Pros and Cons of Prefunding Vehicles

One way to reduce effective costs of retiree health care and liabilities resulting from Financial Accounting Standards rule number 106, without cutting benefits, is to prefund retiree health-care costs using triple-tax-exempt high-growth strategies. The ideal funding method should provide tax deductions for contributions, tax exemptions on income, tax-free benefits and funds to offset the entire liability. No single vehicle will satisfy these requirements. However, companies are creatively using a number of options to prefund through employer and employee contributions. Utilities and government contractors are particularly likely to prefund, because they can build the expense into their rate base. Some prefunding vehicles are:

1. Voluntary Employee’s Beneficiary Association (VEBA).
   A VEBA trust provides advance funding for various types of employee-welfare benefits, including health care. Its effectiveness, however, is restricted by the unrelated business income tax (UBIT) on earnings and by limits on tax-deductible employer contributions. Future liabilities must be calculated based on current medical costs without inflation adjustments.
   
   Despite these restraints, VEBAs appeal to some employers. A VEBA for unionized employees who have a collectively bargained plan isn’t subject to limits on contributions and taxes on investment earnings. Nonprofit, tax-exempt organizations aren’t subject to UBIT.
2. Trust Owned Life Insurance (TOLI).
   The insurance industry is promoting group variable life insurance as an option to VEBAs. Under this plan, the employer makes maximum tax-deductible contributions to a VEBA, which purchases life insurance on a group of employees, naming the VEBA trust as beneficiary. Death benefits, which are directly tied to portfolio investment performance, are used to pay postretirement health costs. Because life insurance is tax-sheltered, the income is tax-exempt. Moreover, the policyholder (the VEBA) can direct investment strategy to maximize potential investment return within an acceptable risk tolerance. Large companies may find TOLIs most effective because life insurance should cover a pool of 2,500 or more insured employees.
   
   The main disadvantage of this funding vehicle is the lack of case law and the potential for future legislative restrictions. Although state laws generally don’t allow trustees to purchase policies on the lives of trust beneficiaries, a VEBA trust is subject to federal law. No ERISA provision prohibits a VEBA from holding life insurance. However, a change in the tax laws or an unfavorable ruling from the IRS could have adverse tax and cost consequences for companies that have purchased a TOLI.
3. Section 401(h) retiree medical account.
   A qualified pension plan may provide retiree health expenses by contributing to a separate account under the plan. Contributions are tax-deductible, earnings are tax-free, and, unlike VEBAs, cost projections include inflation. However, limitations on contributions make it impossible for fully funded pension plans to take advantage of this option.
   
   Section 401(h) specifies that medical benefits must be subordinate to the plan’s retirement benefits. Non-pension contributions can’t exceed 25% of the aggregate contributions made to the pension plan. For an overfunded pension plan, allowable contributions are low and nonexistent.
   
   Combining a 401(h) account with a defined contribution plan substantially increases the allowable contribution. Nevertheless, most companies, especially those that have a high ratio of retirees to workers, still will be unable to fully fund the liability.
4. Health Stock Ownership Plan (HSOP).
   Cincinnati-based Procter & Gamble has creatively redesigned its profit-sharing plan to gain some of the 401(h) advantages. Procter & Gamble converted its employee stock-ownership plan (ESOP) into a combination stock bonus plan and money-purchase pension plan, then attached a 401(h) retiree medical account to the pension plan. The HSOP borrowed convertible preferred stock and will repay the loan with annual fixed contributions from Procter & Gamble, plus dividends on the stock. Upon retirement, the funds in the account will be used to provide medical benefits.
   
   The legal status of an HSOP is questionable. The IRS has approved the plan for Procter & Gamble only; other companies will have to wait for regulators to study both the tax- and health-policy issues. If they agree, Coca-Cola will consider an HSOP to fund its $250 to $300 million liability.

SOURCE: Reprinted with permission from State Street Bank and Trust Company Master Trust Quarterly vol. 3, no. 2.