Disclosures of Postretirement Healthcare Obligations
2007 - Much
financial press coverage has been devoted to large corporations’
future obligations for their employees’ pensions. Many companies
also offer other postretirement employee benefits (OPEB), including
healthcare and life insurance. The costliest by far is healthcare.
companies offer to pay some or all of the postretirement health
costs of their retirees. This is a huge liability. At the start
of 2006, according to The Wall Street Journal’s
Ian McDonald, the collective unfunded postretirement healthcare
liability for Standard & Poor’s (S&P) 500 firms
was $321 billion, more than twice the unfunded pension plans for
these firms (“Health Benefits Ail as Pensions Heal,”
June 6, 2006). Unfortunately, accounting and financial reporting
for the OPEB obligation is complex, and poorly understood by many.
What follows is a summary of the accounting rules for the healthcare
obligation, a simplified demonstration of how to interpret the
information, and an analysis of an actual (Target Corporation)
to McDonald, the obligations stemming from companies’ promise
to pay retirees’ healthcare costs are a large source of
concern; 78% of the obligation is not currently funded. Pension
obligations have gotten much more attention, but only 10% of these
obligations are not funded. There are three reasons why pension
plans are better funded than healthcare obligations. First, the
Pension Benefit Guaranty Corporation (PBGC), which insures the
pension plans of many large companies, requires a specific level
of funding for companies with plans. Second, companies receive
tax benefits for prefunding pension plans. Third, in many cases,
companies are not contractually bound to make healthcare payments.
As a result, they have more flexibility to revise the benefit
for and financial reporting of retiree healthcare benefits is
similar in concept to that for pension plans, and at least as
complex. SFAS 106, Employers’ Accounting for Postretirement
Benefits Other Than Pensions, released in 1990, requires
companies to accrue a liability for these costs during the employees’
service years. SFAS 132, Employers’ Disclosures About
Pensions and Other Postretirement Benefits—An Amendment
of SFASs 87, 88, and 106, and SFAS 132(R) amended the provisions
of SFAS 106 to require fuller, standardized disclosures about
the assets, obligation, and cash flows of benefit plans. Recently,
SFAS 158, Employers’ Accounting for Defined Benefit
Pension and Other Postretirement Plans—An Amendment of SFASs
87, 88,106, and 132 (R), further amended the rules to require
that the funding position of benefit plans be reported in full
on the balance sheet.
and analysis of healthcare disclosures is complicated by three
factors. First, as the data discussed above demonstrate, healthcare
obligations are often unfunded. Second, healthcare costs are less
predictable than pension costs and could spiral upward in the
coming decades. Third, the timing of healthcare payments is less
of terms related to healthcare obligations are important. The
expected postretirement benefit obligation (EPBO) is the actuarial
estimate of the present value of the total amount of healthcare
costs that will ultimately be incurred by current employees and
retirees (and their dependents, if applicable). The accumulated
postretirement benefit obligation (APBO) is the portion of the
EPBO that has already been attributed to employees’ service
years to date. The OPEB APBO is analogous to the projected pension
benefit obligation (PBO). The attribution of the EPBO to service
years is done by assigning an equal fraction of the EPBO to each
year of service from the year the employee was hired to the date
that the employee becomes fully eligible to receive the benefits.
Turnover estimates are made so that the EPBO and annual expense
amounts are related only to employees expected to remain with
the company long enough to earn benefits.
expense each year is very similar to pension expense. It includes
service cost (the portion of the EPBO attributed to the current
period), interest cost (the extrapolation of the obligation from
current to future value), a negative component for return on invested
OPEB funds (if any), and the systematic amortization of a portion
of prior service costs and gains/losses on OPEB assets and/or
the OPEB obligation.
the OPEB Disclosure
the concepts discussed above, assume that a company has one employee
qualified to receive healthcare benefits upon retirement. Assume
that this employee will experience one healthcare event—a
heart bypass surgery in 2020.
step is to determine the healthcare costs today and then adjust
for the estimated cost inflation that will occur between now and
when the employee experiences healthcare needs in the retirement
years. The cost of bypass surgery in this example was $75,000
when the employee was hired in 1991. The cost of the surgery is
predicted to escalate to $477,000 when it occurs in 2020. At the
end of 2005, the present value of this $477,000 cost is $209,000,
representing the current EPBO. Of the $209,000 EPBO, the company
accrued an obligation of $105,000 during the years 1991 through
2005. This represents the APBO, which the company reports as its
current obligation for retiree healthcare costs. Over the period
from 2005 to 2020, this $209,000 EPBO will grow to $477,000. Over
the period from 2005 to 2020, the $105,000 APBO will also grow
to $477,000, due to recognition of service cost and interest cost.
Therefore, in 2020, the company will report a $477,000 healthcare
obligation, which will be paid when the employee undergoes the
heart surgery that year. To this end, during 2005 the company
expensed $9,000 for healthcare costs, consisting of a $2,000 service
cost, a $6,000 interest cost, and $1,000 of recognized losses
on the OPEB obligation. The service cost is the attribution of
a portion of the $209,000 EPBO to the current year. The interest
cost component will cause the APBO to grow from its present value
to the future amount that will actually be paid.
the OPEB Disclosure
example above demonstrates key OPEB concepts. The numbers also
correspond to amounts reported by Target Corporation related to
healthcare benefits, restated in thousands so that the amounts
are feasible totals for one individual’s heart surgery.
The Target disclosures are in millions and relate to all employees
whom Target expects to retire with the company and to qualify
for retiree healthcare benefits. Target’s 2005 OPEB-related
disclosures are shown in the Exhibit.
the amount that the company will pay out, Target uses actuarial
estimates of healthcare costs today and then applies the reported
cost-escalation assumptions (10% in 2005, falling linearly to
5% in 2010 and beyond) to determine the future amount.
is the amount of the EPBO that has been accrued to date. At the
beginning of the fiscal year 2005, this amount was $107 million
for Target. By the end of 2005, the APBO had actually fallen to
$105 million because the amount of benefits paid during the year
($13 million) exceeded the additions to the obligation. This is
the APBO for Target (corresponding to the $105,000 APBO in the
earlier simplified example).
available to pay healthcare costs began and ended the year at
zero. As discussed earlier, this is very common, because most
companies do not fund OPEB costs. Instead, the companies simply
pay the costs when incurred. During the previous fiscal year,
the portion of retirees’ healthcare costs paid by Target
totaled $13 million. Because Target does not fund its healthcare
obligation, the obligation is underfunded by $105 million at the
end of fiscal 2005. On the balance sheet, Target reports an obligation
of only $97 million because recognition of $8 million of actuarial
losses has been deferred. Under SFAS 158, Target will report on
the balance sheet the full underfunded amount ($105 million) rather
than deferring recognition of actuarial gains or losses. This
represents a major change under the standard.
On the income
statement, Target reported OPEB expense totaling $9 million in
fiscal 2005, comprising service cost totaling $2 million, interest
cost totaling $6 million, and recognized losses totaling $1 million.
This means that Target attributed $2 million of its total EPBO
to the employees’ service in 2005. In addition, $6 million
of interest is accrued, because the APBO must grow from accrued
present values to the future values that will ultimately be paid.
Finally, $1 million of actuarial loss is recognized in income
for 2005. Actuarial losses reflect changes in the company’s
assumptions about the timing or amount of future OPEB cash flows.
These losses are amortized to OPEB expense over the remaining
service years of the employees. This will remain true under SFAS
158; however, the losses will be recognized in the APBO under
other comprehensive income until they are recognized in net income.
assumption is that healthcare costs will grow by 10% in 2005 and
decline by one percentage point each subsequent year, until reaching
5% in 2010 and thereafter. If analysts believe that these assumptions
are too low (high), they should expect OPEB expenses to increase
(decrease) in future years as a result. GAAP requires companies
to provide sensitivity data to this end. Target reports that a
1% increase (or 1% decrease) in healthcare cost trend rates would
result in a $5 million increase (or $4 million decrease) to the
OPEB obligation. Target reports that a 1% change will have no
effect on the service and interest cost components of OPEB expense
(this can likely be explained by a figure that was greater than
zero but less than $500,000, and therefore would be rounded to
zero in millions). Income amounts are definitely impacted by increasing
or decreasing healthcare cost trends.
must also provide information about cash contributions that the
company is expected to make during the next five years and thereafter.
Target reports that it expects to pay $11 million, $12 million,
$13 million, $13 million, and $14 million in 2006 through 2010.
These amounts are Target’s estimates of the amounts of retiree
healthcare costs that will actually be incurred during the next
five fiscal years. These amounts are consistent with the $13 million
that the company paid in the most recent year.
healthcare costs are a huge net obligation to many large companies,
yet the accounting and disclosure rules for these costs remain
among the most frequently changed and least understood. The example
above provides a glimpse of the magnitude of the amounts involved
for large corporations and the changes that will be required under
new accounting standards. These retiree healthcare obligations
will remain large for the foreseeable future. CPAs must understand
these measurement rules and assumptions in order to prepare, audit,
and interpret the related financial statement disclosures.
R. Moehrle, PhD, MB (Acc.), is an associate professor of
accounting at the University of Missouri–St. Louis.