Post-retirement’s surprise package
Most companies in the UK provide private medical insurance for at least their senior management, according to our recent research. It is usual for this benefit to be provided under an insurance contract, with the insurance company providing the funding mechanism as well as the administration and care management.
In most arrangements the company meets the costs of its claims indirectly but some larger companies have chosen to self-insure the risk by providing benefits through a healthcare trust. Under this arrangement, instead of paying subscriptions to an insurer, the company pays money into a trust set up solely for the benefit of the employees. The money is then used throughout the year to pay for the cost of treatment. Stop-loss cover can be applied to fund benefits over and above a prescribed limit if required. The main advantage of providing benefits in this way is that the fund is exempt from Insurance Premium Tax (IPT), payable on subscriptions in an insured plan, and avoids some of the provider's profit margin and the Policyholders Protection Board levy.
Some companies continue to provide cover during retirement but we believe there are relatively few who do so. Employers have become increasingly aware of the costs of providing this benefit in retirement and as a result the popularity has waned.
The proposed changes to the UK accounting standards for post-retirement benefits will, once again, put the spotlight on the cost of providing private medical cover to pensioners when the general value of company sponsored private medical schemes is being reviewed.
Let us look at the drivers behind these increasing costs in detail:
q Age escalation The cover offered only includes treatment for acute medical conditions. It is common for the costs of cover in retirement to increase by around 4% each year to allow for the increasing incidence of these acute conditions as a person ages. After age 80 or so, chronic conditions are more prevalent and it is reasonable to keep the scale of private medical costs flat after this age.
q Medical expense inflation A wide variety of factors influence the general escalation in the costs of providing private medical cover. These include: economic trends; medical developments and changing medical practices; social trends; political factors, and changes in the balance between state provision and the private health sector.
Over the period since 1980 the increase in costs in the UK has been significantly in excess of retail price inflation and also in excess of earnings inflation. It is realistic to expect the rate to settle at earnings inflation over the long term. Hence a reasonable assumption is to take medical expense inflation to equal to the earnings inflation assumption, or slightly higher initially.
Once these benefits needed to be recognised and accounted for in the same way as for other retirement benefits, the effects of the above were quantified (often for the first time). Many companies were surprised at the results!
A large company in the food and drink industry, for example, provides private medical cover for 300 pensioners and their spouses. Cover is no longer promised to future pensioners. The current annual premiums paid by the company for this group total £300,000. The liability for the benefit is £5.5m (e8.8m).
As a result most UK companies who provided this continued cover during retirement decided to cut back on the benefit provision.
For employees, the most common change was simply to remove the promise of cover in retirement. As an alternative, a few companies chose to ‘freeze’ the benefit by limiting their contribution to the premiums during retirement to, for example, the current level indexed in line with retail price inflation. Future pensioners would be expected to make up the difference while they wished cover to continue.
For existing pensioners the options were usually limited. The action brought by the pensioners of Philips Electronics showed that it was not always possible to reduce a benefit promised during employment once that employment had ceased. Clearly each company’s circumstances will be different and specialist legal advice is advisable before any diminution of benefits is attempted. For most of our clients the benefits promised to pensioners have had to be retained in full. Some cannot even change the insurer, as this is part of the contractual promise.
The basic principle underlying the UK accounting standards is that the cost of the post retirement medical benefit should be charged over the employee's service in a systematic and rational manner. This is the same method used for pension benefits with the benefit accruing over the employee's service. However, unlike pension benefits, medical benefits do not accrue and so the accruing concept is artificially imposed for the purpose of the accounts.
The UK accounting standard to date has permitted significant flexibility in the choice of assumptions and has led to interesting discussions, particularly regarding the choice of the discount rate.
For most, if not all, UK companies which provide this benefit there are no assets held to back the benefit promises and premiums are paid on an annual basis from cashflow. In calculating the reserves for the accounts it is therefore appropriate to use a discount rate which reflects the company’s long-term internal rate of return, net of tax. In practice, it is usual to start with the gross discount rate used for pension scheme liabilities and some companies reduce this to reflect the company’s position net of tax. However, other companies argue for a higher internal rate of return to be used to reflect their own expectations.
Under the proposed new UK standard, the permitted assumptions are more prescribed and so there will be less flexibility.
The new UK standard (now in exposure draft form for discussion) is expected to take effect for accounting years beginning early in 2001. The impact of the proposed changes to the UK accounting standard for post-retirement benefits is similar to that predicted for pension costs. The main effects will be:
q costs may be more volatile because the discount rate will change to reflect market rates on corporate bonds;
q costs are likely to be higher as the discount rate will tend to be considerably lower than that used previously;
q a significant increase in balance sheet items for companies that have not fully reserved for the benefits in previous accounting periods.
However, as (in general) the liability for post-retirement medical benefits is a fraction of that for pension benefits, the effects on the accounts will be relatively insignificant.
The move to a market-based discount rate brings the UK standard more in line with the equivalent US standard.
Of course, in contrast to pension liabilities, a company’s post-retirement medical benefits are unfunded. It may be appropriate to use a discount rate equal to the market yield of the company’s own corporate debt. However, this will need to be discussed especially if debt of the appropriate term is not available.
Many companies wish to allow for the fact that, at the time the premiums are paid, they may continue to attract relief from corporation tax. Consequently, after discussion with their auditors, some companies have established an asset for this deferred tax relief.
Where the company contribution is capped, and pensioners need to contribute an increasing portion of the cost, it is reasonable to assume that a proportion will withdraw from cover. This issue gives rise to interesting discussions on the wealth of the pensioner group and their propensity to spend some of this on topping up their private medical cover.
In determining the company’s liability for this benefit a projection is made of future costs and this is discounted back to the valuation date. Some considerations regarding the assumptions used to do this have already been mentioned.
It is important that the base point for the projections is well established. In theory this means determining the current cost of claims plus administration and other loadings for the pensioner group. If premiums and claims are available for this group in isolation a good estimate can be made. However, this information is not always available and a more pragmatic approach has to be taken.
In the US, in the absence of a comprehensive National Health Service, corporate provision of private medical cover for employees and their families is very common and extending cover into retirement is not unusual. The federal Medicare programme provides basic treatment for workers and their spouses once they reach age 65. It covers around 80% of hospital and outpatient expenses but does not provide for prescription drugs. Many employers give supplemental cover to retirees who are over 65 and younger retirees often continue to enjoy the cover they had in employment.
The cost of providing such cover is generally funded on a pay-as-you-go basis and used to be accounted for in a similar way – just like used to happen in the UK. Unfunded liabilities which were not recognised in the company accounts grew and, as a result, the US accounting standard Financial Accounting Standards No 106 (FAS106) was introduced in December 1990. This required employers to report the liabilities in their financial statements. These liabilities proved to be very significant, particularly with an ageing workforce and medical costs that continue to outstrip inflation.
For example, General Motors in the US provides post-retirement medical cover to around 400,000 pensioners, representing nearly all of its pensioner population. The liability in respect of these pensioners is around $25bn (e24.8bn).
As a result, many employers have acted to limit their future liabilities. Some have imposed design changes which shift the financing towards retirees; others have withdrawn cover completely for retirees.
In Europe, it is unusual for companies to provide private medical cover for their employees during retirement even though, for many countries, providing some cover for employees is popular.
Graham Knowles is a consultant and Helen Gregson is a principal at Watson Wyatt in London