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July 1992

OPEBs: FASB prescribes strong medicine. (accounting for other postretirement benefits according to the Financial Accounting Standards Board) (Cover Story)

by Johnson, James S.

    Abstract- The Financial Accounting Standards Board's (FASB) SFAS 106 (Employer's Accounting for Postretirement Benefits Other Than Pensions) mandates companies to recognize future expenses related to providing other postretirement benefits (OPEBs) as they are earned by employees and not only when these benefits are given to retirees. Expenses considered part of the overall OPEB cost are service cost, interest cost, return on plan assets, gains and losses, and transition obligation. Businesses planning on an early implementation of the FASB's OPEB accounting model are advised to assess the OPEB promised to employees, collect the information required for the computation of benefits, be ready with actuarial estimates, and assess how the firm's financial statements will be affected by the estimated obligation. Strategies for managing OPEB costs are offered.

Providing benefits such as health care and life insurance to retirees have long been a way of life for many companies. Under traditional accounting practices, companies have been able to satisfy employee demands by promising benefit payments far in the future while accounting for those promises on a pay-as-you-go or cash basis. The FASB's SFAS 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, will change those accounting practices dramatically. This statement will require businesses to recognize the estimated future cost of providing other postretirement benefits (OPEBs) as an expense as employees render service, instead of when benefits are paid.

The new OPEB accounting model will cause reported OPEB expense for most companies to increase from the amounts presently reported on a cash basis. For mature companies with relatively large numbers of retirees, studies indicate that the annual OPEB expense could be anywhere from two to seven times the amount currently expensed on a cash basis. For companies with few retirees and a relatively young work force, the multiple of expense could be much higher.

The FASB's project on OPEBs has focused significant attention on the implications of providing postretirement benefits, including the spiraling cost of health care. In 1990, the U.S. spent more than $650 billion on health care, more than 12% of the Gross National Product. Despite concentrated efforts to contain employee health care costs, medical spending during 1990 increased at an alarming rate and the prospects for the future are not encouraging.

Understanding the new accounting rules for OPEBs will provide companies with the opportunity to plan for implementation and evaluate how cost containment strategies and funding alternatives can be integrated with overall corporate objectives relating to employee benefit programs.



A prominent feature of the OPEB accounting model is how it "ties together" or reconciles a plan's funded status with amounts reported in the balance sheet and income statement. The reconciliation illustrated in Exhibit 1 also can be useful in analyzing the changes that occur as a result of plan amendments or other significant events, such as a plan curtailment or settlement. Because the accounting model provides for the deferred recognition of certain items - such as the transition obligation, gains and losses, and prior service cost - the reconciliation also provides insights into the cumulative amount of benefit costs that have yet to be recognized in the financial statements.


In the example, the company's cash basis OPEB expense equals the amount of benefits paid during the year, or $800. However, application of the provisions of SFAS 106 on a prospective basis increases the annual OPEB expense to $2,600 - more than three times the pay-as-you-go cost. As an alternative, if the company were to recognize the $10,000 transition obligation immediately as the cumulative effect of an accounting change, the annual OPEB expense for the year would be $2,100 ($2,600 minus $500 representing amortization of the transition obligation). However, income (before tax) would be reduced by the $10,000 transition amount.

The example spreadsheet also illustrates the interaction of the various components of OPEB cost defined in SFAS 106.

The Components of OPEB Cost

Service Cost. Service cost represents the actuarial present value of the portion of the OPEB obligation considered to be "earned" during the period. The FASB concluded the estimated total cost of providing the future benefits - referred to as the expected postretirement benefit obligation (EPBO) - generally should be allocated on a straight-line basis over the employee service period. The employee service period begins with the employee's date of hire (or the date that credited service begins, if later) and ends at the date the employee is fully eligible for benefits, even if the full eligibility date precedes the expected retirement date.

The allocation period was extremely controversial because many believe the period that best reflects the nature of the exchange - benefits in exchange for service - would end at the expected retirement date. However, the FASB concluded the total cost of providing promised benefits should be recognized by the time they are earned. If employees do not "earn" incremental benefits during additional years of service, no cost should attribute to those years.

Interest Cost. Interest cost reflects the imputed growth during the period in the portion of the EPBO that has been "earned" by employee services provided as of a particular date - referred to as the accumulated postretirement benefit obligation (APBO) - using the assumed discount rate. Since the APBO is recognized on a present value basis, imputed interest compounds on benefits associated with prior employee service.

Return on Plan Assets. Actual return on plan assets represents the investment return on any plan assets set aside to fund the benefits promised. Since few OPEB plans have been pre-funded, this will not be a significant component for most companies. In the example, the return on plan assets is considered to be zero.

Gains and Losses. Gains and losses arise when the actual experience of the plan is different from initial estimates or if the expected return on assets, if any, differs from the actual return. Because gains and losses can fluctuate significantly from year to year, and losses in one period might be offset by gains in another period, recognition of such amounts may be deferred. However, if the cumulative net amount of previously unrecognized gains or losses exceeds 10% of the APBO, that excess portion must be amortized into income over the average remaining service period through the expected retirement date of active plan participants. Alternative recognition methods are allowed if they result in equal or greater amortization.

Prior Service Costs. Prior service costs result from plan amendments that change benefits and are attributed to employee services rendered before the date of the amendment. A company may amend its OPEB plan to increase benefits promised during retirement, to enhance productivity, reduce turnover, or improve employee morale, thereby increasing the APBO. An increase in the APBO due to a plan amendment is recognized on a prospective basis by assigning equal amounts to the remaining future service periods through the date of full eligibility for active plan participants.

If a plan amendment reduces benefits, referred to as a negative plan amendment, then a reduction in the APBO results. A reduction in the APBO for a negative plan amendment would be accounted for by first reducing any unrecognized prior service cost and any unrecognized transition obligation. Any remaining reduction in the APBO is recognized over future service periods. This is consistent with the method used to recognize plan amendments that increase benefits.

Transition Obligation. The transition obligation represents the unfunded OPEB obligation at the date SFAS 106 is initially adopted. The transition obligation is calculated as the difference between the APBO and plan assets (if any), minus any OPEB liabilities that previously have been recognized on the balance sheet. Companies can recognize the transition obligation as the cumulative effect of an accounting change (included as a charge against net income in the year SFAS 106 is adopted), or over future periods as a component of annual OPEB expense. Prospective recognition will be phased in over the average remaining employee service period through expected date of retirement. If the remaining service period is less than 20 years, an optional 20-year period may be used.

Effective Date

For public companies and companies that sponsor plans which have more than 500 participants in the aggregate, the provisions of SFAS 106 are effective for fiscal years beginning after December 15, 1992. For non- U.S. plans, and for defined benefit OPEB plans of nonpublic companies with no more than 500 participants in the aggregate, adoption is not required until fiscal years beginning after December 15, 1994. Early adoption is encouraged; but restating previously issued annual financial statements are prohibited.



Companies can benefit now by identifying the extent of their OPEB obligation and by considering steps to contain the rising costs of satisfying their commitments to retirees - particularly the cost of providing health care.

Determine Benefits Promised

The new accounting rules are based heavily on what the FASB refers to as the "substantive plan." As a result, companies should first evaluate summary plan descriptions and other benefit communications to determine the extent of their OPEB obligation. In many cases, assessing the benefits that have been promised will require a coordinated effort by different disciplines. In recent litigation involving attempts to reduce benefits, courts have looked not only to plan documents, but also to employee newsletters, past practices and, even verbal promises in employee meetings and exit interviews, to determine what benefits the employer has promised. In evaluating those promises, it is important to consult with legal, human resources, and other appropriate departments within an organization.

Gather Data Needed for

OPEB Calculations

Next, companies will need to accumulate the information needed to measure the OPEB obligation. Demographic information about active and retired plan participants and dependents will have to be gathered (e.g., sex and date of birth for all plan participants and eligible dependents, plus date of hire, turnover rate, full eligibility date, and assumed age at retirement for active plan participants). In addition, historical per capita claims cost data by participant age will be needed.

Few companies presently have adequate information about claims cost readily accessible. Some companies will find that information about retiree medical costs are combined with information about active employees or that the required per capita cost information has not been categorized by age groups. Other companies will find much of the needed information is just not available. In those cases, outside parties - such as insurance carriers, consulting actuaries, or claims processors - might be able to develop the information needed.

Although companies may not be able to avoid the difficulties of the initial information gathering process, they should consider ways to make the process easier going forward. In some cases, modifying existing information systems will provide the ongoing means of accumulating the required information.

Prepare Actuarial Estimates

Once companies have obtained the necessary information, the next step will be to measure the OPEB obligation. Measuring the OPEB liability will require actuarial techniques and the use of assumptions about a myriad of future events. Some of these events include employees' continued active service with the company, retirement dates, life expectancies, medical costs by age group, and future increases in the costs of providing the promised benefits. The rate of expected increases in future health care costs - determined using a health care cost trend rate - includes highly subjective assumptions about future medical inflation, delivery methods, intensity of services, and the impact of technological advances in the health care industry. This assumption will be the most difficult to determine under the SFAS 106 model, not only because limited historical data exists, but also because historical cost patterns might not indicate future trends.

From a financial statement perspective, the use of an appropriate trend rate is critical because of its impact on the estimate of total costs that will be incurred. To the extent that the trend rate assumption is reflective of future costs, the OPEB accounting model will produce financial statement results that are representative of the costs necessary to satisfy, the OPEB commitment. Admittedly, no one can predict with any certainty what health care costs will do in the future. However, most actuaries do agree that the unprecedented increases in health care costs cannot continue indefinitely. While many agree that increases of the magnitude experienced during the last few years are likely to continue in the near term, the long-range outlook is that the trend rate will be approximately 6% to 8%, annually.

Because the EPBO represents a measure of future benefit payment streams, it will he discounted to today's dollars using present value techniques. The discount rate is to be based on the current rate of return on high-quality, fixed-income investments currently available, and expected to he available during the period over which the benefits are expected to be paid. Because the discount rate will fluctuate based on market changes, the requirement to equate the discount rate to current rates will result in some volatility in the calculated amounts.

For purposes of measuring the EPBO, companies can, in certain circumstances, anticipate future plan changes that are designed to shift future cost increase to plan participants. To the extent that a company can demonstrate, either through past practices of maintaining a consistent level of cost sharing or through communications of its intent to institute future plan changes regarding cost sharing provisions, those changes can be anticipated in the measurement process. In the FASB's view, changes of this nature constitute a part of the "substantive plan," which should be the basis for accounting.

To facilitate long-term benefit planning, information about a company's OPEB obligations should be segregated by plan, by participants and dependents, by early and normal retirees, and by current and future retirees. With this type of information, companies can determine the various characteristics of their OPEB obligations and analyze the expected effects of proposed plan changes and cost containment alternatives.

Determine the Accounting


Using actuarial estimates, companies can determine the effect of the estimated obligation and benefit cost on their financial statements. Determining the accounting consequences of promised benefits can also help companies begin planning how to minimize the financial statement impact of the new accounting rules. in addition to the annual expense increases that most companies will experience, companies should consider whether recording OPEB liabilities could result in violations of financial covenants of loan agreements.

In considering when and how to adopt SFAS 106, companies should consider the impact of the FASB's new rules on accounting for income taxes. Under SFAS 109, Accounting for Income Taxes, the potential future tax benefit is recognized, but subject to a "more likely than not" realizability test. Under SFAS 109's predecessor, SFAS 96, the tests for recognition of the deferred tax asset were more stringent. Many companies postponed early recognition of the OPEB liability until SFAS 109 was issued in February 1992.

To minimize the negative impact on future operating results, some companies are considering recording the accumulated postretirement benefit obligation immediately as the cumulative effect of an accounting change. While this approach would result in an immediate reduction in equity and increase in liabilities, future operating results would improve because future periods would not reflect amortization charges relating to the transition obligation (i.e., the unfunded accumulated benefit obligation). Thus, the return on equity would improve - in some cases, dramatically.



In coming to grips with the skyrocketing costs of health care, many companies are challenging the nature and extents of the promises made and are considering various plan design modifications and funding alternatives.

Changes in Delivery Systems and


Before reducing employee benefits, companies should consider changes designed to reduce the cost of health care, without sacrificing quality. Changes in delivery systems and increased emphasis on preventive health practices can reduce current benefit costs for active employees and, ultimately, can result in lower costs for retirees. Changes of this type include: * Alternative Delivery Systems. Use of a restricted network of health care providers; for example, HMOs (health maintenance organizations) and PPOs (preferred provider organizations); * Administrative Efficiencies. Eliminate duplication and inefficiencies in claims processing; * Patient Care Management Offer alternative forms of care to patients care as well as hospitalization); * Wellness Programs. Promote healthy practices among the workforce to reduce utilization of costly medical services.

These approaches can significantly reduce the annual cost increases from those of an indemnity type plan, which typically has exceeded 20% per year for the last several years.

Plan Design Modifications

Some companies are considering benefit reductions or cost-shifting measures to control their share of costs. When reviewing plan modifications, it is important to consider the impact on employees and employee relations. Companies should evaluate potential adverse legal consequences from changing existing plans. In some cases, the courts have ruled against employer actions to reduce or terminate benefits unilaterally. This especially is true if a company, through various communications to employees, has promised benefits beyond those provided in the written plan document.

Among broad types of plan design changes, some companies have considered replacing their existing OPEB plan with other forms of benefit programs. For example, substituting a defined contribution plan for a defined benefit plan would have the immediate effect of placing a ceiling on the costs for which a company ultimately would be responsible. Replacement also could involve providing additional employee benefits through a new or enhanced profit-sharing or pension plan. The objective is to have retirees look to those other arrangements to provide the funds for the payment of their medical expenses, while achieving current tax deductibility, for the company.

Other plan changes should be considered. The level of employee contribution could be based on the type of coverage provided. Employee contributions for spousal coverage could be increased. Varying employee contributions based on the amount of deductibles elected by the employee is another option that can be considered. Cost ceilings, lifetime maximums, and Medicare integration also can be useful cost-management tools.

Companies also are contemplating changes to eligibility requirements for full benefits. As companies focus on how OPEB plans fit into their employee benefit packages, some companies have concluded that it is not equitable to provide the same level of benefits to retirees with only 10 years of service as is provided to retirees with 30 years of service. Instead, the level of benefits or employee contributions provided can be based on the years of service provided. For example, as the years of service increase, the required level of co-insurance or employee contribution decrease. Because the plan's eligibility requirements are such that an employee would not be eligible for full benefits until retirement, the attribution period would be extended to the retirement date - reducing the annual cost charged against income under the new accounting rules.



Future cash flow requirements and funding alternatives also should be explored. To date, funding OPEB plans generally has been unattractive because only limited tax incentives are available under existing law. while there appears to be some interest in Congress for providing additional tax incentives for funding, no substantial legislation appears close to enactment, particularly considering the current emphasis on reducing the budget deficit. Two funding options that presently offer attractive tax advantages are Voluntary Employee Beneficiary Association (VEBA) trusts and Sec. 401(h) pension trusts.



Extensive disclosures, similar in many respects to those for pensions, will be required for OPEBs. Disclosures required by SFAS 106 include:

* Description of the plan, employee groups covered and funding policies; * Components of net periodic postretirement benefit cost for each year presented; * Key actuarial assumptions used in the measurement; and * Reconciliation of the funded status of the plan to the amounts presented in the balance sheet.

The composite health care cost trend rate assumed for the first year after the financial statement date also must be disclosed. A general description of the expected direction and pattern of change in the trend rate for subsequent years, as well as the anticipated long-term rate, must be presented.

A sensitivity analysis is required that discloses the effect of a 1% increase in the health care cost trend rate assumption on the APBO and on the aggregate of the service and interest cost components of net periodic OPEB cost. This disclosure is intended to highlight the degree to which the critical health care cost trend rate assumption can affect the required measurements.

In accordance with SEC Staff Accounting Bulletin 74, Disclosure of the Impact that Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period, public companies are required to disclose the expected financial statement effects of adopting the new standard. if the financial statement effects are not known, companies should disclose that fact. For 1990 annual reports, many companies disclosed only that the complex analysis required to estimate the impact of the new statement had not been completed and that decisions had not been made regarding accounting alternatives. The SEC has stated it expects more quantitative disclosures in 1991 reports than those provided in 1990.

Companies are required by APBO 22, Disclosure of accounting Policies to disclose which accounting principle is being followed when alternative policies exist. SFAS 106 creates an alternative accounting policy until it is required to be adopted. Until companies adopt SFAS 106, SFAS 81, Disclosure of Postretirement Health Care and Life Insurance Benefits, requires disclosure of the accounting and funding policies being followed for postretirement benefit programs. In satisfying those disclosure requirements, nonpublic companies also should disclose that the FASB's recent standard on OPEBs will require the use of the accrual method of accounting. The disclosures could be included in the footnote describing the company's accounting policies.



SFAS 106 involves many complexities and represents a major challenge to the business community. Although the new rules are not effective until 1993, expected problems in gathering data and making estimates, and the need to manage the skyrocketing costs, make it imperative for companies to begin evaluating their situations now.

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