Recognizing retiree health benefits: the effect of SFAS 106 - Statement of Financial Accounting Standards Board - Corporate Investments Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Mark J. Warshawsky, H. Fred Mittelstaedt, Carrie Cristea

In December 1990, the Financial Accounting Standards Board (FASB) |8~ issued Employers' Accounting for Postretirement Benefits Other than Pensions -- Statement of Financial Accounting Standards No. 106 ("Statement No. 106") to apply to financial statements with fiscal years beginning after December 15, 1992. With final promulgation of this accounting standard, the FASB expressed definitively its view that retiree health benefits are a form of deferred compensation and not merely a gratuity. Accordingly, the FASB required that accrual accounting be used for these benefits. The FASB also gave explicit guidelines about most of the assumptions and attribution methodologies to be used in valuing retiree health benefits.

Prior to the adoption of Statement No. 106, companies sponsoring a retiree health plan were required to disclose only limited information. In 1984, as a temporary measure pending the promulgation of final guidelines, the FASB |5~ required employers to disclose the annual cash outlays (pay-as-you-go costs) for retiree health benefits in their annual statements, if such costs were deemed to be material. The interim standard, Disclosure of Postretirement Health Care and Life Insurance Benefits -- Statement of Financial Accounting Standards No. 81 ("Statement No. 81") also required a brief description of the benefits provided, the employee groups covered, and the accounting and funding policies followed for these benefits.

For firms that sponsor comprehensive retiree health plans, the shift to Statement No. 106 is expected to have substantial negative effects on balance sheets and income statements. The primary purpose of this study is to quantify and examine these effects. This study complements the Coopers and Lybrand |3~ study by using less detailed firm-specific information but a much larger sample of firms. Hence, our study may be thought to be more evocative of the aggregate impact of the new accounting standard and also allows some consideration of distributional effects. In particular, the study analyzes which industries will be most affected by the new pronouncement, presents a method for estimating Statement No. 106 expense and liability from Statement No. 81 pay-as-you-go costs, and discusses the financial implications of Statement No. 106. The estimation method can be used by investors to evaluate the sensitivity of company disclosures to alternate assumptions and to make adjustments when performing time-series analyses.(1)

In the first section, the provisions of Statement No. 106 are described in detail. Section II discusses sample selection and analyzes cross-industry differences in the percentage of companies sponsoring retiree health plans. Section III details a method for estimating Statement No. 106 expense and liability from Statement No. 81 pay-as-you-go cost. Using this method, Section IV provides an analysis of the impact of Statement No. 106 on financial statements of firms with material pay-as-you-go costs and evaluates the effect. This section also compares study estimates with recent disclosures by some sponsoring firms. Section V discusses the financial implications of the prior accounting analysis. The final section summarizes results and conclusions.

I. Provisions of Statement No. 106

In general, the method of accounting for retiree health benefits promulgated in the new standard parallels the method adopted in Employers' Accounting for Pensions--Statement of Financial Accounting Standard No. 87 ("Statement No. 87," FASB |6~).(2) In particular, both methods produce an accrued liability which is the actuarial present value of benefits attributed to employee service rendered up to a specified date. Expense recognition for both methods uses a benefits/years-of-service approach that attributes the employer's expected benefit obligation to each year of service in the attribution period.

A. Liability Recognition and Disclosure

The liability for retiree health benefits (accumulated postretirement health obligation) is measured using actuarial assumptions which include the discount rate, and the amount and timing of future benefit payments, which in turn depend on assumptions about per capita claims cost by age, health care cost trend rates, and the Medicare reimbursement rate. The discount rate must reflect rates of return available on high-quality fixed-income investments. The trend rate of health care costs should reflect factors other than changes in the demographics of plan participants, such as health care inflation, changes in health care utilization, and technological advances. The assumed rate of Medicare reimbursement should be consistent with current law; future changes in the program may not be anticipated unless such changes are already enacted into law. An employer is, however, allowed to anticipate his own intended changes in a plan's cost-sharing provisions, if such changes reflect the employer's policy of cost-sharing, as evidenced by past practice or communications with workers. In addition to assumptions specific to retiree health plans, actuarial assumptions must be made about employee turnover, retirement age, mortality, and the number of covered dependents.