VideoIn 2006, when the new prescription-drug benefits kick in, Americans over 65 should finally get a break on pharmaceutical costs, thanks to the Medicare Reform Act signed into law in December. But employers that supply pharmacy coverage to retirees could make out even better.
That's because the framers of the new law included provisions to motivate companies to keep providing these benefits.
For instance, the government will subsidize 28 percent of the total prescription-drug cost (up to $5,000 per retiree) for qualifying companies. Employers won't have to pay federal taxes on the subsidies, so they could be worth even more, notes Mark Beilke, director of benefits research at Seattle-based consulting firm Milliman.
Moreover, companies don't have to wait until 2006 to benefit from the new law. The prospect of future subsidies has had an immediate accounting effect for some companies, reducing their estimates of future benefit liabilities. Firms reporting a reduction of estimated future liabilities include General Motors, which gauged it could sever $4.1 billion of its burden, cutting its obligation by 6 percent to $63.4 billion. Auto-parts maker Delphi Corp., in Troy, Michigan, expects to shave $500 million from its $8.5 billion OPEB (other postretirement employee benefits) obligation this year.
Further, under the new law, companies can take credit for both their own and their employees' OPEB payments. For instance, an employer that splits a $2,000 benefits premium with a retiree would get 28 percent of the full $2,000 (minus a $250 deductible), according to a report by Egan-Jones Ratings Co. That amounts to $490 per employee, rather than the $210 the employer would receive based on its payments alone. An employer with 100,000 covered retirees could hypothetically receive a subsidy of $49 million a year.
Long-range estimates of drug subsidies also provide firms with an opportunity to engage in a bit of earnings management. That's because the forecasts add gray areas to the task of figuring out a company's future overall retiree health-care liabilities. Predicting the eventual size of the subsidies, after all, involves forecasting such big unknowns as the future of retiree prescription-drug use, the prospects for pharmaceutical innovation, and the future cost of the drugs.
(In March, the Financial Accounting Standards Board proposed that companies begin recording the estimated effect of subsidies on retiree health costs for periods beginning after June 15 as a reduction of future postretirement-benefit liabilities. With FASB's blessing, many companies had deferred accounting for the effect of the subsidies in their 2003 annual reports.)
By providing companies with the chance to lowball their liability estimates — and, ultimately, cut reported expenses — the subsidies offer new leeway in using OPEB numbers to hit earnings targets, says Georgia Tech accounting professor Charles Mulford. "The big opportunity [for earnings management in retiree health care] would seem to be in the Medicare drug benefit and how you handle actuarial gains for it," he says.
Therein lies the rub. Clearly the subsidies will provide companies with a welcome incentive to assist seniors with their prescription-drug bills. But the Medicare reform legislation not only muddies the already murky waters of retiree-benefits accounting even further, it also fails to address the looming problem of underfunded retiree health plans.
Accumulated Cloudiness
The clarity of retiree-benefits reporting has been questioned ever since FASB directed companies to switch from cash to accrual accounting.
In 1993, when SFAS 106, the standard governing nonpension retiree benefits, went into effect, some companies took one-time earnings charges to reflect benefit obligations up to that point. Critics asserted that after recognizing those earnings hits — nonrecurring charges likely to be downplayed by investors anyway — some employers seized the chance to slash benefits and gradually take the resulting liability cuts back into net income. In 2003, for example, IBM increased premium costs to retirees by 29 percent, garnering a large earnings gain in the process.
FASB knew it was taking a calculated risk in issuing SFAS 106. On one hand, the previous system left shareholders in a no-man's-land when it came to calculating the cash-draw on companies when benefit payments came due. Failing to recognize that obligation marred "the usefulness and integrity of the employer's financial statements," reasoned FASB. Better, then, for a company to take its best crack at estimating the future worth of the promise.
Estimating the obligation, however, has meant recording future liabilities in such present-value terms as the accumulated postretirement benefit obligation. (Found in 10-K footnotes, the APBO is calculated by discounting the future value of retiree benefits earned to date by current employees.) Without such smoothing techniques, employers might have to absorb outsized benefit payments into earnings in certain years, says Mulford, creating situations that could "render the income statement meaningless."
But smoothing has spawned a less-than-transparent system. In broad terms, it works like this: As employees earn benefits for their years of service, companies accrue a noncash expense on their income statements.
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