How Companies Fund Retiree Medical Benefits
This is a dilemma with which an increasing number of companies are struggling. They no longer can bear the full expense of medical coverage for current and future retirees. According to Retiree Health Benefits: An Era of Uncertainty, a study released in March 1993 by New York City-based KPMG Peat Marwick, the percentage of midsize firms (having 200 to 999 employees) that offer retiree benefits dropped from 44% in 1991 to 37% in 1992. The percentage of large firms (having 1,000 to 4,000 employees) that offer retiree benefits dropped from 56% to 52% between 1991 and 1992. The declines started in the mid-1980s. Before that time, more than 60% of firms having 500 to 999 workers provided retiree benefits.
Certainly, with retiree populations increasing and health-care costs continuously rising, the expense of covering employees' medical costs after they retire is hard to justify, especially within companies that have struggled through these recessionary times. An August 31, 1993, report by the Employee Benefit Research Institute, located in Washington, D.C., indicates that the elderly population currently numbers 32 million, or 13% of the total population. This number will continue to grow as baby boomers age and as the average life span continues to increase. (An August 1993 issue of Employee Benefit Plan Review indicates that a 65-year-old white male will live an average of 14.9 years, as opposed to 13 years in 1969.)
This growth affects postretirement health-care systems significantly, especially considering that the elderly use more health-care services than other groups in the population. According to the Employee Benefit Research Institute, the elderly, although only totaling 13% of the population, account for one-third of all health-care expenditures. Not only do they use more medical services, but their services tend to be more costly as well.
Early retirees who are younger than age 65 are particularly problematic for employers trying to control costs. This group constitutes about one-third of the retiree health enrollment, or 3 million people, estimates the KPMG Peat Marwick study. Not yet eligible for Medicare, these individuals nonetheless have a high medical-benefit utilization rate, making this group more expensive for employers to cover than the 65-and-older group who are covered by Medicare. In addition, the pre-65 population is more likely to have dependents other than spouses, such as children in college, and to want coverage for those people. The study reports that an employer pays approximately 70% more for a 64-year-old retiree than a 65-year-old retiree.
For retirees who are 65 or older, Medicare pays 70% of physician and hospitalization costs. Employer-sponsored supplemental plans must pay only an estimated 30% of total charges for these retirees. However, Medicare doesn't control the cost of prescription drugs, which represents the greatest health-care cost to employers for this retiree group.
The KPMG Peat Marwick study reported that retiree health-care coverage has been increasing at an average annual rate of 17%. In 1992, for example, the average total monthly cost for retiree medical coverage for a single person over age 65 was $124, compared to $40 in 1985. Multiplying this cost by the retiree population equals a substantial liability for the companies that offer retiree health-care benefits.
This became evident this past year as a result of a ruling that went into effect December 15, 1992, by the Financial Accounting Standards Board (FASB), a nonprofit organization that sets accounting standards in the U.S. The Statement of Financial Accounting rule number 106 requires that companies record unfunded postretirement benefits (except pension plans) on their financial statements, rather than reporting expenses as they're paid, which was the case in the past. In addition, it requires that employers recognize the unfunded obligations already accumulated for current actives and retirees. This transition obligation can be amoritized over a 20-year period or can be recorded all at once.
To comply with the FASB rule, Detroit-based General Motors Co. chose to take a one-time charge against its 1992 earnings. The automaker, which currently has nearly 400,000 retirees and almost 350,000 active employees, calculated its liability to be nearly $21 million—the bulk of which pertains to medical coverage. Detroit-based Ford Motor Co. and New York City-based AT&T both also posted one-time liabilities of $7 million.
Although such charges don't affect a company's cash flow, they do certainly skew their debt-vs.-equity ratios. They also serve as a wake-up call. G. Richard Wagoner Jr., executive vice president and chief financial officer of GM, remarked at the time of the charge that it was "significant in highlighting the seriousness of GM's retiree-health-care-cost problem."
Since that time, GM has begun to pass off some of the financial burden to its retirees. The company announced in September that, beginning January 1994, salaried retirees would be responsible for making monthly contributions toward their medical benefits. (One year earlier, GM had made a similar announcement to its active salaried work force.) The retirees' monthly payments will range from $20 to $107, depending on coverage. For example, a single, Medicare-eligible retiree who enrolls in an HMO plan will pay a maximum premium of $20 a month. An employee who isn't yet Medicare eligible and has dependents will pay up to $107 a month for the HMO program. Payments for GM's regular insurance package are less, but this program requires higher out-of-pocket expenses.
GM hopes to initiate cost-sharing of retiree health coverage with its hourly employees as well. It's a topic that will be addressed during contract negotiations with the United Auto Workers this fall. "Given the urgency of the situation, we continue to aggressively pursue steps to further reduce the escalation of GM's health-care costs," says Wagoner.
Employers pass costs to retirees.
Sharing the costs of benefits with retirees, as GM has done, is a popular alternative to eliminating the benefits, as many companies have chosen. According to a 1993 analysis by New York City-based William M. Mercer Inc., fully half of the U.S. companies that recently revised their health-care plans increased retiree contributions. "What we're seeing is that the retiree simply is paying a greater per-month premium than he or she paid in previous years," says George Wagoner, a principal in the Richmond, Virginia, office of William M. Mercer.
The KPMG publication found similar results. According to the study, the percentage of the premium paid by retirees for single coverage jumped from 15% in 1988 to 31% in 1992. For family coverage, the figure increased from 23% to 41%. Only 20% of retirees who have single coverage, and 10% of retirees who have family coverage, receive their retiree health benefits free, compared with 40% of retirees who received their coverage free in 1988.
To keep up with rising costs, Pittsburgh-based Westinghouse Electric Corp. has amended its benefits plans for both active employees and retirees several times within the last six years, each time resulting in the employees paying a larger share of the cost through increased copayments and deductibles. The company offers several plans for the employees and retirees who are younger than 65 and not yet eligible for Medicare. (The retirees who are younger than 65 simply can continue the coverage that they had while on the job.) These employees and retirees can enroll in either an indemnity plan or an HMO.
One of the changes that the company has made to receive greater contributions from the employees and retirees is to charge them based on their salaries. "At one time, everybody paid the same amount," says Len Weaver, assistant director for retiree planning at Westinghouse. "Now, if you make more money, you contribute more to the plan."
Westinghouse charges interested retirees who are Medicare eligible $4.25 a month per person for a supplemental hospitalization plan. The retirees also have an option of purchasing a Blue Cross Medicare-supplement plan through the company.
Another method that companies are using to decrease their costs and increase retiree contributions is to tighten eligibility requirements and base contributions on age and years of service. According to the William M. Mercer survey, slightly more than one-third of the benefits plans that have been revised in the past year have tightened eligibility standards.
Boston-based John Hancock Mutual Life Insurance Co. took this route. Before 1992, a 65-or-older retiree only had to have five years of service with the company and be eligible for a pension to also be eligible for the company's retiree medical benefits. The company covered 100% of the medical coverage for the retiree over age 65. "We felt that we could no longer afford to pay for someone's retirement coverage for 25 to 30 years when that person had been with the company for only five or six years," says Barbara Whitcher, director of benefits.
The company decided to tighten the eligibility for future retirees and to have them share in the cost. "We wanted to base our contributions on the retirees' contributions to the company," says Whitcher. "We decided to go by years of service."
Now, a retiree must have been with John Hancock for at least 15 years to be eligible for coverage, and also must pay a portion of coverage costs. A John Hancock retiree who's 65 years or older and has 15 years of service pays 55% of the cost for his or her medical coverage, and 60% for dependent coverage. That amount decreases by 3% for each additional year of service, up to 30 years. A retiree who has 30 years of service pays 10% of his or her coverage, and 15% of dependent costs. Retirees who are younger than 65 contribute the same amount as active employees, which currently is 15% for an individual and 20% for dependent coverage.
Other companies are forcing retirees to pay a larger portion of their medical benefits by changing their plan design from a defined-benefit plan to a defined-dollar plan, or by placing caps on the amount of money that they will spend for benefits. "Companies are moving from benefits promises to dollar promises," says Werner Gliebe, vice president and group benefits consultant for New York City-based The Segal Co. "In the past, companies promised a particular set of benefits to retirees. Now, instead of the plan driving the cost, the employer is saying, 'I will give you X dollars toward whatever plan is in place.' "
This type of system helps employers better control their expenses, says Gliebe. If a company promises a particular benefit, its costs are dictated by that benefit. If the benefit's rates increase substantially each year, so too does the cost for the employer. If the employer only promises to pay a certain amount of money toward that benefit, however, it can decide by how much it will increase its costs each year, or if it will increase them at all.
One way of switching to a defined-dollar plan is to place caps on company contributions. The William M. Mercer survey reports that more than a quarter of companies that have made changes in their plans have done this. Richmond, Virginia-based Media General has capped its contribution for future retiree medical benefits at $4,500 per year, per employee. Rochester Gas & Electric in New York currently has a $150 monthly cap in place for its retiree benefits. AT&T pays fixed-dollar amounts that vary by formula for employees, based on age and service.
Active employees contribute for future needs.
Rather than asking employees for contributions toward their health coverage after they've retired, some companies are beginning to ask them to help foot the bill while they're still active. "Companies are beginning to look at [retiree medical benefits] the same way that they look at pensions," says Fred Morris, senior vice president in the Post-retirement Health Care Services Group at State Street Bank and Trust Co. in Boston. "Just like a pension liability, companies can put money into a trust fund so that when somebody retires, there's money put aside to pay for that."
Setting up a prefunding account for benefits allows employees to contribute to the cost of the post-retirement medical benefits when they have the money to do so—while they're still working. Employees can contribute via a Voluntary Employee Beneficiary Association (VEBA). A VEBA is similar to a 401(k) plan in principal. An employer sponsors the trust, in which workers may make regular contributions that the employer may match wholly or in part. In contrast to a 401(k), however, in which employees' contributions are made before paying taxes on the money and taxed when withdrawn, employee contributions go into the 501(c)(9) VEBA trust after taxes are paid on the money. The trust earnings and payout for health premiums then are tax-free.
One company that has adopted this prefunding method for its retiree medical benefits is Fort Worth, Texas-based American Airlines. Back in 1990, American informed its employees that they would be eligible for retiree medical benefits only if they contributed to them for at least 10 years prior to retiring. To be eligible to contribute, employees must be at least 30 years old, have one year of service with the company, be on U.S. payroll and be a regular full- or part-time employee.
For employees who joined the trust plan at the onset, the required contribution was a flat rate of $10 a month, payroll-deducted on an after-tax basis. The company determined this rate as an appropriate amount for employees to help share in the costs. The rate can change, based on medical-cost inflation. New hires and employees who signed up after the initiation date pay substantially higher rates based on age. The company matches the contributions dollar for dollar.
At retirement, the company draws from the fund of the employee's contributions and the company's matching contributions in 10 equal installments to pay for that employee's coverage in the Retiree Group Medical Plan. When the employee's share of money in the fund has been spent, the company pays for the remainder of the employee's retiree medical coverage. "We established the trust for employees to prefund their retiree benefits, in response to a nationwide problem of increasing medical costs, and the FASB 106 rule," says Linda Carlson, specialist in benefits compliance for American. "Their contributions help to ensure that the company will be able to provide a high-quality medical plan to our retirees and their families, despite the significant increases in medical costs."
According to Jim Murphy, managing director of compensation and benefits, the company makes no promises as to the future level of medical benefits. "[Our promise is that] to the extent that the company provides health care to retirees, they will be covered based on their prefunding," says Murphy. "What we've done is somewhat innovative. To contrast it with other companies, most companies have done one of two things: either asked their employees to contribute to health coverage in large amounts during retirement years, at a point in their life when they don't have a lot of free cash, or eliminated coverage." Once American Airlines' employees retire, on the other hand, they no longer have to contribute to receive coverage, provided they prefunded their benefits while still active.
State Street's Morris agrees that Americans' method is a creative approach to managing its liability. It enables the company to reduce its share of the retiree medical costs and allows employees to contribute their share while they still have the money. "[The contribution] is a small dollar amount currently, but it ends up over a long period of time meeting an obligation for the future," says Morris.
American currently has a favorable employee-to-retiree ratio because of recent growth. However, it anticipates large liabilities as this ratio shifts.
International Paper Co. has developed a similar system for employees to save for their postretirement benefits. The Purchase, New York-based company offers a variety of retiree medical benefits for both salaried and union employees who were hired before 1987. Retirees younger than 65 have the same options as actives, while those aged 65 and older have the choice of enrolling in a Medicare supplement plan. The company has placed caps on the amount that it will pay for these benefits, however, based on age and service. So to help employees save money for their postretirement medical coverage while they're active, International Paper has set up a VEBA account.
Salaried employees age 50 and older may contribute up to $20 a month into the fund, payroll-deducted after taxes. The company matches the employees' contributions, but on paper only. "[The company contribution] is just a book match, it isn't funded," says Pat Freda, manager of trust operations. This book amount is credited with the same rate of return as the employee piece.
When a contributing employee retires, the funds that have built up in both accounts are used prorata to pay for his or her share of coverage. When the money from both accounts is gone, it becomes the employee's responsibility to pay for his or her premiums.
Although the company won't pay for medical benefits for employees who were hired after 1987, it may make the saving option available to them. Final decisions on the subject haven't been made yet.
There currently exists several vehicles for prefunding retiree benefits as American Airlines and International Paper Co. do. Each provides opportunity to both lower a company's reported liability and to create a system for employees to contribute to their postretirement benefits while they're still working. However, each also has tax and legal limitations (see "Pros and Cons of Prefunding Vehicles").
What Houston-based Cooper Industries has done is different still. In 1989, Cooper announced that it would no longer provide medical coverage to employees who retire after September 30, 1989. "We had run some analysis of the liabilities associated with the retiree medical program, and the costs were huge," says Stephen O'Neill, director of employee benefits. Cooper's bill for retiree health care was $16 million in 1988.
On top of that, Cooper's analysis revealed that only two-thirds of the company's employees were eligible for coverage. "We're a company that has grown by acquisitions throughout the years," says O'Neill. "Some companies that we acquired offered retiree medical programs, and others didn't. We decided that if we were going to make changes, it didn't seem logical to continue to exclude one-third of our employees. But the cost of extending coverage to an additional one-third of the organization was prohibitive. We looked at a lot of alternatives in terms of a redesign to reduce costs and liabilities, and we concluded that none of them was going to produce a significant result."
Although it chose to eliminate all medical coverage for future retirees, Cooper made some provisions for its current work force. For employees younger than age 50 who had been eligible for retiree coverage previously, the company increased its monthly contributions to their pension plans. The contributions range from $10 to $90, based on age. For employees who were at least 50 years old on September 30, 1989, Cooper offered a choice. They could either take increased contributions to their pension fund or a combination of a small pension-fund increase plus transitional retiree medical coverage for up to five years. "Those people [aged 50 and older] were having to make plans for retirement," says O'Neill. "We didn't want to just cut them off; they really didn't have the time to make other arrangements."
For the younger employees, the increased pension-plan contributions are a way for the company to help employees pay their future medical bills or buy insurance between retirement and Medicare eligibility. "We didn't try to pass this off as a one-for-one buyout or anything like that," says O'Neill. "We were taking away something that had value, so we wanted to try to do what we could to provide additional retirement income in lieu of that."
The employees who are hired after September 30, 1989, receive neither the increased pension contributions nor retiree medical coverage. As O'Neill puts it, the company isn't taking anything away from these individuals.
Mary Case and her associates at Fort Lee, New Jersey-based Kwasha Lipton, a benefits consulting firm, propose another prefunding vehicle that also uses a pension plan. The company's theory is to use untaxed pension contributions to pay for cafeteria benefits plans. Here's the reasoning behind it. An employer can receive a tax deduction for the money it spends on retiree benefits. Retirees don't pay taxes on the benefits that they receive. An employer also receives a tax deduction for a pension benefit's cost, but the benefit itself is taxable. By paying for the medical benefits with pension-plan funds, the delivery of the medical benefits remains tax-free.
According to Case, several companies are considering adopting this plan. None have done so yet, however, because the IRS still is contemplating the legality of the plan.
Managed care helps control retiree costs.
Another avenue that employers are commandeering to lessen their retiree medical-benefit liabilities is managed care. "Phasing retirees out of indemnity plans and into managed-care programs designed for seniors can be cost-effective and can produce positive outcomes," says Jim Wade, vice president of human resources for Fountain Valley, California-based FHP Inc.
Wagoner says that William M. Mercer has seen a rise in companies offering managed-care options to their retirees, primarily for the retirees who aren't yet Medicare eligible. Most companies that offer these types of options to their active employee base simply extend them to their pre-65 retirees.
According to Kwasha Lipton's January 1993 edition of Kaleidoscope, managed-care techniques that work for an active-employee population should work equally well, if not better, for a high-cost early-retiree group. Utilization review, case-management programs and the use of primary-care physicians for outpatient care are all effective tools for keeping down the costs for this high-risk group.
KPMG Peat Marwick reports that 27% of retirees were enrolled in a managed-care plan in 1992. However, the study indicated that within the companies that offer these plans to both their active and retiree populations, as much as 55% of their active work forces were enrolled in a managed-care plan. The lower enrollment rates for retirees seems to be more a result of retirees' unwillingness to select these options than employers' unwillingness to offer them. The study cites that about 60% of retirees have the option of selecting an HMO plan, 20% can choose a PPO plan and 20% can pick a POS plan.
According to the firm, there are several factors that contribute to retirees' reluctance:
- An established relationship with a physician
- Weak financial incentives (Medicare-eligible retirees face fewer out-of-pocket costs than active workers)
- A myopic loss of security by giving up a traditional Medicare-supplemental plan.
Because of the desire to stay with their traditional providers, the report says that retirees are more inclined to enroll in PPO or POS plans rather than an HMO. Historically, however, HMOs have the best record for controlling the rising cost of health care. Therefore, employers may not realize potential savings by enlisting managed care for over-65 retirees.
According to Kwasha Lipton, there are certain situations in which managed care can be cost-effective for employers who offer it to the Medicare-eligible retiree group. For example, managed-care companies that integrate their HMOs with Medicare can enable employers to offer their retirees a more generous Medicare-supplemental package than they could otherwise offer, and for nominal fees.
FHP's Wade concurs. "Managed-care companies that offer senior plans will accept the Medicare payment as premium payment and provide seniors with a higher level of medical benefits than what they might ordinarily get from a straight Medicare plan," he says.
The aspect that managed-care can impact most is prescription-drug costs. Kwasha Lipton reports that prescription drugs represent 30% to 40% of total retiree health-care liabilities, compared with 5% to 10% for active employees. This is partly because prescription-drug use increases with age. Also, because Medicare covers most other expenses for retirees over age 65, prescriptions become the greatest expense for employers to cover.
Employers can control these costs by using several managed-care methods. One is the use of mail-order programs for maintenance drugs, which Kwasha Lipton says accounts for approximately 70% of total drug expenditures. Ohio Retirement Systems, the title given to the five retirement systems of Ohio's state employees, has employed this method for several years. All five systems—highway-patrol retirement system, police and firemen's disability and pension fund, public-employees retirement system, school-employees retirement system and state-teachers retirement system—participate together under a joint contract for mail-order pharmacy. "We just recontracted the mail order and did so very aggressively," says Jim Braun, manager of the health-care team for Washington, D.C.-based The Wyatt Company, which consults the Ohio Retirement System. "The rates have seen a significant improvement this year."
Another managed-care method that companies are using to control retiree prescription expenses is the formation of local pharmacy networks. These are most effective when integrated with mail-order programs. This is something else that the Ohio Retirement Systems have aggressively pursued. "Pharmacy costs are a very significant part of the total cost of Ohio's retiree-benefits expenses," says Braun.
Offering incentives for employees to use generic drugs and using formularies are other techniques that companies are using for managing their costs. "Formularies define a set of drugs that can be used under a particular program," says Segal's Gliebe. "What that does is let the plan sponsor negotiate more aggressive rates for those drugs with vendors for volume discounts. Because they're limiting the supply of their competitors, they can participate in that particular program."
Companies must define their roles.
There are countless methods that companies can engage, and are using, alone or in combination with others, to limit their liabilities for retiree medical benefits. With medical costs continuously rising, and the retiree population growing, it's near impossible for employers to continue funding completely their employees' postretirement health-care coverage. But just how much should an employer contribute toward its workers' future health care? That depends on several factors.
Discontinuing coverage completely may be the most cost-effective method. However, a company must weigh the financial benefits against the negative attitude that such an action may create. The decision to discontinue benefits must not be made lightly. Retirees of several companies have sued their employers for discontinuing their coverage, claiming that their employers had promised them lifetime benefits. At Orland, Indiana-based Universal Components, for example, 27 salaried retirees brought suit against the company when it stopped paying for their medical coverage. The retirees won their case in trial court. However, in February, the U.S. Court of Appeals reversed the lower courts decision and ruled in favor of the company.
More than 8,000 McDonnell Douglas retirees sued the Saint Louis-based company for eliminating their benefits. The case still is pending in court.
Asking employees to prefund their own benefits requires a careful look at tax laws and legal requirements.
If a company chooses to limit what it will offer, Kwasha Lipton's Case says that it must first answer several questions. "Should we offer a certain amount of benefits or a certain amount of money? How should the money be allocated among the participants? Should we give more to married people than single people? Should we give more to people who go out before they're Medicare eligible than to people who are Medicare-eligible?"
The questions aren't easy. When the numbers total millions of dollars, however, and affect a company's bottom line, the answers must be contemplated.
Personnel Journal, November 1993, Vol. 72, No.11, pp. 78-86.