Will retiree health benefits survive FAS 106?

A company's costs for providing medical coverage to its active employees are determined by the prices it pays for its portion of employees' health care coverage. The costs are paid during the course of business activity and are reported in annual financial statements as expenses that are deducted from revenue. The costs are therefore paid and accounted for on a "pay-as-you-go" basis.[2]

Until recently, retiree health care costs were paid and accounted for in the same way. Ninety-one percent of large employers (more than 5,000 employees) provide health care benefits to their retirees, at an average annual cost per retiree of almost $2,500 . These costs have been rising rapidly, consistent with retirees being in older age brackets with higher utilization of medical services. Retiree health costs constitute the most rapidly growing segment of overall employer costs in providing health care benefits. Further, the number of active employees per retiree has fallen from about 12 earlier in this century to fewer than 3 today. There are fewer productive workers supporting benefits for more retirees, at much greater cost per productive employee.

Retiree health benefits are fundamentally different from active employee benefits in one important way: an employer's obligation to provide health benefits for an active employee end after that worker leaves. The obligation to pay for health benefits for a retiree, however, continues for an average of 21 years after retirement until the death of the retiree and/or their eligible dependents. Paying and accounting for the cost of health benefits for active employees on a year-to-year, cost-based accounting system make sense. Accounting for retiree benefits by reporting only the current year's costs hides the fact that the employer has a continuing financial obligation. Accurate reporting of an employer's finances therefore demands that retiree health benefit costs be accounted for and reported as those costs are incurred, not simply when they are paid.

Enter FAS 106

The rules governing financial reporting are set by the Financial Accounting Standards Board (FASB), a quasi-governmental body of seven accounting industry representatives. FASB is responsible for the guidelines corporations must follow in their public accounting, including annual reports and Form 10(K) (filed with the Securities and Exchange Commission). This information is the basis for determination of net worth, cash flow, profit margins, and other measures of a corporation's business activity, value, and stock price.

Several years ago, FASB investigated cost-based accounting for retiree health care costs and determined that this practice did not accurately represent corporate liability for retiree health benefits. In line with its mission to promote validity in financial reporting, FASB issued Standard 106, which directs reporting of health care costs on an accrual basis (all the costs in a given period for which an employer eventually becomes liable) rather than on a cost basis (only the money actually spent during that period).

The actual calculation of this FAS 106 liability is complex and involves two different elements:

* The accumulated liability for retiree health care costs must be calculated and reported as a charge against a corporation's equity either as a "one-time hit" or as a 20-year amortization.

* The costs in each successive reporting period must be calculated as they are accrued and must be applied against profit calculations for that period.

These steps allow a corporation to "catch up" and then to stay current with its retiree health benefits obligations. Both a corporation's net worth and its quarterly income statement are directly reduced by recognizing these costs.

Calculating the cost of retiree health benefits begins with current costs per retiree. Next, the estimated age and number of retirees and their death rate must be factored in, and these figures must be compounded in successive annual projections by medical care inflation rates. The net present value of the multiyear net projection is determined using an appropriate discount rate, and the result is charged against a corporation's book value. In later reporting periods, successive costs are calculated and subtracted from the corporation's earnings. Although intricate, these calculations closely parallel those used by employers to account for pension benefits in a defined benefit plan.

Several implications are immediately apparent. Any reduction in the current cost of these benefits is compounded through these calculations and will result in a marked improvement in both net liability and in ongoing charges. Employers suddenly have a powerful interest in controlling their costs for providing retiree health benefits. A more subtle implication is that any change an employer makes that lowers the rate of increase in medical inflation will have a large effect in decreasing FAS 106 liability as well. Employers also have an incentive, therefore, to choose health coverage with a lower rate of cost increases.

Although FAS 106 involves only a "paper loss," which accelerates the recognition of these costs, the effects on some corporations are staggering. This is especially true for older, industrial corporations with many retirees that promised lavish retirement benefits during the |60s and |70s as a way to attract workers. These promises are now haunting employers already threatened by the decline of the U.S. industrial base. GM's one-time charge is the largest to date and represents over 80 percent of the company's net worth, but other employers have also reported staggering losses that threaten their long-term viability: IBM recorded a $2.3 billion loss; AT&T, $7 billion; and GE, $1.8 billion. Ford estimates a $7.7 billion. The total U.S. liability has been estimated to be as high a $2 trillion.

Financial markets have largely ignored these one-time paper charges in valuing a corporation's stock. More significant will be the ongoing quarterly effect on pretax profits, which will decline an average of 17 percent. Corporations with significant liabilities for long-term retiree health benefits costs are facing an immediate, serious threat to their survival.

Employers Respond

Faced with this liability, a number of employers have attempted to stop covering the cost of health benefits for their retirees. A problem arises, however, when a promise has been made to pay for such coverage. Generally the courts have held that companies that have made such promises are obligated to continue coverage. A possible exception is represented by Navistar, a truck maker with 63,000 beneficiaries, which argues that it will be bankrupted if required to continue this coverage. This case is currently in litigation. McDonnell-Douglas and Unisys are among those discontinuing their retiree benefits, because they have made no such promise.[3]

Most employers are seeking to reduce their liability in this area by reducing retiree benefits within the limits of their obligations. This remains a contentious issue, because more than 70 percent of all labor disputes center on health benefit issues, with retiree coverage a central concern. Popular strategies include increased cost sharing, decreased benefits, and decreased eligibility. In fact, more than 67 percent of benefit managers of large corporations have stated that they will reduce benefits over the next few years to mitigate their FAS 106 liability.

Another approach has been to seek coverage that is less expensive for employers. HCFA has long had an interest in including senior retirees within Medicare and currently has a pilot project with three large employers, the Medicare Insured Group (MIG) program. Through this program, HCFA pays the employers 95 percent of the AAPCC, the average cost of a Medicare beneficiary, and the employer assumes the risk for any additional costs and manages retirees' medical care.

This kind of direct involvement in retiree care is not an option for most employers. Retirees can instead be covered within existing Medicare Risk HMOs. Because of lower premiums and lower rates of premium increase, the accumulated FAS 106 liability for retiree care can be as much as 50 percent lower than the liability based on indemnity health benefits. Ongoing accrued costs for the provision of retiree health benefits will be correspondingly reduced. Together, these advantages create a powerful incentive for employers to move their retirees into managed care, where only 12 percent of retirees are currently enrolled.[4]

Using Medicare risk HMOs as the basis of an employer's retiree benefits strategy has its challenges. Retiree enrollment in HMOs is currently limited, often because of little exposure to managed care during those individuals' working years. HMO membership can also be problematic for retirees with long-established provider relations and for "snowbirds" who spend extended periods at different locations in the country. Nevertheless, the incentives are so strong that employers are offering premium rebates and other inducements to retirees to encourage HMO enrollment.

FAS 106 imposes a heavy accounting burden on employers. At its core, however, is consistency with a fundamental accounting principle: the costs associated with a business activity are to be recorded when they are incurred, rather than when they are paid. The result of applying this principle to retiree health benefits is that a company's net worth and the value of its ongoing operations are reported more accurately, although at a lower dollar value. Companies need to find ways to decrease the cost of providing this coverage and to limit the corresponding financial liability they must report. HMO enrollment, especially Medicare risk enrollment, is one way to meet this need and to preserve health benefits for retirees who have labored in the country's industries.

References

[1.] "Health Care Benefits Survey, 1991." New York, N.Y.: Foster-Higgins, 1992. [2.] Napolitano, G., and Cohen, A. "FAS 106: Facing the Future." Strategy Brief Goldman-Sachs, 1992. [3.] "Retiree Health Care." Medical Benefits 9(7): 1, Sept. 15, 1992. [4.] "Employers Can Cut Retiree Health Plan Liabilities With Managed Care." Managed Care Week, Aug. 31, 1992, p. 1.