The Hidden Bite Of Retiree Health
Thanks to a stock market revival, Corporate America's ailing pension plans are earning better returns, and the funding crisis that threatens to siphon cash from its coffers isn't as dire as it once appeared. But that's not the only obligation many companies have to their retirees. Net liabilities for "other post-retirement employee benefits" (OPED) -- mainly health insurance but also possibly dental, vision, life insurance, and other promised benefits -- are substantial. And for many companies, they may pose more of a financial drain than pensions.
That's because companies have stashed away far less money for OPEB plans than for pensions, opting instead to pay much of these benefits out of pocket. With health costs climbing fast, OPEB has a growing claim on the cash flow of many companies. In fact, accounting analyst David Zion of Credit Suisse First Boston says OPEB costs consumed at least 15% of 2002 operating cash flow at General Motors (GM ), DuPont, and Delta Air Lines (DAL ).
To help you assess how these obligations may affect your employer or companies in which you invest, we're examining the footnote for OPEB costs. This footnote -- available in quarterly as well as annual reports starting this year -- is generally the only place where investors can see how much cash is going out the door to cover retirees' nonpension benefits.
DO THE MATH. When a company promises its retirees health insurance and other benefits, it takes on an obligation, or a liability. Attaching a figure to that obligation is an inexact science that involves estimating such factors as how long retirees will live and future health-care inflation, says Janet Pegg, accounting analyst at Bear Stearns (BSC ). To convert the OPEB obligation from future dollars into a current value, actuaries discount it at an interest rate -- now about 6%, on average -- that assumes the company will fund its obligation by investing in high-quality bonds.
For telecom giant SBC Communications (SBC ), the footnote shows a total OPEB obligation of $24.56 billion at the end of 2002 -- up from $20.14 billion at the end of 2001 (Table 1). One reason for the increase: The big decline in interest rates in 2002 inflated the present value of these obligations. This contributed to the $4.9 billion "actuarial loss" in the table.
Partially offsetting the actuarial loss is a $1.1 billion "amendment" to SBC's plan. Amendments occur when a company enhances or scales back benefit coverage. In SBC's case, the footnote's text reveals that the company achieved savings by increasing prescription drug co-payments and retiree contributions. Keep your eye out for future money-saving amendments to OPEB plans. Indeed, the new Medicare prescription-drug benefit is likely to shift some of the burden for drug coverage to the federal government, Pegg says.
This table also reveals that SBC shelled out $1.15 billion to cover retiree OPEB bills in 2002. Not all of that came out of the company's cash coffers, though. To see why, go to Table 2. There, SBC reveals that it used OPEB assets to pay $559 million of the $1.15 billion tab. Subtract the assets used from the total payments, and you conclude that SBC paid the $592 million difference in cash. That's about 3.7% of its operating cash flow for the year.
SBC won't be able to use plan assets to underwrite these benefits for much longer. That's because Table 2 shows it has only $4.9 billion of plan assets left, down from $6.28 billion at the beginning of the year. That's enough to cover just over four years of OPEB bills -- at the 2002 spending rate. Of course, that could change. In fact, the plans' assets are likely worth more today, thanks to the stock market's comeback. Also, in the first quarter of 2003, the company injected $445 million of cash into its plan. This showed up in the footnotes in the 2003 second quarter report as an "employer contribution."
Because SBC's liabilities were five times greater than its assets, Table 2 indicates that the plan is underfunded by $19.6 billion. That's the gap between the $24.56 billion obligation (Table 1) and the $4.9 billion of assets (Table 2). When it comes to OPEB plans, shortfalls are common since "most plans have little to no assets," says Zion. That's in part because, unlike with pensions, companies generally get no tax benefits for contributing to the plans and the gains are taxable, says SBC controller John Stephens.
EYE ON THE FUTURE. That $19.6 billion deficit isn't all sitting on SBC's balance sheet. In fact, accounting rules require the company to record an "accrued post-retirement benefit obligation" of just $10.42 billion. To determine the full liability, you've got to add back the missing $9.2 billion, says Matt Stephani, co-portfolio manager of IDEX Great Companies-America Fund. Because SBC's OPEB liability is growing faster than revenues -- it's up 38% since the end of 2000, while sales are down 16% -- the company will either have to pare benefits or devote a greater percentage of its future cash flow to underwriting them, says Stephani.
You'll want to know the OPEB's impact on net income. For that, go to Table 3. First, there's $293 million in service cost, which reflects the future benefits employees earned during the year. Then there's interest cost on the overall OPEB obligation of $1.43 billion.
A big offset to those costs is a 9.5% "expected return on plan assets," which lowered the expense by $689 million. For 2003, SBC cut that rate to 8.5%. Accounting rules permit companies to use an expected return because a real return would subject these long-term costs to short-term stock market volatility. Roll in a few smaller items, and the footnote shows that SBC's plan reduced the bottom line by $1.055 billion. That's unrelated to the $1.15 billion in benefits paid this year.
Not that the real return goes unnoticed. Table 2 discloses that the actual return was an $802 million loss. When real returns trail expected returns, accounting rules require the losses to be stockpiled, along with gains and losses from other OPEB items. If the losses become large enough -- exceeding 10% of the obligation, or $2.456 billion in SBC's case -- some of the losses must go to the income statement. With "unrecognized net losses" of $10.335 billion at the end of 2002, it's a good bet that more red ink will show up in 2003's financials. Look for that in coming weeks when SBC Communications and others file their next round of reports.
By Anne Tergesen