The future cost of retiree health benefits is staggering. Business Week has estimated that a third of all companies' net worth could be wiped out if they are required to put retiree health care liabilities on the books. Not surprisingly, businesses are trying to figure out ways of prefunding postretirement benefits typically referred to as other postretirement employee benefits or OPEBs).

Unfortunately, because of the current budget deficit, Congress is reluctant to provide tax incentives for funding OPEBs. However, RRA 90 provides that, if excess defined benefit pension plan assets are transferred to a 401(h) account that is part of that plan, the excess assets will not be includible in the employer's gross income, will not be subject to the reversion excise tax, and will not be considered a prohibited transaction. However, the employer will not be entitled to a tax deduction when amounts are transferred to the 401(h) account or when amounts (and attributable earnings) are used to pay retiree medical benefits. Excess assets are defined as the excess of the value of plan assets over the greater of 150% of current liability (or the plan's accrued liability, if less) or 125% of current liability. This funding method potentially raises revenue.

Until Congress provides funding alternatives, the following vehicles will continue to be used by companies to fund OPEBs. They all have advantages; unfortunately, none is completely satisfactory.

Pay-as-You-Go and Buy-Back Funding

Pay-as-you-go is still the norm for most companies. This method, in which medical expenses are paid for retirees as they arise, lessens current cash drain but will require larger outlays in the future.

A variation of this method is to buy back some or all of an employer's commitment to provide medical insurance by offering retirees a cash settlement, either in a lump sum or a series of payments. Clearly, the major disadvantage to this plan is a large, immediate cash drain or, if stock is offered, a dilution of earnings.

Welfare Benefit Funds

One of the two main tax-preferred vehicles for funding OPEBs is as part of a welfare benefit fund through which employers provide welfare benefits to the employees or to their beneficiaries.

The usual method of establishing this sort of fund is through a voluntary employees' beneficiary (VEBA) trust. The deduction from a VEBA may not exceed the "qualified cost" for the taxable year, and "that cost equals the sum of the" qualified district cost" for the taxable year plus additions to a qualified asset account." Qualified direct cost in turn equals, for any taxable year, the aggregate amount that would have been allowable as a deduction if such benefits were provided directly by the employer, and the employer used the cash receipts and disbursements method of accounting.

There are three major problems involved with funding a VEBA.

1. In a noncollective bargaining situation, the current annual cost must be used in determining additions to qualified asset accounts for postretirement medical benefits.

2. A VEBA established to provide postretirement medical benefits is subject to unrelated business taxable income (UBTI) for plan years ending after July 18, 1984, in an amount equal to the lesser of the income of the fund or the amount by which the assets in the fund exceed the qualified asset account limits.

3. The funding requires an immediate use of cash in addition to the current annual cost. Qualified Retirement Plans Under Sec. 401(h)

Sec. 401(h) allows certain medical benefits to be paid to retirees from qualified retirement plans. Such a pension or annuity plan must meet six major requirements:

1. The benefits are subordinate to the retirement benefits provided by the plan;

2. A separate account is established and maintained for these benefits;

3. The employer's contributions to the separate account are reasonable and ascertainable;

4. The principal or income of the separate account cannot be diverted to any purpose other than providing the benefits prior to satisfaction of all liabilities under the plan;

5. If all liabilities to provide these benefits under the plan are satisfied, any amount remaining in the separate account must be returned to the employer; and

6. For each key employee, a separate account must be established and maintained.

The most difficult requirement to satisfy is the first, because the aggregate actual contributions for medical benefits when added to actual contributions for life insurance protection under the plan cannot exceed 25% of the total actual contributions to the plan for normal cost after the account is established.

Corporate-Owned Life Insurance (COLI)

COLI is any life insurance contract that is wholly owned by a corporation and under which the company pays the entire premium and is the sole beneficiary of the death proceeds. in other words, the employer buys life insurance on the life of an employee. The life insurance proceeds are then used to recover the costs for employee benefits provided. The receipt of proceeds from COLI is coincident with the payment of any life insurance or death benefit obligation of the employer. Studies have shown that a great deal of postretirement medical benefit payments occur in the year in which the employee dies.

What are the problems accompanying the choice of COLI funding? There are two that are most important:

1. TRA 86 enacted a limitation on the deductibility of corporate policy loan interest. The aggregate amount of such indebtedness cannot exceed $50,000 for each person. As a result, a number of employers have created larger plans that cover a greater number of employees.

2. The amount contributed usually is not deductible, although it could be if the investments are owned by a VEBA.

ESOPs and Other Choices

Employee stock ownership plans (ESOPs) can be used in a variety of ways. One Fortune 500 corporation recently established an ESOP in which retirees liquidate their stock and use the proceeds to pay for health benefits. One part of the plan allocates stock based on up to twenty years of company employment. Each year, company management assigns a dollar value per year of service, depending on the number of shares available in the ESOP.

Some employers are considering health care spending accounts, a type of account similar to the health reimbursement accounts for active employees. The differences: 1) retirees do not contribute to the account and 2) the balances not used up by the end of the year can be carried forward rather than forfeited. The employer can credit an individual's account either with a lump sum amount at retirement or with annual sums throughout retirement.

What's an Employer to Do?

The first decision a company has to make is whether it is in its best interests to pre-fund postretirement medical benefits. To date there is no requirement to prefund, and, therefore, it is still only an option.

if a company wishes to prefund postretirement medical benefits, there are many funding choices available to employers and each approach has advantages and disadvantages. These will certainly change over time with new tax laws and unpredictable economic climates. But basic questions for all companies remain the same:

* What would be the current cost of any considered plan?

* What should be an equitable division of future cost increases between employees and the corporation?

* Does a selected approach achieve organizational objectives? The plan that fulfills these criteria the best will prove the plan of choice.