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Corporate retiree health benefits threatened by financial pressures.

Many companies, especially larger ones, provide health benefits to their retirees, often to spouses and dependents as well. About 9 million private sector retirees rely on these benefits. Company-sponsored retiree health coverage is especially important to retirees under the age 65 who are not eligible for Medicare, because they tend to have fewer options than active workers to regain health coverage if a company reduces or terminates benefits.

Companies are becoming increasingly concerned about the cost of providing retiree health benefits as their workforces age and health care costs in general continue to rise sharply. Part of the increased cost of health benefits is due to an overall higher rate of inflation than for other goods and services. For example, since 1988, the medical care component of the Consumer Price Index has risen an average of about 4 percent more than the overall CPI in each year. Another source of greater costs comes from an evergrowing number of retirees receiving and approaching eligibility for these benefits. Longer longevity and more retirees will continue to escalate the number covered by corporate retiree health plans.

Recognition of Large Liabilities

In December 1990, FASB approved FAS 106, which requires companies to record unfunded retiree health liabilities on financial statements, effective for fiscal years beginning after December 15, 1992. This new accounting rule adopted by the Financial Accounting Standards Board (FASB) will hit some companies very hard by compelling them to acknowledge substantial unfunded retiree health liabilities.(1) Most companies finance and account for retiree health expenses on a pay-as-you-go (PAYG) basis out of current revenue. Financial Accounting Standard No. 106 will require them to adopt an accrual accounting system for retiree health benefits, in which benefit costs are recognized as expenses as companies accrue them. When a company adopts the new standard, it already has an obligation for retiree health benefits attributable to current and former employees' service to that date. FAS 106 stipulates that this obligation be recognized on the balance sheet either as a one-time charge to that year's earnings or as a charge to earnings over the plan participants' average remaining years of service (usually 20 years). A subsequent standard, FAS 109, Accounting for Income Taxes, will mitigate the FAS 106 burden for some companies.

In mandating that companies' financial statements reflect their retiree health benefit obligations, FAS 106 will conform accounting practice to the view that retiree health benefits are a form of deferred compensation. This is a laudable objective. This change will prompt all companies that offer retiree health benefits to report higher expenses for these benefits. Companies with an older workforce or a richer benefits package will report disproportionately higher retiree health liabilities than their competitors. Some companies are concerned that the dramatic rise in their balance sheet expenses that will result from this switch may impair their financial position by lowering their stock prices or reducing their ability to raise capital. These concerns could prompt companies to reduce or terminate their retiree health benefits, or require retirees to pay more of plan costs. On the other hand, such concerns could lead companies to start advance funding their liabilities, which would increase the security of these benefits.

The FASB standard affects accounting expenses and liabilities; it does not impinge on companies' cash flow.(2) The FAS 106 standard does not require companies to fund -- actually set aside money -- for these promised benefits. The effect of FAS 106 on companies' financial condition is so tenuous that financial ratings organizations are not considering retiree health liabilities in their evaluations.

The fact remains, however, that these costs and liabilities are large. This paper presents estimates of companies' (1) PAYG costs, (2) liabilities, and (3) prefunding costs due to the change in Medicare eligibility. For some companies these costs and liabilities are dramatic. These estimates were generated by the retiree health model I developed for a 1989 report on companies' retiree health liabilities.(3) The few options available to companies that might want to start funding retiree health are then described. In lieu of prefunding, many companies are cutting these benefits; these trends are described. Then estimates of how proposed changes in Medicare would lower the retiree health care costs for most companies are presented. The final section reviews the legal environment surrounding retiree health benefits.

Pay-As-You-Go Costs: About 63 percent of companies' current PAYG costs are for early retirees. Most early retirees are between ages 60 and 64; PAYG costs for these early retirees account for nearly half of companies' total estimated 1993 PAYG costs of $13.7 billion. These benefit costs are projected to continue to increase.

Current Liabilities: The liabilities of U.S. corporations for retiree health benefits are estimated to be $412 billion in 1993. These liabilities represent companies' transition obligation under FAS 106. Companies may book the entire amount of their transition obligation, as some already have, or amortize the amount over the service period of active participants or 20 years.

The accrued liability figure is the present value of (1) benefits currently owed to retirees and (2) accrued benefits for active workers who will retire with these benefits. The portion of companies' accrued liabilities that is for active workers will be about $257 billion in 1993, and the portion for retirees is $155 billion, as figure 1 shows.

Prefunding Costs: If companies were to prefund retiree health benefits, they would make annual contributions for benefits accrued during the year and for the amortization of any existing unfunded accrued liabilities. Few companies prefund their retiree health benefits and FAS 106 does not require companies to prefund benefits. Prefunding costs for retiree health benefits, calculated as if all companies begin prefunding in 1993, would be about $46 billion.

Our estimate of prefunding costs (which include PAYG costs) is roughly the same as the amortized value of the accumulated postretirement benefit obligation (APBO) that FAS 106 allows companies to book on their income statement. This estimate represents the aggregate annual charge that companies would book, should all companies with retiree health benefits amortize their accrued liabilities. However, since some companies have already reported their entire accrued liability, our estimate overstates the amount that would be booked.

Prefunding Options

Few companies now prefund their liabilities for retiree health benefits because no ready means to do so is in the tax code. The Internal Revenue Code (IRC) does offer several tax-advantaged options which could be used to fund these benefits, but each includes limitations that restrict the amount of tax-advantaged prefunding possible. Although lowering the age of Medicare eligibility would reduce companies' prefunding costs, it would not remove these limitations.

Two tax-advantaged funding options provided by the IRC are (1) contributing to a voluntary employee benefits association (VEBA) under section 501(c)(9) and (2) setting aside excess funds from a qualified pension plan under section 401 (h).

Contributions to VEBA trusts for retiree benefits are limited because the cost of health benefits for future retirees used in the calculations must be the same as the cost of health benefits provided current retirees. Since adjustments are not permitted for future medical inflation or increased utilization, companies cannot fund their entire retiree health liability if they limit contributions to the amounts allowed by the tax rules. In addition, investment earnings in a VEBA fund are subject to the tax on unrelated business income, except in certain cases.

The IRC also allows companies to fund their retiree health obligations by setting up a separate account from the excess in their qualified defined benefit pension plan. However, such funds cannot exceed 25 percent of the aggregate contributions made to the pension plan. The 25 percent limit may not permit transfers to this separate account to be as large as needed to fully accrued health liabilities. Also, because some companies' pension plans are overfunded, allowable pension contributions are very low, in some cases even zero, thereby effectively precluding tax-deductible transfers for retiree health.

In the Omnibus Budget Reconciliation Act of 1990, Congress did allow companies with excess pension fund assets to transfer such assets, notwithstanding the 25 percent limit. However, this option cannot be used to prefund future benefits because transfers are limited to the amount a company will pay out of the 401(h) account during the year for current, PAYG, retiree health expenses.

Proposed Health Care Reforms

The "Health Insurance Coverage and Containment Act of 1991" (H.R. 3205) contains a provision that would lower the age of Medicare eligibility from 65 to 60. This provision would shift some retiree health liabilities from companies to Medicare by making retiree health plans secondary payers at an earlier retiree age. Companies' health costs for retirees covered by Medicare are on average about 70 percent lower than their costs for retirees not covered by Medicare. I have estimated its effect on companies' retiree health costs and liabilities.

For current retirees under age 65, costs would decrease as a result of the change in Medicare eligibility, thereby lowering their liabilities. For retirees aged 65 and older, companies' costs would remain the same. The decrease is attributable to lower company health costs for active workers who will retire before age 65. Most workers retire between 60 and 65 at an average retirement age of about 62. Companies in which workers retire on average at age 62 would experience an average of 3 years lower health costs for each retiree. In contrast, companies in which workers tend to retire before age 60 would have on average 5 years of reduced health costs per worker.

Companies will continue to accrue retiree health costs for active workers each year. If the age of Medicare eligibility was lowered to age 60, the reduction in active workers' future accruals would follow the same pattern as the reduction in their current accruals.

This analysis shows that the change in Medicare eligibility would provide significant financial relief for companies by substantially reducing their PAYG costs and accrued liabilities for retiree health benefits. The reductions in accrued liabilities would lower the amounts companies would have to report under FAS 106.

If the Medicare eligibility age was lowered to 60 in 1993, companies' 1993 PAYG costs would decrease about 35 percent, or $4.8 billion.(4) This would be a significant boost to operating revenues for these companies. Overall, companies' accrued liabilities would drop about 30 percent, or $123 billion, if the age of Medicare eligibility was lowered to 60. The portion of companies' accrued liabilities that is for retirees, which I estimate will be $155 billion in 1993, would decrease approximately 23 percent, to $119 billion. The portion of accrued liabilities for active workers will be $257 billion in 1993 and would decrease about 34 percent, to $170 billion. Prefunding costs, which would be paying for this lower liability, would drop about 17 percent, from $46 billion to $38 billion.(5)

Lowering the age of Medicare eligibility would provide several benefits to both the retirees and the companies that provide retiree health benefits. It would (1) increase the security of retiree health benefits for early retirees (those who retire prior to age 65) by making Medicare the primary insurer, (2) make health insurance available to more retirees by extending Medicare coverage to early retirees of companies that do not currently offer retiree health benefits, (3) provide health benefits to eligible spouses of retirees whose companies do not cover them, (4) substantially reduce companies' PAYG costs, accrued liabilities, and prefunding costs for retiree health benefits, and (5) spread the retiree health care burden among companies by helping those with older workforces and high retiree health costs become more competitive, both domestically and internationally, with companies that do not pay for retiree

health benefits and those who do, but have younger workforces.

Lowering the age of Medicare eligibility would reduce companies' health costs for early retirees because Medicare would pay a substantial portion of these retirees' costs. However, the amount of reductions experienced by particular companies would vary depending on the characteristics of a company's workforce and benefits package. Companies with a lower average retirement age, more retirees under age 65, a richer benefits program, or an older workforce, for example, tend to have higher PAYG costs and retiree health liabilities than other companies, everything else being equal. These companies would benefit most by the change in Medicare eligibility because they would experience greater reductions in their PAYG costs and liabilities than other companies. Companies in the auto and steel industries, for instance, would likely experience considerable reductions since they tend to have many early retirees and provide generous benefits.

Not all companies, however, would experience cost savings if the age of Medicare eligibility was lowered. Under the "play or pay" provisions of H.R. 3205, companies that do not offer health benefits would be required to provide basic health insurance coverage or pay an excise tax to help finance a newly created public health plan.

While the change in eligibility age would benefit retirees and some companies, it entails a substantial expansion of Medicare program costs, which would be borne in part by all employers and their employees through higher taxes. The Congressional Budget Office estimates that the eligibility change would increase Medicare outlays by about $25 billion in fiscal year 1997 -- the year that the reduced eligibility age would be fully phased-in under H.R. 3205.

Companies Limit Retiree Health Costs

Since 1984, some companies have terminated a health plan which resulted in retirees losing their coverage, or active workers not being eligible for coverage under retirement. Others are taking measures short of termination to limit retiree health costs or have changed health plan provisions to shift some costs to retirees or reduce benefits. A 1989 report(6) reviewed the changes that a sample of 29 medium and large companies made to limit retiree health costs. All 29 companies changed their health plans during the period 1984-88. These changes included adding cost-containment measures, such as utilization review and mandatory second opinions; increasing medical deductibles and coinsurance amounts; and raising the amount plan participants pay for coverage.

The report also stated that 21 of them had made additional changes in 1989. While many of these were similar to those made in previous years, a few made even larger changes to help limit retiree health costs. For example, one decided to phase out retiree health coverage altogether. New employees will receive no health benefits upon retirement, but current employees and retirees would not be affected. Another company began giving retirees a fixed dollar amount for health benefits in 1991. A third company eliminated dental benefits for retirees.

Under current law, retirees who are receiving benefits, as well as workers who expect to receive health coverage after they retire, have little protection from company actions to reduce or terminate benefits. Retiree health benefits are specifically excluded from many of the protections provided to pension benefits under the Employee Retirement Income Security Act of 1974 (ERISA). For example, companies are not required to advance fund retiree health benefits or to give workers and retirees nonforfeitable rights to benefits accrued (vesting).

Recent court decisions generally have upheld a company's right to modify or terminate its retiree health plan if the plan documents contained explicit language reserving the right to make changes. In some cases, courts have ruled that other kinds of evidence (pamphlets, oral interviews, etc.) can be considered part of the contract between workers and employers.


Many large companies have sizeable liabilities for paying future retiree health care costs that have essentially been hidden because they were unreported (or have not yet been estimated) on financial statements. All that will change in 1993 when the accounting standard, FAS 106, will take effect for all but the smallest companies. These liabilities, over $400 billion in 1993, will show some companies to be in weaker financial condition than they now appear. Because so few have prefunded these benefits, nearly all the liability will go on financial statements because there are no offsetting assets. As the costs of these benefits continue to grow faster than overall inflation, companies continue to change the nature of the defined health care benefit they agree to pay for at retirement. Whether companies can legally get out of paying for these liabilities depends on the facts and circumstances of each case as the courts are now deciding legal challenges to reductions or denial of health benefits for retirees.

Donald C. Snyder is an Assistant Director, U.S. General Accounting Office, Washington, D.C.


1. Financial Accounting Standard No. 106 requires companies to record their unfunded health liabilities on their financial statements, effective for fiscal years beginning after December 15, 1992.

2. PAYG costs affect cash flows, whereas our estimate of the unrecognized benefit obligation (accrued liabilities) and of the amortized transition obligation (prefunding costs) do not, as they constitute accounting costs. PAYG costs represent payments a company makes for health benefits provided to current retirees. Accrued liabilities are the retiree health cost a company records in its financial statements to reflect the benefit liabilities it accrues for workers. Prefunding costs represent the annual contribution a company would have to make in order to begin advance funding its accrued liabilities.

3. Employee Benefits: Companies' Retiree Health Liabilities Large, Advance Funding Costly (GAO/HRD-89-51, June 14, 1989), describes the methodology and assumptions used in the retiree health model.

4. These estimates do not take into account any phase-in of the change in eligibility; they are calculated as if the change in eligibility becomes effective January 1, 1993.

5. This estimate assumes a 25-year amortization period.

6. Employee Benefits: Company Actions to Limit Retiree Health Costs (GAO/HRD-89-31BR, Feb. 1, 1989).
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Title Annotation:Symposium: Health Care
Author:Snyder, Donald C.
Publication:Review of Business
Date:Dec 22, 1992
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