Health Reform Forces Taxing Decision on Retiree Drug Plans

Medicare Advantage group plans also take a hit

By Stephen Miller Mar 26, 2010

Beginning in 2013, employers will no longer be permitted to take an income tax deduction for the Medicare Part D retiree drug subsidies they receive from the federal government, under the Patient Protection and Affordable Care Act signed into law by President Barack Obama on March 23, 2010, and the reconciliation bill enacted a week later.

The health reform law reverses an element of the Medicare Modernization Act of 2003, which established the Medicare Part D prescription drug benefit for seniors and provided a 28 percent subsidy from the federal government to employers that offer prescription drug coverage to retirees. Employers had received the subsidy tax free, plus they were able to deduct the subsidy from their corporate income taxes as an incentive to continue providing retirees with a drug benefit.

While the subsidy will remain nontaxable, it will not be deductible beginning in 2013. This, some employers warn, will significantly increase the cost of providing prescription drug coverage to retirees, with an impact that must be reported on companies' current financial statements.

"America’s largest employers are facing an unpleasant choice: drop their retiree prescription drug coverage or take an earnings hit that could seriously damage the company,” says James A. Klein, president of the American Benefits Council, an employer group. Financial accounting rules enforced by the U.S. Securities and Exchange Commission (SEC), he notes, require that the present value of future taxes be charged against current earnings immediately. "This could substantially increase liabilities for the very companies providing the most comprehensive coverage to the largest populations of current and future retirees," Klein contends. “Absorbing this kind of earnings hit would be deeply disruptive in today’s economic environment.”

In a March 2010 letter to Congress, the Society for Human Resource Management urged lawmakers to consider that "Altering the tax treatment of this subsidy would come at a significant cost to those organizations offering the most comprehensive coverage to current and future retirees."

AT&T, Others Respond Quickly

The corporate response has, in fact, been swift. A March 25, 2010, SEC filing by Caterpillar Inc., a manufacturer of earth-moving equipment, announced a charge against its deferred tax assets, stating: "As retiree health care liabilities and related tax impacts are already reflected in Caterpillar's financial statements, the change will result in a charge to Caterpillar's earnings in the first quarter of 2010 of approximately $100 million after tax. This charge reflects the anticipated increase in taxes that will occur as a result of the [health reform] Act."

The same day, an SEC filing by Deere & Co., a maker of farm machinery, said the new law will increase its expenses by about $150 million after taxes in the fiscal year that runs through 2010.

Shortly thereafter, manufacturing giant 3M Co. said it would take a first-quarter charge against earnings of $85 million to $90 million. And AT&T Inc., which has far more current and future retirees than most other large companies, announced it would take a whopping $1 billion charge against earnings in the first quarter, tied to the loss of the retiree drug subsidy's deductibility. The charge is a third of AT&T's most recent quarterly earnings. Verizon, meanwhile, disclosed it will take a $970 million first-quarter charge related to the lost deduction.

AT&T Inc. is taking a $1 billion charge against earnings due to the loss of the retiree drug subsidy deduction.

"Investors should expect hundreds of charge announcements in the next few weeks as the first quarter ends and companies release earnings," comments Ken Sperling, leader of consulting firm Hewitt Associates’ global health care group. A studyby consulting firm Towers Watson estimates that the aggregate hit on U.S. corporate financial statements would be $14 billion if companies do not move their retirees out of drug subsidy plans. Another study, commissioned by the American Benefits Council, concluded that between 1.5 million and 2 million retirees would not be able to keep the coverage they have because employers would be compelled to move them into Medicare Part D in order to avoid the accounting impact.

“Most ironic of all, this provision has been tacked on to the health care bill as a revenue-raiser of $4.5 billion, but in fact it could end up losing the government money," says the American Benefits Council's Klein. “The $4.5 billion figure only looks at the revenue from the tax; it does not take into account the increased government outlays as retirees are moved to the Medicare Part D program. As more retirees are moved, the revenue collected will go down and the government expense in Medicare will go up,” Klein predicts.

According to a report from the not-for-profit Employee Benefit Research Institute, each retiree who loses employer-based drug coverage and gains it through Medicare Part D will increase the government’s cost by $544.

"After Caterpillar came out and said it was going to take a $100 million hit, it's going to be Wall Street that tells employers that they shouldn't continue" offering this benefit, says Thom Mangan, CEO of Corporate Synergies, a health care consultancy servicing middle-market companies. Offering retirees drug coverage "may be the right thing to do, but the loss of the tax deduction is going to cause companies to rethink this benefit."

A Temporary Retiree Subsidy

Also relating to retiree health benefits, the reform bill includes a new but temporary retiree reinsurance subsidy, to take effect within 90 days of the bill's enactment. The program will reimburse employer-provided insurance plans for 80 percent of claims between $15,000 and $90,000 for pre-Medicare retirees ages 55 to 64, for a given year. It will be administered by the U.S. Department of Health and Human Services (HHS), and is funded with $5 billion. The aim is to provide a bridge until state-run health care exchanges become available for individual coverage in 2014.

Although $5 billion might seem like a lot, it would cover only a fraction of overall pre-Medicare retiree claims, says Thom Mangan, CEO of Corporate Synergies, a health care consultancy servicing middle-market companies. "There is going to be a rush on the government by employers signing up to get it as fast as they can. The first in are going to get the subsidy; those who don't rush out and get it, won't."

“Because the program will begin in mid-June and end as soon as its single funding allocation is exhausted, interested employers should be alert for announcements about the program and consider steps to prepare for participation,” stated a client advisory from consultancy Mercer.

Congress could increase funding for the program, but it was unclear whether that would be likely. (For more on this program, see the HR News article Temporary Retiree Health Subsidy to Be Available.)

Medicare Advantage Plans Take a Hit

Other changes to retiree coverage that employers should note include a decrease in federal payments to Medicare Advantage plans, which combine Medicare benefits with supplemental insurance in a single policy from a private insurer. "Unfortunately, Medicare Advantage group plans, which were very cost-effective, are extinct dinosaurs," Mangan says. "There really wasn't that much of a profit for insurance companies to begin with. Lower federal reimbursement for the Medicare portion of the benefits they provided will make these plans all but nonexistent and force people into the classic Medicare-type plan. So I don't see employers offering Medicare Advantage plans much longer."

Excise Tax Issues

And the 40 percent excise tax on high-value health plans, to take effect in 2018 for plans valued annually at more than $10,200 for individuals and $27,500 for families, is a possible disincentive to providing any kind of retiree medical coverage. "If you offer a retiree health plan, you could be subject to the 'Cadillac tax' on those folks," Mangan says. While the law does not state whether, for purposes of the excise tax, active employees and retirees would be grouped together, Mangan assumes it's likely they will be and comments, "The claims of an average person over 65 and retired are double to triple those of an active employee under age 65. So why would employers continue to provide that?"

Stephen Miller is an online editor/manager for SHRM.


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