The accounting rule for post-medical liabilities that resulted in billions of dollars in reduced operating earnings last year still holds some expensive surprises.
Industry sources warn there may be additional reductions in earnings linked to higher ongoing annual expenses caused by Financial Accounting Standard 106. But the FAS 106 writeoffs apparently have had no effect on stock prices, and analysts and portfolio managers are likely to treat the increased annual expenses with similar lack of concern.
FAS 106 requires employers to accrue as an expense against earnings retiree health care benefit obligations from the date employees are hired until they become eligible for benefits. Employers had recognized these obligations on a pay-as-you-go basis before 1993.
In 1993, most companies adopted FAS 106 and recognized obligations for past service liabilities on the balance sheet, resulting in writedowns of 7% to 12% in book value among Standard & Poor's 500 companies alone.
While many investment managers and financial analysts believe 1993's big writeoffs and resulting earnings losses put the bad news behind, there will be ongoing, albeit smaller, financial problems associated with FAS 106 that could produce a drag on earnings, according to benefits specialists and actuaries.
The adoption of FAS 106 produces higher continuing expenses, which most believe are two to 10 times higher than pay-as-you-go expenses. In addition, the accrued liabilities, most of which are unfunded, ultimately will have to be paid, even though the impact on financial statements has been non-cash accounting charges.
"FAS 106 is not behind us," said John Hickey, partner and actuary at Kwasha Lipton, Fort Lee, N.J. As with FAS 87 accounting for pension liabilities, the discount rate used to calculate the present value of the accrued liability under FAS 106 rises and falls with long-term interest rates. But unlike in pension accounting, there is at least one wild card that can offset or magnify any change in the discount rate: assumptions about long-term health care cost inflation.
"The interesting thing is that coupled with interest rates going up, health care inflation is not. There are some encouraging numbers on health care inflation. We have a number of clients seriously considering allowing the discount rate to go up while keeping the health care cost trend rate the same," said Mr. Hickey.
Assuming no change in health care cost trend rates, he said, for every one percentage point increase in the discount rate, the liability would be reduced 10% to 15%. If, however, the discount rate and the trend rate are increased by the same amount, there would be no change in the accrued liability.
Most actuaries believe it is too early to say exactly how employers will react to lower health care inflation, but most believe discount rates will have to be adjusted upward because of the rise in long-term interest rates in 1994.
After hovering in the low to mid-20% range of annual increases since 1989, the average projected increase in cost for comprehensive medical plans dropped to 15% in 1994, according to a survey of 36 health insurers by Sedgwick Noble Lowndes, a global employee benefits consulting firm. Another survey by Milliman & Robertson Inc., New York, found health care cost increases should average 8% in 1994, down from double-digit increases for the past few years.
"We see health care inflation in the single digits now or no increases," said Mr. Hickey.
According to a survey of 463 large employers by Buck Consultants, New York, the average assumed discount rate for FAS 106 dropped to 7.33% in 1993 from 8.27% in 1992. The average health care cost trend rate also showed lower expected rates of health care cost increases. For 1993, the cost trend rates used to measure the cost of benefits for the next year averaged 11.7%, compared with 12.84% for 1992 disclosures.
Robert Alps, vice president at Sedgwick Noble Lowndes, Chicago, said increasing the discount rate and the trend rate by comparable amounts would likely produce an increase in FAS 106 ongoing expenses because the interest component will rise. Ongoing expenses consist of current service costs and interest costs. The interest component is calculated by applying the discount rate to the liability.
Thus, he said, "expenses could be higher even though the liability remains the same," he said. "And expenses count against income for the year on the income statement."
The big question said Mr. Hickey at Kwasha Lipton, is "whether employers will change the health care cost trend rate. The answer is some will and some won't. Those that do not, could see some relief in FAS 106 expenses," which still will be several times more than the old pay-as-you-go method.
On the other hand, FAS 106 costs would decline somewhat if the discount rate is increased without changing the medical trend assumptions, as seems likely in many cases, said Bill Minor, consultant at the Wyatt Co., Chicago.
"That means people will probably see lower liabilities and lower net periodic costs in 1995. It would be good news for employers and shareholders. No one has an appetite for raising the trend rates now," he said.
But one high-profile FAS 106 expert, Anna Rappaport, managing director at William M. Mercer Inc., Chicago, is optimistic about the probability of reducing both accrued retiree medical liabilities as well as ongoing costs. She believes there has been a "structural change" in the health care industry, of which lower medical cost inflation is the first visible sign.
Ms. Rappaport said the days of 12% to 15% health care cost inflation are past, and she would recommend drastic cuts in the assumed rate. "I would feel personally comfortable with a trend rate much lower, lower than 10%, because I believe the marketplace has changed and medical costs will drop the way computer prices have dropped in the past few years."
She said employers adopting dramatically lower health care cost assumptions and increased discount rates could see their liabilities drop 10% to 20%.
But the investment community seems to be giving the FAS 106 issue little attention even in light of last year's massive writedowns and expected continuing impact on reported corporate earnings.
The reduction in book value because of FAS 106 writeoffs last year and the corresponding increase in price-to-book ratios of the S&P 500 scarcely raised an eyebrow, and many analysts claim the issue is largely in the past.
One value-oriented investment manager said he has adjusted for FAS 106 and does not anticipate further problems.
"We watch several ratios besides price-to-book since these are non-cash issues. We look at price-to-cash flow and price-to-sales. We adjust for the retiree health liabilities in order to make valuations meaningful. It may be a drag on reported earnings, but any smart analyst adjusts for non-cash issues like this. We look beyond this and look at the operating capabilities of the company. I don't mean to make light of it, but it has always been there and now they are recognizing it in their financial statements."
Another value manager agreed, saying FAS 106 expenses and last year's writeoffs "could knock a few points off reported earnings, but we always knew it was there and it was part of the makeup of the company and was factored in. Everyone was worried for a while before FAS 106 but it is behind us now," he said.
Such comments concern some experts who point out the liabilities are still largely unfunded and even though FAS 106 liabilities are non-cash charges to earnings, the liability represents an obligation that must be paid at some point.
LCG Group, Atlanta, commissioned a study in 1993 that found the FAS 106 transition liabilities written off by the Standard & Poor's 400 companies represented a 7% decline in book value with an additional 7.8% reduction expected to occur over the next 10 years as additional charges are taken against book value.
"To me, the most interesting aspect of all this is the fact the country has written off a significant portion of its value. What is lost in all the other writedowns in the industrial and manufacturing world is the writedown of 7% to 8% of book value," said Roger Bransford, principal at LCG. "There is also the incremental amount equal to that on an annual basis to be taken over the next 10 years. When it is finished, you will see 10% to 15% of the book value of corporate America written off. My singular observation is that these are big numbers. The concern is that there will be less value there than before and when you talk with most analysts and portfolio managers, it is seemingly not an event of true significance.