The emergence of this exit approach addresses what most large employers — and finance professionals in particular — have long seen as an intractable cost problem.

For most large employers, sponsoring a retiree medical benefit program has proved a costly, long-term obligation with no strategic value. Yet until now, few employers were willing to risk the potentially adverse consequences of a plan termination, which included union contract issues, retiree lawsuits and concerns about the financial burden placed on retirees.

What's changed? Working in concert with tax and legal experts, Towers Watson developed a new approach to exiting retiree medical that uses customized group annuities and an innovative transaction structure to overcome traditional barriers to an exit strategy without adverse tax and legal consequences.

At its core, the approach relies on a group annuity to transfer an employer's obligation to a third-party insurer. To do this successfully, the annuity has to meet three objectives. First, it has to end an employer's legal obligation once and for all. Second, it has to eliminate adverse tax consequences for both employers and retirees. Third, it has to create economic value for both parties. For employers, this means removing a sizable and volatile balance sheet liability that confers no value to the business or its shareholders. For retirees, this means gaining a reliable source of long-term funding for health care needs.

The approach relies on a group annuity to transfer an employer's obligation to a third-party insurer.

Until recently, four barriers made this approach impossible to implement, forcing most organizations to concentrate on managing costs rather than terminating their plans. But several developments have transpired to remove these barriers, and pave the way for a viable and advantageous exit strategy.

Here's a closer look:

  • Hedging medical inflation risk. An annuity requires the elimination of medical inflation risk, which has traditionally been impossible to hedge. But the shift from a defined benefit to a defined contribution plan that caps benefits is essentially just such a hedge. Over the last five to 10 years, many employers have made this transition as part of their cost management strategy, and the number planning to do so continues to grow. More recently, some employers have begun taking this step via a private Medicare exchange, which brings additional advantages to the transaction. Not only does the organization have a platform for administering the annuity, but its retirees face little or no change in how they purchase plans or are reimbursed for claims.
  • Eliminating individual taxation of annuity benefits. While retiree medical benefits funded through a tax-advantaged account such as a health reimbursement arrangement are tax-free for retirees, existing annuity benefits such as pensions are taxable as income to retirees. However, a provision specifying that distributions from this retiree medical annuity can be used only for medical insurance premiums and other medical costs shields them from individual taxation.
  • Enabling employer deductibility. Because premiums paid for long-term contracts such as annuities must be amortized for tax deductions, employers generally can't deduct the full annuity payment at the time of purchase. However, due to a series of innovative transactions that are commonly used in retirement benefit plans, this annuity allows for immediate deductibility of the purchase price.
  • Removing balance sheet liability. Elimination of the retiree medical liability from the balance sheet requires a clear settlement of the promise. Under the annuity, certificates are issued that irrevocably transfer the employer's liability to the insurance company, thus legally terminating the employer's obligation and permitting its removal from the balance sheet.

The Right Time

The emergence of this exit approach addresses what most large employers — and finance professionals in particular — have long seen as an intractable cost problem. According to the U.S. Department of Health and Human Services, the cost of health care for a person over age 65 is, on average, 3.3 times higher than the cost of health care for someone of a typical working age.* Even with Medicare covering a large portion of the cost, the combination of continuing cost escalation and an aging U.S. population that's living longer will only increase the already-high cost of retiree medical for employers.

In addition, it's a benefit that provides no strategic value to an organization. It doesn't attract or engage talent, yet it creates balance sheet volatility and income statement expense, and diverts management time. Most boards and shareholders view dedicating balance sheet debt capacity to a benefit that's increasingly being eliminated for current and future active employees as an inefficient use of capital. No wonder a 2013 survey of CFOs or equivalents by Prudential and CFO Research** found that 54% were "somewhat likely" to "highly likely" to purchase a retiree medical exit solution if a viable one existed. In dollar terms, retiree medical is an unrewarded risk.

The new annuity-based exit solution marks an end to that risk, and the journey that many employers began decades ago as they experimented with various changes in plan design to reduce their costs and minimize their risks. Now they have an opportunity to fully exit their legal, accounting and regulatory responsibilities while simultaneously ensuring retirees have tax-free funding for medical benefits from a highly rated insurance company for the rest of their lives.


Endnotes

*"Reducing the Cost of Retiree Health Care," CFO.com, December 14, 2011

**"Balancing Costs, Risks and Rewards: The Retirement and Employee Benefits Landscape in 2013," (unpublished result shared with Towers Watson) Prudential and CFO Research, July 2013