Understanding Disclosures of Postretirement Healthcare Obligations

By Stephen R. Moehrle

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Many large 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) OPEB disclosure.

Background

According 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 downward.

The accounting 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.

The interpretation 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 certain.

A couple 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.

The OPEB 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.

Interpreting the OPEB Disclosure

To illustrate 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.

The first 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.

Analyzing the OPEB Disclosure

The simplified 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.

To estimate 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.

The APBO 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).

The assets 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.

Target’s 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.

Companies 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.

A Looming Obligation

Postretirement 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.

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