In today’s fiscally prudent economic environment, companies would generally not be looking to reward short- or long-service employees with retirement gifts in excess of $50,000 just because they worked for a number of years and achieved age 55 while employed.
They would be even less inclined to do so when they realized this retirement gift came with another six per cent to 16 per cent load of tax and administration expenses, and a need to maintain lifetime contact.
However, such gifts are still bestowed on new employees at almost 48 per cent of companies in the form of post-retirement benefits, according to the Aon Hewitt benefit database.
In many cases, the promise of non-pension retirement benefit coverage was introduced when the most expensive drug therapies were under $100 per year and provincial medicare programs provided extensive coverage without income tests or user contribution requirements.
For many employers, the promise of retirement benefits is an important part of the total compensation strategy. But for those looking to extricate themselves from legacy financial promises, it is significantly more difficult to exit these promises. For plan sponsors with sufficient cash resources, there are two options available that can result in a reduction of non-pension, post-retirement benefit liability: insurance settlement and employee buyouts.
Typically, non-pension, post-retirement benefit programs are defined benefit in nature, with a fairly open-ended list of eligible medical and dental expenses. Generally, new therapies are automatically included as eligible expenses. It is this open-ended promise that makes it difficult for a plan sponsor to “buy” its way out of these programs.
There are a number of unfavourable factors a plan sponsor faces when assessing the financial considerations of a program.
• a low discount rate environment for the foreseeable future
• longer than expected lifetimes
• a probable return to persistently high medical inflation
• accounting changes that increased the burden of these plans on the corporate profit- and-loss statement and their balance sheet
• increasing year-over-year cash commitments
• changing provincial medicare programs
• the evolution of new and costly medical therapies.
The concept is straightforward. The solution is to sell the entire obligation (or part thereof) to an insurance carrier in exchange for a single premium payment. The advantages are:
• The complete transfer of risk means the liability can be “settled” from an accounting perspective. This eliminates the obligation from the plan sponsor’s balance sheet and the ongoing expense from the profit-and-loss statement.
• Through the single premium deposit, the benefit commitment to retirees will be fulfilled by the insurance company. By transferring the risk to a third party, the plan sponsor absolves itself of the financial and administrative responsibilities of operating this plan. Should the insurance company fail to meet its obligations, there may be negative fallout for the original plan sponsor. However, assuming best practices and good governance were employed during the initial stages, this fallout can be expected to be minimal.
The reason it is often difficult to find an insurance company ready to accept the risk associated with a retiree benefit program is because the risk is both long-term and complex. There are different types of expenses that are part of the retiree benefit program: physiotherapy and other paramedical expenses; prescription drug expenses; medical equipment and medical service, emergency and non-emergency; and all the different types of dental expenses.
Also making it more complex and long-term is this coverage is for the remaining lifetime of the group of retirees and usually their dependants. The duration of the promise is until the last eligible member of the group passes away — depending on the group, this could be 50 years or longer.
These types of projects are rarely transitioned to an insurance company successfully. Single premiums are often greater than 100 per cent of the obligation recorded on a plan sponsor’s balance sheet, and can sometimes be double this amount because the insurance carrier’s assumptions are more conservative than the assumptions used by the plan sponsor.
This is rightly so, since the insurer is assessing the risk in a very different manner than when the plan sponsor is developing “best estimate” assumptions for the annual balance sheet disclosure exercise. The insurers will also shy away from or request changes to plan design elements that are unlimited (meaning unlimited lifetime maximums on drug or health expenses).
Thus, to successfully execute a single-premium insurance settlement, significant cash reserves are required to purchase insurance coverage. The plan sponsor must determine whether the single premium is worth the transfer of risk.
This employee buyout differs from the insurance solution in that the offer of cash is made directly to the individual retired member. He needs to undertake the risk analysis and determine if the offer of cash is reasonable for the exchange of future rights to benefits.
The offer is typically made only to eligible members who are retired or close to retirement since their promise of benefits during retirement has vested or will soon vest.
There are several considerations that need to be reviewed from the perspective of both the plan sponsor and the retiree.
Plan sponsor perspective
Effective Jan. 1, 2012, the single premium settlement is a taxable benefit at the member’s highest marginal rate. Outside of Quebec, medical and dental benefits provided by a plan sponsor are not currently a taxable benefit.
•Does the amount need to be adjusted for the income tax the member will pay?
•How will the receipt of these monies affect access to other social income benefits?
It’s generally not possible for the plan sponsor or retired member to purchase individual coverage for the same price with the same provisions.
• How will the lack of viable replacement coverage affect the decision of the retirees?
• Should the plan sponsor try to make arrangements through association programs to secure a suitable replacement?
• Does the retiree need replacement coverage? How does the amount of the buyout offer compare to the expected claims level?
•Do the retirees have access to coverage through other means than the individual market? Is there access available through a spousal program?
A significant amount of cash will be required to fund the settlement offers. Cash settlements are expensive at this time due to low interest rate environment.
• Typically the plan sponsor will want to make an offer less than the liability recorded on its balance sheet. What percentage of the total liability will represent the upside limit?
• Even funding the settlement offer equal to the liability, there will be a portion of the population who will not choose this option. What is the maximum number of retired members the plan sponsor wishes to have at the end of the project?
• Is the amount of the offer deemed to be fair and reasonable given the circumstances of the retiree population?
• What other factors outside of the employer-provided retiree program should the retired member consider?
• What other social programs can be accessed by the retired population that aren’t currently being accessed due to the existence of the employer-paid retiree benefit program?
Basis of the offer
Amounts can vary by province, age, marital status and gender and, therefore, must have a defensible process to address retiree’s concerns
• What are the key differentiators among the population that drive unique and individual results?
• How many of these factors need to be considered in coming up with the offer on an individual basis? The greater number of factors used to differentiate the offering add complexity to the process but may increase the take-up rate.
• How many married retired members are in the plan, and will the plan sponsor be reducing its exposure if coverage for retired spouses continues under the plan?
• It is necessary to find that balance between ensuring that the basis for the offer is as equitable as possible among the retired members but, at the same time, ensuring the amounts are as realistic as possible.
• Retirees will communicate among each other and find out the amounts being offered their counterparts. Does the retired population have sufficient information to allow them to make an informed decision?
Adverse selection will play a key role in the final outcome and measurement of success for this sort of an exercise. The types of employees who can be expected to take a buyout offer can be generally classified as follows:
•members with spousal coverage
•healthy members with low claims
•members with terminal illness
•members without alternate coverage who need the cash regardless of the circumstances of their health
•uninformed members who will not know how to make the decision that best suits their needs.
For retired members in the first three categories, the payout will likely be more than the future cost of their claims. In particular, for members married to other retired members, there will be no reduction in liability as the spouse opting for the buyout will continue to submit his claims as a spouse under the program. Special consideration needs to be made for married members who are both covered by the plan.
Those retired members in the last two categories may or may not represent a savings to the plan sponsor. If they are uninformed or need the money, then they are not examining this as an exchange of risk for cash. Instead, they are making the decision strictly on the availability of the cash.
Thus, in general, the plan sponsor will retain the unhealthy and uninsured lives. It is because of this that the liability will not be expected to decrease in proportion to the number of people who take the cash option.
For example, assume a plan sponsor wishes to offer a buyout at 50 per cent of the liability. Based on an unadjusted prorated calculation, it could be expected that for every retired member who accepts the offer, the net effect would be a reduction in the liability of $2 for every $1 paid out. However, due to adverse selection, the majority of the members not taking the option will be people with greater medical needs and, therefore, use the program to a greater extent than the members who will elect the buyout. Thus, in actual fact, the liability will likely reduce between $1.50 to $1.75 for every $1 paid out.
In summary, the insurance settlement option will present less expensive and easier upfront cost and administration than the employee buyout option. However, there is the risk the ultimate cost may be too significant for a plan sponsor to consider, if an offer is even presented by one of the insurance organizations invited to bid.
Notwithstanding, there are certain arrangements that will compel a plan sponsor under this route and pique the interest of insurance companies (for example, where a plan sponsor has no ongoing operations in Canada and a group of orphaned retirees with benefits). The employee buyout offer comes with significant upfront resource and expense requirements, and the ultimate impact on the plan sponsor’s balance sheet cannot be guaranteed. As with any situation where cash is concerned, the decision is not an easy one.
Greg Durant and Nabil Merali are both at Aon Hewitt in Toronto. Durant is chief actuary in the health and benefits practice and Merali is a health-care consultant in the Canadian health management practice. For more information, visit www.aonhewitt.ca.
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