Employers who provide health benefits to retirees could be in for some "nasty surprises" this year because of an upward spike in health care costs and a recent court decision, according to legal and actuarial experts.
Health care inflation increased significantly in the past two years after remaining relatively stable during the previous four years. According to a survey by William M. Mercer Inc., New York, employers' total health care plan costs for active employees increased 7.3% last year and 6.2% in 1998. Employers expect cost increases to average 7.5% this year, according to Mercer.
The rise is sobering news, since the cost trend rate is one of the assumptions used in calculating retiree medical liabilities on corporate financial statements under Financial Accounting Standard 106.
Aside from the runup and its impact on retiree medical liabilities, continuing uncertainty about the federal Medicare program and a recent legal opinion that federal age discrimination law applies to retiree medical coverage pose additional concerns for employers that offer such coverage.
Unlike their approach to pension obligations, most companies do not prefund retiree medical liabilities.
There may be some "nasty surprises" for employers faced with rising health care inflation, said Anna Rappaport, principal at Mercer and expert on retiree medical care.
"If costs have been going along fairly flat and then you see a big bounce, it becomes a big issue again. It bumps up your liabilities and impacts the income statement. It could be a big issue for some companies," said Ms. Rappaport. "A lot of companies looking at FAS 106 will have to revisit their assumptions. After several steady years, some are likely to see a jump. A lot of details need to be considered, but there may be storm clouds on the horizon."
Particularly troublesome, according to industry sources, is a recent legal decision which, if it stands, will force employers to look at whether they can offer retiree medical benefits without overhauling their plans or subjecting themselves to accusations of age discrimination.
Erie County case
The Third U.S. Circuit Court of Appeals for the Western District of Pennsylvania in Philadelphia found that under the Age Discrimination in Employment Act employers may not provide health benefits for Medicare-eligible retirees that is inferior to that provided for younger employees.
In 1998, Erie County, Pa., implemented a new retiree health plan design for county employees in which Medicare-eligible retirees were provided with coverage that, retirees argued, treated them less favorably because of their age in violation of ADEA. A lower court concluded that ADEA did not apply to retirees. The decision was reversed on appeal and sent back to the lower court for a new hearing. The Pennsylvania case affects the court's three-state district - Pennsylvania, Delaware and New Jersey - and a final determination is likely to be decided by a higher court.
If the appeals court decision ultimately is validated, it will have a wide impact. According to a report by attorneys at the Washington Resource Group of William M. Mercer Inc., the appeals court's conclusions "threaten the viability of several common retiree health plan designs" and potentially allow retirees to seek legal recourse under ADEA.
"The decision is sure to prompt calls for Congress to clarify ADEA and may contribute to the decline in retiree health plan coverage," said the Mercer report.
The ADEA generally prohibits employers from discriminating against individuals age 40 or older regarding terms and conditions of employment, including employee benefit plans. However, according to the Mercer report, employers may apply age-based distinctions in benefit plans if they can satisfy one of several statutory exceptions, such as the "equal benefit or equal cost rule," under which employers either must provide equal benefits to older and younger workers, or incur the same costs for each group. The appeals court sent the case back to the lower court to determine whether Erie County complied with the rule.
If the appeals court findings stand, employers would be faced with the uncomfortable choice of increasing benefits for post-65 retirees, reducing benefits for pre-65 retirees or eliminating retiree medical coverage, Ms. Rappaport said. "All of these factors taken together mean there is growing pressure for employers to look at their retiree health strategies and look at ways of reducing costs, risks and perhaps plan design," she said.
According to a 1999 report by the Hay Group, Philadelphia, about 7% of employers offered coverage to pre-Medicare retirees but not to Medicare-eligible retirees. The Hay report also showed the same medical benefits provided to active employees are provided to early retirees in 74% of plans, compared with 69% of plans providing the same benefits to retirees age 65 and over. The Mercer survey showed that 28% of employers with at least 500 employees offered medical coverage to Medicare-eligible retirees, and 35% provided coverage to pre-Medicare retirees.
Under FAS 106, adopted in 1993, companies must accumulate medical liabilities for each worker over his or her working life and show the effect of the liability on financial statements. Increased health care inflation contributes to a higher liability.
"We are starting to see it (health care inflation) pop up," said Barry Barnett, principal at Unifi Network, a unit of PricewaterhouseCoopers LLP, Teaneck, N.J. "Employers aren't changing their assumptions, but they are starting to look at them, and there is pressure to move them up."
Among the issues raised by the Pennsylvania case, said Mr. Barnett, are "how do you value Medicare," since many retiree medical plans have carve-out plans that take Medicare into account when offering retiree coverage.
"For employers, it's going to be a matter of analyzing whether they must provide the same level of benefits (to both groups) and how to value Medicare. It could become a major issue," he said. "But the (appeals) court has pushed it back down to the lower court, and it may end up not applying to all employers."
Henry Saveth, an attorney and principal at Mercer, said the Erie County decision "cries out for legislative correction."
He said Congress never intended ADEA to apply to retiree medical benefits and that, if the Pennsylvania decision stands, then Congress may have to consider an ADEA exemption "so that retirees can't sue for age discrimination and that ADEA not mandate the same benefits for Medicare-eligible retirees and younger retirees."
If the decision stands as is, he said, employers would face upgrading benefits for Medicare-eligible retirees and face increased liabilities, or provide less generous benefits for post-Medicare retirees, or eliminate them altogether, and reduce or eliminate retiree medical liabilities.