The retiree health care question: to prefund or not to prefund?

A recent survey by William M. Mercer Inc., benefits consultants in Richmond, Va., says only 7% of employers prefund retiree health benefits. Employers also prefer pay-as-you-go funding, under which retiree claims are paid as incurred, the survey shows.

Under Statement No. 106 from the Financial Accounting Standards Board, Employers' Accounting for Postretirement Benefits Other Than Pensions (FAS No. 106), employers are under no obligation to prefund. But those that do not may regret it--possible outcomes include increased expenses, liabilities, and falling end-of-year profits.

George Wagoner, a principal with William M. Mercer, says: "If there is no prefunding and you have fewer than two active employees per retiree, you can expect your net periodic postretirement benefit cost (NPPBC) to be about three and a half times the cash cost."

Looking at the positive side of prefunding, Wagoner says the NPPBC can be seven times the cash cost if an employer has between two and six active employees per retiree. "If you have more than six actives, it can jump to 13 times the cash," he says. His statistics assume no change in benefits. "A reduction in benefits lowers these ratios," he says.

Employers that have few retirees coupled with a young workforce will reap the most benefit from prefunding in terms of expense reduction. Those with a more mature workforce are likely to suffer financially. For those that want to prefund, the main problem is the shortage of suitable tax-advantaged vehicles. Ineed, Mercer's survey found that 60% of employers said they would prefund if tax incentives were more favorable.

Two major funding vehicles are currently in use. More than 50% of employers that do prefund use a trust under Internal Revenue Code section 501(c)(9), called a VEBA, or voluntary employee beneficiary association. Another 20% use an account under Internal Revenue Code section 401(h) within a pension plan. Some employers use more than one vehicle, and some use savings plans to supplement funding by employees and the employer.

John Hickey, a partner in Kwasha Lipton, employee benefits consultants in Fort Lee, N.J., says the ideal benefit-funding vehicle would provide three advantages: tax-deductible contributions; tax-free accumulation of earnings; and tax-free benefits to beneficiaries.

It is difficult to find all three advantages in one package because of tax laws but "there are options for plan design and funding for achieving objectives," Hickey says. The options range from terminating plans, which is not uncommon, to leaving plans and funding alone. Hickey says, "Most employers fall somewhere in the middle." Under FAS No. 106, companies can reduce retiree health plan obligations with fixed-dollar plans. This strategy will open the way for tax-effective funding vehicles, including profit-sharing and savings plans.

In effect, prefunding can affect an employer's cash flow and expenses dramatically, Wagoner says. See "Cash flow vs. FAS No. 106 expense with 100% prefunding" and "Cash flow vs. FAS No. 106 expense with no prefunding." The charts outline the expenses for an employee who is single and was hired at age 30. The employee is eligible for retirement at 55, but opts to retire at 62.

The expenses outlined, assuming no prefunding, show the annual build-up in FAS No. 106 accrued expenses. The figure assumes pay-as-you-go funding. The accrued expense starts at $60 when the employee is age 30. It then increases steadily to more than $1,100 when he is 54 and approaching the retirement eligibility age. The pre-Medicare cash cost of the retiree benefit when he is 64 is about $2,400.

For a married employee with dependents, the cost could be more than double. Although it is not shown in the chart, the balance-sheet liability for the employee totals about $17,000 at retirement. The chart outlining expenses with 100% prefunding shows a dramatic reduction in accrued expense by prefunding. The expense at age 54, for example, falls from $1,100 to about $460.

This figure will continue to decline and will cease at retirement. The total cash flow from age 30 to age 62 is $5,200. Wagoner says these prefunding estimates reflect ideal tax and inflation assumptions.

After reviewing these figures, many employers will conclude that prefunding is attractive. In fact, some employers may want to seek prefunding possibilities that are more aggressive than a VEBA or 401(h) plan, but their tax treatment is unclear. One possibility is the health stock option plan (HSOP), which matches the many tax benefits of an employee stock option plan (ESOP) with the payment of retiree health benefits.

Hickey says that, before they change from one plan to another, employers should review benefits carefully and consider the funding implications. Employees should be encouraged to save for any event, he says. To get maximum company matching funds, employers should also advise employees to use tax-advantaged vehicles, such as 401(k) and similar plans.

Hickey says: "Tax laws change and retirees should have dollars to use for anything they need, and that includes medical costs." The VEBA trust still offers funding benefits, but the Deficit Reduction Act of 1984 (DEFRA) limits its tax advantages except for collective-bargained agreements.

Employers say DEFRa has had a major impact on how they use VEBAs. Dwight Peterson, vice president and treasurer of 3M, a diversified multinational manufacturer in St. Paul, Minn., says using a VEBA has allowed the company to meet about 50% of its obligation. "We've kept a VEBA in place hoping there will be changes in the rules," he says.

With about 90,000 employees worldwide, and only 995 retirees in the United States, Peterson says 3M's after-tax charge to equity for the retiree obligation is about $250 million. "We've identified the obligation, have over $6 billion in equity, and there is no reason to rush into adopting FAS No. 106." The employer plans to make a final decision about prefunding later this year.

Robert W. Martin, vice president of finance and chief financial officer at Fairfield Manufacturing Co., in Layfayette, Ind., says the company, which manufacturers custom gears and axles, has no plans to change its health plan or funding as a result ofFAS No. 106. The company, which employs about 1,000 people and has 230 retirees, has used a VEBA for years and funds it regularly.

Fairfield has a qualified savings plan that both employer and employees contribute to. Martin says it is tax-effective for both parties and operates almost like an Individual Retirement Account. "Employees can accumulate money for all of their retirement needs, but one of the problems is explaining the savings benefit to them," Martin says.

For many companies, the 401(h) account remains a viable tax-effective funding vehicle, but it has some restrictions. Employer's medical and life insurance contributions, for example, cannot exceed 25% of the total medical, life, and pension contributions after a 401(h) plan is adopted. This limit restricts the account benefits for employers with fully funded pension plans.

Let's say an average sized employer's retiree health obligations as of Jan. 1, 1993, when FAS No. 106 becomes effective for large employers, is $63.4 million. Thus, $63.4 million is called the accumulated benefits obligation (ABO) and represents the benefits earned as of Jan. 1, 1993.

An employer can take a one-time charge, which in this example increases the liability and decreases net worth by $63.4 million. A company could take the charge if it has a one-time gain from asset sales or from other sources to offset the adverse balance-sheet impact.

Alternatively, the company might have a strong balance sheet. Peter B. Blanton and Lawrence N. Bader, vice presidents of Salomon Brothers Inc., investment bankers in New York, say well-capitalized companies may elect a lump-sum adjustment. In their report The Financial Executive's Guide to Retiree Medical Benefits, they say the lump-sum adjustment eliminates the uncertainty surrounding the retiree health benefit issue.

Such an adjustment also demonstrates aggressive and positive action, reduces future expense, and cuts the health cost impact on regular earnings. It eases, and in some cases eliminates, adverse changes in financial structure.

Nonetheless, few companies without an appreciable offsetting gain will want a substantial one-time hit. This could also be the case for utilities and other employers subject to rate-of-return regulation and cost recovery. The total ABO liability can exceed all other balance-sheet liabilities or even erase net worth.

Employers that do not take the one-time charge will, on average, amortize the ABO over 20 years. They must, however, accrue interest each year on the outstanding balance.

Amortizing the ABO could have dramatic results. Unless an employer prefunds the expense, the accrued balance-sheet liability will increase as future expense is charged to future income. This would lead to still higher interest expense in 1994, effectively starting an escalation of expenses and liability costs. Given all this, should employers take the balance-sheet hit up-front or spread it out in an effort to control it?

Blanton says there is no universal solution. "Companies with weak financial structures and marginal credits might face higher borrowing spreads and a decrease in negotiating postures," if they take the one-time charge, Blanton says. Such employers might be better off if they opt to phase in the liability to buy time to review the issue. Employers should still report the total obligation in footnotes to statements.

Companies with strong balance sheets might do better to recognize the expense immediately. General Electric Co., in Fairfield, Conn., for example, last fall took a $1.8 billion charge against its first-quarter 1991 earnings to cover its change in accounting for future retirees. (See "Using Medicare to ease the FAS No. 106 burden," February.)

To amend its plan and funding, a company can, for example, eliminate its medical plan and increase its pension or add a savings plan, such as a 401(k) or an ESOP. These plans can be funded with deductible contributions and accrue earnings free of tax.

If the employee contributes to a medical plan, the company can match the contributions by increasing another benefit. In such a case, however, employees receive taxable benefits.

Many employers have changed to a defined contribution or benefit plan to reduce their obligations under FAS No. 106. They can also make funding adjustments to compensate the employees for the taxability of benefits.

Carolina Power and Light Co., Raleigh , N.C., says it is positioned to move quickly next year when it adopts FAS No. 106. The utility employs 8,100 people, and has about 1,100 retirees. J. Henry Oehmann, manager of employee benefits, says the company has always funded with a VEBA and a 401(h) account.

The current use of the accounts amounts to an "arbitrage" use of inside cash to pay down expense, he says. "We drop the money in to take the tax advantages, but we are not in a substantial funding mode now, and we're waiting to see what happens."

Oehmann says the 401(h) account is limited, but he admits "there is a benefit to having the option and if new options open up, the 401(h) will be grandfathered."

Funding methods need careful evaluation. It is not just a question of taxes. Blanton of Salomon says the choices can affect a company's flexibility and debt capacity. Segregated funds, for example, usually held in trust and restricted to payment of retiree benefits, can offset the FAS No. 106 liability.

In deciding whether to prefund or not, employers should consider what retirees want, and balance that against what the business can actually afford to provide. With the economy still uncertain many employers are hoping the retiree health plan puzzle will simply fade away. Before prefunding, employers should consider their cash needs, liquidity, credit, debt capacity, restrictions in loan agreements, and future tax and interest rates. Blanton and Bader raise the wealth transfer question also: "Should cash be legally separated for the benefit of employees at the expense of unsecured bondholders and stockholders?"

Changing an obligation from an unsecured to a secured debt by prefunding also raises its value to employees by lowering the discount rate. Employers can evaluate the effect by using different discount rates.

The following present-value analysis of funding methods uses a 12% discount rate, which, for illustration, represents the cost of long-term, secured debt for a company with less than a prime credit rating. The future obligation is $17,000.

* ay-as-you-go: The $17,000 liability in 32 years (age 62) will be tax deductible to the company and cost $11,220 after taxes, assuming a tax rate of 34%. The employer can separate an amount now to grow after tax to $11,220.

* VEBA: The present value of a nonbargained plan funded in a VEBA is the same as the pay-as-you-go method. There is a difference in the timing of the tax deduction. A bargained plan funded in a VEBA has the same present value as a 401(h) plan.

* 401(h): The company makes a tax-deductible contribution that grows to $17,000 in 32 years. Earnings accumulate free of tax and benefits and are not taxable to the retiree.

* Other plans: Retirees pay tax on benefits at an assumed 31% rate. Grossing the $17,000 by 0.69 produces a need for $2,463 in 32 years.

This analysis shows a clear advantage for collectively bargained VEBAs and 401(h) funding because of the tax treatment. Other plan funding costs more because of grossing. Without grossing, the value equals the bargained VEBA and the 401(h). Pay-as-you-go funding has the highest cost.

Shorter discounting times change relative and absolute values dramatically. Discounting the obligation for 10 years, for example, increases the pay-as-you-go present cost to $5,236. The 401(h) plan has a present cost of $3,613, and other plans, a present cost of $5,211.

Richard B. Stockton specializes in writing about finance. He lives in New York City.

COPYRIGHT 1992 A Thomson Healthcare Company
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