How Cuts in Retiree Benefits Fatten Companies' Bottom Lines

The loud message comes from one company after another: Surging health-care costs for retired workers are creating a giant burden. So companies have been cutting health benefits for their retirees or requiring them to contribute more of the cost.

Time for a reality check: In fact, no matter how high health-care costs go, well over half of large American corporations face only limited impact from the increases when it comes to their retirees. They have established ceilings on how much they will ever spend per retiree for health care. If health costs go above the caps, it's the retiree, not the company, who's responsible.

Yet numerous companies are cutting retirees' health benefits anyway. One possible factor: When companies cut these benefits, they create instant income. This isn't just the savings that come from not spending as much. Rather, thanks to complex accounting rules, the very act of cutting retirees' future health-care benefits lets companies reduce a liability and generate an immediate accounting gain.

In some cases it flows straight to the bottom line. More often it sits on the books like a cookie jar, from which a company takes a piece each year that helps it meet its earnings targets.

The art of minimizing retiree-benefit costs while creating income is arcane and poorly understood by the public -- and by the retirees. Here's a field guide to seven techniques.

Hitting the Ceiling

Big companies began in the early 1990s to set ceilings on how much they would ever spend for retiree health care, regardless of what happened to medical costs in general. ConocoPhillips, Delta Air Lines and Coca-Cola Enterprises Inc. are among the many that did so. A cap can be a fixed annual amount per retiree, a per-retiree average or, less commonly, a fixed sum for a group. In any case, once it's reached, a company is largely insulated from future medical-cost increases for those retirees.

The fate of retirees can be very different. When Robert Eggleston retired from International Business Machines Corp. 12 years ago, he was paying $40 a month toward health-care premiums for himself and his wife, LaRue, with IBM paying the rest. In 1993, IBM set ceilings on its own health-care spending for retirees. For those on Medicare, which provides basic hospital and doctor-visit coverage, the cap was $3,000 or $3,500, depending on when they retired. For those younger than 65, the cap was $7,000 or $7,500. Spending hit the caps for the older retirees in 2001, the company says, pushing future health-cost increases onto retirees' shoulders.

Mr. Eggleston, 66 years old, has seen his premiums jump more to $365 a month for the couple. Deductibles and copayments for drugs and doctor visits added $663 a month last year. "It just eats up all the pension," which is $850 a month, Mrs. Eggleston says. Her husband has brain cancer. Though he gets free supplies of a tumor-fighting drug through a program for low-income families, he has cashed in his 401(k) account, and he and LaRue have taken out a second mortgage on their Lake Dallas, Texas, home.

IBM retirees as a group saw their health-care premiums rise nearly 29% in 2003, on the heels of a 67%-plus increase in 2002. For IBM, with its caps in place, spending on retiree health care declined nearly 5%, after a drop of 18% the year before.

IBM confirms that retirees' spending has risen as its own has fallen. It describes the retirees' increased cost in 2003 as not very dramatic, averaging $158 a year, or $13.15 a month, for each of the 190,000 retirees and dependents who participate in the plan. IBM says its costs are down because more retirees are older and eligible for Medicare, so the company's contribution is lower. It says that this year it established a "zero premium" plan for retirees, although this plan carries deductibles double those of other plans.

Caps Plus Cuts

Just because companies have shelter from retiree health-cost inflation doesn't mean they can't also cut their retirees' health benefits.

In January last year, Aetna Inc. said it would phase out health-care benefits for workers who retire starting this year. "Health-care costs have increased," says a spokesman for the company. Yet federal filings show Aetna's spending on its retirees' health benefits had not been rising substantially, thanks to ceilings Aetna imposed a decade ago. From 1998 through 2002, its annual spending for retiree health benefits ranged between $35 million and $39 million.

Aetna says it made the January 2002 benefit cut to strengthen its business. "Wherever it makes sense, we've been trying to reduce expenses in order to be competitive," says its spokesman, adding that Aetna's overall benefits remain "very competitive." Aetna recorded losses early this decade but has turned around, reporting fourth-quarter profits double those of a year earlier.

Aetna's spending on health benefits for 12,000 retirees did rise the following year, 2003, to $44.2 million. A company spokesman said it was unclear why.

Profits From Cuts

For many big U.S. companies, cutting benefits doesn't merely relieve them of future spending. More important, though less visible, is the instant income the cuts can create. It's all because of an accounting rule adopted nearly 14 years ago.

The rule said an employer that provided a retiree health benefit had to estimate what it would cost to pay that benefit over the lives of the retirees. The total became a liability. It created a big obligation on the balance sheet. But at a time when legions of companies were taking this hit, it was generally ignored by securities analysts. There was even some advantage to putting a jaw-dropping obligation on the books: Employers could point to it as a reason that, to survive, they needed to slash benefit levels.

But when a company now changes one of the assumptions that went into that liability, it gets to reduce the liability. In accounting, reducing a liability generates a gain. Voilà: income.

As an accounting credit, this isn't money that can be spent. But it looks the same in the bottom line -- which affects the stock and often management's pay incentives.

Just setting a spending cap typically brings an accounting gain, because it reduces the amount the company expects to pay out over time for the benefits. A company that goes further and cuts the benefit structure reaps more paper gains. It may sound strange that a company can get income from cutting benefits it hasn't paid and may never pay, but that's how it works.

These sums can bump earnings up significantly. Caterpillar Inc. in 2002 added $75 million to income -- 9.4% of pretax earnings -- with the accounting gain it got from boosting the health-care premiums its retirees had to pay and making other changes to retiree benefits. The move will lift pretax earnings about $45 million a year for several more years. Caterpillar confirms the information but says it didn't cut benefits to boost earnings; rather, it did it to help retirees -- by keeping the plan more affordable for the company. "The best way to protect the health care for the long term was to make some of these changes now," says a spokeswoman.

Whirlpool Corp. picked up $13.5 million in earnings, or 19 cents a share, in last year's second quarter from accounting gains, after imposing both caps and cuts in health care for its retirees. This gain more than offset charges of 16 cents a share primarily for a recall of microwave-oven products. Whirlpool then just beat consensus estimates of $1.31 in second-quarter earnings. Whirlpool confirms the information but says it didn't cut retiree benefits to help it meet earnings targets.

Cuts Redux

Gradually, the pools of accounting gains generated by early rounds of benefit cuts and caps run out. When that happens, companies sometimes cut further, replenishing the pool.

International Paper Co. capped its spending soon after it adopted the retiree health-care liability required by the accounting rule, Financial Accounting Standard 106, in 1991. This cap reversed much of the liability. It generated a pool of accounting gains that trickled into the company's financial statements -- to the tune of $17.7 million a year -- until 2000.

Then the stockpile was used up. International Paper again cut benefits in 2000, 2001 and 2002, primarily by capping the benefits of retirees of newly acquired companies. This generated a new batch of accounting gains. They have added a total of $65 million to International Paper's income so far.

A company spokeswoman confirms the figures, noting that they reflect standard accounting practices. She says the company "simply made plan design changes as part of our focus on controlling our costs while maintaining a competitive benefits program."

New Formulas

When a company's liability for retiree health care soars, it's usually just because of some change in the assumptions that went into the liability formula -- a change the company itself made.

Most commonly, it involves interest rates. Liability calculations assume a particular rate at which the assets used to pay benefits will grow. A lower rate leads to a higher liability. Think of it this way: If the return on the money you set aside for an obligation is going to be lower, you have to set more money aside.

For instance, UAL Corp.'s liability for retirees' health care surged more than $1 billion in 2002. Reason: The airline had lowered the rate used in its liability calculation -- known as the discount rate -- to 6.75% from 7.50%. Companies have considerable latitude in picking the interest rate they use and deciding when to make a change, though rates were certainly declining when UAL made its change.

A shift could be in store. If interest rates rise from current historic lows, billions of dollars in corporate liabilities for retiree health care will vanish.

Also feeding into this murky mix is a company's estimate of health-cost inflation. As with the interest rate, companies have wide leeway to change their assumptions about health-cost trends -- giving their liability figure either a bump up or a push down. For example, in 2002, Motorola Inc. boosted its assumption of annual health-care inflation to 12% from 6%. This was a key reason its liability for retiree health care jumped by $122 million.

Rather than focusing on health-care liability, which companies have so much latitude to adjust, shareholders might want to look at what a company actually spends year-to-year for retiree medical benefits. At Bank of America Corp., for example, the liability for retiree health benefits rose by $69 million, to $1.1 billion, in 2003. But federal filings show that what the bank actually spent for these benefits in 2003 declined to $63 million from $84 million the year before, a 25% drop. Retirees' portion rose 27% to $62 million.

Contrary to conventional wisdom, it isn't uncommon for companies to report declines in their actual spending on retiree health care. Those whose filings reveal lower "benefits paid" last year include Altria Group Inc. (down 5%, to $246 million); R.J. Reynolds Tobacco Holdings Inc. (down 11%, to $63 million); Clorox Co. (a 33% fall, to $4 million); Ball Corp. (down 21%, to $8 million), and Black & Decker Corp. (down 28%, to $13 million).

This "benefits paid" figure still doesn't tell whether a company is spending more or less per retiree. The total might be up simply because there were more retirees, perhaps because the company had layoffs or did an acquisition.

But it's still a better measure of the burden of health care than one other number that companies report: their "expense" for retirees' health care. This is essentially an accounting measure of how much a benefit plan pushes corporate income up or down, driven largely by changes in liability.

Dropout Roulette

When employers cap or cut retiree medical programs, the companies don't benefit just by spending less and reaping accounting gains. They also can benefit from a spiral of dropouts.

As retirees see their out-of-pocket costs rising, some of the healthier retirees quit the company program. Their good health lets them buy cheaper coverage elsewhere. But their departures concentrate the remaining pool with sicker people, costs go up, more dropouts ensue, and the pool gets more concentrated again, in what the industry sometimes calls a death spiral.

Each dropout reduces a company's immediate outlays, since it no longer has to pay even a capped benefit for that person. Dropouts also generate accounting gains for the company, since the concern gets to reverse the liability it had booked for covering those retirees for life.

A company in this situation -- with its own expenses capped -- has little incentive to negotiate the lowest possible prices with medical providers. In fact, it has an incentive not to: Rising expenses not only won't hurt the company but will tend to drive more retirees from the program.

At Sears Roebuck & Co., thousands of retirees have dropped out of a retiree health-benefit plan in recent years, at a time when retirees' share of costs was going up. While no one is saying Sears sought this dropout spiral, the dropouts follow a series of caps Sears established in the 1990s to limit its own expenses. The number of retirees taking part in its health plan has fallen 18% since 2000, to 51,500. Sears has 115,000 retirees in all. It can't say how many are eligible.

Sears says that while cost may prompt some retirees to drop out of the health plan, a more significant factor is that older retirees are dying and fewer people are eligible. Benefits Vice President Liz Rossman says Sears works hard to keep its plan affordable for retirees.

Sears has fed $383 million into earnings since 1997 from accounting gains that arose when the company capped its spending and retirees dropped the increasingly costly coverage.

In January, Sears announced it was further tightening the cap on its spending on retirees' health care, and also eliminating future retiree health benefits for most current employees. Sears says the steps will make it more competitive but declines to say how much they will generate in accounting gains.

What makes such moves different from other accounting quirks is that retirees end up paying the price. In Jeannette, Pa., in early January, about 100 retirees of GenCorp Inc., formerly called General Tire & Rubber, met in a union hall to discuss the latest rise in their health-care premiums. The new cost of coverage for a couple was $568 a month. For most, this exceeded their company pensions. Because of the higher cost, many of the retirees at the meeting, whose ages hovered around 80, said they were dropping their employer's coverage.

Mabel Kramer began working at the company in 1944 making gas masks for World War II soldiers, and met her husband there. Now a widow, she collects a pension of $179 a month based on his 34 years with the company. Her GenCorp retiree medical benefits cost her $284 a month, consuming the pension and part of her $810 Social Security check. "If they raise it any more, I'll drop it," says Mrs. Kramer, 78. "It's enough to make you sick."

Others don't dare drop it. Edward Peksa, who spent 24 years in GenCorp's tennis-ball department, said he needs the coverage to help pay for five drugs his wife, Anna, takes for arthritis, hypertension and thyroid and cholesterol problems. The couple's premium more than erases his GenCorp pension of $320 a month. To make ends meet, Mr. Peksa, 75, works 30 hours a week as a greeter at Wal-Mart Stores.

These retirees were paying nothing for their health-care coverage until 2000, when the company began charging them. Their premiums have risen steadily since then. GenCorp says the reason is the ceilings it placed in 1995 and 1997 on its own spending on retirees' health care.

GenCorp's spending on the retiree health-care benefit has fallen over the past six years, its filings to the Securities and Exchange Commission show. It paid $30 million for the benefit in 1997 but just $25 million in 2003, according to its annual report. The liability on its books for retiree health care is down 40% since 1995.

Among the reasons is that no one hired since the mid-1990s will get the retiree benefit, GenCorp says. It adds that the liability also shrinks as retirees die or drop out of the health-care plan because they have "other options or coverage available, or possibly because they can't afford it any more."

Medicare Checks

Medicare's new prescription-drug benefit is giving companies a whole new source of accounting-generated income that boosts their earnings.

And some employers may get federal subsidies even after transferring costs to their retirees.

Congress was worried that if Medicare paid for prescription drugs, companies would cut retiree health-care benefits even faster than they already were. So when it passed a Medicare drug benefit last year, Congress added subsidies for companies that retain retiree drug coverage. The U.S. will reimburse employers for 28% of the cost of retiree prescription-drug spending over $250, up to a subsidy of $1,330 per retiree per year.

This means companies can reduce the liability they're carrying on their books for drug coverage. They won't get the subsidy until 2006. But accounting rules let them estimate how big a subsidy they'll get over the lives of current and future retirees and deduct this figure from their liability right now -- and start dropping immediate accounting gains to their bottom lines.

General Motors Corp. estimates the Medicare prescription-drug plan will cut $4 billion from its liability for retiree health care. Other companies' estimated cuts include $1.3 billion at Verizon Communications Inc., $572 million at BellSouth Corp., $415 million at AMR Corp., $450 million at U.S. Steel Corp., and $280 million at UAL. All of these will boost the companies' income.

The new Medicare law means some companies can get federal subsidies (and thus fresh accounting gains and earnings) even if they shift part of the cost of their retiree drug coverage to the retirees themselves. That's because the way the law is written, the subsidy is based on the whole cost of a company's retiree drug program -- including the part retirees have to pay for.

TRICKLE-DOWN EFFECT

Companies often reap accounting gains, and therefore earnings, when they cut retirees' health-care benefits or cap their own spending on these benefits. Here are the steps as taken at International Paper Co.

1991

Records $405 million balance-sheet liability at year-end for then-current program of health coverage for retirees.

1992

Caps what company will pay per retiree per year in the future. This step reduces the obligation and creates a $133 million pool of accounting gains that will trickle into income over time. Company adds $18 million of this to 1992 income.

1993-1999

Adds $17.7 million from this pool of gains to earnings each year, exhausting the pool.

2000-2002

Makes various benefit changes, including imposing caps for plans at newly acquired companies, thus reducing liability again and replenishing pool of accounting gains.

2000-2003

Adds $65 million to earnings from new pool.