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Underlying problems facing post-retirement medical plans in the public sector.

Many public- and private-sector employers provide medical benefits for their retirees. These plans, in combination with Medicare for retirees aged 65 and older, offer important financial protection to retirees. The rate of increase in the cost and accrued liabilities of these plans has accelerated in recent years, forcing many public and private employers to begin redesigning the scope of medical benefits provided to retirees.

Economic and demographic factors that have contributed to rising retiree medical plan costs include:

* medical price inflation;

* marketplace cost shifting from Medicare, Medicaid and managed care plans;

* aging of the workforce; and

* increased life expectancy.

In response to these economic and demographic forces, many private employers have implemented managed care features in their post-retirement medical plans in an effort to slow down the rate of increase in plan costs from year to year. In addition, many private employers have reduced their future financial commitment to these plans in response to the requirements of the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. FASB Statement No. 106 requires private employers to report the actuarially determined annual contribution to retiree medical plans for active as well as retired employees as an expense on their financial statements. This requirement is having a substantial adverse impact on the annual net income of many private employers since these costs, usually funded on a pay-as-you-go basis, previously were recognized only during the year that benefits were paid.

Many private employers have reduced their future obligation to post-retirement medical plans by implementing a defined-dollar benefit (DDB) plan design approach, in which the employer sets a tolerable dollar-cost limit on its contributions to the retiree medical plan. Retirees and dependents must pay the balance of plan costs. In many cases, the actual employer contribution is linked to a retiree's length of service so that only a career employee with, for example, 25 or 30 years of service would receive maximum employer contributions. Using this approach, an employer's retiree medical plan obligation is fixed from year to year; future increases in employer contributions are within the employer's control.

State and local government employers also offer post-retirement medical benefits to their retirees as part of the medical plan covering active employees, as a separate plan or, as in Ohio, as part of a statewide retirement system. Public-sector post-retirement medical plans are experiencing the same dramatic increases in plan costs each year as their private-sector counterparts because they are experiencing the same adverse effects from medical price inflation and other economic and demographic forces that are driving up private-sector retiree medical plan costs.

Public employers, just like their private-sector counterparts, do not have control over outside economic and demographic forces that drive up plan costs. They do, however, have control over the design of their medical plans (i.e., the level of benefits being offered and the share of retiree contributions) and how these benefits are delivered (i.e., through a traditional indemnity program, which reimburses retirees for services rendered, or through a managed care program, which controls the unit price and utilization of health care services).

Over the past five years the problems underlying the design of indemnity medical plan coverage for public-sector retirees, in combination with an expanding retiree population and other demographic and economic forces, have driven up total costs of some post-retirement medical plans at a rate of 20 percent or more per year. Demographic and economic factors affecting these plans are outside an employer's control. The only key areas in an employer's control are plan design and the delivery of health care services.

This article briefly reviews key problems that underlie the design of state and local government-sponsored post-retirement medical plans and approaches to resolving those problems.

Underlying Problems

Most post-retirement medical plans have been traditional indemnity programs, which typically reimburse retirees for a percentage of reasonable and customary charges after an annual deductible has been met. During the course of the year, if a retiree's out-of-pocket expenses reach the maximum limit specified by the plan (i.e., the annual out-of-pocket maximum), the plan usually pays in full most future medical expenses incurred by the retiree during the balance of the year. For example, if a plan's annual out-of-pocket maximum is $500, most covered expenses incurred by the retiree for the balance of the year generally would be paid in full by the plan.

The inherent problems that underlie indemnity medical plans have contributed directly to the rapid rise in medical plan costs for public-sector retirees (and for active employees) over the past decade. Key problems are discussed briefly below.

* Indemnity plans pay the full "retail" price for medical care, since physicians and hospitals charge indemnity plan participants their maximum price for services rendered. In contrast, managed care programs, such as preferred provider organization and point-of-service health maintenance organizations (HMOs), negotiate hospital and physician provider discounts in advance.

* The "retail" price charged to indemnity plans is an integral part of the dynamic known as marketplace cost shifting, in which providers make up for lower fees paid by Medicare, Medicaid and managed care plans by charging higher fees for services rendered to indemnity plan participants.

* Most indemnity plans have some elements of utilization review, such as hospital precertification of nonemergency hospital admissions but, typically, these cost management features are not as comprehensive and far reaching as the cost management requirements of managed care programs.

* Annual deductibles and out-of-pocket maximums have been eroded by medical price inflation because they have not been adjusted periodically as medical prices have risen. In some cases, state and local government post-retirement medical plans have not increased these cost-sharing requirements for five years or longer. As a result, the relative portion of medical expenses paid for by a plan participant has declined as deductibles and out-of-pocket maximum limits remained fixed while the rate of increase in medical price inflation has risen at more than twice the rate of general price inflation.

* The rate of increase in costs associated with the treatment of mental health and substance abuse problems typically has been higher than the rate of increase of most other covered medical plan benefits. Unmanaged mental health and substance abuse treatment typically provides limited benefits for less expensive outpatient care than for inpatient mental health coverage, which generally is provided at the same level of coverage as for any other illness or condition. With an appropriate mental health and substance abuse provider network, a managed mental health and substance abuse treatment program can improve the quality of care, as well as slow down the rate of increase in the cost of these benefits.

* Outpatient prescription drug benefits also represent one of the most rapidly rising components of medical care prices. They can account for as much as 20 to 25 percent of the total cost of post-retirement medical plan benefits. These benefits usually are reimbursed under an indemnity plan at the same coinsurance rate (e.g., 80 percent) as any other outpatient expense up to the plan's annual out-of-pocket maximum and at 100 percent thereafter.

Alternatively, employers offer prescription card programs for retail drugs with copayments generally ranging between $2 and $10 per prescription for up to a 34-day supply. In many plans, a prescription card or indemnity coverage is supplemented by a mail-order prescription drug program for maintenance drugs, with copayments also generally ranging from $2 to $10 per prescription for a 90-day to 120-day maximum supply. Retirees are the highest utilizers of maintenance drugs, which represent 70 to 80 percent of all drugs dispensed in this country. These drugs are used for the ongoing treatment of a particular condition or illness, such as high blood pressure or heart disease. Prescription drug card and mail order programs offer employers discounts for brand-name and generic drugs, with mail order programs offering steeper discounts because of the potentially higher volume and utilization.

Because there are no controls over the price or utilization of prescription drugs covered under an indemnity plan, the cost of unmanaged prescription drug coverage is the most expensive approach to providing prescription drug benefits. Without proper utilization and cost controls, prescription card programs also can be a very expensive approach to providing retirees with prescription drug benefits. And mail-order programs, often thought of as an effective approach to "cost containment" for prescription drugs, frequently prove to be expensive programs to offer plan participants unless proper plan design and managed care features have been incorporated into the plan.

Cost Management Strategies

Unless the inherent problems with indemnity plans are addressed, costs will continue to rise rapidly and the unfunded accrued liabilities of these plans will continue to mount as the active employee workforce ages. Left alone, these post-retirement medical plans could threaten a state or local government's credit rating, just as unfunded pension liabilities compromised the credit ratings of some state and local governments during the 1970s.

Although managed care programs are not a panacea for resolving the cost issues associated with post-retirement indemnity medical plans in the public sector, they do offer dimensions of utilization and cost control not available through indemnity plans that help slow down the rate of increase in plan costs.

Managed care programs range on a continuum that includes the following:

* preferred provider organizations (PPOs), which offer higher levels of coverage to participants who use physicians, hospital and other network providers than participants who use providers that are outside the network;

* point-of-service (POS) HMOs, which mirror the design of PPOs with the exception that retirees who use network providers always must go through a primary care physician who serves as gatekeeper for all patient care within the network; and

* closed-panel HMOs (individual practice associations and staff model HMOs), which offer their participants all covered care through the HMO provider network, and participants may not opt for medical care that is outside the HMO network unless it is in an emergency situation.

In varying degrees, each of these managed care approaches provides tighter control over 1) the unit price of medical services through negotiated provider discounts and 2) the utilization of health care services through more restrictive utilization management techniques than traditional indemnity plans. A participant's "freedom of choice" is inversely related to the degree of plan control over the unit cost and utilization of services. Thus, the rate of increase in plan costs of a closed model HMO typically is the lowest, followed by a POS HMO and then by a PPO. With control over the key elements of unit costs and utilization, each of these managed care approaches can be expected to have lower annual rates of increase in plan costs than indemnity plans, which have no control over the unit price of medical services and only selective control over the utilization of certain types of services.

Some managed care approaches may not fit well into a retiree population. For example, it is probably not feasible for Medicare eligibles to be covered under a POS managed care arrangement because they receive most of their inpatient hospital coverage from Medicare (Part A) and are covered for most physician and other provider services under Part B of Medicare. Since Medicare does not require Medicare-eligible individuals to seek care in a managed care network, let alone to use a primary care network physician as the gatekeeper for all care rendered in the POS HMO network, there would be considerable difficulty in coordinating health care delivery and reimbursement of physicians and other providers in a POS network covering Medicare eligibles.

In some cases, Medicare risk contracts can be an efficient mechanism for providing coverage for Medicare-eligible retirees. Under Medicare risk contracting, an HMO or other approved health plan provides participating Medicare beneficiaries with the full range of covered Medicare services in exchange for a monthly payment by the U.S. Health Care Financing Administration, which administers the Medicare program. Participating Medicare beneficiaries must receive all of their medical care through the health plan, except in emergency situations. In other cases, a PPO arrangement that is available to non-Medicare-eligible retirees may be appropriately continued when they become eligible for Medicare so that the balance of expenses not covered by Medicare Part B can be covered on a discounted basis by network physicians.

Notwithstanding the complex coordination issues in dovetailing a managed care program with Medicare, a managed care approach for non-Medicare eligible retirees certainly makes sense. Non-Medicare-eligible retirees may account for as few as 20 percent of the retiree population but can generate two-thirds to three-fourths of claims in a post-retirement medical plan.

Other managed care approaches focus on such specialized, high cost areas as prescription drugs and mental health and substance abuse treatment. When appropriately designed, managed care programs that specifically address these areas can significantly reduce the rate of increase in the cost of these benefits.


Indemnity medical plans covering retirees in the public sector will become unaffordable as the state and local government workforce ages and the retiree population expands and lives longer. Unmanaged care in a retiree population is a recipe for unrelenting future increases in plan costs each year and mounting unfunded retiree medical plan liabilities.

Unless state and local governments begin to develop a cost management strategy that includes redesigning their current post-retirement medical benefits and moving away from an indemnity environment to a managed care environment, public employers will not have the resources to pay for these benefits. If appropriate changes in these plans are not implemented soon, public employers may be forced to take the same route that many private employers have taken in response to the requirements of FASB Statement No. 106--i.e., to offer retirees a defined-dollar benefit in which the employer sets a fixed contribution to the retiree medical plan and the retirees pay the balance of the cost for coverage.

Preservation of the future financial viability of post-retirement medical benefits in today's environment will require state and local governments to implement a carefully designed blueprint for change that balances the need to provide an appropriate level of medical plan coverage with the resources available to pay for those benefits.

ROBERT W. KALMAN is a health care consultant with Gabriel, Roeder, Smith & Company, consulting actuaries and employee benefit consultants, where he specializes in design, financing and cost management issues affecting health benefit plans covering active and retired employees in the public, private and not-for-profit sectors. He also serves as an advisor to GFOA's Committee on Retirement and Benefits Administration.

THOMAS R. ANDERSON is executive director of the School Employees Retirement System of Ohio, which sponsors a post-retirement medical plan covering 50,000 retired employees of school districts throughout the State of Ohio. He is chair of GFOA's Committee on Retirement and Benefits Administration.
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Title Annotation:Spotlighting Small Governments
Author:Kalman, Robert W.; Anderson, Thomas R.
Publication:Government Finance Review
Date:Apr 1, 1993
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