Your retiree health benefits plan: good design, safe funding.

Now that FASB statement 106, on retiree health benefits, is final, how can you develop a plan that satisfies your employees and your balance sheet?

Harold Dankner, John M. Bertko,

Jean M. Wodarczyk, and Lee E. Launer

Partners

Coopers & Lybrand

Already concerned about rising health care costs, employers are now confronted with accrual accounting for retiree health benefits under the FASB's Statement 106, Employers' Accounting for Postretirement Benefits Other than Pensions, issued in December. In considering plan design changes and funding alternatives to manage costs and limit obligations and expense under accrual accounting, employers will want to understand how changes to their current retiree health plans will affect their financial statements under the new standard. What plan design and funding strategies should companies consider, and what are the implications of choosing specific alternatives?

(Refer to Financial Executive, January/February 1991, for a discussion of the key accounting and measurement issues of Statement 106 and a comparison of the major provisions of the final statement with the exposure draft.)

Designing the plan

One of the most important factors influencing plan design will be the substantive-plan requirements of the FASB standard. Under Statement 106, the measurement of obligations and expense should reflect the terms of the "substantive plan," not just the written plan.

Recognition of the substantive-plan provisions will require an employer to anticipate, in measuring obligations and expense, future changes to the plan under certain situations, such as the following:

* If your company has had a consistent practice of cost-sharing under the plan-such as contributions by retirees and their dependents, individual and family deductibles, coinsurance, and yearly out-of-pocket maximums-this practice becomes part of the substantive plan.

* If your company does not have a past practice of changing the plan's cost-sharing provisions, but intends to make changes in the future, those changes would be included as part of the substantive plan. To take advantage of this provision, however, you must communicate your intentions to plan participants. For example, if an employer announces in 1992 its intent to introduce retiree contributions beginning in 1993, the firm may anticipate a possibly significant reduction in obligations and expense resulting from the future plan amendment.

Putting in writing its intent to change the plan in the future allows an employer to more clearly define its promise and to simplify the complex judgments needed to apply the FASB's substantive-plan approach. For example, a cost-sharing relationship, such as applying the 70 percent/30 percent (company/retiree) formula or indexing retiree contributions by the percentage of increase in the employer's health care costs, could be written into the plan or otherwise communicated to employees.

Making this procedure more formal, however, may cause the employer to lose some flexibility to make ad hoc changes to the plan in the future. Given the dynamic forces affecting retiree health care plans, flexibility is important.

Plan design implications

Employers are examining many plan design options. Reductions in obligations and expense under Statement 106 will vary considerably depending on the specific change in plan design and the employer's demographics. Before making final decisions on changes to the current plan, employers should measure the potential impact of these changes on their obligations and expense. Any plan design strategy should of course take into account the company's overall retirement benefit policies, in particular the effect on early retirement.

The following three plan design strategies are the most commonly implemented.

Strategy 1: Varying retiree contributions by years of service

Many retiree health plans have historically operated on an "all or nothing" basis, with benefits and retiree contributions the same for all employees who have met the age and service requirements of the plan (e.g., retirement at age 55 with 10 years of service). To reward longer-service employees, many companies vary retiree contributions by years of service. For example, retirees with 30 years of service will pay 10 percent of total costs (90 percent paid by the employer); those with 25 years will pay 15 percent; and so on.

For some employers, future benefit payments as well as obligations and expense under Statement 106 will not be significantly affected by changing from a conventional plan to a years-of-service approach. For example, if retirees are generally expected to work 25 or 30 years for the employer, most retirees will still be at the lowest retiree contribution levels. Nevertheless, this strategy may be attractive to those employers who expect to have fewer long-service employees in the future or who wish to encourage long service.

Strategy 2: Ad hoc increases in cost-sharing

Many employers currently increase retiree contributions and adjust other cost-sharing provisions each year or periodically as is appropriate. Retaining the flexibility to change the plans as the employer sees fit, while also being able to anticipate future changes to the plan under Statement 106, will require that employers establish a "consistent past practice" prior to the adoption date of the standard (e.g., 1993).

If an employer develops a practice of ad hoc increases in retiree contributions at a rate equal to the trend in overall health care costs, accounting for the substantive plan would include an anticipated contribution increase matching the health care trend rate.

Strategy 3: Dollar-denominated benefits

Some employers may change their program to provide a fixed-dollar amount toward the cost of retiree health benefits, rather than continue an open-ended commitment to pay for health care benefits regardless of cost. While this design may initially limit obligations and expense under Statement 106, some companies find that dollar-denominated benefits are too extreme because all cost increases are passed on to retirees.

Accordingly, some employers may provide for "indexing" the cap or for making ad hoc increases in the dollar-denominated amounts. For those employers choosing ad hoc increases, it's important to note that the substantive plan under Statement 106 may require them to anticipate increases in the dollar-denominated amount if:

* A company communicates its intent to raise the amount in the future (e.g., to keep pace with inflation), or

* The actual increases in the dollar amount reflect a consistent past practice.

However, these dollar-denominated approaches, which can significantly reduce obligations and expense (see the figure on page 50), may lead to unexpected increases in the future. If the company has a consistent past practice of increasing benefits, that practice could become part of the substantive plan. Thus, at the time when increases are anticipated the accumulated postretirement benefit obligation (APBO) may dramatically increase and annual expense under Statement 106 may go up by 100 percent or more ! Beyond these three plan design strategies, companies must examine other implications of Statement 106, such as collectively bargained plans and deviations from the substantive plan.

Plans subject to collective bargaining may not be subject to the substantive-plan requirements under Statement 106. Because employers may not have the right to change unilaterally the benefits subject to a collective bargaining agreement, the written plan will generally be the basis for measurement. This issue is especially important to a company establishing, through union negotiations, a dollar-denominated benefit with an increasing benefit cap.

As for substantive-plan deviations, Statement 106 requires that the impact of temporary deviations on the current year be recognized immediately as a loss or gain on the employer's income statement. That is, it should not be included with other actuarial gains and losses accounted for under the delayed recognition provisions of the statement. For example, the substantive plan may specify that excess costs would be recovered from increased retiree contributions in the next year. However, if the employer decides to bear the excess cost, Statement 106 requires immediate recognition of the resulting loss, In addition, if the higher contribution amounts are not implemented in the following year, the substantive plan may change.

Funding the plan

Another important issue facing employers with retiree health benefit programs involves financing or prefunding these benefits. "Prefunding" means setting aside funds, preferably in a tax-sheltered manner (similar to the way pensions are funded), to pay for future benefits and to offset reported liabilities and expense in the employer's financial statements. Various techniques are available, and some advantages and disadvantages of each are shown in the table on pages 52 and 53. In the coming months, companies may try other prefunding techniques-for example, enabling employees to "save" for their own future retiree health benefits-as they continue to examine the issues.

What effect will prefunding have on financial statements? it will reduce reported liabilities for those benefits covered under Statement 106, and the expected earnings on a plan's assets will reduce the postretirement benefit expense. But it is important to consider not only the impact on reported liabilities and expense, but the impact on your financial statements as a whole.

To meet Statement 106's definition of a plan asset that will reduce reported liabilities and expense for retiree health benefits, You must segregate and restrict assets, usually in a trust, to be used only to provide these benefits. Accordingly, such assets have to be removed from the business, which will reduce business earnings. This reduction in earnings might offset the reduction in postretirement expense, with the net result that prefunding would have little impact on net income or net worth, particularly in its initial years. Over the long term, however, tax advantages of certain prefunding vehicles (e,g., tax-free investment earnings) may result in lower postretirement benefit expense and increases in net income.

For companies in rate-regulated industries, prefunding has additional considerations. To recover their accrued retiree health costs in their rate bases, regulated companies may have to prefund the postretirement benefits. In some cases, earnings they receive may approach or equal the accrued postretirement expense and therefore have a positive impact on financial statements. Some of these companies also can take advantage of certain prefunding vehicles, such as collectively bargained VEBAs (see the pages 52 and 53), that generate tax benefits.

Prefunding may also be of interest to employers with government contracts. In general, for companies to recover post-retirement costs from the government, amounts have to be paid currently or placed in a dedicated funding vehicle-and not merely accrued under Statement 106.

Recent developments

The demands of financing retiree health benefits are causing many companies to take a hard look at the alternatives. Several developments have taken place that influence corporate decisions, such as the following.

Transfer of excess pension assets-A provision of the Omnibus Budget Reconciliation Act of 1990 permits companies to, under certain conditions, transfer excess pension assets to a 401(h) account to pay for retiree health benefits. A 401(h) account is part of the pension plan, but the assets in the 401(h) account must be used to pay for retiree health benefits.

If certain conditions are met, the new law permits employers to make one transfer each year from 1991 to 1995 to pay for retiree health benefits for that year. (An additional transfer is permitted in 1991 for retiree health benefit payments in 1990.) Some of the conditions include:

* Pension benefits earned as of the date of the transfer must be fully vested.

* Amounts transferred in excess of that year's retiree health benefit payments must be transferred back to the pension plan and are subject to a 20-percent excise tax.

* Employer-provided retiree health benefits must be maintained for covered retirees at no less than the same dollar level for four years after the transfer.

This new law may have immediate cash flow benefits for employers with overfunded pension plans, since companies would use excess pension assets instead of current operating funds to pay for current retiree health costs. On the other hand, it may require an employer to make a pension contribution earlier than originally planned, since the transfers essentially use Lip excess pension assets. Management should analyze the current and projected funding status and contribution requirements of the pension plan. as well as detailed estimates of retiree health benefit payments, to determine the appropriateness of the transfer.

Despite these immediate cash flow advantages, the numerous conditions imposed by the new law and the relatively small amounts and short-term nature of the transfers may make the asset transfer undesirable for many employers. However, those employers whose plans are substantially overfunded may find this a good opportunity to reduce their excess pension assets, thus benefitting their cashflow.

"HSOP" Late in 1990, the Procter & Gamble Company announced that it would prefund retiree health benefits through a 401(h) account attached to a leveraged employee stock ownership plan (ESOP). The combined arrangement is referred to as an HSOP. Under this arrangement, the company initially places ESOP shares in a suspense account; as the ESOP debt is paid down, the shares are allocated to the 401(h) account on behalf of individuals. The assets in the HSOP are restricted to paying retiree medical benefits,

At first, many companies were interested in this arrangement, since it appeared to combine the ESOPs' favorable tax treatment with favorable accounting implications under Statement 106. However, the IRS quickly announced that it would no longer issue determination letters to plans combining ESOP and 401(h) account features, and that it had tax and policy concerns about the arrangement.

As a result of the IRS position, and because some accounting issues remain unresolved, most employers aren't pursuing HSOPs at this time. The IRS' action also indicates how it will react to new prefunding techniques that are likely to be "revenue losers."

After-tax employee savings contributions-As an adjunct to prefunding and benefit design strategies and to some cost-shifting strategies, some employers are looking for ways for active employees to set aside funds to pay for their future retiree health benefits. These arrangements also have some financial statement implications for the employer, since employee contributions would be anticipated in measuring the employer's obligation under the provisions of Statement 106.

Of course, employees can use their own contributions set aside in a qualified plan (e.g., a pension or 401(k) plan) to pay for individual health insurance after they retire. However, pension or 401(h) distributions to retirees probably will be taxable even if they're used to pay for medical benefits. Since this taxation may be viewed as an impediment to employee savings, some companies are examining several techniques that avoid the taxation.

Among the alternatives are after-tax employee contributions to a VEBA and after-tax employee contributions to a group annuity. in either of these arrangements, employees are asked to contribute funds, on an after-tax basis, to a tax-sheltered investment vehicle. Some employees may, however, be reluctant to make the contributions, and many employers are reluctant to provide employees with additional funds. In a VEBA that receives only employee

contributions (no employer contributions are made), earnings accumulate tax free. Employees who leave the company prior to retirement could receive their contributions, plus interest, as severance benefits. Likewise, employees who die before retirement could have their contributions, plus interest, used as death benefits. For employees who retire, VEBA contributions plus interest would be used to purchase retiree health benefits, and those amounts would not be taxable to the retiree. Under Statement 106, a liability would be recorded equal to the amounts estimated to be returned to employees leaving before retirement.

Companies also can ask employees to make after-tax contributions to a group annuity plan. As with an employee contribution-only VEBA, amounts in the group annuity contract are credited with interest that is not currently taxable. At least one employer that has adopted this arrangement believes that money out of the group annuity to pay for retiree health benefits is not taxable to retirees. However, investment in a group annuity contract may not be attractive for some employers for various reasons.

From several perspectives

Clearly, there are no quick fixes for plan design or for prefunding retiree health benefits either for the employer or the employee. A combination of measures may be the best alternative, or no prefunding or plan design at all. In any case, employers need to be cautious in evaluating plan design and prefunding vehicles or alternatives, taking into account such items as taxes, the economy, the financial statement, and human resources.

Statement 106, particularly the substantive-plan provisions, makes it even more important that the advantages and disadvantages are compared from an employee and retiree relations perspective as well as from a financial and accounting perspective. Finally, companies must realize that, with increased strain on the Federal budget, Congress or the IRS may deny a tax-advantaged status to a particular prefunding strategy or Congress may change Medicare to shift more of the burden to employers.

The authors are partners in Coopers & Lybrand's Actuarial, Benefits, and Compensation Consulting Group. They were involved with the 1989 FERF study, Retiree Health Benefits: Field Test of the FASB Proposal, and the 1990 NAA study, Retiree Health Benefits: How to Cope with the Accounting, Actuarial, and Management Issues. The authors appreciate the assistance of Murray Akresh, Amy Bergner, and Terri McKenna in developing this article.