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How to fund retiree liability.

The sun is setting on pay-as-you-go retiree medical benefits.

When FAS 106 regulations take effect in 1993, American corporations will be required to account for future post-retirement medical costs for retired and active employees on an accrual basis. Accustomed to paying only for medical services as they're utilized by retirees, employers now will be forced to recognize the costs of retiree medical benefits in advance of their payment--much as they've handled pension benefits in the past.

The effect of this regulatory shift on our company, H.B. Fuller, a worldwide manufacturer of adhesives and other specialty chemical products, is probably typical of that on other U.S. corporations. The implementation of the new FAS regulations will have a substantial impact on H.B. Fuller's income statement. Our projected expenses under FAS 106 for retiree medical benefits will more than quadruple from $900,000 on a pay-as-you-go cash basis to a net, after-tax figure of more than $4 million.

But not so typical, perhaps, is our response to the change--the establishment of a tax-free investment trust funded by life insurance policies taken out on employees. A look at our decision-making process may provide useful perspectives for others facing this issue. First I will explain why we took the course we did, then explain how.


Faced with exploding health-care liability costs, many companies have launched plans to reduce, or even eliminate, their retiree medical benefits. But Fuller sought a way to fund, and thereby secure, retiree medical benefits without creating a financial hardship on the company. Reducing or eliminating the benefits simply was not considered a responsible option. Further, our senior executives wanted to structure a fund that replicated key characteristics of the company's pension fund--in which contributions are deductible and asset appreciation is tax free.

Achieving this goal was no simple matter. It required a cooperative effort involving our benefits, tax, and treasury managers, and outside fund managers. Also key was the adoption of trust legislation in Fuller's home state of Minnesota.

Ultimately, the chosen vehicle for funding by Fuller was a variable life insurance program wrapped in a voluntary employee beneficiary association (VEBA). At Fuller, funds for future retiree medical benefits will stem from life insurance policies taken out on current employees and from underlying asset fund investments managed by the insurance carrier, with the VEBA trust named as beneficiary.

I outlined this strategy at a recent Chief Executive roundtable session on covering retiree health-care liability and provided some fundamental arguments for a corporation taking a responsible, active position in funding current and future retiree medical benefits.


At Fuller, concern for employees ranks second only to that for customers--and ahead of concern for stockholders or the community. Our definition of corporate social responsibility requires us to perform with excellence over the long term to all of our constituencies. Only then will we achieve growth, quality of sales, and profitability.

Employee loyalty and commitment can only be built on trust--mutual trust. Company policies and practices help foster this. For example, if you do your job well and get a satisfactory performance rating, the company's job security policy will keep you employed. Instead of layoffs, the policy first cuts everyone back to reduced hours if there's a drastic work slowdown, preserving employment for all.

Fuller is strongly competitive in direct compensation and considers its benefits program well above average. Some examples of our unique benefits include:

* a special vacation policy (paid time off) which, after 10 years and every five years thereafter, rewards employees with an extra two weeks of paid vacation and an $800 travel stipend, in addition to their regular vacation allocation.

* a program that provides financial assistance to first-time home buyers.

* a worldwide profit-sharing bonus plan which, over time, will create a significant direct employee ownership stake in the company, with year-end performance-driven bonuses paid in a combination of cash and company stock.

How do our employees feel about our commitment to develop, support, and reward them? One indication is our annual employee turnover rate of less than 5 percent. Another is their decision to invest more than half their 401(k) plan in H.B. Fuller common stock. All of which serves as a backdrop to why Fuller views FAS 106 as not just a challenging issue of economics, but also one of employee and retiree security.

Simply put, Fuller's goal long has been to help preserve in retirement the standard of living its employees have grown to expect while in active service. We provide continuing medical and dental benefits to retirees, at the same levels of coverage as those of active employees.


The Fuller Board of Directors had pledged to deliver retiree medical benefits long before FAS 106 came along. (That steered us to look at developing a funding strategy rather than reducing benefit coverage in response to the FAS 106 rules.) As such, the new regulations only affect the timing of the liability recognition associated with those benefits.

Reduced benefits create hardship for retirees, who have limited ability to absorb cost shifts. The elimination of coverage is truly traumatic. Retirees find it difficult to convert from group insurance to individual coverage. Pre-existing conditions can leave retirees exposed to catastrophic claims. Coverage is expensive at advanced ages, and it's a complex and emotional issue, often overwhelming to retirees.

In short, the ability to live an independent and dignified life in retirement is hugely affected by the issue of health care.

Even more fundamental, however, is the issue of responsibility. Who, ultimately, is responsible for the health care of senior citizens?

The options are for corporations to provide private health-care plans that integrate with government services or to abdicate the entire responsibility to government--and pay higher taxes. Fuller believes that a consortium of private and public sector institutions operating cooperatively is the most efficient response to most health-care needs.

But beyond committing the company to do its part in providing its retirees with medical benefits, we also felt it behooved us--and it makes good sense from a corporate finance standpoint--to enhance the security of those benefits by prefunding them. Benefit security involves not only finding a payer--be it a company or the government--but also providing meaningful coverage over the long term.

Unfortunately, the current U.S. tax code does not give employers incentives for the advance funding of post-retirement medical plans. Ultimately, government is responsible for responding to the health-care needs of senior citizens. By installing tax incentives similar to those applied to pension benefits, government could and should encourage corporations to carry their portion of the burden. Corporate responsibility would do the rest. Given the right tax treatment, this is a supporting role in society that every socially responsible company should be prepared to play.


As described earlier, FAS 106 will create a large, previously unrecognized pretax liability on the Fuller balance sheet of $20 million to $25 million. And while leaving that liability unattended goes against the company's philosophical and financial standards, it's also important to note that the establishment of new investment instruments to cover the liability carries with it some new risk and costs.

Transaction costs on available investment vehicles are currently high, as often is the case when breaking new ground. So new, in fact, that the creative development of workable funding mechanisms can even involve the amendment of standing legislation in order to allow them.

In structuring a funding mechanism for FAS 106 retiree medical benefits, our management team insisted the plan not create a financial burden for the company. It set as a goal that the plan would mirror the company's pension plan in two regards: Contributions to it would be deductible, and its equity appreciation would be tax free. Further, we aimed to eventually fund the benefit as securely as our pension plan, which currently has $1.65 in assets for every $1 in liabilities.

To begin, our team, headed by assistant treasurer Lee McGrath and corporate benefits manager Mark Tanning, identified three existing funding options for preliminary consideration: 401(h) pension plan accounts; company-owned life insurance; and a 501(c) (9) VEBA trust.

Unfortunately, an evaluation of the three quickly proved that none satisfied our requirements.

Because contributions to a 401(h) pension account are limited to one-fourth of a company's pension plan contributions, and because Fuller's contributions to its well-funded pension plan are marginal, a 401(h) approach would be inadequate to cover our future post-retirement medical costs.

Company-owned life insurance presented two key negatives: Premiums are not deductible, and assets cannot be used to offset post-retirement medical liabilities.

And third, the earnings of 501(c) (9) VEBA trusts are taxable as unrelated business income.


Faced with these dead ends, we decided to blaze our own trail. Insurance consultants Monroe Larson and Charles Garrity put us in touch with the Premit Group, a New York-based consulting firm, for help.

Premit noted that if the assets of a VEBA trust were put into a tax-exempt investment, including life insurance, earnings no longer would be taxable. In addition, contributions to the VEBA would be deductible. In other words, a combination of the VEBA and life insurance options appeared to be the solution.

Such a plan offered several important features:

* Assets within the VEBA could be used to offset the balance-sheet liability.

* The secondary purchase of bonds, equities and other investment funds by the insurance carrier could provide good investment flexibility.

* Recognizing that health-care costs could continue to grow at a rapid rate, the secondary investments in equities would provide the best long-term opportunity to offset those increases.

* The VEBA would receive insurance policy death proceeds tax free.

* Funds from the investments could be used to pay for retiree medical expenses as an "unwind" strategy, in the event of a further change in health-care regulations.

* The VEBA vehicle would be cost-effective.

Meanwhile, we found that we were able to mirror our pension-investment strategy by arranging with Massachusetts Mutual Life Insurance to invest the majority of premiums in an equities fund managed by Wells Fargo/Nikko Investment Advisers.


Still, two significant challenges remained.

Fuller employees--roughly 500 of them, to start with--would need to agree to have a life insurance policy taken out on them, with the VEBA named as beneficiary. Also, Fuller would have to set up the VEBA in a state that allowed a trust to be the named beneficiary of individual life insurance contracts. As of 1991, such an allowance could only be found in the state of Georgia's insurance code. Regulations in all other states--including Minnesota--were, at best, indecisive on this complicated issue.

We were prepared to take our trust to Georgia, but we preferred to keep it in Minnesota. A discussion ensued with representatives of First Trust, a unit of Minneapolis-based First Bank System, which administers Fuller's 401(k) and pension plans. In turn, First Trust brought the issue to the attention of state legislators who discerned the advantage to Minnesota of attracting a new type of trust investment. By the close of the 1992 legislative session, the state insurance code had been amended to clearly allow a trust to have an insurable interest in its insured's lives.

At the same time, we moved to explain the plan to a select group of 530 employees, asking their permission for the trust to hold an insurable interest in their lives. Our supervisors distributed a memo, and meetings were conducted to further spell out the plan and to respond to all concerns.

We needed to assure our employees that they would suffer no negative effects from participating in the plan--no tax consequences or obstacles to obtaining other personal insurance. We agreed to pay all related expenses, and emphasized that most of the funds would actually be invested in equities--not in traditional life insurance. We also pointed out that it would be to Fuller's advantage if participants lived to a ripe old age, thereby allowing us to make more contributions to the trust and, in turn, in tax-deferred equities. The death benefits of the plan, we pointed out, were largely incidental.

Employee confidence and trust in the company was apparent in the response. Of the 530 solicited, 504 signed up.

We are looking to extend plan funding in the future. But there are several immediate benefits. Our balance sheet will be stronger--which means our shareholders will breathe easier. We've illustrated the ability of the private sector to respond to a fiscal challenge without government help--particularly now amid a hue and cry for socialized medicine. And perhaps most important, we've reaffirmed our value system and philosophy to our employees. And we've let them know we will continue to play an active role in enhancing their quality of life and developing creative solutions to the problems they face--both now and after they retire.

Anthony L. Andersen is chairman and chief executive of H.B. Fuller Co., a $934 million worldwide manufacturer and marketer of adhesives, sealants, coatings, paints, and other specialty chemical products.
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Title Annotation:Health Care
Author:Andersen, Anthony L.
Publication:Chief Executive (U.S.)
Date:Mar 1, 1993
Previous Article:Street fighter.
Next Article:Covering retiree health-care liability.

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