By: Tom King and Josepha Conway
For companies that provide retiree benefits, administration and funding tend to be dually burdened by the requirements imposed by the Employee Retirement Income Security Act (“ERISA”) and the often significant financial reporting standards of the U.S. Generally Accepted Accounting Principles (“GAAP”). Adding further to the burdens are the significant cost increases over the last decade, primarily as a result of lower discount rates. As a result, plan sponsors are faced with the difficult decision of choosing between reducing or eliminating retiree medical benefits.
Luckily for sponsors of retiree medical plans, a potential solution exists that promises to add financial efficiencies, while potentially lowering costs and lowering cost volatility. That solution is a captive insurance company writing a fronted Trust Owned Health Insurance (“TOHI”) Program, which according to the May 9th, 2014, Internal Revenue Service (“IRS”) Revenue Ruling 2014-15, may be just the right mechanism for funding retiree benefits.
Plan sponsors have traditionally funded retiree medical benefits through pay-as-you-go funding (paying current retiree benefits without any advance funding) or through one of the following funding vehicles:
- -Voluntary Employee Beneficiary Association (“VEBA”)
- -VEBA with Trust Owned Life Insurance (“TOLI”) through a captive (rather than holding traditional investments, the VEBA can purchase life insurance policies)
- -401(h) account
- -Trust Owned Health Insurance (“TOHI”) through a captive (rather than holding traditional investments, the VEBA can purchase health insurance policies)
Pre-funding retiree benefits through a VEBA is often inefficient. Employers who fund a portion (or all) of the APBO are able to offset the liability. However, while contributions to the VEBA may be tax-deductible, the investment income from the VEBA may be subject to the Unrelated Business Income Tax (“UBIT”), which taxes investment earnings on funds supporting non-collectively bargained benefits.
TOLI in a Captive
Purchasing life insurance through a VEBA to cover retiree medical benefits, while cost-effective, has a number of drawbacks. It requires that the plan sponsor deliver the challenging message that they are purchasing a life insurance policy on an employee who may not be eligible for retiree medical benefits. In addition, the policy is mismatched to the liability (life versus health) and requires a significant amount of cash flow management. Ultimately, it is the trust and other employees and retirees that receive the payment of the death benefit of an employee versus the employee’s beneficiary.
Funding retiree medical benefits through a 401(h) account requires that plan sponsors meet high Qualified Pension Plan funding levels (typically, in excess of 125%), set by ERISA, in addition to more stringent funding requirements. In addition, contributions made to a 401(h) account are permanent, and restrict the Plan Sponsor’s ability to reduce or eliminate benefits in the future.
TOHI in a Captive
Prior to the IRS issuance of Revenue Ruling 2014-15, plan sponsors seeking to fund retiree benefits through a captive arrangement with TOHI were required to obtain both a Private Letter Ruling (“PLR”) from the IRS for the tax treatment of the TOHI policy and a Prohibited Transaction Exemption (“PTE”) from the United States Department of Labor (“DOL”).
In addition to these regulatory requirements, employers were required to fund ERISA governed employee benefits through an audited captive that covered property and casualty (“P&C”) insurance. In other words, employers could not establish a new captive specifically for funding ERISA benefits.
As a result, the use of captives to fund retiree health benefits has been limited to employers with already established captives or to employers funding non-ERISA employee benefits which do not require DOL approval. In short, the regulatory and established captive requirements have historically resulted in the under-utilization of a captive for the financing of retiree benefits.
Summary of RR 2014-15:
With the issuance of IRS Revenue Ruling 2014-15, employers can now fund retiree medical benefits with a non-cancellable accident and health insurance policy (i.e. TOHI) and have it receive life insurance treatment without obtaining a Private Letter Ruling. The impact of life insurance tax treatment is that reserves grow tax-free. In order to receive life insurance treatment without obtaining a PLR, the following facts and circumstances must be met:
- -The Company maintains a VEBA Trust that satisfies the requirements of 501(c)(9) (the VEBA code section) and contributes directly to the VEBA for the provision of retiree health benefits
- -The Company purchases a non-cancellable accident and health coverage policy from an insurance company, who then reinsures the policy through the Company’s captive
- -Both the Company and the VEBA retain the right to cancel the retiree health coverage at any time
The result is:
- -The Company’s captive is regulated as a life insurance company and gets life insurance company tax treatment (i.e. tax free accumulation if used to pay benefits)
- -VEBA Assets used to purchase the policy are no longer subject to UBIT
- -The policy receives life insurance reserving treatment, which is effectively tax free growth in reserves if held until the benefits are paid
- -Employers may receive accelerated deductions subject to an IRS limit
- -Reduction in ASC 715 Expense (formerly FAS 106)
- -Overfunding in the captive can be used to fund active employee health benefits
A few things to note:
1.) The non-cancellable accident and health insurance purchased by the VEBA is deemed life insurance because under 26 USC §816(a), captive that writes more than 50% of its business in life insurance during the year is treated as a life insurance company.
2.) Risk shifting occurs because the retiree health benefits provided by the plan are spread across a large group of retirees. By pre-funding the retiree medical benefits in a captive, this risk is transferred from the retirees to the captive.
3.) While the issuance of a PLR from the IRS is no longer required, the PTE requirement remains as the funding of the benefits is a prohibited transaction.
Impact on Retiree Medical funding:
U.S. GAAP sets out stringent employer requirements when it comes to accounting for the accrual of estimated total retiree medical and other benefits. This includes retiree medical and retiree life insurance payable to current employees throughout their lifetimes, which must be listed on the company’s balance sheet (the Accumulated Postretirement Benefit Obligation, or APBO). This requirement, however, does not force employers to fund these obligations. Employers are merely required to recognize them. Recognition nonetheless creates a liability without an offsetting asset, and always begs the question, “How will the company pay for these benefits?”
Employers offering retiree medical benefits often respond to the above question by either restricting eligibility requirements, closing the plan to employees who retire after a certain date, increasing the retirees’ portion of the premiums, increasing co-insurance payments and deductibles, and/or modifying or reducing plan benefits.
Due to IRS Revenue Ruling 2014-15, however, employers may be more easily able to use funds from the VEBA to purchase a TOHI or non-cancellable accident and health insurance policy which is then reinsured through a captive. The captive will then hold the assets that were previously held by the VEBA, and properly offset the liability, decrease ASC 715 Expense, and minimize the net present value costs of operating the plan.
How this works:
When a contribution is made to the VEBA, employers can deduct the contribution, subject to the Qualified Asset Account Limit (“QAAL”). For post-retirement medical and life insurance benefits, the QAAL for any taxable year may include a reserve funded over the working lives of the covered employees and actuarially determined on a level basis, and typically covers 30%-50% of the APBO. If a company’s unfunded APBO is $100 million, the company will generally be able to contribute up to $50 million into the VEBA while deducting the contribution. At a 35% effective tax rate, the value of the tax deduction is $17,500,000. As a result, the net cash required to offset $50 million of liabilities is $32,500,000.
When the VEBA in turn purchases a TOHI policy, benefits may include tax-free reserve accumulation (due to the captive being treated as a life insurance company for tax purposes), reduced balance sheet volatility, and increased operating income through the reduction of retiree medical costs. Moreover, a company engaging in pre-funding retiree medical liabilities demonstrates a clear financial commitment to retirees’ welfare.
In closing, the IRS Revenue Ruling 2014-15 explicitly permits companies to use captives for the purpose of funding retiree health benefits without obtaining a PLR from the IRS provided certain conditions are met. This ruling, while specific to retiree medical benefits, could potentially be extended to pension plan benefits. While further analysis is required, employers with funded or unfunded retiree benefits should take note of the ruling and take a closer look at funding their retiree benefits through a captive.
Image credit: Simon Cunningham via flickr