Corporate Board Member November/December 2006
The Complex Pain of Cutting Retiree Health Benefits
by Susan Littwin
As former employees struggle to pay bills they never expected, companies defend themselves by citing rising medical cost and obligations to shareholders. Directors can no longer duck this fraught issue.
John Devitto spent 39 years at Lucent Technologies’ corporate predecessors, Western Electric and AT&T Network Systems. An engineer and supervisor, he moved his wife and children from Maryland to Pennsylvania and then to Ohio so he could serve the company where he was most needed. In 1995 he retired, half a year shy of 60, believing that he had full health benefits for himself, his wife, and his youngest child.
Three years later the benefit cuts began. Devitto, now 70, is paying over $700 a month in health-insurance premiums for his wife and teenage son. He’s also carrying the cost of a $200-per-month life-insurance policy whose premiums the company stopped covering. “I’m paying $1,000 a month more than I expected,” Devitto says. “I’m not on welfare. But my wife has gone to work, I’ve given up my golf membership, and we don’t go away on vacations.”
Had he known 11 years ago that the company would renege on its promises, “I would have worked longer,” he says. “And my wife might have gone to work when she was younger and gotten a better job.”
In 1988 two-thirds of all large employers offered health insurance to retirees, according to a survey by the Kaiser Family Foundation and the Health Research and Educational Trust. By 2005, according to the survey, the share had declined to one-third. Says Michelle Kitchman Strollo, principal policy analyst at the Kaiser foundation: “We have also found, among companies that still offer benefits, that they have been reducing their generosity. This comes in the form of higher copays at the point of service, increases in deductibles, and, most striking, between 2004 and 2005 seven companies out of 10 increased the amount the retiree must contribute to the insurance premiums.”
Nevertheless, cutting retirees’ health benefits is the corporate act that dare not speak its name, the issue board members and corporate officers will talk about only in whispers and in private. Corporate Board Member’s attempts to get more than 40 directors to discuss the issue yielded only six on-the-record interviews. (Lucent director Daniel S. Goldin, 65, said typically, “If you wish to have that discussion, I suggest you call media relations at Lucent. I can give you the number.”) And repeated calls to seven companies that have modified benefits to retirees—including Delphi Corp., 3M, and Verizon—resulted in no corporate officers who would be interviewed. “I’m sorry to disappoint you,” Robert S. Miller, 64, chairman and CEO of Delphi, said affably. “But we’re in the middle of labor negotiations, and I can’t discuss that.” Caterpillar Inc., a defendant in a lawsuit brought by retirees over its reduction in benefits, issued this statement: “We will not comment on the status of health-care benefits of either current or retired employees due to the pending litigation.”
Leading the list of major companies that have reduced benefits is General Motors, the world’s largest private provider of health care for employees and retirees. GM is now requiring its more than 475,000 retirees to pay part of their own premiums, at an annual cost of as much as $752 per family. In addition to Caterpillar, Delphi, GM, Lucent, 3M, and Verizon, major companies that have made cuts include International Flavors & Fragrances and Unocal (now part of Chevron).
“This is a topic that is on the horizon for all of us,” says Bruce Stender, 64, CEO of Labovitz Enterprises, an investment firm in Duluth, Minnesota, and lead director at Allete, a Midwest utility and real estate company. “We’re looking at a changing business landscape.”
Just what is the picture that directors confront when they’re asked to sign off on benefit cuts? The savings are obvious and large. The GM cuts, for instance, will amount to as much as $1 billion. But how steep is the downside? Did corporations enter into a sacred promise, or at least a social contract, when they offered benefits to employees like Devitto? What are the risks of lawsuits, damage to the morale of current employees, and injury to corporate image? And how do directors balance these risks against the interests of their shareholders—including, in some cases, the need to avert bankruptcy?
Board members willing to be interviewed cite the evident reasons for reducing benefits. The first is the soaring cost of health care. According to surveys by the Kaiser Family Foundation and Hewitt Associates, the cost of retiree health benefits increased by 12.7% in 2004 and another 10.3% in 2005. “If you look at the millions of baby boomers marching toward retirement and their greater life expectancy, the cost of caring for them is going up dramatically,” says John T. Cardis, a retired senior partner at Deloitte & Touche and a director of Edwards Lifesciences, Energy East Corp., and the office-supplies company Avery Dennison.
Anthony W. Schweiger, 64, CEO of the consulting firm Tomorrow Group, whose directorships include insurance provider Radian Group Inc., is among those who believe the benefits were ill conceived to begin with. “I can’t rationalize, as a director, how the company can be held responsible for open-ended postretirement benefits they have no control over,” he says. “The company must continue to maintain a viable enterprise, or every bit of the retirees’ insurance will be jeopardized. Something is better than all of nothing.”
Directors also emphasize companies’ obligations to their several constituencies. “You have to look at it holistically,” says Gordon R. Parker, 70, a former CEO of Newmont Mining Corp. and, at the time of this interview, in his last week as a director of Caterpillar. “I’m a retiree, and I’m totally opposed to cutting benefits.” But he voted “with a pang of regret” for Caterpillar’s reductions, which in 2000 capped retiree health benefits at their 1999 level and required everyone who had retired after January 1992 to pay a monthly premium making up the difference between the 1999 rates and the current costs. “You have to take a total approach to the success of the business. I think of it as a readjustment of wages and benefits so the business can survive. You have to do the right thing for your shareholders. You must look after your employees, your vendors, your customers. And sometimes the balance is, you have to cut.”
Retired steelworkers from Bethlehem Steel and LTV Steel know about getting nothing. After those companies closed their doors, 49% of retirees under 65 and therefore not eligible for Medicare said that they or their spouses had gone back to work because they had lost health benefits. Even among the Medicare-eligible, 10% reported that they had taken jobs to pay for insurance that covered some expenses not paid by Medicare.
Stephen Skvara, 59, is among them. Badly injured in a 1997 automobile accident, Skvara retired on disability from LTV Steel in Indiana after three decades as an electrical repairman. He took with him full health benefits for himself and coverage at $138 a month for his wife and youngest son. In 2002 LTV Steel went bankrupt, and though pieces of the company were acquired, the obligations to retirees were not. As required by law, Skvara’s pension was assumed by the federal Pension Benefits Guarantee Corp., but it was reduced from $1,900 a month to $1,200 and his $360-a-month special disability payment was eliminated. No law protected health benefits, so his and his family’s vanished. Skvara managed to find insurance that would cover what his Medicare disability payments didn’t, at $295 a month. His wife, a substitute teacher, and son, then 16 years old, were uninsured—and remain so. “I went into the steel industry right out of high school,” Skvara says. “I thought I’d have a comfortable life and provide for my family. Health care is a basic necessity, and it really hurts that I can’t provide it for them.”
A third reason that board members cite for the cuts is global competition. According to Thomas Getzen, the director of the International Health Economics Association and a professor of health insurance at Temple University in Philadelphia, the U.S. is the only major industrialized country that doesn’t provide universal national health insurance. Some employers in other countries offer private insurance as an extra—with benefits such as special access to doctors—but American dependence on employer health insurance is unique, and a direct cost foreign competitors don’t bear.
American companies that have fared badly in the global market have done so for reasons well beyond the burden of generous health care. But benefits are an easy target for cost-cutters, perhaps even a scapegoat. GM often blames its obligations to retirees for its competitive problems, but the pension funds for the company’s rank-and-file workers are bulging, with $9 billion more than is needed to pay out projected pensions for the foreseeable future. GM’s unfunded obligations to the retirement of executives, however, burden it with an annual $1.4 billion liability—largely offset by the annual $1 billion saved with cuts in retiree health-care benefits.
Employer-paid health care appears to be an accident of U.S. history. During World War II wages were frozen and labor was scarce, so employers offered health care in lieu of raises to attract and keep workers. The National War Labor Board ruled in 1943 that health-care contributions were tax-exempt for workers and tax-deductible for employers, and by the end of the war the number of workers in the U.S. with health insurance had tripled. According to a June 2006 report by the Employee Benefit Research Institute, the popularity of employee health coverage was driven mostly by continuing labor shortages—but the tax breaks didn’t hurt. The Revenue Act of 1954 affirmed the deductibility of employer health-care contributions. Health-benefit increases became a popular bargaining chip for both labor and management, and companies were amenable to making provisions for retiree health benefits because they were the equivalent of a long engagement—a zircon ring on the finger and nothing to pay now.
But a marriage of sorts did take place. The benefits may not have been taxable income, but workers came to regard them as part of their compensation, as money bargained for and earned. It became the American way: Employers paid for health insurance.
Among the reasons for reducing those benefits now, says Nell Minow, editor of the Corporate Library, a corporate governance watchdog based in Maine, is “a dirty little secret. Certainly benefits are getting very expensive, but we are aware of and interested in the juxtaposition between cuts in benefits and increases for top executives. They cut benefits to make the balance sheet look stronger. The executives then reap the benefit of the stronger balance sheet by paying themselves better.” The cure for that, Minow says, “is that increases in executive compensation should be for operational growth rather than balance-sheet growth.”
The median pay package for chief executives of the largest U.S. companies was $6.8 million in 2005, according to a study by Mercer Human Resource Consulting. Patricia Russo, chairman and CEO of Lucent Technologies, which cut Devitto’s benefits, landed among the top 11 examples in a Corporate Library study, Pay for Failure: The Compensation Committees Responsible, which identified chief executives paid over $15 million despite negative returns to shareholders. (For more, see “Get Ready for the Next Spotlight on CEO Pay” in Corporate Board Member’s September/October issue.)
The discrepancy does not go unnoticed by retirees. “Those things bother me,” says Devitto. “Executives who didn’t do so well by the company left with big golden parachutes. Retirees who made a major contribution to the company were left holding the bag.”
The golden parachutes and hefty executive salaries in the face of benefit cuts may be a tactical error. “Either they’re seeing a more complex picture than I am, one that makes sense to them, or they’re tone-deaf,” says David W. Anderson of the Toronto-based consulting firm Anderson Governance Group. “What I would say to boards is, ‘It may be a correct business decision to take a difficult and unpopular path, but you must communicate it clearly.’ An inconsistent message is a real problem. For instance, they’re saying, in effect, ‘We must cut costs to survive, so we’re cutting health benefits. But we need great executives, so we give big bonuses.’ It may all be true, but it sounds inconsistent. Good leaders know they have to lead by example. When executives gets perks and higher salaries, it looks like favoritism.”
Thomas F. Donovan, 73, a retired bank executive who has served on at least eight boards, including Amerigas’s, and is now a director of three private foundations, says, “I’m troubled whenever I see benefits reduced to people who gave good service in the past. I can’t say categorically that I would never serve on such a board, but I would not sit by while benefits were reduced for retirees while executive compensation for the chair was increased.”
Another cause of benefit cuts—and one avoided as a corporate talking point—is changed accounting standards. The Financial Accounting Standards Board’s Rule 106, adopted in 1990, required companies to record on their balance sheets an actuarial estimate of their entire health-benefit liability, instead of the pay-as-you-go method many had been using. The rule left a host of thriving companies looking, on paper at least, as if their heads were barely above water.
Last March the FASB put out for comment another proposed change that would require companies to move certain pension and other retiree-benefit obligations out of the footnotes and up front onto the balance sheet. “Current accounting standards just don’t provide complete information about these obligations,” said FASB member George Batavick at the time.
The new disclosures would be ugly for traditional unionized companies. An analysis by Bear Stearns found that Ford Motor’s balance sheet for 2005 would show about $20 billion more in benefit obligations, and GM’s about $37 billion more.
The proposed accounting rule aims to protect shareholders from invisible risks. Dennis R. Beresford, a former chairman of the FASB and now a professor at the University of Georgia business school, points out that the requirement wouldn’t change the real worth of a company, only its balance sheet. But it would make it look bad to investors. “Sophisticated investors know what’s going on,” he says. “They’ve been reading the footnotes.” But novices wouldn’t like the way things looked. Nor would top executives whose compensation may be linked to net-worth growth.
When he was on the FASB board, Beresford recalls, he was confronted by a CEO. “He told me that if companies were forced to account for this expense, many of them would be forced to take away the benefit, and that would be on my conscience. That didn’t make me feel very good, but I said, ‘Sir, I’m not the one who made those promises. You now have to measure your decision, whether to cut back or cut out. We’re just making you own up to it.’”
For companies contemplating a cut, Lucent offers a cautionary corporate narrative. In her 2004 book, Optical Illusions: Lucent and the Crash of Telecom, Lisa Endlich writes: “This is the story of a financially sound company steeped in world-class talent, dominant in one of the world’s fastest-growing industries, that in the space of two painful years [2000 to 2002] found itself branded with a junk-bond credit rating, under investigation by the SEC for its fraudulent accounting practices, fighting off rumors of insolvency, and, hat in hand, begging its bankers for a little more time.” Endlich traces hasty acquisitions, attempts at reinvention, and other corporate missteps. Lucent’s stock price dropped by 99%, and job losses came to more than half a million.
In 2003 Lucent eliminated death-benefit insurance for all management retirees and cut reimbursement to retirees and their spouses for the Medicare Part B supplement (outpatient care), leaving retirees with a cost of about $300 a quarter. In 2004 the company stopped paying dental-insurance premiums for retirees and eliminated the health-care-premium subsidy for dependents of management employees who had retired after March 1990 with a salary of $87,000 or more; in 2005 it lowered the salary minimum for this last cut to $65,000. Next, in January 2006, health-care premiums for management retirees were increased.
Lucent was compelled to make the cuts, says spokeswoman Mary Ward, because of the rising cost of health care and pressure from competitors. “We clearly recognize and acknowledge what retirees did for the company,” she says, “and we understand the impact this has on them. But it came down to what we could afford to do and remain a viable company.”
In September Lucent was on the verge of a merger with the French telecommunications company Alcatel, a deal that many regarded as an acquisition by Alcatel. If the merger closed, Russo, who became CEO in 2002, could collect at least $1.78 million in stock awards even if she remained chief executive at the merged company. Lucent spokeswoman Joan Campion cited the pending merger as the reason company officers and directors refused to discuss the cuts in benefits.
Lucent retirees were much more forthcoming. The Lucent Retirees Organization was chartered in 2003. Its original purpose was to help the troubled company however it could, says president Ken Raschke, who retired as vice president for manufacturing of a North Carolina facility that made transmission equipment. Among other things, members offered to do clerical work for free. But when the benefit cuts snowballed, the retirees’ organization turned against Lucent with the energy its members had once put into designing cell phones.
The group brought five proxy proposals to annual shareholders’ meetings. At the 2006 meeting it proposed that executive compensation be more strictly tied to performance. The proposal passed by 54%, but no action has been taken on it. The retirees also called for federal scrutiny of the merger to ensure that they’d still be collecting their pensions and remaining benefits. “No one should want a foreign company to own a $34 billion pension fund—worth more than twice Lucent’s market value—unless safeguards are in place to protect the pensions and benefits of 235,000 retirees and their dependents,” Raschke says.
The retirees’ organization has also provided documents and other support to the lawyers of three plaintiffs who are suing Lucent over the cancellation of their retiree health benefits. The lawsuits claim violations of the Internal Revenue Code and the implied contract of the pension and benefit plans described to employees in various letters and publications. “I signed hundreds of these letters, congratulating people on their retirement and describing their benefits,” says Raschke.
Should lawsuits like this one worry board members? So far the law is unclear. Katherine Stone, a labor-law specialist at UCLA School of Law, says the suits depend largely on the clarity of the contractual obligations to employees. “Was there an unambiguous promise to provide benefits for life?” she says. “The more usual situation is a plan that describes the benefits to employees and reserves the right to modify, alter, suspend, or terminate the benefits.” The basis of an unambiguous promise could be found in letters, booklets, or even speeches at employee meetings.
ERISA, the Employee Retirement Income Security Act of 1974, does not mandate benefits, says Georgeann Peters, a benefits attorney in the Columbus, Ohio, office of Baker & Hostetler. Still, in a lawsuit by retirees against Caterpillar, the complaint cites violations of sections of ERISA. Stone argues that there is liability under ERISA “if the plan administrators knowingly misrepresented the plan. For instance, if they promised lifetime coverage knowing that it was not forthcoming, and employees relied on that promise and took early retirement or neglected to get separate coverage of their own and later found themselves ineligible.”
The Caterpillar and Lucent suits do not name board members as defendants. But Stone notes that directors have a fiduciary duty to protect the company. “If the firm is taking steps that open it up to liability, the board member might have to examine what promises have been floating around,” she says. Directors must also be aware of the image problem: Cutting medical insurance for retirees can make a company seem like Darth Vader. Raising the issue of a broken moral obligation, Ed Beltram, communications director of the Lucent Retirees Organization, says, “Those of us in management were always told to tell employees that their pay increases might not be so high, but they had secure pension and health-care benefits.”
Board members need not worry, it seems, about the impact those cuts will have on morale and recruiting. According to a 2004 survey by the EBRI, only 5% of current workers consider retiree health care their most important benefit. “The new economy is conditioning workers to see the landscape differently,” says one director.
What can be done to help current and future retirees? The National Retirees Legislation Network is a lobbying group representing more than two million retired people. It has been pressuring Congress in favor of HR 1322, the Emergency Retiree Health Benefits Protection Act, a bill that would give ERISA-like protection to health benefits. But Network spokesman Jim Norby admits that the act has no chance of passage today. A bill passed by Congress in August provides greater protection for retirees’ defined-benefit pension plans, but not their health benefits.
Allen Karp, 65, formerly CEO and chairman of Cineplex Odeon Corp. and currently a director of Alliance Atlantis Communications Inc. and Teknion Corp., among other companies, suggests that gradual reductions are possible for an outfit that is in good financial shape. “The company can provide a less painful transition for those who are most impacted,” he says, “and then take further steps for those who have many years until retirement.” Karp also suggests bringing everyone into the discussion: “Talk to the unions, the human-resources team. Everyone is terrified of the unions, but you have to try to bring them onto your side.” He cites GM’s cuts, which were negotiated with the United Automobile Workers. “The union was realistic,” he says. “It’s not in the employees’ interest to see the company become an uneconomical enterprise.”
But what about the valued former employee whose retirement is crimped and penny-pinching because a chunk of his pension now goes to health-insurance premiums—or, still worse, who doesn’t get the medical care he needs?
“We’ve all been around,” says Anthony Schweiger, the Radian Group director. “Stuff happens. Life isn’t as fair as you’d like it to be. You gotta do what you gotta do.”
You do…don’t you?