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Prescription Change

The new Medicare drug benefit feels good, but it doesn't really solve underlying issues.
David M. Katz, CFO Magazine
June 1, 2004

In 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.


Rather than reporting their actual retiree-benefits payouts on the income statement, however, the companies record them as cash flow. And since both the balance sheet and the income statement reflect smoothing mechanisms drawn out over many years, they don't portray the true economics of the plan, says David Zion, an accounting analyst at Credit Suisse First Boston (CSFB).

Smoothing mechanisms also provide fertile ground for earnings management. There's "a huge potential" for manipulating net income in accounting for retiree health-care benefits overall, says Standard & Poor's analyst Scott Sprinzen. Estimating future Medicare subsidies is just another part of that potential, he asserts.

Swing Time
Under the FASB standard, one major assumption employers use is a discount rate applied to future benefits payouts. In the bigger plans, a swing of a point or two in an assumed discount rate can have a massive impact. For 2003, GM dropped its discount rate 50 basis points to 6.25 percent, adding $3.8 billion to its benefit obligation.

Usually pegged to the interest rates of high-quality bonds, discount rates don't often vary much. More elastic is the "health-care-cost-trend rate" assumption, in FASB's parlance. "Disclosures surrounding this assumption produce the greatest amount of inconsistency across companies in the S&P 500," according to a CSFB report on OPEBs. There's a good reason for the wide discrepancies: predicting national and corporate medical costs, including drug outlays, can be extremely subjective. And there is no law requiring a company to use one cost measure over another. If pension accounting, for which the requirements are much more concrete, is considered an inexact science, accounting for retiree health benefits is that much more speculative.

Even among health-insurance pros, such soothsaying can be dicey. "Estimating future costs in the retiree sector is fraught with danger," says Gregory Scott, CFO of PacifiCare Health Systems Inc. in Cypress, California. Hard-to-predict events like a sudden advance in medical biotechnology could expand benefits obligations by increasing retirees' life spans, he adds.

Then there's the economic volatility of the health-insurance industry to consider. Following the erratic fortunes of managed care in curbing costs during the past 15 years, medical inflation has risen, flattened, and soared again. According to a Towers Perrin survey, average medical expenses have increased by double-digit percentages for the past 4 years, topping out at 16 percent in 2003. Survey respondents expected costs to grow 12 percent this year. Of these costs, pharmacy expenses are growing the fastest — an average of 18 percent in the past decade.

At the micro level, however, actuarial forecasters — and the finance executives who must sign off on their work — envision milder hikes over the long term. Health-care costs simply can't rise by 10 percent a year indefinitely, "or the U.S. will produce nothing but doctors and hospitals," argues John Ehrhardt, a Milliman principal. By 2009, GM expects to be absorbing only a 5 percent yearly boost. "It's not like we haven't been there before," says Walter Borst, GM's treasurer. "In the mid-1990s, health-care inflation was below 5 percent."

But Where's the Funding?
Even though accrual accounting helps employers assume more-graceful curves in their future OPEB burdens, the system arguably masks the potential for serious benefits shortfalls in a given year. Indeed, spikes in retiree medical claims are absorbed directly by the many companies that self-insure the benefits, says Zion. Investors don't often realize that when they buy shares of such a company, "there's a health-insurance company baked in there," he notes.

What's more, the huge underfunding of OPEB plans provides corporations with scant buffering against annual spikes in medical claims. Of the 328 companies in the S&P 500 with retiree health plans in 2002, 314 were underfunded, according to the CSFB report. In fact, OPEB underfunding beat pension underfunding by a score of $309 billion to $220 billion.

Why have companies funded so little of their retiree health benefits? The main reasons seem to be that executives consider these benefits a relatively "soft" obligation and believe that their companies can make much better use of cash elsewhere.

To be sure, S&P treats OPEB promises as "debt-like" in its ratings. Nevertheless, retiree-benefits claimants inevitably take a back seat to creditors and pension beneficiaries in bankruptcy negotiations, analysts at CreditSights, a rating agency, contend. In a report last year, the firm argued that OPEB shouldn't be characterized as debt-like, but should instead be considered "a major cost problem that is impairing profitability for those companies with generous health-care benefits and a heavy base of retirees."

Under the Employee Retirement Income Security Act, companies must fund their pensions. No such proviso dictates funding of OPEBs. Thus, while Delphi can handle its retiree health benefits on a pay-as-you-go basis, it must pay down half of its $4 billion pension-funding shortfall from 2004 through 2006, says Delphi CFO and vice chairman Alan Dawes.

Since the claims on pension assets tend to be less sporadic than medical claims (which occur only when retirees visit health-care providers or hospitals, or use drugs), pension assets can be invested in less-liquid, higher-earning vehicles. "We've generally preferred to fund pensions and reinvest in the business," notes Dawes.


Another difference between defined-benefit pensions and retiree health plans is that employers can reserve the right to cut medical benefits. "Management can change these plans, which is not true on the pension side," says Ed Rasmussen, controller of Consolidated Edison, a New York utility.

Roughly half of the companies with retiree medical plans have caps on health spending, according to Rich Ostuw, a Towers Perrin principal in Stamford, Connecticut. What's more, in April the U.S. Equal Employment Opportunity Commission approved a rule that would permit employers to cut or drop health benefits when retirees reach Medicare eligibility at age 65.

That long-standing practice was called into question in 2000, when a federal court held that, under the Age Discrimination in Employment Act, employers must provide equal benefits to retirees above and below the Medicare cutoff point.

To be fair, companies are under no legal obligation to provide retiree health benefits. And many executives argue that further changes to accounting or disclosure rules will only create new incentives to shift more of the burden to retirees, or abandon retiree health-care coverage altogether. And while employers welcome the Medicare prescription-drug subsidies, some claim they need a lot more help in slimming down their share of overall health-care costs.

Delphi, for instance, argues that its OPEB burden makes it tough for it to vie with rivals like Robert Bosch in Germany and Denso in Japan because the governments of those countries pay for benefits. "We cannot price for this," says Dawes. "If health care increases by 8 percent a year, that puts pressure on us to stay competitive."

Indeed, some employers might not get the bang out of the subsidies that others will. Dawes says that the $500 million cut in its future OPEB burden is largely "theoretical" because the bulk of the payouts is slated for decades hence. According to Delphi, the subsidies will cut its payments by just $50 million during the next 10 years.

The reason the gain is so small, according to the finance chief, is largely demographic: when GM spun Delphi off in 1998, the automaker kept most of Delphi's retirees. That left the new company with a relatively youthful population — the average employee won't retire for another 12 years.

Meanwhile, investors could start to chafe at employers' handling of their retiree health benefits. CSFB estimated that at the end of last year, the plans of 25 companies were underfunded by more than 25 percent of their market caps. At those companies, plan claims may account for more than one-quarter of the shareholder stake.

In such a climate, investors might look closely at how companies use the Medicare drug subsidies, suggests Mulford. Employers embroiled in tight union negotiations might decide to use the new money to put benefits givebacks on the table. "It's a risk for investors to assume that all of the gain will accrue to shareholders," says the professor. "Employees might see this as a windfall accruing to the company and say, 'We want it.' "

Then there is the chance that the Medicare Reform Act could be repealed or changed. Democratic Presidential candidate John Kerry has already stated that he will push for changes to Medicare reform if he is elected.

That could be a good thing for companies with large retiree-benefits obligations. Any prescription-drug benefit the Democrats decide to offer seniors — and by extension, plan sponsors — is likely to be larger than the current one, and could include importing cheaper drugs from Canada. That prospect alone could be a boon to companies that provide retiree benefits. Unless, of course, those companies are in the pharmaceutical or health-insurance industries.

David M. Katz is deputy editor of CFO.com.

Getting In On the Act
What the Medicare Reform Act Offers to Seniors

Companies are eligible for subsidies if they provide retirees with prescription plans that are actuarially equivalent to the benefit that will be provided to seniors under the new Medicare Prescription Drug Improvement and Modernization Act of 2003. Under Part D of the act, seniors will pay an average $35 monthly premium for coverage. After a $250 deductible, they'll foot 25 percent of the cost up to $2,250.

Once a participant's out-of-pocket drug expenses hit $3,600, Medicare will pick up the bulk of the tab, minus various copayments and coinsurance. (Participants will still be required to pay either a 5 percent coinsurance or a $2-to-$5 per prescription copay, whichever is higher.)

The plan indexes participants' deductibles and payouts to annual percentage increases in average per-capita spending on Medicare-covered pharmaceuticals. Drugs that will be covered include prescription pharmaceuticals, biological products, insulin, vaccines, and smoking-cessation aides.

Plan sponsors will be required to provide an annual attestation that the actuarial value of their plans is equal to or greater than the Medicare plan. The subsidy will not cover any administrative costs to the plan. The Health and Human Services Department, which administers Medicare, has yet to decide exactly how companies will report claims and receive the subsidies, but more details are expected this summer. —D.M.K.






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