Still Worthwhile? Weighing Retiree Drug Benefits Without a Subsidy Deduction

Employers that provide retiree drug coverage should analyze their increased future tax liability

By Bill Boies, Amy M. Gordon, Susan M. Nash, and Maggie McTigue of McDermott Will & Emery LLP July 28, 2010

As of 2013, employers that currently receive a federal subsidy for providing retiree prescription drug coverage will no longer be able to take a deduction related to the subsidy under the health care reform overall enacted in March 2010.

History of the Retiree Drug Subsidy

The retiree drug subsidy was established by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) for employers that sponsor group health plans providing prescription drug benefits to retirees. In addition, the MMA created the Medicare Part D program to provide prescription drug coverage to Medicare participants.

The retiree drug subsidy was designed to encourage employers to continue offering prescription drug benefits to their retirees as opposed to terminating their retiree prescription drug benefit plans and thus requiring retirees to seek benefits through Medicare (which would be costly to taxpayers). Under the MMA, certain employers were qualified to receive a subsidy equal to 28 percent of covered prescription drug costs for their retirees. Employers were entitled to an income tax deduction on receipt of the subsidy and were permitted to take into account this deduction when accounting for their retiree prescription drug expenses.

Below are answers to frequently asked questions about the subsidy and health care reform:

How does the elimination of the income tax deduction for the retiree drug subsidy affect employers that provide retiree prescription drug coverage?

The health care reform legislation (the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act) retains the retiree drug subsidy but eliminates employers’ ability to deduct the amount of the subsidy. This change increases an employer’s income tax liability, in effect increasing the employer’s cost of providing prescription drug coverage to retirees. The amount by which an employer’s tax liability will increase depends on the amount of the subsidy and the employer’s applicable corporate tax rate, which currently ranges from 15 percent for income below $50,000 to 35 percent for income over $10 million.

Although employers will not face the higher tax liability until 2013, under financial accounting rules employers must now include the present value of the future taxes as a current liability charged against earnings.

How are employers responding to the elimination of the retiree drug subsidy deduction?

In response to the increased cost of providing retiree prescription drug coverage, some employers are considering eliminating their retiree prescription drug benefits. If an employer decides to eliminate these benefits, retirees who were previously covered by the employer’s prescription drug plan would be eligible to enroll for prescription drug coverage under Medicare Part D.

Although Medicare Part D historically has had a gap in coverage (the "doughnut hole") that made the program a much more expensive option for retirees compared to coverage under an employer’s prescription drug plan, the health care reform law established a system to eliminate this gap. Essentially, before health care reform, the program provided expansive benefits for the initial $2,830 in prescription drug costs and for prescription drug costs above $6,440, but it required enrollees to bear the full cost of prescription drugs within the doughnut hole (between $2,830 and $6,440). However, the reform law provides for enhanced Medicare Part D coverage, which narrows this gap progressively between 2011 and 2020, thus making Medicare Part D a more financially viable alternative to employer-provided prescription drug coverage.

This enhanced Medicare Part D coverage provides many employers with an additional reason to consider eliminating retiree drug benefits. By terminating its retiree drug benefits, an employer would avoid the increased tax liability and current accounting hit to earnings. However, there are practical and legal concerns that an employer should consider before eliminating retiree prescription drug coverage.

Legal Concerns

Employers should consider the probability of litigation when terminating a retiree drug plan. Under the Employee Retirement Income and Security Act (ERISA), lawsuits can be filed by disgruntled plan participants or groups of retirees. The likelihood of success for these lawsuits depends on what types of promises have been made to retirees and whether the employer has reserved adequately in plan documents the right to terminate its retiree prescription drug plan.

Lawsuits challenging retiree benefit changes generally are not successful where the company has been careful to reserve the right to amend or terminate health benefits and retirees have not been led to believe through written plan communications and documents that their retiree medical benefits are vested. However, lawsuits can be more complicated where there are union contracts (particularly contracts that are unclear about the scope of retiree coverage) and where the company has represented that retiree medical benefits are guaranteed for the life of the retiree.

To evaluate litigation risks, employers considering eliminating retiree prescription drug coverage should review carefully the wording of their benefit plan materials, union contracts, employee/retiree communications and other applicable documents.

Other Practical Concerns

In addition to legal concerns, employers considering eliminating retiree prescription drug coverage should consider the likelihood of negative reactions from retirees. Termination of retiree prescription drug coverage might result in negative press for the company. In anticipation of these negative responses, employers that decide to eliminate retiree prescription drug coverage should be prepared by creating written materials (e.g., participant mailings, call center scripts, news media kits) that describe the mechanics of and reasons for the change clearly and by providing retirees with assistance in electing drug coverage timely under Medicare Part D.

Next Steps for Employers

Employers that provide retiree prescription drug coverage should analyze the increased future tax liability and the current accounting charges necessary to retain retiree prescription drug coverage and should evaluate the practical and legal risks of eliminating this benefit. Employers that decide to retain retiree prescription drug benefits should ensure that they incorporate the future tax liability of these benefits into their current and projected earnings. Employers that decide to eliminate retiree drug benefits should prepare for the likely negative responses and potential litigation associated with that decision.

The authors are attorneys with the employee benefits and pensions practice group of global law firm of McDermott Will & Emery LLP. Bill Boies regularly represents benefit plan sponsors and fiduciaries in ERISA class action litigation concerning pension plan administration, fiduciary duty, responsibility for asset losses, and changes in welfare benefits. Amy Gordon focuses her practice on the areas of welfare benefits, including self-funded and insured health plans, counseling clients with respect to HIPAA, ERISA and the Internal Revenue Code. Susan Nash focuses her practice primarily on the area of health and welfare benefit plans, including compliance with COBRA, HIPAA, ERISA, other federal laws affecting group health plans and the Internal Revenue Code. Maggie McTigue is an associate with the firm and focuses her practice on a variety of employee benefits matters relating to pension and 401(k) plans, health and welfare benefit plans, and executive compensation.

© 2010 McDermott will & Emery LLP. All Rights Reserved.

This article should not be construed as legal advice

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