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Funding the $2 trillion retiree benefit liability.

Funding the $2 Trillion Retiree Benefit Liability

The total unfunded liability for retiree benefits may represent the greatest crisis in employee benefits since the unfunded pension liability uproar resulting from the enactment of ERISA. In 1983, the U.S. Department of Labor estimated the accrued liability of private employers for retiree health benefits at $98.1 billion. In 1989, that figure has risen to over $2 trillion.

The funding crisis exists for several reasons. First, the retiree population continues to increase at a staggering rate. In 1985, approximately 28 million Americans were over the age of 65, while it is estimated that by the year 2020, the same age group will total over 49 million people. In addition, the life expectancy of retirees is increasing, resulting in longer benefit payment periods. For example, in 1908, the life expectancy of the average male was 51.6 years, whereas, by the year 2020, the life expectancy of the average male is estimated at 82.7 years.

This funding crisis is also due in part to the fact that, since 1965, the increase in health care costs have been approximately three times greater than the increase in the Consumer Price Index. From 1984 to 1987, per capita medical care costs for individuals over the age of 65 increased 85 percent. Also, most employers discharge their retiree medical liabilities on a pay-as-you-go basis. Recent studies have shown that only 1 percent of employers have prefunded these plans.

According to findings of a survey by the Institute on Aging, Work and Health in Washington, DC, many of the larger employers in the United States plan to redesign their retiree medical benefit plans within the next year. The reason most companies intend to make this change stems from the anticipated accrual accounting requirements of the Financial Accounting Standards Board (FASB).

Eighty-five of the 95 companies responding to the survey have either increased plan deductibles, copayments or premium contributions within the past two years, or plan to make such changes by 1990. In addition, 68 percent of the firms surveyed said their plans to redesign their retiree medical benefits included adding managed care, 50 percent said they would expand their onsite wellness programs, and 33 percent planned to offer employee-paid long-term care insurance. Ninety-eight percent of the companies surveyed were extremely interested in using a tax-favored prefunding vehicle for future retiree health benefits. Of those mechanisms suggested by the respondents, 85 percent said they would use a tax-favored health care trust, or 501(c)9 Trust (VEBA).

The FASB study came about as a result of its concern about the lack of information in financial statements on the cost of and obligation for retiree benefits. Most importantly, FASB is questioning the pay-as-you-go method commonly used by most employers.

In November, 1982, FASB published preliminary views regarding retiree benefits. The board concluded that "The cost of retiree's health care and life insurance benefits would be accrued during the service lives of employees who are expected to receive those benefits, provided the amounts involved are material. Pay-as-you-go (cash basis) and terminal funding (accrue at retirement) methods would not be acceptable for recognizing such costs in accrual-basis financial statements." The board stated that this proposal was based on its belief that post-employment benefits are a form of deferred compensation. Therefore, the cost is incurred and should be recognized during the years in which the employee provides services.

In 1984, FASB published Accounting Standards No. 81 requiring, for years ending after December 15, 1984, that certain disclosures be made in financial statements. All financial statements must include a description of retiree health care and life insurance benefits and the employee group covered, the cost included in the employer's net income for the period, and a description of the firm's current accounting and funding policy.

On February 14, FASB issued an exposure draft which requires benefit accruals, effective for fiscal years beginning after December 15, 1991, and balance sheet recognition of the retiree liability, effective for fiscal years beginning December 15, 1996. This action requires employers to expense retiree medical benefits over their employee's working lifetimes. FASB appears to be moving in the direction of recognizing the cost of these benefits during the employee's years of service. If required, this would provide employers with additional motivation for prefunding.

Potential Liabilities

A 1986 Department of Labor report found that most employers misunderstand their potential liabilities for retiree health insurance benefits. Most believe that they had a great deal of flexibility and discretion in eligibility requirements and in terminating the plan. Since the report was published, the courts have not consistently upheld this view. For example, in Cardman vs. Bethlehem Steel Corporation, the district court held that even though the formal plan document provided for the amendment or termination of the plan, the retirees had the rights to medical benefits through numerous booklets that implied titlement. As a result, the company was not allowed to reduce the benefits.

Because federal law does not provide the kind of tax incentives for funding retiree health care and benefits that are provided for retiree income benefits, most employers do not prefund their retiree medical liabilities. Due to the size of the federal budget deficit, the approval of increased tax incentives through pension-type funding is not expected any time soon.

There is some speculation that Congress may authorize the use of excess pension assets to help fund retiree liabilities. However, many practitioners believe that this option has little chance of actually becoming law.

Increasingly, employers are utilizing corporate owned life insurance (COLI), a non-qualified funding vehicle, in combination with a tax-qualified funding approach. It is becoming apparent to many employers that the emerging retiree liability is of such a magnitude that it requires the utilization of all available funding techniques.

Tax Incentives

Tax write-off plans such as a 401(h) Trust or a 501(c)(9) Trust are attractive but somewhat limited. The cost of a write-off plan is the after-tax cost of deposits into the trust. Obviously, this approach reduces the expense for retiree health care over what it could be on a pay-as-you-go basis.

Asset plans such as COLI are attractive to most employers and are also somewhat limited. A company is restricted in the size of its plan by the number of participating employees and by a $50,000 loan limitation as it relates to the tax-deductability of the policy loan interest on each employee. The cost of a COLI plan is significantly less than that of a write-off plan because the corporation recovers its initial capital outlay during the first plan year. Thereafter, a positive cash flow is created in each subsequent year the policy is in use.

By utilizing COLI in conjunction with a 401(h) Trust, a 501(c)(9) Trust or both, an extremely powerful funding strategy is created. This approach results in tax-free COLI cash flows being deposited on a tax-deductible basis into a trust, in which the assets grow tax free. To reverse the current course of this liability crisis, it is imperative for CFOs and risk managers alike to fully understand the nuances and fine print associated with retiree health care benefits, as well as the full scope of the limited tax incentives at their disposal.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Lightfoot, Donald G.
Publication:Risk Management
Date:Dec 1, 1989
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