retiree medicalThe retiree medical marketplace is going through significant changes. For over a decade, employers have been addressing increasing healthcare costs for retirees by modifying or eliminating retiree medical benefits. Now, with the establishment of healthcare exchanges making insurance available for pre-65 retirees, as well as those eligible for Medicare, more employers are considering reducing or modifying benefits.

However, even with these changes, if an employer is still promising any benefit, they have a liability on their books and must decide to fund or not. While it may be tempting to leave the benefit unfunded, it can be cheaper in the long run to fund now.

A retiree welfare program is unusual in that it is a promise to provide future benefits, but it is not required to  be backed up with hard assets. The employer can choose to prefund, set aside assets in order to cover some part of future benefits, or follow a pay-as-you-go method, which involves only contributing funds for the current benefits of current retirees.* Given the lack of a requirement to prefund, why do some employers choose to use assets to prefund benefits?

To examine the question of prefunding, we must first fully exam ine what happens when an employee earns retiree welfare benefits. When an employee performs work for an employer, that employer immediately pays for it in the form of wages, health insurance, 401(k) contributions, and other benefits. Pension plans also require a cash contribution which is related to the employment during that year.

All of these involve the employer paying in the current year in return for the labor that the employee provides in that year. Retiree welfare benefits, however, only need to be funded with a promise. If the employer is using a pay-as-you-go method, the only cash required is for the current retirees, whose labor stopped benefiting the company long ago.

It may be easier to think about this situation in terms of a municipality rather than a corporation at first. If I live in a city that pays for retiree welfare benefits on a pay-as-you- go basis:

  • I should selfishly want my city government to offer lavish unfunded retiree benefits
  • The city will then hire lots of employees paying them with promises rather than my tax dollars
  • I will enjoy the benefits of quality garbage collection and police protection paid with promises
  • Before these promises come due, I will move to another city that made fewer promises, sticking the bill for the services I received onto the people who live there after me

Of course, I also have to hope that the generation before me did not figure out the same trick first. Although I say this is what someone should desire, we can probably agree this is not a good strategy in the grand scheme. Also, the fact that some local governments seem to have done this in reality does not make it a good idea.

To take the analogy to the corporate world, the payment of current labor with a promise rather than cash benefits the current stockholders at the expense of future stockholders. While the company currently pays an accounting cost on their profit & loss statement (P&L), the cash cost is deferred for decades.

If the company employs fewer people in the future due to increases in efficiency or decreases in the market, most of their labor cash costs adjust with the size of their labor force, but retiree medical payments do not. This company may find it hard to manage the smaller size if forced to pay for labor provided decades ago.

Retiree Medical

The discussion above is partially offset by the fact that a promise of retiree welfare benefits is not an unbreakable promise, in many cases these benefits can be cancelled at any time. However, in reality, many employers do not want to remove benefits for those in retirement or near retirement age. Additionally, we assume that the current benefit program represents the company’s expectation of future benefits, and it is appropriate to act on that expectation.

If the benefit is not prefunded, there is a large unfunded liability on the balance sheet representing the future obligations of the company. External analysts examine this liability when considering a company’s financial position. While some employers are planning changes to their retiree medical plan, including moving retirees to exchanges set up under healthcare reform, these changes do not remove the liability if the employer is still planning to make some form of payment.

Of course, funding retiree medical benefits in advance must benefit the company financially in order to be a viable option. Prefunding these benefits is generally cheaper than leaving it unfunded, due to the long term nature of the investments supporting the benefit. Spring can help a company examine the financial factors surrounding prefunding, including P&L benefits, as well as provide analysis of the most desirable funding vehicles, well known and rare, and their expenses, cash flow benefits, and tax management issues.

*The discussion in this article applies to most U.S. corporate employers. The situation described may vary depending on employer type (corporate, municipalities), bargaining status (Union/Non Union) and other situations (government contractors, public utilities, etc).

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Steven Keshner

Steven Keshner

Partner and Chief Actuary at Spring Consulting Group, LLC
Steven Keshner, FSA, MAAA is a Partner and Chief Actuary for Spring Consulting Group. Steven has over 25 years of actuarial, financial, underwriting and strategic insurance experience with a group, life, health and retirement focus. Steven’s experience allows him to be qualified as an Appointed Actuary enabling him to sign off on employer, insurer and captive insurer reserves as well as actuarial feasibility studies and other actuarial certifications. Steven has worked with clients to develop DOL and product initiatives focused on improving rate competitiveness through medical plan designs, product language, consumer driven health plans, and value added benefits such as low cost, minimally underwritten LTD plans. Steven’s ability to gain cost efficiencies led him to design a new underwriting and pricing model for life and disability captive programs. Prior to joining Spring, Steven was CFO and Chief Actuary of Nippon Life Benefits, a subsidiary of Nippon Life Insurance Company, a global mutual life insurer.
Steven Keshner

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