Designing benefits plans in an accrual environment

Designing Benefits Plans in an Accrual Environment

Joel L. Cooper

Essentially, the FASB’s exposure draft on accounting for postretirement benefits other than pensions says the current practice, used by most fTirme, of expensing the met (known as OPEBs, or “other postretirement employee benefits”) on a pay-as-you-go basis, with no other recognition of liability, does not accurately reflect the mmpanfs obligation. The FASB believes these benefits, which are paid to an employee after completion of active service, are actually e u d over the employees’ working Metimes. Therefore, it is a more &Wid financial representation to show a liability for the portion of the benefits already earned but not’yet paid out as benefits. In other words, a d accounting is appropriate for OPEBs. (For a more in- depth analysis of the draf’t, see page 3.)

This is not a surprising conclusion, because it is similar to the accountingappdusedforpensions. Infh&,theFASBveryclosely followed its Statement 87, ‘‘Accounting for Pension,” in developing the details of the exposure draft on OPEBs. Although there are some differences of opinion, it seemsthe msjority of corporate and consultc ing people involved in the benefits area agree with the concept of accrual accounting for these benefits. The main differences with the FASB seem to stem h m its approaches to measuring the liability and allocating it back to the employees’ working lives.

This article will not detail the provisions of the exposure draft, nor will it comment on the appropriateness of the methods suggested by the FASB. Rather, it will concentrate on the design of OPEB plans in an accrual accounting environment, and on what factors a company might consider in evaluating its current plans.

Similarities and Di%rence!e with Pensions Although the accounting pdbssion is now drawing some very

strong parallels between pensions and postretirement medical benefits, the two benefits really have little in common--except they are offewd to mughly the same group of people. Typically, defined benefit pensions plans are based on a retiree’s length of semice, salary at retirement, age at retirement, and dependent status. The amount a retiree wil l receive from a pension plan can be predicted fhirly accurately based on these parameters. Likewise, the amount an employee earns during any one year of service also can be

Journal of Carporate Accounting Q Financdhtuxun 1989 17

Joel L. Cooper

In a s e w , OPEBs am ~ e a t l y a hybrid of active medical benefite andpensione. TIcese benefits have many of the design and finding characteristics of active mediedplans, but am established for the 8- W U P of PeOPb as pension plano.

calculated with some precision. On the other hand, the amount a person will receive from a

postretirement medical benefit plan is usually not a function of any parameter particular to that person’s employment. The benefits are not a function of length of service, age at retirement, salary at retirement, dependent status, or job classification. This seems to be random and imprecise when compared to pension benefits, but it is not so when compared to medical benefits for active employees. These active benefit plans am also moetly independent of the particulars of a person; the amount a person receives in any one year from the active medical benefit plan is a function of the amount of medical expenses incurred in that year. It is not surprising to find that OPEB plans seem mare closely related to active medical plans than pension plans, since many postretirement medical benefit plans do not have a plan design of their own but merely continue the coverage provided to active employees.

The use of pay-as-you-go accounting, although very Merent h m pension accounting, is also the way most companies account for their active medical benefit plans. Administrative services only (ASO) contracts for active medical benefits, when the benefits are only accounted for on a pay-as-you-go basis, are considered the preferred method of funding active benefits. With many companies not keeping good records of separate claims experience for active and retired employees, it is reasonable that most OPEB plans currently are funded on the pay-as-you-go basis, rather than on an accrual basis.

In a sense, OPEBs are really a hybrid of active medical benefits and pensions. These benefits have many of the design and funding characteristics of active medical plans, but are established for the same group of people as pension plans. Although OPEBs have historically been associated more with active medical benefits than with pensions, the advent of a d accounting will force a rethink- ing of this relationship. If med id benefits for retirees are to be accounted for in a manner similar to pension benefits, their designers in the future will consider some of the same factors considered in the design of pension benefits.

Viewing OPEBs on an Accrual Basis The basic concept ofaccrual accounting for postretirement medi-

cal benefits is that employees accrue the benefits to be received at mtirement over their active servioe lives. As such, the company is adding a portion to the employee’s total compensation by putting aside an amount of money each year (whether the benefit is actually prefunded or a liability established) 80 the employee has a M y funded benefits promise at retirement. For pensions, this amount is readily definable and is calculated by applying the plans benefit formula Whatever form of measurement and attribution is finally BIlmmeredoutbytheFASBandthecorporatecommunityforOPEBs, companies wi l l have to perform a calculation annually to determine what each active employee has earned towards his or her retirement

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Journal of Corporate Accounting & FinandAutumn 1989

medical benefits in that year. When viewing OPE& in the light of this annual accrual, there are areas a company may want to reexamine with respect to the plan provisions. These include:

LengAofactivcre~.MostOPEBplaneonlyspecifjammini- mum length of service required before an employee is eligible for benefits. Beyond this length of service, the number of years worked does not enter into the benefits formula By comparison, the amount a dime is eligible to receive from a defined benefit pension plan is directly proprtional to the length of active service. From an accrual acoounting perspective, the shorter the active semice life of an employee, the more a company has to accrue each year for the postretirement medical benefits. TherefoFe all employees are not accming their future medical benefits at the same raw, thoee with shorter expected d c e with the employer are accruing faster.

&e af ntirrement. The age at which an employee retires effects all postretirement benefits. In general, the younger the retirement age, the longer the retiree will receive benefits. For defined benefit pension plane this is accounted for by imposing an actuarial ductioninthemonthlybenefits paidtoemployees whoretireearlier than was expected. The reduction is of an amount needed to make the present value of the benefits expectd to be paid over the longer time period as equal to the present value of the benefits which the retiree would have received if retirement had taken place on the expected date.

For OPEBs there is no such Feduction for early retirement. In fact, quite the opposite happens. Typically, early retirees (those re- prior to age 66) and normal retirees (those retiring at age 65 or later) am entitled to receive the same level of benefits. The difference between the two groups is that the benefits of normal Fetireee are reduced by the amount ofbenefits paid by Medicare. This makes the plan, fmm the sponsoring companies’ perspective, much more expensive for early retirees than for normal retirees. Therefore, someone retiring early will not only be entitled to benefits for a longer period, but the benefits available &om the company for the time between the actual retirement date and the time the person reaches age 66 will be greater than the annual benefits mceived from someone age 65 or older.

Depending on the plan design, and exactly how Medicare is integrated into the plan, a person retiring at age 60 could have a liability at retirement equal to twice what that same employee would have ifretirement occumd at am 65. This in turn would translate into a higher annual scud for employees who are expected to retire t?arly.

Dependent rtcrtw. Pension benefits are earned by the employee during hie or her working lifetime. These benefits are employee- specific and are independent ofthe familJr statue of the person when he or she retires. The only difference the dependent status makes is

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19 Journal OfCarpOrate Accounting 8 FinandAutuxnn 1989

Joel L. Cooper

in the payment option. If the retiree chooses a joint and survivor option, an actuarial reduction-based on the fact that benefits could be paid for a longer period of time-is made. Again, this reduction is made so that the present value ofthe benefits earned is the same, regardless ofthe payment option chosen.

“his is not the case for OPEBs. The present value of the liability for aretireewi~aspo~(iftheplan~ersspousesattheeameleve1 as retimes) a d d be more than double that of a single retiree. Therefore, the expected dependent statue of an employee at the time of retirement will affect the amount which needs to be accrued each year for that employee.

Relatiomhip to o d w . Pension plan benefits almost always have a dim& relationship to the employee’s salary. OPEBs am almost never salary-related. Typically, all employees are entitled to the same level of medical benefits at retirement. Therefore, lower- paid employees will accrue these benefits at a much higher percentage of compensation than highly compensated employees.

Consistency of benefik ozw time. Benefits under a defined benefit pension plan bear a direct relatianship to some measure ofthe employee’s salary at the time of retirement. The amount of the benefits are then fixed over time, regardless of the condition of the economy. Futureinflationisnot takeninto account when calculating the pension amount. OPEBs are usually in the form of a percent of the service fee. Since the service fee inflates over time, these benefits in- crew in value over time, even aRer the employee has retired.

With postretirement medical benefits being accounted for on the same accrual basis as pension plans, companies sponsoring OPEB plans might want to reconsider the benefit design in light of the issues mentioned above. Typically, these were not taken into account in the design of postretirement medical benefit plans, as these plans mirrored the active plans which are accounted for on a year-to-year basis. However, with accrual accounting, plan spsora may want to consider the issues involved with equity in the annual accrual of the benefits.

Plan Design The design items mentioned in the preceding section all focueed

on the rate of annual a d . These types of considerations are new totheareaofOPEBa.However,theideaofcuttingthe annualcostfor both active and r e the medical benefits has received much attention in the past decade. With the cost of medical care increasing at unprecedented rates, most companies have redesigned their active medical benefits plans in an attempt to reduce the effects of this Mation. While some of these plan design changes have been c(IlFied forward to retiree medical plans, most have not. There also has been very little consideration of plan design changes specifically geared toward OPEBs. Now, due in part to the FASB exposure draft and in

20 Journal of Corporate Accounting & Financdhtumn 1989

Deuigning Benefit8 P l a w in an Accrual Rnvirrwuncnt

I f , &r conuidemtion of appmpriate benej3t kmk QIUI c 0 1 ) o y penditureq it ir &termined that increase8 in contributions fbr retime medical coverage conoidemtion u A w k l be given to having different contribution rate8 fir diffimnt 8 i t U a t h u .

part to the agingofthe population, companies will need t o f m COB+ containment efforts spe&cally on poetretirement medical benefits. ThereductianoftheaMual~tawill,eimilartoacti~medicaibene- fits, be a conaideration. In addition, the accrual coete for OPE& also will have to be loohed at. Some ofthe plan design features, and their effect on the annual caeta and d, are:

Contributbnu. The majority ofpoetretirement medical benefit plans require a smaller contribution than corresponding active medical plans. Until recently, it was common for these OPEB plans to require no contributions at all. Asking pensionem, current or hture, for larger contributions is always a difficult ism-ven if the communications material distributed by the company specifically s t a h it has the right to inmase these contributions. However, increasing the level ofcantributions may help to hold off cute in benefits levels.

I€, after consideration of appropriate benefit levels and company expenditures, it is determined that increases in contributions for retiree medical coverage are needed, consideration should be given to having different contribution rates for different situations, such as higher contributions for retirees with dependent coverage, early retirees, or retimes who had less than a certain length of service.

Although contributions can be used as a method of reducing the annual coet as well as reducing the inequities in accruals produced by the situations described in the pmceding section, caution must be used in setting the contribution levels. Keeping in mind that one of the driving forces behind plan changes to the postretirement medical benefit plans in the future will be reducing the FASB-defined liability, it is important to realize that not all contribution changes result in the same level of cost reduction. The exposure draf't does not allow for the inclusion of firture plan changes in the liability calculation. Therefore, a flatdollar contribution wi l l be assumed to remain at ita cufient level even as costs far benefits rise. The result of this is a substantial =duction in the OPEB liability as defined by the FASB. A larger liability reduction will result h m setting the contributions as a percentage of the plan cost; contributions will be assumed to rise as the cogt of the plan arises, and will therefore produce a larger reduction in liability.

Deductibku and CoinouFarnCe. These are particularly important features to examine, especially for retirees age 65 or older, since the company plan is typically integrated with Medicare. There are several ways in which a company postretirement medical benefits plan can be integrated with Medicare. While there are no standards as to how this integration should occw-or even what the different integration methods am called-it is possible for the plan adminis- trator to apply a Merent method than the one the company has used.

The effect of the integration of two plans, each with its own

Journal of Corporate h u n t i n g & F'inancdAutumn 1989 21

Joel L. Cooper

deductibles and coinsurance level, produces a single plan with deductibles and coinsurance Werent than either plan originally had. Although the actual effects will be different for different plan designs, the most common method of Medicare integration produces coinsurance levels that have participants pay less than the plan without the integration. This means that in many plans the normal retirees are paying a smaller coinsurance percentage than the company's plan calls for. A company could reap cost savings by studying the effect of M e d i m integration and making the changes which will bring the combined deductibles and coinsurance levels to a more appropriate level.

Cost containment. Over the past decade, cost containment has been the watchword of all people involved in medical care plans for active employees. "he use of various costantainment techniques has changed the way people purchase care, and the way the medical profession provides it. For many reasons, cost-containment techniques used for active employees do not always find their way to the retiree plans. Some of these techniques, such as the use of alternative care facilities could produce cost savings for these plans, if geared toward the needs of retirees.

When reviewing the cogt-conCainment features of the active plan for inclusion in the retiree plan, it helps to consider the medical care needs of the elderly. As the needs and the levels of care are different for this group, different strategies for cost containment will be effective. Care should be exercised here. The techniques used for active benefits often are geared toward immediate savings as o p posed to longer-term savings. When the calculation of the OPEB liability is to be considered, longer-term savings may have a bigger impact on the reduction of the liability than the immediate savings.

New Types of Plans With the advent of accrual accounting for postretirement medi-

cal benefits, there a m many Werent aspects of plan design to consider. For some companies that sponsor these types of plans, conclusions based on these new aspects might suggest abandoning the old-style plan completely and substituting a plan designed specifically for OPEBs on an accrual basis. The type of plan will vary from company to company, dependilig on their particular objectives. However, there are two major categories of plan designs which are very rare today, but may become the norm in the future. These categories are:

Defined contribution plans. These plans are similar in concept to defined contribution pension benefits. The sponsoring company promises to set aside a certain amount of money each year, the total of which could be used to purchase medical benefits when the employee retires. In its simplest form this type of plan design eliminates the inequities produced by short-service versus long- service employees, early versus normal retirees, single versus mar-

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Journal of Corporate Accounting & FinancdAutumn 1989

D e r i g n i ~ Benefit8 Planr in aa Accnual8nvimnment

When all the smoke ckars, the biggest impact will be moving them benefU8 mm the m d m of apay-as-you-

only the current co8t8

conridemi, into the m d m of benefits that accrue over the working lifetime of the employee.

80 8i#U&b4 Whem

Of the beMm8 W

ried retireee. If the plan ie salary-related, it also produces equitable accruals for all employees.

Additional advantages of this type of plan in an accrual environment are that the amounts attributable to each year of service are readily definable, and the benefits promised are not locked in to long- term medical care inflation. However, there are cautions to be applied. In a defined contribution arrangement, it is possible that groups of employees will not accumulate enough money by retirement age to purchase significant benefits. The number of employees in this categoq will grow as medical care inflation outstrips the general rate of inflation.

It is possible to link a defined contribution type of plan with a fee- for-service type arrangement, which most companies currently have. If a base! plan is established that provides a minimum amount of postretirement benefita to all eligible retirees, no retiree wi l l be left without benefits. To back up this plan, a more comprehensive one could be established that would be paid for h m the defined contribution portion of the plan.

Defined b e w t plum. These are defined benefit plans in a pension sense, rather than in the current sense as applied to postretirement medical benefit plans. Currently, most OPEB plans are fee- for-service types. This means, for example, that the plan promises to pay 80 percent of physician feee for the retiree. There is no limit on what the physician fee will be in the future. If the current physician fee is $100, the plan promises to pay $80. If this same fee rises to $1,OOO in the fbtuFe, the plan promises to pay $800.

The new type of defined benefit plan would promise to pay only up to the current fee for a retiree at the time of retirement. In other words, using the example of the preceding paragraph, the employee who retires today would continue to receive a maximum of $80 for physician fees regardless of how high the fees rise. Someone who retires five yeam later, when the average physician fee has risen to $200, could never receive more than of $160 for physician fees after retirement.

Here again, the costs have been unlocked from medical care Mation at the time of retirement. This greatly reduces the liability for these benefits, as defined by FASB. However, it also creates potential hardship for retirees as the length of time after retirement increaSeS.

Conclusion Conventional wisdom says that liabilities for the postretirement

medical benefits were not created by FASB, but by the ampany’s promise to provide the benefits to its retirees. The FASB is only saying that, if these promises are made, their effect should show up on the companfs financial statements. Although this is true, the exposure draft, and eventually the statement, still will have a large impact on postretirement benefits. When all the smoke clears, the biggest impact will be moving these benefits from the realm of a pay-

Journal of Corporate Accounting & FinancdAutumn 1989 23

Joel L. Cooper

as-you-go situation, where only the current costa of the benefits am considered, into the realm of benefits that accrue over the working lifetime of the employee. In thie type of benefit, the considerations as to the design and amt of the benefits change drastically.

24 Journal of Corporate Accounting & FinandAutumn 1989

Documents

Designing benefits plans in an accrual environment