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CCH® BENEFITS — 04/14/10

Major Employers Announce Costs Of Drug Subsidy Change; Long-Term Impact Is Uncertain

from Spencer’s Benefits Reports: Some major employers have announced large non-cash charges against their retiree medical liabilities as a result of a provision in the Patient Protection and Affordable Care Act (P.L. 111-148). As of Jan. 1, 2013, the law removes the amount of the Medicare Part D retiree drug subsidy (RDS) these firms receive from the amount of prescription drug costs that they claim as a deduction in their corporate tax returns.

AT&T issued a press release stating that the repeal of the RDS tax-preference caused it to take a $1 billion non-cash charge against earnings for the first quarter, as required by Financial Accounting Standard (FAS) 106. FAS 106 requires companies to take a one-time charge for obligations for current and future retirees’ benefits in the quarter in which a tax law change is enacted. The $1 billion amount that AT&T reported is said to represent one-third of the company’s earnings for the fourth quarter 2009. Deere & Company said it is taking a $150 million charge, Caterpillar $100 million, and 3M, $85 million to $90 million.

These firms, along with the American Benefits Council, and some unions, fought the inclusion of this provision, and they continue to do so.

Currently, as allowed under the Medicare Modernization Act that enacted the prescription drug benefit, employers that sponsor retiree drug benefits that are actuarially determined to be equivalent to the Part D benefit can receive from Medicare a tax-free subsidy (commonly referred to as a retiree drug subsidy or RDS) of 28% of the employer’s claimed cost for the drug benefit they provide their Medicare-enrolled retirees. At the same time, the employer may deduct from the firm’s annual corporate taxes the entire amount it claims it paid for retiree drug benefits, unreduced by the RDS amount.

For example, a firm claims, and deducts from its business income tax, $100,000 in retiree prescription drug costs and does not reduce this amount by the $28,000 RDS it receives from the government. As provided by the health reform legislation, employers still may obtain the tax-free RDS, but they would have to deduct the RDS amount from the retiree drug costs they claim as a deduction on their annual corporate taxes. Using this example, the firm would be able to deduct $72,000 from their income taxes.

The Obama administration has characterized the RDS tax deduction as “a loophole that allows companies to receive a tax-free subsidy, then take a deduction for it.”

“Essentially, what’s happened is that they’ve lost a tax deduction opportunity, which is ‘comparable’ to taxing the RDS,” said John Gross, principal and actuary of Hewitt’s Health Management Consulting Practice, in an interview with Spencer’s Benefits Reports. “The bottom line is that employers are losing the special tax benefit of the RDS which will increase their net drug costs over time.”

“The RDS is still tax-free, it just is not tax deductible,” said Mary P. Kirby, vice president and consulting actuary for Sibson Consulting, a division of Segal. “Part of the issue, is that Congress intentionally created this loophole,” the ability to deduct the amount of the RDS as a business expense.

If a firm has a combined retiree medical and prescription drug plan and the retiree makes a single contribution for the plan, the firm has flexibility in its actuarial attestation on how it allocates that retiree contribution, Ms. Kirby continued. For example, the firm can say that the retiree’s entire contribution goes for medical and that the employer picks up the entire cost of drug benefits. This allows the plan’s equivalency to pass so that the firm can collect the subsidy. “The government gave companies some flexibility to put their subsidies for retiree medical for drugs first, so they can qualify for the RDS,” Mr. Gross agreed.

“What we’re seeing now, is companies having to account for the change in the law,” Mr. Gross explained. “They have to undo a projected tax benefit that they were plannning to get. The charge taken this quarter is an estimate based on the present value of future benefits There’s actually the possibility of that number being corrected or adjusted over time as actual reality plays out over the next 20 to 30 years. But we wouldn’t expect reality to be dramatically different from the estimate. It’s a very long term projection based on the employer’s current and communicated plan design.”

How reasonable are these employers’ FAS 106 non-cash charge claims? “I would characterize them as best estimate actuarial projections related to the change that follow actuarial standards of practice,” said Mr. Gross. “These projections are reviewed and signed off on by auditors. Employers generally don’t have choices when it comes to these kinds of adjustments; they are driven by accounting and tax standards.”

“I was surprised at the size of the numbers,” Ms. Kirby said. “But I think it was just bad timing—the numbers are coming out a lot quicker because companies with calendar year fiscal years must report now for the first quarter of 2010.”

“This could be tested rather easily in terms of reasonableness by getting information on each subsidy payments for the past few years,” explained Steve Arbaugh, principal for ATTAC Consulting Group, LLC, an Ann Arbor, Mich.-based management consulting firm that works with insurers, managed care firms, regulatory agencies, physicians and other health care providers. “The employers ‘screaming’ about this tend to be those with a large percentage of unionized workers (those that can’t change benefits or contracts easily in the latter case to move to a straight Part D contract and ditch the subsidy) and in older, manufacturing, governmental, or utility type industries where they have a large number of retirees and likely early retirees given the downsizing that’s happened of late, So reasonableness? Hard to absolutely say, substantive impact, yes potentially. Loss of a government “gimmee?” Absolutely.”

Nevertheless, employers cannot actually deduct the costs until they are incurred, clarified Ms. Kirby. The employers are accruing liability presuming that the company is not makiing any changes to the plan design in the future, she added, which is why the valuation for the current value of benefit is done every year or evey other year.

The Patient Protection Act also provides that employers will be reimbursed for medical costs of retirees younger than age 65 that exceed a certain amount, a type of reinsurance program. The program is effective beginning June 23, 2010, and will continue until the $5 billion allocated for the program is exhausted. Why are employeers sponsoring medical benefits for early retirees not recognizing the potential savings from this program? For one, “the $5 billion allocation goes away very quickly,” Ms. Kirby noted. “Also, we don’t know how it’s going to work, and I’m sure there will be more claims than there are reinsurance dollars. Actuaries would need to determine if the reinsurance amount would be significant enough to value for FAS 106.”

The proportion of employers with 200 or more workers that provide retiree medical benefits has plummeted to 29% in 2009, from 66% in 1988. And in its 2010 Retiree Health Care Cost Survey, consulting firm Towers Watson found that only 45% of respondent companies subsidized retiree medical benefits. Furthermore, many retiree medical plan sponsors have capped the amount they will pay for retiree medical and long ago reached those caps. Once the sponsor reaches cost caps, retirees pay the excess.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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