Money and Drugs – What Health Care Charges, Like AT&T’s $1 Billion, Mean to Investors

Monday, March 29, 2010

Following the passage of the new health care plan, many companies are announcing earnings charges. The end points appear ominous: New health plan –> Higher company expenses.

Actually, the charges are one-time adjustments of a balance sheet asset that contains an unusual income tax benefit previously booked as earnings. Here is how that benefit arose, what’s happening to it and how investors should react.

The tax benefit and how it arose

When the new Medicare prescription plan was signed into law in December 2003, many large employers had their own retiree prescription benefits. These companies had already been capping and cutting those benefits because of increasing costs. So, with the newly available Medicare plan, it looked like a good time for corporations to drop their expensive retiree plans.

To prevent the sudden shift, congress approved a 28% prescription cost subsidy to qualifying large employers. [Note: The 28% applies to total costs, including those paid by the retirees.]

The tax benefit came about because congress allowed companies to continue deducting their total costs – essentially making the subsidy a tax-free payment.

For example, assume a company’s retiree prescription plan costs $1,000. (This example is simplified, removing some calculation details.)

  • The first government benefit is a subsidy check. The amount is $280 (28% times the total $1,000).
  • The second government benefit comes from the subsidy being tax-free. Assuming a 35% tax rate, this amount is $98 ($280 times 35%).

So, the company receives government benefits of $378 ($280 plus $98).

Important: Most (all?) large companies require retirees to pay a portion of the cost. Because the subsidy is based on total costs, regardless of whether the company or the retiree pays, there is a large leverage effect from the government benefits. In the example above, if retirees pay one-half the cost ($500), the company’s cost drops from $500 to $122. $622 from retirees drops the cost to zero. Any retiree payments above $622 actually flow to the company as earnings.

The change taking place and how the accounting works

Under the new health plan, the 28% subsidy remains, but, starting in 2013, it will no longer be tax-free. The charges we are reading about are due to this tax-free change.

When companies have long-term revenue or cost items, they account for them in their income statements and balance sheets. Future retiree health care cost is one of those items. So, too, are the future government subsidy payments and the associated tax benefits. The tax benefits end up on the balance sheet as a deferred tax benefit asset. Each year, the actual cost, subsidy and tax benefit flow through the income statement along with adjustments to the corresponding assets and liabilities.

In 2004, when the subsidy and its tax-free status were approved, companies were able to book non-cash earnings as they set up their balance sheet items. This is when the subsidy’s deferred tax benefit asset was born, even though the subsidy didn’t start until 2006. The amounts were large (e.g., GM’s was about $4 billion).

The charge companies are taking today is the adjustment to that deferred tax benefit asset. Companies are removing the benefit for 2013 and after, when the tax benefit will be gone. The non-cash charges are the reversal of the previously booked earnings for those later years.

So… As investors, we can do what the analysts will do: basically, ignore the charges. Analysts focus on operating earnings, not one-time charges, especially when they are outside the company’s business and control.

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To read more, here are four good articles from The Wall Street Journal – two from when the subsidy was introduced, and two from last week. (Ellen E. Schultz, the reporter on all four, has covered corporate retiree benefit activities and effects for the Journal over many years.)

January 8, 2004 – “U.S. Drug Subsidy Benefits Employers” (Page One)

This is an explanation of the then-new benefits, how they are booked and what they mean to the companies that get them.

March 16, 2004 – “How Cuts in Retiree Benefits Fatten Companies’ Bottom Lines” (Page A-1)

See the last section, “Medicare checks,” for more explanation. The rest of article presents company concerns about retiree health benefit costs and the actions taken to control them.

March 26, 2010 – “Companies Take Health-Care Charges” (Page B-1)

March 27, 2010 – “AT&T Joins in Health Charges” (Page A-1)

These two articles explain the changes taking place today and provide some companies’ reactions.

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