Continuation of Coverage in Addition to COBRA | Plan Provisions and Taxation

Even before the passage of COBRA, it was becoming increasingly common for employers (particularly large employers) to continue group insurance coverage for certain employees—and sometimes their dependents—beyond the usual termination dates. Obviously, when coverage is continued now, an employer must at least comply with COBRA. However, an employer can be more liberal than COBRA by paying all or a portion of the cost, providing continued coverage for additional categories of persons, or continuing coverage for a longer period of time. Some states have continuation laws for insured medical expense plans that might require coverage to be made available in situations not covered by COBRA. One example is coverage for employees of firms with fewer than 20 employees; another is coverage for periods longer than those required by COBRA.

Retired Employees

Even though not required to do so by the Age Discrimination in Employment Act, many employers continue coverage on retired employees. Although coverage can also be continued for retirees' dependents, it is often limited only to spouses. Retired employees under age 65 usually have the same coverage as the active employees have. However, coverage for employees aged 65 or older (if included under the same plan) may be provided under a Medicare carve-out or a Medicare supplement. The lifetime maximum for persons eligible for Medicare is often much lower (such as $5,000 or $10,000) than for active employees.

The subject of retiree benefits has become a major concern to employers since the Financial Accounting Standards Board (FASB) phased in new rules between 1993 and 1997 for the accounting of postretirement benefits other than pensions. These rules require that employers do the following:

• Recognize the present value of future retiree medical expense benefits on the firm's balance sheet with other liabilities.

• Record the cost for postretirement medical benefits in the period when an employee performs services. This is comparable to the accounting for pension costs.

• Amortize the present value of the future cost of benefits accrued prior to the new rules.

These rules are in contrast to the long-used previous practice of paying retiree medical benefits or premiums out of current revenue and recognizing these costs as expenses when paid. Although the rules are logical from a financial accounting standpoint, the effect on employers has been significant. Employers who have elected to immediately recognize the liability have had to show reduced earnings and net worth. Firms that have elected to amortize the liability (often because immediate recognition would wipe out net worth) will be affected for years to come.

The FASB rules have resulted in two major changes by employers. First, many employers have lowered or eliminated retiree benefits or are considering such a change. However, there are legal uncertainties as to whether benefits that have been promised to retirees can be eliminated or reduced. Many employers also feel that there is a moral obligation to continue these benefits. As a result, most employers are not altering plans for current retirees or active employees who are eligible to retire. Instead, the changes apply to future retirees only. These changes, which seem to be running the gamut, include the following:

• The elimination of benefits for future retirees.

• The shifting of more of the cost burden to future retirees by reducing benefits. Such a reduction may be accomplished by providing lower benefit maximums, covering fewer types of expenses, or increasing copayments.

• Adding or increasing retiree sharing of premium costs after retirement.

• Shifting to a defined-contribution approach to funding retiree benefits. For example, an employer might agree to pay $5 per month toward the cost of coverage after retirement for each year of service by an employee. Thus, an employer would make a monthly contribution of $150 for an employee who retired with 30 years of service, but the employer would make a contribution of only $75 for an employee with 15 years of service. Many plans of this nature have been designed so that the employer's contribution increases with changes in the consumer price index, subject to maximum increases (such as 5 percent per year).

• Encouraging retirees to elect benefits from managed care plans. With this approach, retirees are required to pay a significant portion of the cost if coverage is continued through a traditional indemnity plan.

A second change is that employers have increasingly explored methods to prefund the benefits. However, there are no alternatives for prefunding that are as favorable as the alternatives for funding pension benefits. One alternative is the use of a 501(c)(9) trust (or VEBA). There are limitations on the deductible of contributions to a 501(c)(9) trust. Furthermore, a 501(c)(9) trust can be used to fund retiree benefits only if it is currently being used to fund benefits for active employees.

Another alternative is to prefund medical benefits within a pension plan. Contributions are tax deductible, and earnings accumulate tax free. The IRS rules for qualified retirement plans permit the payment of benefits for medical expenses from a pension plan if certain requirements are satisfied:

• The medical benefits must be subordinate to the retirement benefits. This rule is met if the cost of the medical benefits provided does not exceed 25 percent of the employer's aggregate contribution to the pension plan. For many employers, this figure is too low to allow the entire future liability to be prefunded.

• A separate account must be established and maintained for the monies allocated to medical benefits. This account can be an aggregate account for nonkey employees, but individual separate accounts must be maintained for key employees, and medical benefits attributable to a key employee (and his or her family members) can be made only from the key employee's account.

• The employer's contributions for medical benefits must be ascertainable and reasonable.

Although the rules for funding retiree medical benefits in a pension plan are restricted and administratively complex, they offer an employer the opportunity to deduct at least a portion of the cost of prefunded benefits.

Surviving Dependents

Coverage can be continued for the survivors of deceased active employees and/or deceased retired employees. However, coverage for the survivors of active employees is not commonly continued beyond the period required by COBRA, and coverage for the survivors of retired employees may be limited to surviving spouses. In both instances, the continued coverage is usually identical to what was provided prior to the employee's death. It is also common for the employer to continue the same premium contribution level.

Laid-off Employees

Medical expense coverage can be continued for laid-off workers, and large employers frequently provide such coverage for a limited period. Few employers provide coverage beyond the period required by COBRA, but some employers continue to make the same premium contribution, at least for a limited period of time.

Disabled Employees

Medical expense coverage can be continued for an employee (and dependents) when he or she has a temporary interruption of employment, including one arising from illness or injury. Many employers also cover employees who have long-term disabilities or who have retired because of a disability. In most cases, this continuation of coverage is contingent on satisfaction of some definition of total (and possibly permanent) disability. When continuing coverage for disabled employees, an employer must determine the extent of employer contributions. For example, the employer may continue the same premium contribution as for active employees, although there is nothing to prevent a different contribution rate—either lower or higher.