is symptomatic of the fact that neither business, labor, nor government has sorted out its priorities in the employee benefits area--in particular, as regards health care. We all need to decide how much our society can afford and who should pay for what. If employer-sponsored retiree health care is deemed a high priority, a tax-favored funding vehicle will give business a good chance to solve the problem. But the terms and conditions of such a solution must result from compromises by all parties.

Perhaps the debate on retiree health care will focus attention on the urgent need for developing a comprehensive national retirement income and retiree health care policy. Those of us in the benefits community at one time believed that this policy should be developed independently of revenue considerations. However, in today's world, this is not realistic. Revenue issues must be considered for the foreseeable future.

To summarize, the only way I know to offset the retiree health care liability is to set assets aside to cover it--either those assets we have already set aside for pensions which are excess for that purpose or new assets purchased through an advance funding vehicle. As Representative Rod Chandler has said, "it's time we recognized that the need for adequate retirement income and financing retiree health care are part of the same fabric." Accordingly, if assets set aside for pensions are excess for that purpose, they should be used to satisfy retiree health needs--and, if retirement income warrants tax-favored funding, then retiree health care should receive the same treatment.

PHOTO : Jessica, Thomas Dewling, c. 1905

PHOTO : The Lost Greenhorn, Alfred Jacob Miller, 1851

Mr. Nehrling is chairman of FEI's Ad Hoc Committee on Other Postemployment Benefits. This article is adapted from an address he made before the New York Society of Security Analysts.