Ken Hackel, president of institutional equity manager, CT Capital, and author of Security Valuation and Risk Analysis (McGraw-Hill, 2010), warned about six months ago, of the impending pension liability. Now, as expected, firms with large defined benefit plans are fessing up to the power of the discount rate on the ultimate liability, which is now resulting in stepped-up contributions. Hackel estimates that for many firms, with 10-year Treasury bonds at 2.5%, a further 1% reduction in current yields could very well have the same impact as a 20% reduction in the estimated long-term investment return assumption. When Kenneth first started writing of the liability, a 1% reduction was roughly equivalent to a 15% decline.
But now, Kenneth addresses health care costs, the liability for which may rival or exceed that of pensions for many firms.
Ultimately, the rise in health care spending affects cash flow and market values for all companies. While some firms are cutting back on their exposure by eliminating health care benefits for retired employees who may purchase private plans, the bill for the active workforce remains a large, often unpredictable expense, unlike that of pensions having a defined contribution plan.
A firm is required to disclose information about the terms of the plans, the participants, the assumed rates (including health care cost trend rate), the affects of a one-percentage-point increase in the assumed health care cost trend rates, and the types of assets held to discharge postretirement obligations, if any.
Each year, under generally accepted accounting principles (GAAP), firms must estimate the current and five-year health care cost trend rate. Consulting firms make similar forecasts, for example Hewitt Associates estimates costs will rise by 8.8% this year. Aon Consulting is predicting a rise of over 10% as is Segal in its most recent survey. Since consultant forecasts are running higher than most company estimates the difference represents potential hits to analysts and internal cash flow and leverage ratio estimates.
Over the coming five years, medical inflation and the rising cost of health care could well absorb greater amounts of cash flow from operations.
SG&A expenses, as a percent of net sales, improved ten basis points compared to 2009. If the effect of gasoline price inflation on net sales in 2010 is excluded, these expenses increased three basis points compared to 2009. Warehouse operating costs, excluding the effect of gasoline price inflation, increased seven basis points, primarily due to higher employee benefit costs, particularly employee healthcare and workers’ compensation.
Source: Costco Wholesale Corp (COST) 2010 10K.
An increase of 100 basis points in the initial healthcare cost trend rate would have increased our post-retirement benefit expense by $4 million and increased our projected benefit obligations by $73 million.
Source: Qwest Communication (Q) 2010 10K
Unless corporations can successfully shift additional burden onto their employees-now about 22%-Kenneth expects to see an impact on market valuations. At CT Capital, we account for this liability into our cost of equity capital model. It will be interesting to see if corporate Boards recognize the evidence and raise trend rates if their firm’s expectations are not set in reality.
Under the Patient Protection and Affordable Care Act, insurers must justify their increases to state regulators. But even for states, the impact is huge. New York State, for example, has estimated a liability for future health care approaching $ 205 billion. The problem of states ultimately impacts the valuations of publicly held firms if state taxes need to be raised, employees cut, or a federal bailout required.
The new federal law, which requires employers to provide health care or face penalties, does not take effect until 2014, although some provisions take immediate effect, such as coverage up until age 26 (from 19 or student graduation) for children who are dependants.
In CT Capital’s model, the penalty to cost of equity capital is dependent on the size of the expense, its actual rate, consultant forecasts, and its (the expense) relation to operating and free cash flows. When firms do not release their healthcare expense it must be crudely estimated, if material, based on their number of employees and the difference between their estimated trend rate and industry forecasts. This must include any Federal or State subsidies or other tax credits which reduce periodic cost.
In December 2003, the U.S. Congress enacted the Medicare Prescription Drug, Improvement and Modernization Act of 2003 for employers sponsoring postretirement health care plans that provide prescription drug benefits. The Act introduced prescription drug benefits under Medicare as well as a federal subsidy to sponsors of retiree health care benefit plans. Under the Act, the Medicare subsidy amount is received directly by the plan sponsor and not the related plan. Further, the plan sponsor is not required to use the subsidy amount to fund postretirement benefits and may use the subsidy for any valid business purpose. Under the Obama health care legislation, this subsidy is to be taxed, which forced many firms to lower their deferred tax asset, which, at the time, was a non-cash charge. It could have later impaired cash flows.
Unlike pension plans, postretirement plans are largely unfunded and typically highly underfunded. Disclosure requirements for funded plans are similar to those of pensions. For example, a firm is required to disclose the amount of the net periodic postretirement cost, showing separately the service cost component, the interest cost component, the actual return on plan assets for the period, amortization of the transition amount, and other amortizations and deferrals. A firm is also required to provide information about assets and liabilities: the fair value of plan assets; the actuarial present value of the accumulated benefit obligation (identifying separately the portion attributable to retirees, other fully eligible employees, and other active plan participants); unrecognized prior service cost; unrecognized net gain or loss; unrecognized transition amount; and the amount included on the balance sheet (whether an asset or a liability).
What are the implications for the analyst? The direct effects of the accounting standards regarding other postretirement benefits on cash flows are likely to be minimal, although the impact on the balance sheet resulting from the increased liability could prove sizable, as seen for some reporting companies. As with pensions, a high ratio of retirees to active workers will raise the liability. To the extent that the liability interferes with financial flexibility and cash flows, the impact could force cash to be allocated among operating companies in a different manner, especially if particular subsidiaries have younger workforces allowing for lower contributions.
When General Motors adapted SFAS 106, analysts considered it to be another accounting rule providing little information of value because GM’s shareholders’ equity was about $28 billion at the time. When the rule was adopted, GM took a $24 billion hit to earnings to set up the reserve for postretirement health benefits.
Unlike fixed debt obligations, the sponsor could amend plan benefits to reduce the liability but might require employee or union acceptance. If the company is successful in reducing health care costs, as stated, operating cash flows will improve.
Regarding the financial structure: if the health care cost trend rate is inappropriately low, the potential liability would be greater than portrayed by the company and future operating cash flows lower than expected. This would include any tax subsidies received by the entity that are used to offset health care costs.
A decrease in the discount rate would result in an increase in the real benefit obligation and a decline in the funded status, whereas an increase in the discount rate would result in a decrease in the benefit status obligation and an improvement in the funded status. But because there is no legal requirement to fund these plans, the company could continue to fund current costs without addressing the liability, unlike pension obligations. To the extent that such benefits are implied, the analyst should consider the effect the postretirement liability might have on leverage and working capital ratios and debt covenants.
For additional information, including a complete discussion related to the analysis of pension and other post-retirement benefits see Security Valuation and Risk Analysis, McGraw-Hill, 2010.
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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis,” McGraw-Hill, 2010.
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