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Volume 1, Issue 1 | November 2008
Design Your Retiree Medical Plan for Maximum Flexibility
By Michael Morfe, ASA, MAAA, FCA, Senior Vice President
Today, U.S. employers are finding it increasingly difficult to sustain the level of retirement benefits
provided to workers over the last half century, particularly retiree medical benefits. According to
current accounting standards, employers must accrue the cost of retiree medical benefits over the
active lifetime of employees. The actuarial expense is a function of the actuarial liability of the plan,
which is the focus of our discussion.
Actuarial Liability Management
Plan sponsors have many ways to manage the liabilities
and expenses associated with retiree medical plans. As
marketplace and competitive pressures change,
sponsors may implement plan changes every few
years, or even annually. Management of the actuarial
liability can focus on three main components:
> Who gets the benefit and when does it start
(“eligibility”)?
> What is the financial benefit borne by the employer
(“financial commitment”)?
> How is the package of benefits structured (“benefit
delivery”)?
More on Actuarial Liability or
“Present Value”
The actuarial present value of all expected future
cash flow is called the “actuarial liability” of a
benefit. This liability is what sponsors must accrue
while a person is actively working according to
relevant accounting standards. Using
assumptions, an actuary calculates the “present
value” of retiree medical benefits and estimates
the cost, in today’s dollars, to pay for all the future
expenses that a retiree and his or her covered
dependents are likely to incur under the terms of
the employer’s plan. That cost is then allocated
over an employee’s working lifetime to create an
actuarial expense.
Eligibility
Eligibility for retiree medical benefits is typically defined as attaining a certain age and meeting a
minimum number of years of service. In most circumstances, in addition to satisfying the age and
service conditions, an individual must be actively working and covered by the employer’s medical
benefits program at retirement to gain access to the employer’s retiree medical program.
To help manage the actuarial liability, plan sponsors may change the eligibility requirements. Many
plan sponsors are tightening their retiree medical benefits and retirement income plans, such as
pension plans, for a variety of reasons. Some of these include:
> Expense of retiree medical benefits prior to Medicare eligibility.
> Changing nature of what is seen as an “appropriate” retirement age.
> Discouraging “brain drain” of talented senior leaders.
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A typical change to manage the liability for a plan that provides an 80 percent employer subsidy
(“full” benefits) for retirees meeting an age 55 threshold and 10 years of service requirement would
be to increase both the service component and the initial eligibility age, as shown below.
Traditional Scenario
Changes to:
“Full” benefits at age 55 with 10 years
of service
First eligibility at age 62
“Full” benefit of 80% coverage of plan
cost at first eligibility
“Full” benefit accrued after 25 years of
service, and partial benefits earned
after 15 years of service
Schedule of benefits between 15 years
of service and 25 years of service:
Service
Benefit paid
15
50%
16
53%
17
56%
18
59%
19
62%
20
65%
21
68%
22
71%
23
74%
24
77%
25
80%
(Note that adding a service-graded schedule is also a financial commitment change, as discussed in
the following section.)
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Financial Commitment
The financial commitment to a retiree medical plan can be structured in a number of ways.
However, we discuss the financial commitment in five major categories:
> Defined benefit.
> Defined dollar benefit.
> Aggregate account.
> True defined contribution.
> Access only/no financial commitment.
Employer Financial Commitment
At
retirement,
the retiree
receives
Defined
Benefit
Access to
a benefit
and may
need to
contribute
to
participate
Defined
Dollar
Benefit
Dollar amount
formula granted
annually, to be
spent each year
for medical
premiums
Aggregate
Account
Amount in a
notional account,
to be spent over
the retiree’s
lifetime on
medical
premiums;
accounts typically
not pre-funded
True Defined
Contribution
Actual contributions
to individual
interest-bearing
accounts, made
while an active
employee; may
require a transition
benefit for existing
employees
Access
Only
Access to
benefit;
fully paid
by retiree
Benefit
delivery
Companysponsored
plan
Companysponsored plan
or individual
market
Companysponsored plan
or individual
market
Companysponsored plan or
individual market
Limited to
companysponsored
plan
Company
financial
commitment
Linked to
cost of one
or more
benefit
plans
Amount may
remain fixed or
increase over
time with a
formula
Amount booked
to account may
remain fixed or
increase over
time—interest
growth is optional
Amount contributed
to account may
increase over
time—interest
growth is intrinsic
None
Actuarial
expense for
company
Yes
Yes
Yes
None
None
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Examples of these five options include:
> Defined Benefit plans: The coverage level is typically based on years of service, as illustrated in
the example shown above (50 to 80 percent schedule, based on years of service).
> Defined Dollar Benefit plans: An annual fixed dollar amount is defined, typically based on years
of service at retirement; for example, at $100 per year of service, a retiree with 25 years of
service at retirement is provided $2,500 per year. A “cap plan” is a form of this benefit.
> Aggregate Account plans: A notational account pool of dollars is provided at retirement based on
a “grant amount” per year of service. For example, if the grant amount is $2,000 per year of
service, a retiree with 25 years of service at retirement would have an account of $50,000
(assuming no interest). Employers may credit book interest under these plans as well.
> True Defined Contribution plans: Actual contributions are made to individual interest-bearing
accounts while the employee is active. For example, if the annual contribution is $2,000 per year
of service and investment earnings average 6 percent, a retiree with 25 years of service at
retirement will have an account balance of about $110,000 at retirement. For conversions, a
transition benefit may be provided for existing employees.
True Defined Contribution plans typically generate no actuarial expense; instead the expense is
the actual contribution into the accounts while employees are active. Gains due to forfeiture are a
factor. True Defined Contribution plans require a trust administrator for individual accounts. For
plan sponsors that are federal tax-paying enterprises, the tax treatment of these trusts may be
complex, and are outside the scope of this discussion.
> True Access Only plans: These plans offer no financial commitment, thus there is no actuarial
expense. However, employers must be mindful of any implicit subsidization of any benefit
delivery offered, which may give rise to the need for actuarial expense.
Sharing Risk
Moving among these financial commitment options determines the level of risk assumed by
employers and retirees. The following table shows the risk allocation among the various options.
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Financial Commitment Options—Risks of Employers and Retirees
Defined
Benefit
Defined
Dollar
Benefit
Aggregate
Account
True
Defined Contribution
Plan
Purchasing Power
Risk (Inflation)
Employer
Retiree
Retiree
Retiree
Longevity Risk
(Mortality)
Employer
Employer
Retiree
Retiree
Investment Risk
Employer
Employer
Employer
Retiree
Plan sponsors manage their liability by making explicit their financial commitment for these risks.
For example, some Defined Dollar plan sponsors state in plan documents that their financial
commitment will increase by no more than a fixed percentage per year. This fixed increase
(typically three to five percent per year) replaces the Defined Benefit uncertainty of being subject to
medical inflation (typically anywhere from five to 15 percent per year).
Benefit Delivery
While financial commitment addresses the level of subsidization that a plan sponsor provides for
retirees, benefit delivery refers to the actual package of benefits. Plan sponsors are reducing the
cost of the benefit delivery in a variety of ways. In addition to a pure financial commitment change,
some are:
> Requiring more cost-sharing.
> Utilizing less expensive plans.
> Improving the health status of the plan participant (not covered here).
Plan sponsors typically get an actuarial liability reduction for a cost reduction in benefit delivery only
in Defined Benefit offerings.
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Cost Sharing
Requiring more cost-sharing can take the form of more traditional means (copayment amounts,
annual deductibles, and out-of-pocket maximums payable by the plan participant). Perhaps a less
obvious consideration is how the employer’s plan coordinates with Medicare for the Medicareeligible population.
For eligible retirees, Medicare is primary and the employer plan is secondary. Three typical types of
Medicare coordination methods are described below.
Coordination Method
Come Out Whole also
referred to as
Coordination of Benefits
Non Duplication also
referred to as
Carve Out
For Retiree
For Employer
How Prevalent?
Most expensive
Least used method, but
may still be prevalent in
union agreements,
public sector plans, and
for grandfathered
retirees
Most expensive
Least expensive
coverage
Complex calculation
often results in minimal
payment until the
retiree’s out-of-pocket
maximum has been
satisfied. Most common
method used by
employer plans due to
low cost
Richest
coverage
Government Exclusion also
Middle ground
referred to as
coverage
Medicare Exclusion
Middle ground
expense
Medicare expenses are
treated as ineligible
expenses, and then the
benefit formula is
applied to the balance
For prescription drug coverage, most plan sponsors use the Retiree Drug Subsidy (RDS) option,
whereby the employer plan continues to provide coverage and is reimbursed by Medicare pursuant
to a formula. This RDS option may be the most cost-effective strategy for employers. The
evaluation of the cost-effectiveness will depend on plan design, the spending patterns of retirees,
and whether the plan sponsor is a federal tax-paying enterprise.
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Using Less Expensive Plans
The remaining option, utilizing less expensive plans, also has a Medicare twist. Many larger plan
sponsors maintain self-insured plans that coordinate with Medicare, and they can garner some
savings by optimizing vendor costs. Plan sponsors that maintain fully-insured plans can gain
potentially more savings by switching to less expensive plans that cover the promised level of
benefits.
Medicare Advantage (for medical) and Medicare Prescription Drug Plans do not coordinate with
Medicare on a point-of-sale basis. Instead, they provide comprehensive coverage that replaces both
the plan sponsor’s benefit and Medicare. Using a complicated formula, the Center for Medicare and
Medicaid Services (CMS) makes a payment to the Medicare Advantage and Medicare Prescription
Drug Plans based on demographic factors and plan participant risk scores. This sometimes creates
a favorable cost for plan sponsors utilizing one of these plans, compared to a more traditional
approach of paying secondary to Medicare. The favorable cost often materializes for plan sponsors
with retirees living in rural versus urban areas.
The marketplace for these plans is both group and individual. Insurers can sell group Medicare
Advantage and Medicare Prescription Drug Plans to employers with the accommodations
employers are accustomed to receiving:
> Customized plan designs.
> Group enrollment and billing.
> Customized communication.
Often these group plans will produce lower cost than similarly situated employer plans that are
secondary to Medicare.
Conclusion
Plan sponsors have an array of options to consider in their quest to control volatility while accurately
measuring and fashioning plans that support employee needs. Plan sponsors who amend their
retiree medical plans will pay careful attention to the plight of the retiree who has few options for
responding to rapid change. Employers are well aware of the message indiscriminate change
sends to current and prospective employees, thus influencing their efforts at attracting and retaining
talent and warding off bargaining threats. In addition, the issue of reputation risk in the marketplace
will drive decisions about this benefit. Employers should consider moving through the array of plan
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options in a careful and considered fashion to assure adequate warning to their workforce balanced
against the business of financial ratings and shareholder demands.
#####
For more information on managing your retiree medical plan, contact
Michael Morfe at [email protected] or 732.537.4073.
Volume 1, Issue 1 | November 2008
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