Employer-Sponsored Retiree Health Insurance: An Endangered Benefit?
CRS Report for Congress
Employer-Sponsored Retiree Health Insurance:
An Endangered Benefit?
April 13, 2006
Neela K. Ranade
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress
Employer-Sponsored Retiree Health Insurance: An
The coverage offered by employer-sponsored retiree health insurance plans has
been shrinking. Although high retiree health care costs were the root cause for
cutbacks in coverage, changes in accounting requirements were the triggering event.
The trend towards reducing coverage began in the private sector in 1990, when the
Financial Accounting Standards Board (FASB) released Statement of Financial
Accounting Standards No. 106 (SFAS 106). The trend in cutbacks to employer-
sponsored retiree health insurance could spread to state and local governments. The
Government Accounting Standards Board released Statement 45 in June, 2004. This
accounting standard will require accrual accounting for postretirement health
insurance plans sponsored by state and local governments. Many state and local
governments may decide to trim retiree health insurance plans in an attempt to
control costs reported under the new accounting standard. In addition, FASB has
undertaken a project for revision of accounting requirements for private sector retiree
health insurance plans that may have further repercussions for the coverage provided
by such plans.
This report summarizes the current coverage levels for retiree health insurance
for private and public sector retirees. It outlines the provisions of SFAS 106 and
GASB Standard 45 that govern employer accounting for postretirement health
insurance plans as well as the new FASB project for revision of private sector
accounting for such plans.
Prefunding of a postretirement health benefit plan increases benefit security for
plan participants and reduces the accounting cost for the plan. This report
summarizes the prefunding options available to private and public sector employers
under current tax law. The report includes data that demonstrate the low level of
prefunding and low employer credit ratings for some of the largest retiree health
insurance plans in the private sector. The combination of limited prefunding and
strained employer finances is likely to lead to further cutbacks in retiree health
insurance benefits for some of these plans.
Cutbacks in retiree health benefits cause considerable distress to those already
retired and to older employees close to retirement. This report describes the public
policy options that have been considered and others that might be considered by
Congress to address the problems created by the erosion of employer-sponsored
retiree health insurance plans. It does not include a list of specific legislation. Such
a list is included in CRS Report RL32944, Health Insurance Coverage for Retirees,
by Hinda Ripps Chaikind and Fran Larkins.
In troduction ......................................................1
Accounting for Employer-Sponsored Retiree Health Insurance..............6
Private Sector Employers........................................6
FASB’s Proposed Revisions to SFAS 106......................7
State and Local Governments....................................8
Voluntary Employee Benefit Association..........................11
401(h) Subaccount of a Defined Benefit Pension Plan................12
Transfer of Excess Pension Assets to a 401(h) Subaccount ...........12
Section 115 Trust.............................................13
Other Prefunding Vehicles......................................13
Prefunding of Retiree Health Benefit Plans is Limited................13
Public Policy Implications..........................................14
List of Tables
Table 1. Employment by Category for U.S. Civilian Workforce, 2003........2
Table 2. Current Retirees Covered by Employer-Sponsored Health Insurance
Table 3. Ten Largest Other Post-Employment Benefit Plans in the S&P 500,
Employer-Sponsored Retiree Health
Insurance: An Endangered Benefit?
The coverage offered by employer-sponsored retiree health insurance plans has
been shrinking. Although high retiree health care costs were the root cause for
cutbacks in coverage, changes in accounting requirements were the triggering event.
The trend towards reducing coverage began in the private sector in 1990, when the
Financial Accounting Standards Board (FASB) released Statement of Financial
Accounting Standards No. 106 (SFAS 106). The percentage of large employers (500
or more employees) offering retiree health insurance was 28% for pre-Medicare
eligible retirees and 20% for Medicare-eligible retirees in 2004. The corresponding
numbers were much higher at 46% and 40% respectively in 1993.1
The trend towards reduction in coverage could spread to the public sector. The
Governmental Accounting Standards Board (GASB) released Statement 45 in June,
retiree health insurance plans and will become effective beginning in 2007. Many
state and local governments that have evaluated the postretirement health benefit
costs that must be reported under GASB 45 have reported large increases compared
to the costs currently reported.3 Many state and local governments are likely to
consider cutting back retiree health benefit coverage in an effort to control the
postretirement health benefit cost.
This report focuses on accounting developments and how these are likely to
influence employer decisions regarding retiree health coverage. The report does not
attempt to provide a complete picture of retiree health coverage and design trends.
CRS Report RL32944, Health Insurance Coverage for Retirees, by Hinda Chaikind
and Fran Larkins provides a more comprehensive analysis of these issues.
1 Mercer 2004 National Survey of Employer-Sponsored Health Plans
2 The FASB and GASB are not governmental agencies, and they do not have enforcement
authority to require private sector entities (in the case of FASB) or state and local
governments (in the case of GASB) to comply with their standards. However, compliance
with FASB or GASB standards is required for accounting statements to be considered to
conform with Generally Accepted Accounting Principles (GAAP). When certified public
accountants issue opinions on financial statements, they are required by auditing standards
to test whether the statements are fair presentations, in all material respects, of financial
information in conformity with GAAP.
3 Retiree health insurance plans are also called retiree health benefit plans or postretirement
health benefit plans. In this report , we have used these terms interchangeably.
Employer decisions regarding the level of retiree health benefit coverage for
over-65 retirees may be influenced by the availability of Medicare benefits. Effective
January 1, 2006, a new voluntary prescription drug benefit was added to Medicare
under the Part D program. In order to provide an incentive to employers to continue
to offer prescription drug benefits to their Medicare-eligible retirees, the law provides
for payment of subsidies to those employers who offer qualified retiree prescription
drug coverage. For a complete discussion, see CRS Report RL33041, Medicare
Drug Benefit: Retiree Provisions, by Jennifer O’Sullivan.
In 2002, the proportion of early retirees (generally those under 65) covered by
employer-sponsored retiree health insurance was 28.7%, while the proportion of
Medicare-eligible retirees covered by employer-sponsored retiree health insurance4
was 25.5%. On account of the erosion of retiree health insurance plans in the private
sector, and the likelihood of cutbacks in state and local government plans in response
to GASB 45, the proportions of future generations of retirees covered by employer-
sponsored retiree health plans will certainly be much smaller. Fidelity Investments
has predicted that the population with access to employer-sponsored health care in
retirement will decrease by 25% to 50% as more companies see health care as too5
great a liability. In addition, the proportion of individuals retiring early may decline
since individuals may not be able to afford retirement without employer-sponsored
retiree health coverage.
Table 1. Employment by Category for U.S.
Civilian Workforce, 20036
Numbers in millionsPercentage
Federal Government - Civilian32%
To t a l 138 100%
Source: Total U.S., federal, state, and local employment figures from Statistical Abstract of the United States:
2006, Tables 451, 496, and 576. Private sector employment determined as the difference between total
employment and governmental employment.
4 Employee Benefit Research Institute analysis of data from the Survey of Income and
Program Participation (SIPP), 2001 Panel. The SIPP is conducted by the U.S. Census
Bureau and is based on a sample of all U.S. households.
5 “For Retired Couples, Coverage for Health May Mean $200,000,” The Wall Street Journal,
Mar. 7, 2006.
6 2003 is the latest year for which such data is available.
Note: Table excludes self-employed persons, private household workers, unpaid family workers, agricultural
workers, and armed forces.
As may be seen from Tables 1 and 2, although the vast majority of Americans
is employed by the private sector (84%), among current retirees entitled to employer-
sponsored health insurance, only 39% owed the benefit to a private sector employer.
Another 39% of current retirees owed their retiree health insurance coverage to prior
service with a state or local government (Table 2). The majority (61%) of current
retirees with employer-sponsored retiree health coverage are former governmental
Table 2. Current Retirees Covered by Employer-Sponsored
Health Insurance in 2005
(numbers in millions)
Age < 65Age 65+Total -NumberTotal -Percent
Private Sector 184.108.40.2069%
Public Sector -220.127.116.119%
State and Local
Public Sector -0.31.92.222%
T otal 2.6 7.2 9.8 100%
Source: Analysis of data from 2005 Current Population Survey by the Employee Benefits Security
Administration Division of the Department of Labor.
Note: Excludes dependents of retirees.
Retiree health benefits constitute the primary form of Other Postemployment
Benefits (OPEB).7 Statement of Financial Accounting Standards No. 106 (SFAS
106) requires private sector firms to quantify annually their OPEB obligation.8 In the
private sector, the obligation for retiree health benefit coverage is concentrated
among a few very large employers. As may be seen from Table 3, at the end of
2004, the OPEB obligation for the Standard and Poor’s 500 (S&P 500) companies
was $420 billion, for which they had set aside only $84 billion in assets. Table 3
shows key information for the ten largest OPEB plans in the S&P 500, based on their
OPEB obligation at the end of 2004. The OPEB obligation for the ten largest plans
in the S&P 500 was $219 billion, or 52% of the OPEB obligation for the S&P 500
7 Other examples of OPEB benefits are life insurance and tuition assistance.
8 The OPEB obligation, also called the Accumulated Postretirement Benefit Obligation, is
defined by SFAS 106 as the actuarial present value of benefits attributed to employee
service until the measurement date. Pages 5-7 of this report describe the requirements of
The credit rating of a company provides an assessment of the company’s
capacity to pay interest and repay principal on its debt and can be used as a rough
measure of the ability of the company to pay retiree health benefits as promised under
its plan. According to S&P, the debt of companies rated at BBB or below is
considered to be speculative grade and indicates vulnerability to default. General
Motors, Ford, and Lucent fall in this category. Delphi is in a worse financial
position, having filed for Chapter 11 bankruptcy on October 8, 2005. The OPEB
obligation for the above four companies together is $132.7 billion, 31% of the total
OPEB obligation for the S&P 500 companies. These four companies are under
financial pressure and are likely to cut back retiree health benefits in order to free up
cash for other needs.
Table 3. Ten Largest Other Post-Employment Benefit
Plans in the S&P 500, 2004
(amounts in illions)
CompanyS&P Credit RatingOPEB ObligationOPEB Plan Assets
General Motors CorpB$77.47$16.02
Ford Motor CoBB-39.126.76
Verizon A 27.08 4.55
SBC Communications A25.118.69
Delphi CorpNA - in bankruptcy9.610
Total (Ten Largest)219.0243.62
Total (All S&P 500420.0084.00
Source: OPEB obligation and plan asset data from Credit Suisse report “The Buck Stops Where?”
by David Zion and Bill Carcache, February 15, 2006; organization credit ratings from Standard and
Poor’s website at [http://www.standardandpoors.com], accessed as of March 7, 2006.
Indeed, General Motors announced cutbacks to the retiree health plans of its
hourly employees on October 17, 2005, and salaried employees on February 7, 2006,
that would reduce its retiree health obligation by $15 billion and $4.8 billion
respectively.9 Retiree health benefit cuts were also announced by Ford, and Delphi
is in the process of negotiating benefit cuts with its unions as part of its bankruptcy
reorganization. Lucent has made several cuts in its retiree health benefit plans in the
last few years. With a retiree to active ratio of 10 to 1, Lucent still would face
difficulty in paying retiree health benefits if it did not have a well-funded pension
plan. Lucent and its employee unions, the Communications Workers of America and
the International Brotherhood of Electrical Workers, have lobbied Congress to relax
asset transfer rules under Section 420 of the Internal Revenue Code so that more of
the excess pension assets can be employed for payment of retiree health benefits.10
Companies that are financially sound have also announced cuts in retiree health
benefits. Citing competitive pressures from companies that do not contribute to
retiree health premiums, Verizon eliminated retiree health benefits for managers with
less than 15 years of service at retirement.11 The above examples illustrate the
continuing erosion of retiree health plans in the private sector.
State and local governments are currently much more likely to sponsor retiree
health plans than private sector employers. All fifty states offer health benefits to
their retirees in some or all age groups.12 Some local governments offer retiree health
benefits. State and local governments have started measuring their retiree health
benefit liabilities and costs in preparation for the implementation of GASB 45.
Confronted with the magnitude of the unfunded liabilities, many are likely to
consider cutbacks in retiree health benefits.
Retirees fortunate enough to be covered by employer-sponsored retiree health
insurance may be required to pay substantial premiums for the coverage. According
to consultant surveys that provide a breakdown for under- and over-65 retirees, and
private and public sector plans, of those employers that sponsor retiree health
insurance plans, 30% to 40% provide “access only” plans in which retirees pay for
the full cost of coverage.13 Since it is often difficult for older individuals to find a
reasonably priced plan in the individual health insurance market,14 employees
consider even “access” only plans to be valuable.
9 “GM, UAW Tentative Health Care Deal Expected to Save $1 Billion per Year,” BNA
Pension & Benefits Daily, Oct. 18, 2005; “General Motors to Freeze Health Care for
Salaried Retirees, Alter Pension Plan,” BNA Pension & Benefits Daily, Feb. 9, 2006.
10 “Joint Union - Management Committee Devises Plan to Preserve Retiree Health Care
Funding,” BNA Pension & Benefits Daily , June 22, 2005.
11 “Verizon Says it Will Freeze Pensions, Cut Retiree Health Care for Managers,” BNA
Pension & Benefits Daily, Dec. 8, 2005.
12 Retiree Health Care: A Growing Cost for Government, California Legislative Analyst’s
Office, Feb. 17, 2006.
13 See Mercer 2004 National Survey of Employer-Sponsored Health Plans and Segal 2003
State Health Benefits Survey: Medical Benefits for Employees and Retirees.
14 See CRS Report RL32944, Health Insurance Coverage for Retirees, by Hinda Ripps
Chaikind and Fran Larkins for information regarding the high cost of health coverage for
older individuals in the individual insurance market.
Accounting for Employer-Sponsored
Retiree Health Insurance
Private Sector Employers
SFAS 106. Since the early nineties, accounting standards have had a major
influence on the level of retiree health coverage offered by private sector employers.
In 1990, the FASB released SFAS 106 that dramatically changed accounting
standards for postretirement health benefits provided by private sector employers.
SFAS 106 stated that similar to pensions, retiree health benefits were to be
considered a form of deferred compensation that created an obligation for employers
as employees rendered service. Prior to SFAS 106, employers had shown the retiree
health benefit cost for a year as the “pay-as-you-go” amount or the amount paid out
for retiree health benefit claims for that particular year. SFAS 106 specified a new
method for determining the postretirement health benefit cost.15
The postretirement health benefit cost determined under SFAS 106 required
recognition of health care benefits to be paid not only to current retirees but also to
future retirees. The postretirement health benefit cost determined under SFAS 106
was typically several times higher than the pay-as-you-go amount that it replaced on
the employer’s income statement. Higher costs lower an employer’s profits and can
lead to a lower stock price for a publicly traded company.
It should be noted that while the accrual accounting specified under SFAS 106
results in a higher cost in the year of implementation, the cost shows a more level
pattern than under prior accounting practice. Under pay-as-you-go accounting, the
postretirement health benefit cost typically increases year after year as the employee
Under SFAS 106, an employer is required to post each year the difference
between the postretirement health benefit cost and the amount funded by the
employer for postretirement health benefits, as a liability to the employer’s balance
sheet. The amount funded by the employer for postretirement health benefits is the
amount put aside by the employer in an irrevocable trust for prefunding of the retiree
health benefit plan, or the pay-as-you-go retiree health benefit amount if the employer
is not prefunding the retiree health benefit plan.
SFAS 106 also required the obligation for postretirement health benefits to be
disclosed in the footnotes to an employer’s financial statement. The obligation was
to be determined as the actuarial present value of future retiree health benefits to be
paid to employees that were attributed to service provided by employees up to the
15 In this report, we have used the term postretirement health benefit cost to mean the same
as the postretirement health benefit expense. The postretirement health benefit expense is
the amount recognized in an employer’s income statement. Usually this is the same as the
postretirement health benefit cost.
measurement date. The obligation was not posted to the employer’s balance sheet
where it would have directly reduced shareholders’ equity.16
For most employers, the effect of implementation of SFAS 106 was a higher
postretirement health benefit cost on the income statement and the disclosure of a
large postretirement health benefit obligation in the footnotes to its financial
statement. The FASB’s objectives in developing SFAS 106 were to improve the
“representational faithfulness” of the employer’s reported results in the income
statement and the statement of financial position. The FASB succeeded in making
the retiree health benefit promise much more transparent.
However, faced with new large costs on their income statements, many
employers began cutting back on retiree health benefit plans. Beginning in the early
nineties, private sector employers redesigned retiree health plans by instituting caps,
reducing commitment based on the age at retirement or years of service of a retiree,
increasing retiree premium sharing or eliminating coverage altogether for either
future retirees or all retirees.
Some have blamed the FASB for the cutbacks in employer-sponsored retiree
health benefits, although all that the FASB standard did was shed light on a promise
whose magnitude was until then obscure. The underlying reasons for the high
postretirement health cost under SFAS 106 are high health care inflation, increases
in health care utilization, growing numbers of retirements, and increasing life
expectancy. Employers point out that one of the factors in the high health care
inflation is the cost shifting by health care providers for costs that they are
constrained from charging the Medicare and Medicaid programs.
FASB’s Proposed Revisions to SFAS 106. Although SFAS 106
improved the accounting of postretirement health benefit plans from the prior pay-as-
you-go accounting, many investors and creditors believe that the current accounting
requirements need to be further revised to make it easier to assess an employer’s
financial position and its ability to carry out the obligations of its plans. To address
these concerns, the FASB has embarked on another project that will significantly
affect the accounting for postretirement health benefit plans. In the first phase of the
project, the FASB issued an Exposure Draft on March 31, 2006, that makes two
major changes to current accounting procedures. The net funded status of a
postretirement health benefit plan (fair value of plan assets less accumulated
postretirement benefit obligation) would be moved from an employer’s financial
statement footnotes to its balance sheet. In addition, plan sponsors would be required
to measure assets and obligations for the postretirement health benefit plan as of the
balance sheet date. Currently, under SFAS 106, plan sponsors are allowed to
measure plan assets and obligations up to three months earlier than the balance sheet
date. Aligning the measurement date with the balance sheet date is intended to
reduce some of the delayed recognition available under SFAS 106.
16 For a public corporation, the total assets less the total liability constitutes shareholders’
equity. This is also called the book value of the corporation and is used as a rough guide as
to whether the corporation’s shares are reasonably valued.
FASB’s goal is to make the changes proposed in the Exposure Draft effective
for financial years ending after December 15, 2006. That would mean 2006 financial
statements for firms on a calendar year reporting time table. The second phase of the
FASB project is expected to be more ambitious and controversial. In the second
phase, FASB will consider whether to eliminate “smoothing mechanisms,”
accounting rules that allow for delayed recognition of plan asset losses and increases
in plan obligations. Those changes could sharply increase postretirement health
benefit cost in certain years.
The FASB Exposure Draft provisions apply to defined benefit pension plans in
addition to OPEB plans.17 Under the FASB proposal for balance sheet posting of
funded status, the result will be reduced shareholder equity for many publicly traded
companies. This could affect the cost of borrowing and credit ratings for such
companies. An employer seeking to address the situation is more likely to cut retiree
health benefits than pensions. Unlike pensions, there are few legal barriers to
reducing retiree health benefits. Furthermore, retiree health benefit plans generally
have larger deficits than pension plans; therefore, cutting them would have a more
favorable impact on the employer’s financial position. Credit Suisse has estimated
that for the S&P 500 companies, as of year end 2004, the underfunded balance for
Other Post Employment Benefits (consisting primarily of postretirement health
benefits) is $336 billion, or 104% higher than the underfunded balance for pensions
of $165 billion.18
Reflecting the funded status of OPEB and pension plans on the balance sheet
would have the most dramatic impact on the balance sheets of old industrial, old
economy companies with heavily unionized work forces. It is estimated that if the
proposed FASB accounting rule had been in effect as of the end of 2005, the net
worth of Ford and General Motors of $14 billion and $15 billion respectively would
have been wiped out and each would have shown a net liability instead. Unfunded
retiree health care benefits would be a bigger contributor to this swing than unfunded
State and Local Governments
An accounting standard similar to SFAS 106 was released recently for retiree
health plans sponsored by governmental employers. The Government Accounting
Standards Board (GASB) released Statement 45 in June, 2004. This statement
applies to states, counties, and municipalities. Other governmental entities covered
by GASB reporting requirements may include school districts, public railroad and
transit administrations, and public university and health care systems. GASB 45
17 The accounting standard that applies to private sector defined benefit pension plans is
SFAS 87. The FASB Exposure Draft would make analogous changes to SFAS 87 as to
18 Credit Suisse Report, “The Buck Stops Where?” by David Zion and Bill Carcache, Feb.
19 “Shocks Seen in New Math for Pensions,” Mary Williams Walsh, The New York Times,
Mar. 31, 2006.
follows the broad principles established by the Financial Accounting Standards
Board (FASB) for private sector employers a decade earlier.
GASB 45, like its predecessor SFAS 106, requires the cost of a postretirement
health plan to be determined taking into account health care benefits to be paid not
only to current retirees but also to future retirees. Currently most governmental
employers record the postretirement health benefit cost for a year on a pay-as-you-go
basis. The pay-as-you-go amount is the amount of health care benefits paid out for
retirees in that year. The postretirement health benefit cost determined under GASB
45 is called the Annual Required Contribution (ARC). For large state and local
governments, GASB 45 is effective for financial statements for periods beginning
after December 15, 2006.
Though there are technical differences in the way the postretirement health cost
is determined under SFAS 106 and GASB 45, the postretirement health cost
determined under either standard is likely to be much larger than the pay-as-you-go
cost recorded under prior accounting convention. The postretirement health cost
under GASB 45 could be 5 to 10 times the pay-as-you-go cost. For example, in New
York City, the retiree health benefit cost under current pay-as-you-go accounting is
$911 million. This is expected to shoot up to between $5 billion to $10 billion under
GASB 45.20 For the state of Maryland, the retiree health cost under current
accounting for the fiscal year 2006 is $311 million. The retiree health benefit cost
using GASB 45 accounting would be $1.959 billion.21
Under GASB 45, the employer is also required to disclose the actuarial accrued
liability, which, according to consultants, could be as large as 50 times the annual
retiree health benefit claims. For example, for the state of Maryland, the unfunded
accrued liability for retiree health benefits is estimated at $20 billion.22 In addition,
the employer must post the net postretirement health obligation to the balance sheet
equal to the cumulative difference between the ARC and any contribution that the
employer has made to an irrevocable trust for prefunding retiree health benefits.23 If
the employer does not set aside additional funds each year for the payment of retiree
health benefits, the net postretirement health obligation is likely to grow rapidly. A
large net postretirement health obligation is likely to adversely affect a state or city’s
credit rating and increase the interest rate it pays on borrowing.
There are two ways a state or local government can reduce the net
postretirement health obligation: limit retiree health coverage or start prefunding the
retiree health benefit plan by contributing monies to an irrevocable trust to be used
20 See “Huge Rise Looms for Health Care in City’s Budget,” The New York Times, Dec. 26,
21 “Change in Financial Reporting Obligations May Affect State, Local Retiree Benefits,”
BNA Pension & Benefits Daily, Feb. 28, 2006.
23 If the employer is not prefunding the retiree health benefit plan, the net postretirement
health benefit obligation is the cumulative difference between the ARC and the retiree
health benefit claims paid out.
for payment of these benefits. In a departure from SFAS 106, GASB 45 allows the
use of a higher interest rate for determination of the postretirement health benefit cost
if the ARC is set aside in a trust dedicated to payment of the retiree health benefits.
Since the use of a higher interest rate lowers the cost and net obligation (a general
rule of thumb is that a 1% increase in the interest rate reduces the ARC and actuarial
accrued liability by 15%-20%), this provision will provide further incentive to state
and local governments to prefund retiree health benefits.24
Although state and local governments are likely to evaluate plan designs with
an eye on limiting liabilities, it is unlikely that they will cut benefits to the extent that
private sector employers reduced benefits in the wake of SFAS 106. Changing
retiree health benefits requires legislation for most states and also for some local
governments. Employees in state and local governments are unionized to a larger
extent than in the private sector and are likely to put up greater resistance to cuts in
A sponsor of a retiree health benefit plan is not legally required to make annual
contributions to a trust. Prefunding via an irrevocable trust makes the promised
benefits more secure. Funds set aside for payment of retiree health benefits may not
be accessed for other purposes by either the employer or creditors. Funding also
lowers the accounting liability and cost for the retiree health plan. In many instances,
funding may lead to a higher return on assets set aside in the trust compared to the
return on the employer’s general operating funds.
The tax code in general does not provide as favorable a tax treatment for
prefunding of retiree health benefits as for pension benefits. With respect to assuring
that benefits will be paid to employees as promised, an ideal funding vehicle for the
prefunding of retiree health benefits would have the following characteristics:
!Sufficient contributions may be made to allow accumulation of
adequate funds for payment of retiree health benefits.
!The rate of return on assets in the trust compares favorably to
alternate uses of employer funds.
!Contributions made to the trust are tax deductible to the employer
and tax free to employees.
!Retiree health care benefits paid out of the trust are tax free to
!Assets accumulated in the trust are not accessible to creditors of the
employer in the event of employer bankruptcy.
24 For an example of the effect of the interest rate on ARC and the retiree health liability, see
“Managing OPEB Costs under New GASB Rules,” by Milliman Consultants and Actuaries,
April 2005 at [http://www.milliman.com].
25 2004 CPS data for active employee and dependent populations indicates that for state and
local governments, 50% of the population is unionized whereas for the private sector only
!Trust assets are recognized as an offset to liabilities for accounting
If such an ideal vehicle for prefunding retiree health benefits were to be made
available on a broad basis under the tax code, Congress might opt to add other legal
requirements that are currently missing. For example, minimum standards for
participation, vesting, and funding might be established. Congress might also
consider adding an insurance mechanism to protect benefits in the event of
termination of an underfunded retiree health plan.
We discuss below the primary prefunding vehicles currently available under the
Voluntary Employee Benefit Association
An employer may prefund a retiree health benefit plan via a Voluntary
Employee Benefit Association (VEBA) trust organized under Section 501(c)(9) of
the Internal Revenue Code (IRC). However, unless the VEBA has been established
under a collective bargaining agreement or is an employee-pay-all-VEBA
(contributions to the VEBA are made by employees only), the maximum allowable
contribution is limited and may not take future health care inflation or utilization
increases into account. Furthermore, investment income on the VEBA trust assets
is subject to Unrelated Business Income Tax (UBIT) unless the VEBA is a
collectively bargained VEBA, an employee-pay-all-VEBA, or a VEBA sponsored by
a tax-exempt organization. Tax rates applicable to trusts are used to calculate the
UBIT for VEBAs.
Certain types of VEBAs enjoy preferential treatment under the IRC. A VEBA
trust established pursuant to a collective bargaining agreement for prefunding of
retiree health benefits has favorable tax treatment. Investment income on the trust
is not taxed, employer contributions to the trust are tax deductible, and adequate
contributions may be made to the trust taking into account future health care inflation
and utilization increases.
If contributions to a VEBA trust are made by a tax-exempt employer such as a
state or local government or a non-profit entity, earnings on assets in the trust are not
subject to tax. However, health care inflation or utilization increases may still not be
taken into account in determining the limit on VEBA funding in a year.
Some employers have established employee-pay-all VEBAs for prefunding
employee out-of-pocket health care costs in retirement. In this type of VEBA,
employees make all of the contributions, with no contributions made by employers,
and the investment income on the VEBA accumulates tax free. Employees can
withdraw funds after retirement from the VEBA to pay health care costs without
paying taxes on the withdrawals. However, current law poses some problems in the
application of employee-pay-all VEBAs for saving for out-of-pocket health care costs
in retirement. Amounts contributed by an active employee to the VEBA can not be
refunded to the employee or his family upon job termination or premature death. In
addition, although investment income on funds in an employee-pay-all VEBA is not
subject to UBIT, if employee and employer funds are commingled in the same
VEBA, all investment income is subject to that tax.
An employee-pay-all VEBA can be used effectively in an industry where an
employee leaving one employer is likely to take up a job with another employer
within the same industry. This is particularly true for employers that are not subject
to tax. An example is a program called Emeriti Retirement Health Solutions that was
recently marketed to academic employees of nonprofit colleges. The program allows
employees to contribute on an after-tax basis to an employee-pay-all VEBA.
Employee contributions earn tax-free interest. Each employer also makes annual
contributions on behalf of employees to a separate VEBA up to the level it wishes to
support, and these contributions accumulate tax free because the colleges are
nonprofit entities. Upon retirement, employees withdraw funds tax free to pay
premiums for one of several choices of health care plans.26
For employer-funded VEBAs, separate accounts must be maintained for key
employees. Employers usually avoid the cumbersome procedures this imposes by
excluding key employees from the VEBA, although not from retiree health coverage.
Under Section 4976 of the IRC, any reversion of VEBA assets to the employer
is subject to a 100% excise tax. This has the effect of committing VEBA assets only
for payment of the benefits for which the VEBA was funded.
401(h) Subaccount of a Defined Benefit Pension Plan
A limited amount of prefunding for retiree health benefits can be achieved
through a subaccount of a defined benefit pension trust established under Section
401(h) of the IRC. Unlike a VEBA, future increases in retiree health care costs may
be taken into account in determining the contribution to a 401(h) subaccount.
However, retiree health benefits provided through a 401(h) subaccount must be
subordinate to pension benefits, meaning that the employer’s contribution to the
401(h) subaccount may not exceed 25% of the total employer contribution to the
pension fund. Investment income on assets in the 401(h) subaccount accumulates tax
free, and retiree health benefit payments made from the subaccount are not taxable
Transfer of Excess Pension Assets
to a 401(h) Subaccount
Section 420 of the IRC allows an “overfunded” defined benefit pension plan to
transfer excess pension assets (defined as the excess of plan assets over the greater
of the accrued liability under the plan’s funding method, or 125% of the current
liability of the plan) to a 401(h) subaccount for payment of retiree health benefits.
The amount of transfer is limited to the amount of current retiree health benefits. In
other words, such a transfer may not result in prefunding. If prefunding has been
done for current retiree health benefits through a VEBA, then the amount of transfer
permitted is limited to take into account VEBA prefunding.
26 Making Retiree Health Care Affordable,” Jerry Geisel, Business Insurance, Jan. 23, 2006.
An employer that makes a Section 420 transfer must fully vest all employees in
their pension benefits, including employees who terminated service one year before
the date of transfer. In addition, there is a “maintenance of cost” requirement under
which the employer may not reduce the per capita cost of the retiree medical plan for
five years after the asset transfer.
Section 115 Trust
Governmental employers can establish a trust under IRC Section 115 to fund an
essential government function, including providing retiree health benefits.
Contributions to a Section 115 trust are not limited, unlike contributions to a VEBA
or 401(h) subaccount. The investment income on a Section 115 trust is not taxed,
and the benefits ought to be tax free to the retiree when received. However, the IRS
has issued little guidance with respect to the use of Section 115 trusts for funding
retiree health benefits. Consultants advise that governmental employers obtain an
opinion from the IRS to confirm that benefits paid to retirees would be tax free
before establishing a Section 115 trust for this purpose.
Other Prefunding Vehicles
VEBAs and 401(h) accounts of defined benefit pension plans are the most
common funding vehicles used for prefunding of retiree medical plans. Employers
have sometimes used both a VEBA and 401(h) account for the same retiree health
plan in order to maximize prefunding. Some employers have also sought to
maximize the after-tax investment income on VEBA assets by investing trust assets
in Trust Owned Life Insurance or Trust Owned Health Insurance.
More esoteric funding vehicles that have been used by certain employers include
money purchase pension plans.
Prefunding of Retiree Health Benefit Plans is Limited
Although tax policy with respect to prefunding of retiree health benefits is not
as clearly favorable as for pension plans, a private sector employer so inclined could
accomplish full prefunding for unionized employees and at least limited prefunding
for non-union employees. However, very few private sector companies prefund the
postretirement health obligation to any significant extent. According to Credit
Suisse, of the S&P 500 companies, 331 offer OPEB (mostly retiree health benefits).
Of these, 186, or 56%, have no plan assets, which makes payment of retiree health28
benefits dependent on availability of cash each year. Prefunding of state and local
government plans also appears to be limited.
27 For a more detailed description of prefunding vehicles, see “Design and Funding of Other
Post-Employment Benefits,” Society of Actuaries Study Note, Course 8, April 2000, by Dale
28 Credit Suisse Report,”The Buck Stops Where?” by David Zion and Bill Carcache, Feb.
Since so few employers have earmarked assets to an irrevocable trust for
payment of retiree health benefits, employees are vulnerable. In addition, retiree
health benefits can generally be reduced or terminated by an employer at any time,
as long as the employer has reserved the right to modify the retiree health plan and
there is no bargaining agreement in effect with an employee union. An employer in
Chapter 11 bankruptcy reorganization may not terminate a retiree health benefit
program without first negotiating proposed modifications with representatives of
retirees, and second, seeking and receiving court approval to make the
modifications.29 However, many employers undergoing a Chapter 11 reorganization
do end up eliminating or dramatically reducing retiree health benefits.
Public Policy Implications
Over-65 retirees without employer-sponsored retiree health insurance have
access to fairly comprehensive health insurance through Medicare, even though
payment of significant Medicare premiums is required. In 2006, the monthly
Medicare Part B premium is $88.50 and the average monthly premium for the
Medicare Part D Prescription Drug program is $32.30 However, Medicare coverage
has many gaps. The most notable of these are the lack of hospital coverage for very
long stays and the so-called “doughnut hole” in Medicare Part D coverage for
prescriptions. Medicare does not cover any prescription costs that fall in this hole.
In 2006, for example, Medicare Part D provides no coverage for prescription costs
between $2,250 and $5,100. In addition, a Medicare beneficiary is responsible for
payment of many deductibles, coinsurances, and copayments. An employer-
sponsored retiree health insurance plan would typically fill some of the gaps in
Cutbacks in over-65 retiree health insurance benefits would increase the
Medicare beneficiaries’ share of out-of-pocket health care costs and strain the limited
resources of these retirees. Legislation has been introduced in the 109th Congress that
would prohibit profitable employers from making any changes to retiree health
benefits once an employee has retired.
Elimination of employer-sponsored retiree health insurance for under-65 retirees
and older employees close to retirement can cause even greater distress. Under-65
retirees who lose employer-sponsored health insurance are put in a bad position since
the marketplace does not offer many alternatives for reasonably priced individual
health insurance. Employees who had planned to retire before age 65 can find
themselves unable to do so without access to reasonably priced health insurance.
Legislation introduced in the 109th Congress attempts to provide solutions. One
policy option that has been discussed would expand provisions of the Consolidated
29 For more on the treatment of retiree health benefits in bankruptcy, see CRS Report
RL33138, Employment Related Issues in Bankruptcy, by Robin Jeweler.
30 [http://www.cms.hhs.gov/apps/media/press/release.asp?Counter=1557], accessed on Mar.
Budget Reconciliation Act (COBRA) to allow individuals who retire before reaching
age 65 to purchase health insurance coverage through their employers until age 65.
Another policy option would increase health insurance coverage for younger retirees
by allowing individuals to purchase Medicare prior to attaining age 65. Yet another
would allow individuals aged 55- 65 who do not have health insurance to buy into
the health insurance program for federal employees and retirees. For a detailed
discussion of policy options and legislation introduced in the 109th Congress, see
CRS Report RL32944, Health Insurance Coverage for Retirees, by Hinda Ripps
Chaikind and Fran Larkins.
Some are advocating the use of Health Savings Accounts (HSAs) for
accumulating assets to pay out-of-pocket health care costs in retirement. Although
HSAs could possibly be put to this use in future, it would take ten or more years for
an individual to accumulate a meaningful amount to be used for payment of out-of-
pocket retiree health care costs.31 The Bush Administration has proposed increasing
the maximum amount of contribution allowed into an HSA. If the proposal is
enacted into law, it would allow for accumulation of larger HSA balances that could
be used for payment of out-of-pocket health care costs in retirement.
A more direct way to promote employee savings for retirement health care costs
might be to modify the current laws and regulations that apply to VEBAs. Although
employee-pay-all VEBAs can be used to accumulate funds for out-of-pocket health
care costs in retirement, current law does not allow payment of an employee’s VEBA
balance upon termination or premature death. Allowing such payments or allowing
rollover of VEBA balances to a tax-free health retirement account for the employee
or spouse would make an employee-pay-all VEBA a more useful savings vehicle for
accumulation of funds for an individual’s out-of-pocket costs in retirement.
Congress may also consider allowing investment income on an employer-funded
VEBA to accumulate tax free to promote increased prefunding by employers.
As state and local governments evaluate unfunded retiree health liabilities under
GASB 45, some of them are likely to join the private sector in reducing retiree health
care benefits. This will lead to renewed calls for national level solutions to the
problem of lack of access to reasonably priced health insurance.
GASB 45 is likely to lead many states and local governments to begin
prefunding retiree health benefit plans. Some state and local governments may
reduce outlays for other programs, whereas others may increase property taxes, sales
taxes, or other taxes.
As employers cut back retiree health benefit coverage, many older employees
are likely to choose to work a few years longer in order to retain health insurance
31 For numerical illustrations of HSA accumulations, see EBRI Issue Brief No. 271, July