With so much control over the size of the liability, one might expect employers to use a low health care inflation rate, since this would make their obligations look smaller. But many companies did just the opposite, choosing to assume that double-digit health care inflation would persist for decades. They did this even though most experts at the time believed that the worst period of health care inflation was over and the rate of increase was declining, thanks to the spread of managed-care programs, which were intended to reduce unnecessary health care costs. (By 1995, in fact, health care costs were flat, before trending upward again.) Among the pessimists who continued to predict steady inflation were Kimberly-Clark (16 percent), Teledyne (11.5 percent), and Allied-Signal (12 percent).
These high inflation assumptions, combined with other assumptions, including that benefits plans would never change and that the retirees would live a really long time, led to whopping obligations. As the companies had hoped, the media was awash in stories about this new, unexpected threat to the viability of the nation’s largest companies. A sample from late 1991: “Automakers Face Massive Charges” (Associated Press); “Rude Awakening on Health Costs…. The numbers are shocking many” (
There was little downside to putting huge retiree liabilities on their books. Securities analysts and shareholders tend to ignore earnings hits that are the result of accounting changes that all companies must adopt. Speaking candidly to consultants at an actuarial conference in 1996, Ethan Kra, then the chief retirement actuary at William M. Mercer, summed up Wall Street’s sentiment: “The Street views FAS 106 obligations as ephemeral.”
Reporting a giant retiree liability was also an opportunity for some big-bath accounting, a process in which publicly traded companies pile a lot of bad items into a single year, so subsequent years’ income will look better by comparison. It could also be called “you can’t fall off the floor” accounting. Expecting costs from layoffs? Need to write off that bad loan? Doing badly anyway? Get all the bad news out of the way at once, so when net income rises in subsequent quarters, even if only a little, management will look like a hero for turning things around.
PUMP AND DUMP
McDonnell Douglas was one of the first companies to claim the sky was falling. In 1991, the giant aerospace-and-defense contractor lost a lucrative Department of Defense contract to develop a stealth aircraft because of perpetual delays and cost overruns. It was in need of an earnings lift, and FAS 106 came at a fortuitous time. McDonnell Douglas adopted the new accounting rule in January 1992, estimating that health care costs would rise 15 percent a year and that the benefits would remain unchanged. This produced a shocking obligation, for which the company took an immediate $1.5 billion after-tax charge.
But just nine months later, McDonnell Douglas pointed to those whopping costs and announced it would phase out all health coverage for its twenty thousand nonunion retirees. “Health care costs continue to skyrocket,” explained John McDonnell, then the company’s chief executive, in an October 7, 1992, letter to retirees, adding that there was also a new accounting standard that “threatened to deal a heavy blow to our bottom line.”
I’m writing to tell you we’ve found a solution. It may seem complicated at first glance, but, when all is said and done, you will have the same coverage under the new plan…. So here’s what we’re going to do. First, health care coverage provided by McDonnell Douglas to non-union retirees will end Dec. 31, of this year, and retirees are then responsible for obtaining and paying for their own coverage. BUT, second, as of that date, coverage identical to what you have had (but
What was really happening: McDonnell Douglas would be paying for the additional coverage—using pension assets—for four years. After that, well, the retirees would pick up 100 percent of the costs (with their premiums being subtracted from their pensions). McDonnell maintained in his letter that this plan, which supposedly would enable retirees to continue their benefits “without denting your pocketbook,” would save the company millions. In fact, McDonnell Douglas’s pump-and-dump maneuver gave it a pretax gain of $698 million. Without the gains from cutting retiree medical benefits, the company would have had a loss for the year. Companies could take the gains all at once, even if the cuts wouldn’t take effect until later; the bigger the bath, the bigger the pile of gains.
CFOs and consultants didn’t call attention to this, and most analysts were oblivious to the way non-cash gains from benefits plans were enhancing income. But one prescient observer, Jack Ciesielski, an independent accounting analyst in Baltimore, warned in a 1994 client newsletter that the new rules gave employers an incentive to inflate their liabilities. “Companies that were the most adversely affected may have made the most dire assumptions in setting up their postretirement benefits liabilities—and thus have the largest ‘reserves’ to call upon should they need a little earnings help in the next economic downturn,” he wrote. “It’s programmed-in earnings improvement…. By bulking up their assumptions, they created a piggy bank of earnings improvers.”
McDonnell Douglas illustrates another key difference between pensions and retiree health plans. While federal law dictates that companies can’t cut pensions that have already been earned, this is not the case for health plans. Unless the benefits were protected by a union contract (and sometimes not even then), companies could pull the plug on benefits that employees, including retirees, had already earned.
McDonnell Douglas’s profits came at the cost of thousands of retirees like Robert Taylor, who joined the company shortly after the Second World War and retired in 1979. He died four years later, at age seventy-nine, just when the company started passing the costs on to the retirees. As the company phased out its share of the coverage, the retirees’ share grew, until they were paying 100 percent of the costs. Rhada Taylor, Robert’s widow, continued to get the coverage, which supplemented Medicare and covered such things as prescription drugs. Initially, the premium she paid for this was $168. As is common practice, the company deducted the ever-increasing premium from her widow’s pension of $420 a month. The premiums increased bit by bit each year, and by 2000 her pension had disappeared altogether, leaving her with only a Social Security check of $1,009 a month to live on.
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
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.
