What's the best way to pay for retiree health benefits?

From: Blog

Retiree health benefits are one of the biggest, and most contentious, bargaining chips used to negotiate solutions to severe and chronic underfunding of state and local worker pensions. Barron’s reported that the Illinois state legislature passed a bill to prop up two of Chicago's underfunded municipal pension systems. The solution for now— raising employee contributions and cutting cost-of-living adjustments—stopped short of raising property taxes. Neither plan is currently anywhere near the goal of 90% funding by 2055.

Chicago is also trying to use the Affordable Care Act (ACA), or Obamacare as it is popularly and often pejoratively known, to force the federal government fill gaps in health-care coverage for early retirees. Last October Mayor Rahm Emanuel proposed a three-year phaseout of city-subsidized health insurance for most retired city workers. There is a court challenge but, if the phaseout is enacted, some retirees will be looking for coverage under the ACA by 2017.

The fifth and latest edition of the classic textbook, Taxes and Business Strategy, A Planning Approach, includes a great tax-oriented discussion on the best way to fund post-employment retiree health care benefits. (It also includes a compact primer on the tax issues surrounding the 2005-2007 stock option backdating controversy, covered in an earlier post.)

Merle Erickson, a professor of accounting at Chicago Booth, joins Myron Scholes, Professor of Finance Emeritus at Stanford University, Nobel Prize winner, Chicago PhD and former professor of finance at Booth from 1974 to 1983, and four more distinguished authors in a book that provides business professionals of all kinds with a general framework for thinking about tax issues at the corporate and individual level.

Bankrupt Detroit has $18 billion in debt and future obligations that will likely mean 22,000 city retirees and 8,500 current employees will share bondholders’ pain and accept cuts in pensions and health coverage. Barron’s, again, reported in March that retirees “will be pushed onto Medicare or, in the case of police and fire, onto the Affordable Care Act exchanges, with only modest monthly stipends from the city to partially finance their coverage.”

On April 11 the deeply divided US House approved a fiscal 2015 budget drafted by Wisconsin Republican Representative Paul Ryan, the House Budget Committee chairman. The budget proposes to scale back health insurance coverage and subsidies available as part of ACA. The proposal received a “no” vote from every Democrat member.

Retiree health benefits were first offered, Erickson and his fellow authors say, in the 1940s. Union collective bargaining agreements, a booming post-war economy, and manageable costs based on small percentage of retirees to total employees drove companies to offer benefits they thought then would never have to end. When Medicare was enacted in 1965, the employer’s cost was substantially lowered. Since profits seemed perpetual, most employers were comfortable funding benefits on a “pay-as-you-go” basis.

What’s changed? The workforce has aged, retirees are living longer, and many companies have been cutting their workforce constantly. That means the ratio of retirees to active workers has grown. Add ballooning healthcare costs to the mix and the thought of providing retiree health benefits now seems untenable for many public and private employers.

Changes in accounting rules in 1990 provided an additional disincentive for companies to generously fund retiree health care. Companies were required to estimate the present value of unfunded retiree health benefits and recognize that total liability and an expense for each year of each employee’s working life. As a result, large liabilities appeared on balance sheets and profits dropped. That encouraged many companies to reevaluate earlier commitments. Some have severely modified or dropped retiree health care plans because negative earnings and weakened balance sheet metrics also affect share prices and, therefore, incentive compensation.

What is the best way for employers to fund retiree health benefits? Few companies and even fewer government entities will now commit to funding the benefits in advance. Advance funding of retiree health benefits has few tax benefits. Advance funding of pensions has more, but companies and governments have been caught way short there as well.

The pay-as-you-go approach is a tough sell when health care costs have been increasing at an unpredictable pace. A bankruptcy or leveraged buyout can expose employees to substantial risk of default on unfunded obligations. In 1999 only 20% of Fortune 500 companies surveyed by Watson Wyatt Consulting prefunded their retiree health benefits. A recent report for the California Pension and Retirement System (CalPERS) said the $64 billion debt or “unfunded liability” for its state worker retiree health care exceeds the $57 billion unfunded liability for state and local pensions.

One of the few alternatives anyone has is to force retirees to pay for their own health benefits or for more of them. Sweetening their pension benefit to compensate for the loss would be nice, but that is not proposed as often as simple cuts. The US resists a single-payer health care system and instead settled for an imperfect health care insurance system under ACA. As a result, employers and taxpayers will stay in the middle, footing the bill and constantly foraging for new solutions to a problem that is growing and not going away.

—Francine McKenna
Cat: Policy, Business, Sub: Accounting,