Retirement Heist

by Ellen E. Schultz

  R.R. Donnelley, a printing company based in Chicago, dispatched a similar letter to its retirees in October 1992, also blaming “skyrocketing” health-care costs and FAS 106: “We have another problem—a new accounting rule we must use, beginning in 1993. This of course has a serious negative impact on our earnings.” Regretfully, the company began to charge retirees for their once free health care, “to remain competitive.” That last part was true: It remained competitive with the other companies that were cutting retiree health coverage.

  While some companies like McDonnell Douglas chose to report all of its gains in a single year, R.R. Donnelly took the more common approach and spread them over several years. Donnelley’s gains were fed into income throughout the nineties.

  LET THE GAINS BEGIN

  Few noticed that companies were gaming the system, and people who pointed it out didn’t score any points with private industry. Jeffrey Petertil had been an adviser to the accounting-board task force that drafted the new rule, and he wasn’t happy with the outcome. “FAS 106 not only overstates the value of future retirees’ health benefits, but its complexity presents another hazard,” he wrote in a 1992 editorial in The Wall Street Journal. “The value a company assigns to future health benefits can be wrong, whether by mistake or by design, and nobody will much know. The FASB rule leaves loopholes that let a company reduce or increase cost almost as it wishes. One reason there has been little outcry, considering its estimated financial impact, is that some consultants and managers know that by making minor changes to the plans they can greatly reduce the FASB cost.”

  He also pointed out something that ought to have been obvious: Employers could make their retiree health liabilities go away. “There is a question of whether there is a liability at all,” he wrote. “Many companies extend health benefits to retirees but change them often. Recent court cases indicate that the employers’ right to change or terminate the benefit will be upheld.” Within twenty-four hours of the editorial’s publication, his largest client, a Big Six accounting firm, fired him.

  Defense contractors and public utilities had an additional incentive to inflate their obligations, because they could use the high figures to ask for more money in their government contracts or to ask utilities commissions for rate increases to offset the cost of the benefits. Pacific Gas & Electric reported a large liability in 1993, then asked the California Public Utilities Commission for permission to raise rates to cover its retiree health costs. It obtained a $181 million rate increase that year. But PG&E then reduced what it would pay for benefits and cut its workforce by 17 percent. By 1999 it had reduced its annual retiree-benefits expense by 90 percent.

  California ratepayer advocates ultimately caught on and pointed out PG&E’s retiree-liability two-step to the utilities commission. The commission required the company to credit $191 million to ratepayers for the years 1993 through 1995. By the late 1990s, more ratepayer advocates were hiring auditors to review utilities’ requests for rate hikes to pay for retiree health costs. When evaluating a request by New Jersey water utilities for a rate hike, the advocates’ office hired an expert who found that virtually every assumption—health care inflation, mortality rates, salary increases, expected rates of return on the assets, and so on—was unrealistic. The rate board nixed the increases. Similarly, the Massachusetts Attorney General’s Office and the Rhode Island Division of Public Utilities and Carriers, an agency that represents consumers, hired a consultant to conduct an audit of New England Electric System’s retiree health costs. The auditors determined that ratepayers had overpaid for the benefits, and the utility was forced to refund $20 million.

  HUSTLING THE JUDGES

  The giant liabilities that companies reported for retiree health care also had a powerful effect on the courts. Unisys, like many other companies in the late 1980s and 1990s, promised lifetime, company-paid health coverage to older employees as an inducement to get them to retire. Albert Shaklee was one of thousands of Unisys career employees who took the deal. But the coverage didn’t last long. In October 1992, Unisys sent a letter to 25,000 former employees saying that because of “increasing medical costs and growing worldwide competition” the company would shift 100 percent of the cost of coverage to the retirees over three years. “This new plan will be cost-effective, will provide financial protection against the high cost of illness or injury, and will continue to be available at group rates,” the letter said.

  Shaklee, who had moved to Lake Kiowa, Texas, when he retired, hung on to his coverage as long as possible, because his wife, Doris, hadn’t yet hit the Medicare eligibility age of sixty-five and, with a cancer diagnosis, was uninsurable. When his premiums reached $784 a month in 1996, exceeding his $727 monthly pension, he dropped out of the plan. Though he had earned $70,000 a year, in order to get health coverage Shaklee had to take a minimum-wage midnight-shift job at a partsgrinding factory in nearby Gainesville. He was seventy at the time.

  Unisys retirees sued, pointing to the written promises, but the court rejected their claim. “Just as in war, there are no winners,” wrote a U.S. district court judge in Philadelphia in a 1996 decision. “This is a corporation that provided a generous benefit and may have continued providing it if medical costs had not escalated and FAS 106 had not become a reality.”

  HITTING THE CEILING

  For all their talk of skyrocketing costs and burdensome accounting regulations, these companies weren’t facing as much peril as the public assumed. Generally, the benefits cover only people who retire between fifty-five and sixty-five, assuming the person had worked long enough to be eligible—usually a minimum of fifteen years. Employers had largely closed that barn door long ago, shutting out people hired after a certain date, so the population of employees eligible for benefits had largely stopped growing. Another factor that limits employers’ liabilities: When the retiree turns sixty-five, employer coverage, if it continues, becomes secondary to Medicare, which provides basic hospital and doctor-visit coverage. That means the employers’ costs drop sharply. As unlikely as it sounds, the older retirees get, the less expensive they become to their former employers.

  Nor did employers face much exposure to rising costs. That’s because when they adopted FAS 106, most companies, including Sears, R.R. Donnelly, Delta Air Lines, and Caterpillar established ceilings on how much they would spend for retiree health care, regardless of how high they rose in the future. What this means is that, once these companies hit their pre-set spending ceilings, say, at $20 million a year, or at an annual limit for an individual, they’re protected from rising health care costs, no matter how sick their retirees get or how long they live.

  In 1993 IBM set ceilings on its future spending. For retirees under sixty-five, the cap was $7,000 or $7,500 depending on when they retired. For those on Medicare, the cap was $3,000 or $3,500. The ceilings effectively shifted the risk of rising health care costs to the retirees, because once the costs increased enough to hit the company’s pre-set ceiling, any costs over the cap are passed on to the retirees. When IBM hit its spending ceiling around 2002, its spending stopped growing. All the increased costs were passed on to the retirees, whose health care premiums rose 67 percent, while IBM’s spending declined 18 percent. With spending caps in place, companies see a steady decrease in costs as their aging retirees become eligible for Medicare, drop the coverage, or die.

  RETIREE DROPOUTS

  By the late 1990s, about two-thirds of retirees were dropping their employer-provided coverage within several years after retiring, according to Labor Department figures. Among them was Elaine Russell, a Sears retiree in Seattle, who dropped the coverage when it had reached one-third of her pension. Medicare didn’t cover medications for her thyroid condition and colitis, so she paid for her prescriptions with her grocery budget and relied on the $2.50 lunches at the senior center and on the local food bank, where she got free canned food for herself and her cat.

  Though the retirees’ share of costs was rising, Sears’s was
shrinking, not just because of the cost shifting, but because it changed its estimate about health care inflation. By 1999, the retailer had slashed the health care trend rate to 6 percent from 14 percent. Revising that assumption downward, of course, lowered the obligation on the books. So did the benefits cuts. By the end of the decade, Sears’s IOUs for retiree health care had fallen 69 percent, to $900 million.

  When retirees like Russell drop coverage they can no longer afford, companies benefit in two ways. One is that they no longer have to pay their share of the benefits. That’s a cash savings. The other is that because the company will no longer have to pay anything for the retiree dropouts, for the rest of their lives, the company can total up the overall lifetime savings and reduce its obligation by that amount. That produces gains that boost income.

  By 2005, when Sears merged with Kmart, the number of retirees in the Sears plan had fallen from 100,000 to 50,500. Sears doesn’t disclose how many had died and how many had dropped out. Liz Rossman, Sears’s vice president for benefits, dismissed the notion that retirees were dropping out because they couldn’t afford the benefits. Apart from those who had died, others might have gotten jobs with health coverage. “We were trying to strike a balance between duty to shareholders, so they could get an adequate return on investments, with our duty to retirees.” And the Sears plan was “far more generous with benefits than others in our industry.” She pointed out that the company had boosted other retiree benefits, such as doubling the discount retirees receive on clothing purchases at the store, from 10 percent to 20 percent.

  In 2006, Sears stopped paying retiree medical costs altogether.

  DEATH SPIRAL

  These ceilings not only protect companies from rising health care costs but also provide them with a perverse incentive: A company that has hit its spending cap 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.

  Meanwhile, retirees with preexisting conditions and serious health problems remain in the health plan, driving up costs further. Robert Eggleston, an IBM retiree in Lake Dallas, Texas, had brain cancer, so even when his monthly costs for retiree coverage exceeded his pension, he remained in the plan, which also covered his wife, LaRue. To get by, he cashed out his 401(k) account and took out a second mortgage on his home. Luckily, he was eligible for free supplies of a tumor-fighting drug through a program for low-income families, but this was an unexpected end for a career IBM employee.

  Some employers hastened the death spiral by segregating retirees into their own risk group rather than keeping active employees and retirees in the same “risk pool” and spreading costs among a wider group of people, as had been common practice in the past. When retirees are segregated into their own pool, the per capita costs rise, because an older, sicker population needs more medical care.

  After Xerox split its active and retired employees into two pools in 2003, its retirees under sixty-five began paying 50 to 60 percent more than employees their age. Eugene Nathenson, a retired controller of Xerox Financial Services, saw his premiums shoot up from $1,645 in 2003 to $3,196 the following year, while the deductibles he and his wife paid pushed their out-of-pocket costs beyond $6,000 a year.[10]

  REPLENISHING THE COOKIE JAR

  By the late 1990s and early 2000s, many companies had used up the actuarial gains they’d stockpiled after the early rounds of cost shifting and benefits cuts, just as they had spent the surplus in their pension piggy banks. So they turned to a tried-and-true solution: Cut more benefits.

  Companies continued to cut retiree health benefits throughout the 2000s. International Paper cut benefits in 2000, 2001, and 2002, telling retirees that health care costs were spiraling. What had actually happened was that it had used up the pool of accounting gains generated after the company recorded a huge liability in 1991, and then set a cap on benefits. Unlike McDonnell Douglas, which took all the gains at once, International Paper trickled the gains into income in subsequent years, to the tune of $17 million a year. After this stockpile was used up, cutting the benefits generated a fresh pool of accounting gains that added a total of $65 million to its income by 2004. In 2004, the company then closed the plan to salaried employees whose age plus years of employment with the company totaled less than sixty as of January 1, 2004. Another cut in 2009 whittled another $40 million in obligations.

  IBM’s cookie jar of earnings enhancements was also running low by the end of the 1990s. IBM’s solution was to establish “health care accounts” for future retirees, which was essentially a way to further limit the amount it would pay for their health benefits. This step, which the company took in 1999, reduced the company’s liability by $127 million and generated a fresh pool of accounting gains that the company added to income over a period of years.

  Benefits consultants helped their clients replenish the cookie jars. William Falk, who oversaw the retiree medical consulting practice at Towers Perrin, addressed the problem of diminishing income at an actuarial conference in the late 1990s: “So the clients are saying, ‘Well, what can we do about this? We don’t want our costs to jump up next year. Management and shareholders won’t accept it.’ Well,” he told his fellow consultants at the meeting, “they’re doing a lot of things. They’re looking at reduction in benefits again.”

  Towers Perrin sent marketing materials to current and potential corporate clients, saying employers needed to think about “new strategies and approaches to managing health benefits.” Among them: tightening eligibility by requiring higher ages and years of service; getting some dependents out of the plan, such as dependent children; and increasing premiums, deductibles, and out-of-pocket expenses, “especially when you can’t get people [like union retirees] out” of the plan. Companies could also adopt “more aggressive assumptions” for health care inflation, administrative expenses, and participation rates. Health care inflation trends “have been low, but we’ve kept them high. Now we have room to move back down” and generate some new accounting gains.

  Of course, companies that announce benefits cuts don’t say they’re cutting benefits because they’ve run out of accounting gains generated by earlier cuts. They generally just blame rising health care costs. That was what Aetna did in 2003 when it announced it would phase out health care benefits for workers who retired starting in 2004. The reality: Aetna’s costs were going up because it had used up the pool of gains generated when it capped the benefits in 1994. It had used as much as $23 million a year from this pool to reduce its annual expense. By 2002 those gains had run out, and to keep its expense from rising, Aetna needed to cut benefits again.

  But was Aetna actually spending more money? Not really. Thanks to the ceiling on spending, the amount the company actually paid—that is, dollars out the door—remained roughly flat from 1998 through 2002, ranging between $35 million and $39 million. Asked to explain why it was cutting benefits when it wasn’t spending more, Aetna responded by saying that it needed “to reduce expenses in order to be competitive.” That answer, at least, made more sense: The maneuver increased Aetna’s pretax income by $34 million in the first quarter of 2003. That was 6.4 percent of its earnings. The gains continued to lift Aetna’s pretax earnings about $45 million a year for several more years.

  Companies could time the cuts to generate gains at opportune moments. With a little preparation, companies can determine how many cents per share they need to meet earnings targets, and then identify which bits of their retiree plans to trim to generate the gains the company needs to clear the earnings hurdle. Caterpillar increased retirees’ premiums and made other benefit cuts in 2002 that reduced obligations by $475 million. This resulted in a $75 million accounting gain that year, which amounted to 9.4 percent of pretax earnings. The flexibility built into the accounting rules—and employers’ ability to trim benefits—has enabled companies to cannibalize their retiree health
plans whenever they need to generate gains to boost income.

  At Whirlpool, the retiree health plan has offset the cost of defective appliances over the years. In the second quarter of 2003, trims to its retiree medical benefits generated a one-time gain of $13.5 million. This added 19 cents a share—enough to offset a one-time after-tax charge of 16 cents a share to cover the cost of recalling defective microwaves, with three cents left over. This enabled the company to report earnings of $1.35 a share—beating the $1.31-a-share consensus estimates.

  In March 2009, Whirlpool made another benefits trim: It suspended the annual credit it provided to the retiree health savings accounts. The $89 curtailment gain this cut generated neatly offset a one-time charge for a voluntary recall of 1.8 million refrigerators sold in the United States and Canada between 2001 and 2004. And in March and June 2010, the $62 million in gains from other cuts to the retiree health care plan largely offset the $75 million charge for recalling 1.8 million dishwashers sold in the United States and Canada between 2006 and 2010.

  Chapter 5

  PORTFOLIO MANAGEMENT

  Swapping Populations of Retirees for Cash And Profits

  ONE OF THE LAST LETTERS Bill Jelly received before he died in 2003 was from his benefits administrator, informing him that the death benefit from his employer, Western Electric, was going to be canceled—in one month. He’d earned the benefit decades ago, when death benefits, like retiree health coverage, were commonly offered to people who’d spent most or all of their careers at a particular company.