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The myths and misconceptions of retiree benefits.

The Myths and Misconceptions Of Retiree Benefits

The Financial Accounting Standards Board (FASB) is presently putting the finishing touches on a proposal that will greatly affect the way companies account for all benefits, other than pensions, that will be paid to retirees. This long-debated, controversial proposal will require most companies to recognize their future health care benefits liabilities for retirees on their balance sheets in advance, instead of when the bills are due and the benefits are paid.

FASB believes that retiree health care costs will represent a significant future cost that can be charged to current earnings. The board argues that a failure to account for these costs will make corporate balance sheets look stronger than they really are. This is a radical departure from current accounting practices for retiree health benefits. Companies are no longer required to book the expense until it is actually paid. Although the proposal has created its share of anxiety among Corporate America, only some of their concerns are justified.

Changing to accrual accounting will decrease reported earnings, and adding a new liability may decrease the borrowing ability of some companies. This could lead to stockholders and lenders putting strong pressure on some companies to reduce any new liability by cutting back on employee benefits. If benefits are reduced, active employees and retirees may have to pick up more of the cost through increased deductibles and higher co-payments. As a result, the level of benefits may not only be reduced, but some benefits could be eliminated. The FASB proposal also covers other retiree benefits, including life insurance, housing, education, travel and a number of other benefits that are due to retirees, their dependents and survivors.

The FASB proposal will cover accounting for all retiree benefits other than pensions, but the medical benefit component is the greatest concern. This is based on the continual increase in health care costs at a rate of 15 percent to 20 percent per year. Since Medicare reimbursement levels have not been able to keep pace with these increases, many employers are forced to foot more of the bill. And since our population is aging, the total number of retirees will continue to grow.

If adopted, the current proposal will generally become effective for fiscal years beginning after December 15, 1991. For non-U.S. plans and plans covering less than 100 participants, the starting point is December 15, 1993. By 1997, all single-employer benefit plans would be required to recognize a minimum liability for retiree benefits on their balance sheets.

The final draft of the proposal has yet to be completed, but the 225-page exposure draft was made public on February 14, and hearings were held in New York and Washington, DC, in October and November. By the time all the comments are addressed, release of the final draft could be delayed pushing back the deadlines for implementation. In fact, in early September, Standard & Poor's announced it had decided to ignore the FASB proposal and would not "downgrade corporate debt."

There are a number of issues regarding the proposed standard that have been misunderstood. As with most new proposals, the new FASB proposal is replete with myths--many completely unfounded. Of all the myths currently circulating, the most widespread is that employers do not have to be concerned with the proposal until it takes effect in 1992. But waiting for 1992 can be a mistake for most companies for several reasons.

First, employers need to determine as soon as possible to what extent, if any, their future profits will be affected. To reduce the impact of the proposal on profitability, decisions must be made regarding the redesign or modification of benefit plans. Should an organization decide to change its retiree health care plan and make these changes as soon as possible, the changes will cause a greater overall impact and allow more lead time for communication and procedure revision.

Similarly, employers will have greater flexibility when choosing their accrual method if they start accruing the costs now, rather than waiting for the proposed standard to become effective. Most organizations will find that early accruals can reduce costs in later years. A company's human resource data system should also be reviewed as soon as possible to determine whether it is adequate for the job of performing retiree valuations. When it comes to improving any type of data system, a lengthy lead time is usually necessary.

Since accounting for retiree health care benefits can impact the future profitability of a business, the effects of the proposal should be taken into consideration when assessing the value of a company. In fact, the FASB proposal must be factored into almost any strategic planning a company undertakes.

A second myth is that the proposed standard will wipe out stockholders' equity for many organizations. In fact, there is no possibility of a mandatory direct charge to equity prior to the requirement of a minimum liability in 1997. At that point, there may be special adjustments if the liabilities for retirees and employees eligible for retirement exceed the total of accrued, but unpaid, benefit costs. Even so, chances are that any additional liability will be offset by an intangible asset, rather than by a reduction in equity.

Many organizations also believe that the proposal will require them to prefund their benefits when, in fact, it requires them to accrue a cost for future benefits. These accrued costs are to be included on their balance sheets as a future debt to be paid, but the benefits do not have to be funded in advance. This makes accounting for retiree health care benefits considerably different than accounting for pensions (See Exhibit 1). Any analysis of the financial advantages and disadvantages of prefunding must take into consideration the human resources and financial objectives of the specific organization.

There are a number of advantages to prefunding the liability for future benefits. Prefunding gives employers and employees the security that the funds will be available when needed, and all investment earnings from prefunded accounts will reduce an organization's total benefit expenditure. In addition, putting cash into a tax-qualified funding vehicle gives a company a current tax deduction for the retiree health care benefit expense required by FASB.

However, tax-qualified funding vehicles, such as a voluntary employee benefit association (VEBA) or an IRC Section 401(h) plan, have severe limitations. In a VEBA, the investment earnings are generally taxable unless tax exempt investments, such as corporate-owned life insurance (COLI) or municipal bonds, are used. There are also Internal Revenue Service limits on the amounts that can be contributed to VEBA or a 401(h) plan; and without tax advantages prefunding ties up capital a company could be using productively.

A final misconception that arises when discussing the future cost of health care benefits in general, and the FASB proposal in particular, is that the medical care component of the Consumer Price Index (MCPI) is a reliable measure for predicting the increase in per capita health care costs. In reality, the MCPI does not measure every component that accounts for total medical care cost increases.

The MCPI is actually a blend of indices that measure hospital, physician and other costs. The problem is that the items in the index are heavily weighted to costs borne primarily by consumers such as nursing homes, medication and physicians, while the costs carried primarily by plan sponsors such as hospital and surgical fees, are given less importance.

Therefore, the MCPI measures the overall increase in health care costs to consumers, but does not give an accurate picture of the increase in costs to third parties. To better understand third party costs, a redesigned index that emphasizes hospital and surgical fees should be used.

In addition, an organization's health care costs depend not only on the price of services, but also on changes in the percentage of costs paid by the employer and by the diversity and number of paid services. An employer's share can increase due to a leveraging of deductibles and cost shifting from other third party payers, such as Medicare. An employer's choice of services can change as a result of technological improvements or revisions in the practice of medicine. The number of services an organization chooses to offer to its employees can increase or decrease with utilization. As the population ages, the utilization rate of these services will increase.

It is important to remember that the FASB proposal does not change the cost of benefits. Companies with sufficient capital to pay for the present cost of benefits will still be able to afford the same benefits once the proposed standard is in place. The only difference will lie in the timing and method required for recording these costs. [Exhibit 1 Omitted]

Stephen A. Meskin, Ph.D., is vice president and health actuary with Martin E. Segal Company in Washington, DC.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
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Title Annotation:includes related information
Author:Meskin, Stephen A.
Publication:Risk Management
Date:Dec 1, 1989
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