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Session 304 - Funding Retiree Welfare Benefits
Presenters: Dale H. Yamamoto, Stuart H. Alden
Recorder: Briana S. Summers

There are several issues an employer should consider when deciding whether to fund their retiree welfare benefits.  First, and most obviously, does pre-funding make sense from a financial perspective?  Even if the company has the cash to fund these benefits, is it an optimal use of their funds?  Will it even make sense from an employee relations perspective?  While pre-funding can provide a sense of security, it may also increase the expectations of participants and/or current employees.  However, pre-funding can increase a company’s earnings from operations because the investment earnings from retiree welfare assets increase earnings from operations (on a FAS106 basis) while current investment earnings do not.  Other pros for pre-funding are a) some contributions are tax-deductible when made, b) the investments accumulate tax-free, and c) any assets offset liabilities for accounting purposes.  The basic funding approaches are 401(h) accounts, captive insurance companies, voluntary employees’ benefit associations (VEBAs), health savings accounts (HSAs) and health reimbursement arrangements (HRAs).

401(h) Accounts

401(h) accounts are a distinct and separate account within a pension plan (either a defined benefit plan or a money purchase plan).  There is no minimum contribution required to be made each year to the 401(h) account.  When determining the contribution that can be made, the “subordination limit” holds the 401(h) contribution to 1/3 of the contribution made on behalf of the pension plan (or 25% of the total contribution).  This limit is applied on a cumulative basis.  The method used to calculate contributions must be in accordance with a generally accepted actuarial method that is reasonable.  Sponsors are allowed to assume future increases in medical costs when determining contributions.

OBRA 1990 added a provision by which surplus pension assets may be transferred to a separate 401(h) account through what is known as a 420 transfer.   There may only be one transfer per year, but the transfer may happen in multiple years.  All transfers must be made by December 31, 2013.  The amount transferred from the pension segment of the trust to the separate 401(h) account may not exceed the retiree medical payments made during that year, so most sponsors wait until the end of the year to determine the maximum amount that can be transferred.  Any excess that may be in the account at year-end is returned to the pension plan trust and the plan sponsor must pay a 20% excise tax on that amount.  If a transfer is to occur, the IRS, DOL, any unions and all participants must be notified at least 60 days prior to the transfer.  This notification must include the amount of the excess pension assets, the portion transferred to the 401(h) account, and the amount of medical benefits expected to be provided by the transfer.  No assets transferred may be used to pay for the medical benefits of key employees of the company.

The Pension Protection Act (PPA) has expanded asset transfers beyond just the current year.  Sponsors may now transfer assets for future years (up to ten years) by transferring the pay-as-you-go cost for the current year plus the present value of payments for future years.  By transferring assets for 10-year costs, the employer makes cost maintenance requirements easier to satisfy.  It is also administratively easier to do this.  However, it is likely that transferred assets would be invested in less-risky instruments, reducing expected returns with a multi-year transfer. 

Captive Insurance Companies

A new topic in the funding of retiree welfare benefits is captive insurance coverage.  In a traditional insurance relationship, premiums are paid to an outside insurance company.  In a captive relationship, premiums are paid to a captive insurance company whose reserves are protected from taxes.  These premiums reduce profit, but also reduce the risk element of traditional insurance.  In addition to reducing risk charges and participating in underwriting gains, the main reason to use a captive is to improve the overall tax deductibility for other captive premiums. 

The DOL has granted a class exemption if not more than 50% of the captive’s annual premiums are derived from related business.   Those captives with more than 50% of the premiums from related business may obtain individual exemptions from the DOL.  There are currently two companies that are creating a window of opportunity in the captive arena: Columbia Energy Group and Archer Daniels Midland.   Companies may now receive accelerated approval for a captive relationship through an Expedited Exemption Procedure (EXPRO), as long as the transactions are substantially similar to two prior exemptions (like the two companies listed above).  This can reduce the approval time from an average 1-2 years to a mere 90 days.  

Voluntary Employees’ Beneficiary Associations (VEBAs)

VEBAs are a partially tax-advantaged trust, where the investment income is subject to Unrelated Business Income Tax (UBIT).   However, the welfare benefits paid from the VEBA are not taxable to the participant when they are received.  The UBIT does not apply to VEBAs established for collective bargained groups or those established by a tax-exempt organization, making it a very attractive funding vehicle for these groups.  VEBA assets are considered assets for purposes of FAS 106 accounting if the assets are dedicated to paying postretirement benefits.  If the VEBA pays both active and retiree medical benefits, then none of the assets may be considered for purposes of FAS 106.  

VEBAs have nondiscrimination requirements, as described in Code §505(b).  Life insurance benefits in excess of $50,000 may not be pre-funded (for non-collectively bargained groups).  The tax-deductible contribution limit is equal to the cash-basis benefits paid (called the “qualified direct cost”) plus an addition to qualified asset account (AQAA).  The AQAA allows the employer to bring the contribution up to a level called the account limit, which is a ceiling on the qualified asset account for deduction purposes.  This account limit is essentially the amount needed to cover incurred-but-unpaid benefits and expenses, or the “run-out.”  The tax court ruling in Wells Fargo v IRS allows employers to immediately fund the full present value of benefits for inactive participants, since they have no remaining working lifetime.  

Separate accounts are required for the pre-funding of key employees so that these contributions can be identified and counted towards the 415 limit.  Employers frequently exclude their key employees from the funding calculations and pay their benefits from the company’s general assets.  If the employer makes contributions that are considered non-deductible, these contributions may be carried forward and deductions may be taken as soon as they become available.  Reversions of excess contributions would not be tax-qualified until all obligations are satisfied.  

VEBAs funding collectively bargained benefits appear to be generally free of account limit restrictions, but contributions that cause assets to exceed the present value of benefits would most likely not be deductible.  This provides a practical and reasonable upper limit on contributions. 

VEBAs are typically invested in stocks and bonds, but the presence of UBIT requires more attention to the tax situation.  Some VEBAs may choose municipal bonds to avoid certain taxation.  Other tax-friendly options include Trust-Owned Life Insurance or Trust-Owned Health Insurance.  Both of these take advantage of the tax-sheltered aspect of insurance company reserve investments.  In Trust-Owned Life Insurance, the VEBA pays a premium to an insurer, and upon death of the individual covered, the policy proceeds are paid to the VEBA.  There could be some cash flow matching issues since deaths and medical expenses are not necessarily correlated.  Trust-Owned Health Insurance (TOHI) attempts to address some of the issues found in Trust-Owned Life Insurance.  TOHI are “corridor” policies (for example, between $100 and $750 per year per participant) that operate differently from an excess or stop-loss policy.  Favorable claims and/or investment experience causes the corridor to widen in subsequent years, accelerating the return of funds to the VEBA.