OPEB, COLI and Post-Retiree Needs

[Editor's Note: The recently passed COLI Best Practices ' 101(j), Deferred Compensation ' 409A and the Medicare Act of 2003 require advisers to review all qualified and nonqualified benefit programs. These legislative changes and the courts' review of COLI provide attorneys with a different approach to help solve their benefits planning problems. While pensions have been codified, limited, and scrutinized since 1974 with ERISA, non-pension post-retiree benefits (OPEB-GASB 45, FAS 106, and IAS 19) have been less regulated ' until now. Judicial action, legislation, and administrative agency action have caused a paradigm shift in benefits planning. Last month, the article focused on OPEB limitations and court cases. Part Two discusses safe harbors.]

Safe Harbors

At the same time steps are being instituted to curtail COLI, there is an ever-increasing need to fund for employee medical care and post-retirement medical expenses. The use of COLI and the new Health Savings Accounts (“HSA”) can provide a robust funding vehicle. Since 1996, a pilot program has made Medical Savings Accounts (“MSA”) available to small businesses and the self-employed. Because of the many restrictions, only about 70,000 people have these accounts. A U.S. Treasury Department ruling in 2002 allowed large companies to establish Health Reimbursement Arrangements, and at last count, 1.5 million employees had enrolled. However, these accounts are also unreasonably restricted. Flexible Spending Accounts (“FSA”) offer consumers the chance to withhold funds tax free for medical care. These funds have a use-it-or-lose-it feature that requires employees to forfeit unused funds to employers at the end of the year. This forfeiture provision encourages employees to waste money on unnecessary care and makes most people apprehensive about depositing money except when they can precisely predict their future medical needs. The Medicare Prescription Drug, Improvement and Modernization Act of 2003, signed by President Bush, affected planning starting after Dec. 31, 2003 with two powerful tools that can coordinate and expand COLI.

HSAs are flexible and consumer-friendly accounts. They allow individuals and employers to make pre-tax deposits each year equal to their health insurance deductible. The health insurance policy that accompanies an HSA must have an overall deductible of at least $1,000 for an individual or $2,000 for a family policy. A typical plan will work like this: When individuals enter the medical marketplace, they will spend first from their HSA. If they exhaust their HSA funds before reaching the deductibles, they will then pay out-of-pocket. Once they reach their deductibles, insurance pays all remaining costs.

Annual HSA deposits cannot exceed the amount of the health insurance deductible, and typically cannot exceed $2,600 for individuals and $5,150 for families. However, the account balances can earn interest or be invested in stocks or mutual funds, and they will grow tax free. Thus, a young employee could accumulate hundreds of thousands of dollars by the time he or she retires.

HSA balances belong to the individual account holders and remain theirs if they switch jobs, become unemployed or retire. The funds can be used to pay expenses not covered by insurance, insurance premiums while unemployed, and health expenses during retirement. In the event of death, HSAs may be bequeathed to a spouse, or (like an IRA) the funds may flow to other heirs.

HSAs are a defined contribution health care arrangement enabling employees and employers to make deductible and excludible contributions, which grow tax-free, in order to pay for qualified medical expenses.

Coverage Options

There are four different routes for coverage: 1) traditional Blue Cross/Blue Shield type indemnity coverage; 2) Health Reimbursement Arrangements (“HRAs”) coupled with a Flexible Spending Arrangement (FSA), where the FSA pays the first dollar expenses until exhausted; 3) MSAs, which are likely to go away as a result of the enactment of HSAs; and 4) HSAs, where an employer offers a HDP that can be funded by the employee and/or the employer. (BNA Parishioners Forum Discussion on Health Savings Accounts, Michael Thrasher, Dec. 8, 2003.) MSAs were only available to small employers. HSAs are now available to all employers and even individuals who are covered under a HDP, as long as the individual is not covered under a non-HDP. MSAs can only be offered with an HDP. HRAs can be a stand-alone arrangement, coupled with an HDP, or even offered with an FSA (subject to specific ordering rules). HSAs can even be offered as an option under a Code Section 125 cafeteria plan.

Unlike HRAs, both MSAs and HSAs permit non-health distributions. However, a penalty tax is imposed (10% excise tax under HSA and 15% under MSA) on non-health distributions made before death, disability or becoming Medicare-eligible, i.e., age 65. Thus, individuals 65 and over can make non-health withdrawals from their HSAs without incurring a tax penalty. Such amounts would still be includible in income in the year of distribution.

HSAs are attractive because the employee may have access to the money. Under HRAs, however, the employee cannot have access to the money because, by definition, an HRA must be funded solely with employer money. This may be a design issue in that if employers want to give employees access to the money, HSAs are attractive. But if the employer does not want the employee to gain access to the money, or the employer wants the potential benefit of forfeitures, an HRA is better suited. Therefore, HSAs may be good for employees but not good for employers because HSAs must be funded, whereas HRAs may be unfunded and simply be maintained on the employer's books. Most HRAs are currently unfunded book accounts.

Health Care

Employers are looking for better options for providing health coverage to employees, and HSAs may just be the answer.

Companies not only have pension liabilities that are underfunded but retiree health costs have become staggering. (See, Terrenes, Anne. “The Hidden Bite of Retiree Health,” Business Week, Jan. 19, 2004, p. 86.) Net liabilities for “other post-retirement employee benefits” (“OPEB”) ' mainly health insurance but also possible dental, vision, life insurance, deferred compensation and severance and other promised benefits ' are substantial.

Medicare

The Medicare Act of 2003 introduced Medicare Part D, which can integrate with COLI. In addition to including numerous other provisions that have potential effects on an employer's retiree health plan, the Medicare law included a special subsidy for employers that sponsor retiree health plans with prescription drug benefits that are at least as favorable as the new Medicare Part D benefit. Although the federal government will share the costs of the retiree health plan through that subsidy, the Financial Accounting Standards Board (“FASB”) staff proposed a prohibition on accounting for the law until the FASB had sufficient time to fully address all of the new law's aspects. In a meeting on Jan. 7, 2004, the FASB reversed its staff's draft position, permitting retiree health plan sponsors to select either immediate or delayed accounting treatment. If a plan sponsor is prepared to fully reflect the Medicare law in its financial statement, it may choose to include the effects in the accounting period during which the law was enacted.

An employer is not required to adopt immediate treatment, even if the employer is prepared to reasonably measure the law's effects. However, if the employer does not reflect the law immediately, it is precluded from accounting for the law until the FASB issues further guidance on the issue, unless the employer adopts a substantive amendment to the retiree health plan in the interim. Upon any plan amendment, all effects of the Medicare law must be fully reflected in the employer's accounting.

Much of the initial interest and controversy over accounting for the Medicare law focuses on the effect of the special subsidy. For the subsidy to affect the employer's obligations and costs, the plan sponsor must reasonably ascertain that the plan will satisfy conditions for the subsidy and must make reasonable estimates of the portion of costs and obligations that would be shared via the subsidy. The accounting methodology itself remains an open issue, although the FASB acknowledged that one potentially acceptable approach would be to immediately reflect the entire present value of future expected subsidy payments as a reduction in the employer's obligation under the plan, passing that reduction through net income.

In addition to the special subsidy, the FASB pointed to two other elements of an employer's accounting for its retiree health plan that the Medicare law could affect: a) The employer might amend its plan in response to the law; and b) actuarial assumptions, including utilization rates and medical cost trends, could be affected. The FASB expects employers to view all three elements ' the special subsidy, plan amendments, and assumptions ' as a single, combined package. For instance, if the employer amends its plan, the new law should be taken into account. Conversely, an employer should not elect immediate treatment solely to reflect the special subsidy if it is not prepared to reasonably estimate the effect on actuarial assumptions.

If the employer elects immediate accounting treatment and chooses to fully reflect the present value of expected future subsidy payments as a reduction in obligations and a current income item, the amount must be shown in the employer's income statement as a separate line item. Employers should note that the FASB may eventually determine to use a different methodology for the special subsidy and that any such different treatment might force the reversal of some or all of any immediate recognition.

Whether an employer chooses immediate or delayed accounting for the Medicare law, the footnotes in the financial statements must acknowledge the new law and provide a narrative of how the law has or has not been taken into account. The disclosure should indicate that future FASB action could affect any of the amounts that are currently being shown for the plan.

An employer that sponsors a retiree health plan that might be affected by the new Medicare law should decide whether to reflect the statute immediately. To adopt immediate accounting, the employer must be prepared to take all aspects of the law into account, including: a full assessment of the law on all parts of the retiree health plan (including any plan benefits other than prescription drugs); satisfaction of the plan's drug benefits of the law's conditions for obtaining the special subsidy; an estimation of plan costs that would be covered by the special subsidy; and any other aspects of the plan and the actuarial assumptions affected. If the employer is prepared with the information from those steps, it must decide the appropriate accounting methodology to reflect the new law, either immediately reflecting the full present value of any change or following any other acceptable methodology. Throughout this process, of course, the employer should be considering any plan amendments that might be appropriate, given the new law. With or without immediate accounting of the financial effects of the Medicare law, new disclosures must be prepared for the employer's financial statements. On Dec. 26, 2003, The American Academy of Actuaries Joint Committee on Retiree Health supported the FASB Staff Position (“FSP”) on FAS W6.

Accounting immediately for the Medicare law could produce a significant decrease in the liability reported for the retiree health plan, resulting in a material income item. However, employers have a very short time to make the calculations that would be necessary to elect the immediate accounting treatment.

Many employers are not prepared for the costs. The accounting rules require the employers to estimate the future total costs of the benefits based on such factors as the expected life span of retirees and the growth rate of health care costs and record that as an expense and liability, or an obligation over the period the employee worked for the employer. The FASB has encouraged transparency and more immediate recognition with the changes to FAS 106 in proposed FAS 158. These shortfalls can be offset by the proper use of COLI to start funding now before the liability comes due.

Conclusion

Deferred Compensation, COLI and health care accounts have undergone scrutiny not only by the three branches of government, but also by the news media. Attorneys must be sensitive not only to the letter of the law but also the perceptions of the benefits. We are constantly reminded about how health care costs have become unmanageable from both the employer and employee perspective. We can use existing benefit arrangements, recognized by the courts, the Congress and the administration in an approach that will comply with the laws and maximize benefits to the employer and employee to better address our employment community needs. The future of this benefit must be modified to overcome perceived tax abuses (see, Table 1 below). Advisors following the guideposts can provide planning opportunities for themselves and their clients.

[IMGCAP(1)]

Lawrence L. Bell is Counsel Special Projects for Lynchval Systems Worldwide. He is a qualified expert, and testifies on taxes and benefits. He served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, BOLI, GASB, FASB, IASB, and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A, and Benefit Planning.

[Editor's Note: The recently passed COLI Best Practices ' 101(j), Deferred Compensation ' 409A and the Medicare Act of 2003 require advisers to review all qualified and nonqualified benefit programs. These legislative changes and the courts' review of COLI provide attorneys with a different approach to help solve their benefits planning problems. While pensions have been codified, limited, and scrutinized since 1974 with ERISA, non-pension post-retiree benefits (OPEB-GASB 45, FAS 106, and IAS 19) have been less regulated ' until now. Judicial action, legislation, and administrative agency action have caused a paradigm shift in benefits planning. Last month, the article focused on OPEB limitations and court cases. Part Two discusses safe harbors.]

Safe Harbors

At the same time steps are being instituted to curtail COLI, there is an ever-increasing need to fund for employee medical care and post-retirement medical expenses. The use of COLI and the new Health Savings Accounts (“HSA”) can provide a robust funding vehicle. Since 1996, a pilot program has made Medical Savings Accounts (“MSA”) available to small businesses and the self-employed. Because of the many restrictions, only about 70,000 people have these accounts. A U.S. Treasury Department ruling in 2002 allowed large companies to establish Health Reimbursement Arrangements, and at last count, 1.5 million employees had enrolled. However, these accounts are also unreasonably restricted. Flexible Spending Accounts (“FSA”) offer consumers the chance to withhold funds tax free for medical care. These funds have a use-it-or-lose-it feature that requires employees to forfeit unused funds to employers at the end of the year. This forfeiture provision encourages employees to waste money on unnecessary care and makes most people apprehensive about depositing money except when they can precisely predict their future medical needs. The Medicare Prescription Drug, Improvement and Modernization Act of 2003, signed by President Bush, affected planning starting after Dec. 31, 2003 with two powerful tools that can coordinate and expand COLI.

HSAs are flexible and consumer-friendly accounts. They allow individuals and employers to make pre-tax deposits each year equal to their health insurance deductible. The health insurance policy that accompanies an HSA must have an overall deductible of at least $1,000 for an individual or $2,000 for a family policy. A typical plan will work like this: When individuals enter the medical marketplace, they will spend first from their HSA. If they exhaust their HSA funds before reaching the deductibles, they will then pay out-of-pocket. Once they reach their deductibles, insurance pays all remaining costs.

Annual HSA deposits cannot exceed the amount of the health insurance deductible, and typically cannot exceed $2,600 for individuals and $5,150 for families. However, the account balances can earn interest or be invested in stocks or mutual funds, and they will grow tax free. Thus, a young employee could accumulate hundreds of thousands of dollars by the time he or she retires.

HSA balances belong to the individual account holders and remain theirs if they switch jobs, become unemployed or retire. The funds can be used to pay expenses not covered by insurance, insurance premiums while unemployed, and health expenses during retirement. In the event of death, HSAs may be bequeathed to a spouse, or (like an IRA) the funds may flow to other heirs.

HSAs are a defined contribution health care arrangement enabling employees and employers to make deductible and excludible contributions, which grow tax-free, in order to pay for qualified medical expenses.

Coverage Options

There are four different routes for coverage: 1) traditional Blue Cross/Blue Shield type indemnity coverage; 2) Health Reimbursement Arrangements (“HRAs”) coupled with a Flexible Spending Arrangement (FSA), where the FSA pays the first dollar expenses until exhausted; 3) MSAs, which are likely to go away as a result of the enactment of HSAs; and 4) HSAs, where an employer offers a HDP that can be funded by the employee and/or the employer. (BNA Parishioners Forum Discussion on Health Savings Accounts, Michael Thrasher, Dec. 8, 2003.) MSAs were only available to small employers. HSAs are now available to all employers and even individuals who are covered under a HDP, as long as the individual is not covered under a non-HDP. MSAs can only be offered with an HDP. HRAs can be a stand-alone arrangement, coupled with an HDP, or even offered with an FSA (subject to specific ordering rules). HSAs can even be offered as an option under a Code Section 125 cafeteria plan.

Unlike HRAs, both MSAs and HSAs permit non-health distributions. However, a penalty tax is imposed (10% excise tax under HSA and 15% under MSA) on non-health distributions made before death, disability or becoming Medicare-eligible, i.e., age 65. Thus, individuals 65 and over can make non-health withdrawals from their HSAs without incurring a tax penalty. Such amounts would still be includible in income in the year of distribution.

HSAs are attractive because the employee may have access to the money. Under HRAs, however, the employee cannot have access to the money because, by definition, an HRA must be funded solely with employer money. This may be a design issue in that if employers want to give employees access to the money, HSAs are attractive. But if the employer does not want the employee to gain access to the money, or the employer wants the potential benefit of forfeitures, an HRA is better suited. Therefore, HSAs may be good for employees but not good for employers because HSAs must be funded, whereas HRAs may be unfunded and simply be maintained on the employer's books. Most HRAs are currently unfunded book accounts.

Health Care

Employers are looking for better options for providing health coverage to employees, and HSAs may just be the answer.

Companies not only have pension liabilities that are underfunded but retiree health costs have become staggering. (See, Terrenes, Anne. “The Hidden Bite of Retiree Health,” Business Week, Jan. 19, 2004, p. 86.) Net liabilities for “other post-retirement employee benefits” (“OPEB”) ' mainly health insurance but also possible dental, vision, life insurance, deferred compensation and severance and other promised benefits ' are substantial.

Medicare

The Medicare Act of 2003 introduced Medicare Part D, which can integrate with COLI. In addition to including numerous other provisions that have potential effects on an employer's retiree health plan, the Medicare law included a special subsidy for employers that sponsor retiree health plans with prescription drug benefits that are at least as favorable as the new Medicare Part D benefit. Although the federal government will share the costs of the retiree health plan through that subsidy, the Financial Accounting Standards Board (“FASB”) staff proposed a prohibition on accounting for the law until the FASB had sufficient time to fully address all of the new law's aspects. In a meeting on Jan. 7, 2004, the FASB reversed its staff's draft position, permitting retiree health plan sponsors to select either immediate or delayed accounting treatment. If a plan sponsor is prepared to fully reflect the Medicare law in its financial statement, it may choose to include the effects in the accounting period during which the law was enacted.

An employer is not required to adopt immediate treatment, even if the employer is prepared to reasonably measure the law's effects. However, if the employer does not reflect the law immediately, it is precluded from accounting for the law until the FASB issues further guidance on the issue, unless the employer adopts a substantive amendment to the retiree health plan in the interim. Upon any plan amendment, all effects of the Medicare law must be fully reflected in the employer's accounting.

Much of the initial interest and controversy over accounting for the Medicare law focuses on the effect of the special subsidy. For the subsidy to affect the employer's obligations and costs, the plan sponsor must reasonably ascertain that the plan will satisfy conditions for the subsidy and must make reasonable estimates of the portion of costs and obligations that would be shared via the subsidy. The accounting methodology itself remains an open issue, although the FASB acknowledged that one potentially acceptable approach would be to immediately reflect the entire present value of future expected subsidy payments as a reduction in the employer's obligation under the plan, passing that reduction through net income.

In addition to the special subsidy, the FASB pointed to two other elements of an employer's accounting for its retiree health plan that the Medicare law could affect: a) The employer might amend its plan in response to the law; and b) actuarial assumptions, including utilization rates and medical cost trends, could be affected. The FASB expects employers to view all three elements ' the special subsidy, plan amendments, and assumptions ' as a single, combined package. For instance, if the employer amends its plan, the new law should be taken into account. Conversely, an employer should not elect immediate treatment solely to reflect the special subsidy if it is not prepared to reasonably estimate the effect on actuarial assumptions.

If the employer elects immediate accounting treatment and chooses to fully reflect the present value of expected future subsidy payments as a reduction in obligations and a current income item, the amount must be shown in the employer's income statement as a separate line item. Employers should note that the FASB may eventually determine to use a different methodology for the special subsidy and that any such different treatment might force the reversal of some or all of any immediate recognition.

Whether an employer chooses immediate or delayed accounting for the Medicare law, the footnotes in the financial statements must acknowledge the new law and provide a narrative of how the law has or has not been taken into account. The disclosure should indicate that future FASB action could affect any of the amounts that are currently being shown for the plan.

An employer that sponsors a retiree health plan that might be affected by the new Medicare law should decide whether to reflect the statute immediately. To adopt immediate accounting, the employer must be prepared to take all aspects of the law into account, including: a full assessment of the law on all parts of the retiree health plan (including any plan benefits other than prescription drugs); satisfaction of the plan's drug benefits of the law's conditions for obtaining the special subsidy; an estimation of plan costs that would be covered by the special subsidy; and any other aspects of the plan and the actuarial assumptions affected. If the employer is prepared with the information from those steps, it must decide the appropriate accounting methodology to reflect the new law, either immediately reflecting the full present value of any change or following any other acceptable methodology. Throughout this process, of course, the employer should be considering any plan amendments that might be appropriate, given the new law. With or without immediate accounting of the financial effects of the Medicare law, new disclosures must be prepared for the employer's financial statements. On Dec. 26, 2003, The American Academy of Actuaries Joint Committee on Retiree Health supported the FASB Staff Position (“FSP”) on FAS W6.

Accounting immediately for the Medicare law could produce a significant decrease in the liability reported for the retiree health plan, resulting in a material income item. However, employers have a very short time to make the calculations that would be necessary to elect the immediate accounting treatment.

Many employers are not prepared for the costs. The accounting rules require the employers to estimate the future total costs of the benefits based on such factors as the expected life span of retirees and the growth rate of health care costs and record that as an expense and liability, or an obligation over the period the employee worked for the employer. The FASB has encouraged transparency and more immediate recognition with the changes to FAS 106 in proposed FAS 158. These shortfalls can be offset by the proper use of COLI to start funding now before the liability comes due.

Conclusion

Deferred Compensation, COLI and health care accounts have undergone scrutiny not only by the three branches of government, but also by the news media. Attorneys must be sensitive not only to the letter of the law but also the perceptions of the benefits. We are constantly reminded about how health care costs have become unmanageable from both the employer and employee perspective. We can use existing benefit arrangements, recognized by the courts, the Congress and the administration in an approach that will comply with the laws and maximize benefits to the employer and employee to better address our employment community needs. The future of this benefit must be modified to overcome perceived tax abuses (see, Table 1 below). Advisors following the guideposts can provide planning opportunities for themselves and their clients.

[IMGCAP(1)]

Lawrence L. Bell is Counsel Special Projects for Lynchval Systems Worldwide. He is a qualified expert, and testifies on taxes and benefits. He served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, BOLI, GASB, FASB, IASB, and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A, and Benefit Planning.