With an aging workforce and retiring boomers, questions about retiree benefits are becoming more prominent within organizations and in general conversation. You can tell the baby boomers are about to retire when the discussion of retiree benefits moves from the corporate boardroom to the dining room.

The past 10 years have brought significant changes. In 2002, according to Aon Hewitt benefits prevalence data, 62% of employers offered medical and/or dental retiree benefits to new hires. In 2011, that number dropped to 49%.

Today, plan sponsors find themselves in a world where providing retiree benefits is subject to competing priorities.

Growing needs – With increasing lifespans and public to private healthcare cost-shifting, retirees need employer-provided health benefits more than ever.

Escalating costs – Even in recent years, health insurance costs are increasing far faster than inflation.

Few good funding options – There are few tax-effective pre-funding mechanisms for health benefits.

Increasing transparency – Future liabilities are a problem today. Under International Financial Reporting Standards, the accounting cost of these future liabilities is evaluated every year or even every quarter.

Competitive pressures – Retiree benefits can be attractive for older employees, but the return on investment must be weighed against the cost of providing these benefits.

Employee populations
Asking what benefits coverage should be provided can lead to a complicated set of answers. In order to walk through the range of solutions, many employers will split their target employee populations into several groups.

New hires – The easiest group to make decisions for is the employees who will start working tomorrow. These individuals have no strong expectations or history of legacy plans, and plan sponsors can make decisions based on a balance of needs against competitive pressures. Most employers use this group as the benchmark for the organization’s long-term plans.

Existing retirees – Decision-making should be straightforward for this group as well. As legal precedents have shown, organizations need to carefully review their ability to make changes. However, minor changes to the existing benefits structure, such as updating reasonable and customary limits or annual or lifetime caps, can help to modernize the plan when the environment has changed.

Employees who are several years from retirement – Once the ends of the spectrum have been identified (existing retirees and new hires), employers can build the transition rules. While the company may have to deal with communication issues and changes to future promises, these are employees for whom sufficient notice can be provided so that there are fewer contentious issues associated with the change.

Employees who are close to retirement – This is usually the most challenging group to address, as employers often feel a responsibility to maintain benefits for long-service employees, and the legal issues surrounding notice of change are important to consider. Implications for this group also serve as a check for the rationale behind a new benefits plan design. If an employer is uncomfortable putting an employee with 26 years of service into the plan for new hires, is this really the right plan for the organization’s future?

Design components
While many companies have an overall goal of reducing current costs and future liabilities—due either to their paternal inclination or to the fact that the benefits are part of a collectively bargained process—they often end up providing benefits into retirement. There are several key considerations in being able to offer adequate coverage to retirees on a sustainable basis.

1. Plan eligibility
Employers are extending service requirements to qualify for retiree benefits. While two years of service may have been the original plan requirement, 10 or 15 years of service at retirement is now common.

2. Retiree contributions
Although administratively challenging, adding retiree contributions often serves as a solid balancing point. For many retirees, the access to comprehensive group coverage is worth paying a portion of the cost.

3. DB versus DC arrangements
Eliminate the impact of inflation and still offer some level of financial assistance to retirees by providing a fixed annual maximum reimbursement. This isn’t the same as a DC pension plan, since there is no tax-effective funding mechanism for these promises. However, one solution could be to offer an employee life and health trust—a new trust that has been specifically designed to facilitate payments for employee benefits programs on behalf of a series of employees and/or retirees.

4. Catastrophic versus budgetable expenses
Another approach is to focus the plan sponsor’s funds on the elements of greater value in a group-purchasing arrangement and away from those elements where a group purchase has less effect. For example, true insurance (e.g., travel or life insurance) is less expensive to arrange on a group basis. However, a routine dental checkup is essentially the same cost to the individual as it would be under a group program.

5. Indexed versus non-indexed design
Non-indexed design involves capping benefits costs at their levels when the member retires. This design will eliminate inflationary pressures on the retiree group but could introduce difficulties in administering the reimbursement restriction.

Funding and financing trends
Regardless of the nature of the promise to future retirees, there’s still the issue of the tax-effectiveness of putting money aside for retiree benefits obligations, many of which will continue far into the future.

When a plan sponsor closes a DB pension plan, there is the option to buy annuities for the members and remove any future liabilities. While today’s interest rate environment certainly makes annuitizing pension plans more challenging, a robust market to annuitize pension liabilities exists.

However, no such market currently exists for DB non-pension liabilities, due to the risk associated with the open-ended nature of these promises. Given the uncertainties around the cost of providing healthcare coverage to retirees for life, insurance companies are reluctant to take on the risk. For many of the same reasons that employers are reducing or eliminating coverage, insurers do not want to insure the same long-term, open-ended promises. While this is a challenge for plan sponsors, several alternatives are beginning to emerge.

Employee buyouts – From a legal perspective, a plan sponsor cannot unilaterally reduce benefits coverage for an existing retiree. However, if retirees are offered a compelling choice, many could be enticed to voluntarily opt out of their retiree benefits, thereby eliminating the liability, future administration and future risk. For example, a 65-year-old retiree with $5,000 of life insurance coverage may be willing to take $2,000 in cash today in lieu of future life insurance.

The disadvantage of this approach is that it is optional. Typically, not all retirees will agree to such an offer—and those who remain in the plan will likely be those with the greatest need to use the benefits in the near future. Buyouts may be useful to help minimize the number of retirees with benefits, but they will rarely remove the benefits entirely.

Insurance at a premium – For some benefits, it may be possible to work with an insurance carrier to get a single-premium quote to cover all future costs. The insured premium will, in many cases, be in excess of the accounting liability. But depending on the business situation, this might be an acceptable trade-off as part of eliminating the coverage and risk.

Similar offers might exist for retiree health benefits in certain situations, although the margin between the accounting liability and the premium will often be greater due to the greater uncertainty and risk. Paying this margin is not often attractive, but depending on the circumstances, it may be worth investigating.

Other financial instruments – Likely the most intriguing—but least-used—option for managing the ongoing cost of retiree benefits is to transfer the risk to another financial arrangement, either within the plan sponsor organization or with a separate organization. Vehicles such as health and welfare trusts or captive re-insurance arrangements (a method used by companies to self-insure different types of business risks) have been used successfully by Canadian companies as ways to transfer their liabilities on a tax-effective basis.

While it will rarely make sense to open a health and welfare trust or launch a captive re-insurance arrangement solely for the purpose of managing Canadian retiree benefits, for many large organizations, there are multiple uses for these vehicles. If they already exist—or if there are multiple business reasons to consider them—the opportunity to manage retiree benefits costs through these vehicles may be a viable option.

Decision-making on how to handle retiree benefits continues to be difficult for Canadian employers. On one hand, employers need to provide a competitive total compensation package to attract and retain late-career employees, and they have a strong desire to protect and reward long-service employees in their post-employment years. However, these needs and desires must be balanced against the cost and potential long-term risks involved with making promises that extend many years into the future.

Now more than ever, plan sponsors need to consider the full range of solutions when reviewing their retiree benefits plans—both in terms of the design and pricing of the plans, as well as the long-term financing alternatives that exist.

Tim Clarke is health and benefits innovation leader with Aon Hewitt, and Greg Durant is chief actuary, health and benefits, with Aon Hewitt. tim.clarke.2@aonhewitt.com; greg.durant@aonhewitt.com

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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