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Retiree health coverage is a sweetener fewer companies are willing to offer.
Alix Stuart, CFO Magazine
February 22, 2005
John Devine is well known on Wall Street for his candor, and during last October's earnings conference call, the CFO of General Motors Corp. didn't disappoint. Yes, he acknowledged, retail incentives and rising operating costs continued to erode GM's bottom line. "But frankly," Devine added, "the larger drag we're getting on our profitability in North America comes from health-care costs and overall legacy costs."
Although GM stopped promising retiree medical benefits to new workers in the early 1990s, the automaker still carries an enormous liability. In 1997, soon after the Financial Accounting Standards Board required companies to put their promises for retiree medical care on the books, GM set up a dedicated trust to cover its obligation. The trust balance now stands at $16.5 billion, with $5 billion added in 2004 alone. But the annual cash outlay for the benefits has outstripped contributions to the trust almost every year, rising from $2.3 billion in 1998 to $3.6 billion in 2003.
GM is hardly the only company facing crippling retiree health obligations. About 60 percent of large U.S. employers still offer retiree medical benefits, a number that is likely to go down as more companies look to get out from under their onerous retiree health-plan obligations. Certainly few companies have enough assets to offset the liabilities, because they are not legally required to do so. The S&P 500's OPEB (other postretirement employee benefits) obligations were only 12 percent funded in 2003, according to Credit Suisse First Boston analyst David Zion, leaving companies with unfunded liabilities of $339 billion at the end of that year.
Thanks to the Securities and Exchange Commission, the problem is going to get even worse. The agency is now reviewing the assumptions GM and Ford Motor Co. used in calculating future health-care liabilities. The scrutiny is spurring many companies to look harder at their own assumptions, which generally "have simply not kept pace with reality," says Mark Oline, managing director of Fitch Ratings. Most businesses have used projections that health-care costs would increase between 8 percent and 11 percent in 2004, declining gradually to about 5 percent over a five-year period, according to Oline's research. In fact, health-care costs have been increasing more than 10 percent per year for the past four years, and are likely to continue at that rate for 2005.
To reduce costs, an increasing number of corporations—8 percent in 2004—are following GM's example and simply eliminating retiree health benefits for new hires or current employees. As for current retirees, companies are delicately chipping away at those benefits as well. Some 79 percent in 2004 raised the portion of the premium they expect retirees to pay. Thirteen percent went so far as to shift the full cost of premiums onto retirees. Meanwhile, over half simply capped what they will spend per retiree.
For employers with the means to prefund their obligations, recent developments provide some hope. In general, the trusts that GM and others use—so-called voluntary employee benefit associations, or VEBAs—have offered few advantages. For nonunion employees, annual tax-free employer contributions are capped at the level of annual expenses, making it hard to get ahead. Plus, asset gains are taxable, and the cash is irrevocably locked into the account, even if the liabilities turn out to be lower than initially thought.
A 2003 tax court ruling may make VEBAs more viable, however. The ruling, in response to a dispute brought by Wells Fargo & Co., eases the annual restriction on companies setting up new trusts, allowing employers to contribute large lump-sum amounts for current retirees and take the full tax deduction.
Life insurance policies could also make the trusts more attractive, says Peter Neuwirth of Clark Consulting. Under this arrangement, a VEBA uses a portion of its assets to pay for life insurance policies on its retirees, then collects the proceeds of the policy tax-free when a retiree dies. Trust-owned life insurance policies "work well because they mature at death and the preponderance of health-care costs are incurred in the year that the individual dies," says Neuwirth. One company exploring this option is Whirlpool Corp., which is currently petitioning the Department of Labor to allow it to reinsure the policies through a captive insurance company in hopes of getting further tax benefits.
Still, such tax advantages for advance funding will not stem the current cash drain that many companies face. A brighter prospect for many companies is the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The act, which offers qualifying employers a 28 percent subsidy for the cost of any drugs they help Medicare-eligible employees pay for, could slice up to 15 percent off total retiree medical costs, says Frank McArdle, head of the Washington, D.C., office of Hewitt Associates.
The promise of subsidies has enabled some businesses to take the costs out of future liabilities with FASB's blessing, adding much-needed dollars back to net income. GM, for one, subtracted $4 billion from its OPEB obligation as a result. Savings are not insignificant, either: Lucent Technologies expects to save $65 million in cash annually starting in 2007.
Exactly how the subsidy will work—and how companies will maximize the benefits to employees—is still uncertain. Experts warn that providing coverage that wraps around the Medicare plan can be tricky, thanks to the "doughnut hole" that is built into the benefit. Medicare does not cover a retiree's out-of-pocket drug expenses if they fall between $2,250 and $5,100; above that point, catastrophic coverage kicks in. Employer dollars would not count against employee out-of-pocket expenses.
Meanwhile, about 8 percent of companies have simply dropped their prescription-drug coverage since the Medicare reform act was passed.
Shape of The Future
Increasingly, companies are trying to find ways to encourage employees to save their own money for medical costs in retirement. The new health savings accounts (HSA) established by the 2003 Medicare Drug Act are one option. They allow employees to save up to $2,650 pretax per year for medical care. The employee-owned accounts are portable and allow funds to accumulate tax free.
HSAs, though, can't do much for those in or near retirement. Cara Jareb, director of retiree medical consulting at Watson Wyatt Worldwide, says she is seeing "a newfound interest" in health reimbursement arrangements for retirees, which allow employers to credit a discrete amount of money toward retiree medical benefits to individual employees over any length of time.
The accounts cannot be tapped before retirement and typically do not vest until then, meaning they do not require continuous funding. The approach may not reduce liabilities, but it does limit cash outflow in a more appealing way than a cap on benefits. "It gives employees a lot more flexibility," says Jareb, "and it sends a more positive message to tell retirees how much money they have, rather than how much they have to kick in."
Considering the current lack of choices for maintaining retiree medical benefits, the real message may be that employers are doing their level best to live up to promises made to workers.
Alix Nyberg is a contributing editor of CFO.