Employers are rethinking their retiree health benefit strategies in response to a provision in the recently passed health care reform legislation that changes the tax treatment of federal subsidies they've been receiving for providing prescription drug coverage to Medicare-eligible retirees.

However, few of those employers are likely to completely abdicate their entire retiree health obligations, benefit consultants say.

Instead, they may decide to transition their Medicare-eligible retirees into individual Part D programs, which could prove to be less expensive for employers, but just as generous to employees after 2020 when the “donut hole” is closed, benefit consultants predict. The “donut hole” is the gap in coverage that occurs for retirees who spend more than $2,830 annually on prescriptions.

Another option employers are considering is to contract with an insurer or a pharmacy benefit manager to offer employer group waiver plans, which consultants describe as “group” Part D programs that enable employers to cover retirees altogether under a single, national program, either on a fully insured or self-insured basis.

Under the Medicare Prescription Drug, Improvement and Modernization Act of 2003, employers that retain prescription drug coverage for retirees that are at least equivalent to Part D coverage receive a tax-free contribution from the federal government equal to 28% of the employer's annual drug costs that are between $310 and $6,300 per beneficiary. In addition, they are permitted to deduct their entire retiree prescription drug expense, including costs for which they receive the tax-free government subsidy.

But health care reform legislation signed into law last month by President Barack Obama will alter that tax treatment beginning in 2013. While the tax-free subsidies will continue, employers receiving them no longer will be allowed to take a tax deduction for the portion of prescription drug expenses subsidized by the government.

Because U.S. accounting rules require publicly traded companies to immediately recognize the impact of such a change on their financial statements, many companies that had been accepting the tax-free subsidy began reporting one-time earnings charges as soon as the legislation passed Congress. Perhaps the biggest earnings hit was announced by Dallas-based AT&T Inc., which reported a $1 billion non-cash charge on March 26, while other companies reported lesser amounts (see box).

The loss of the retiree drug subsidy tax deduction will cost employers approximately $233 per retiree per year based on average annual retiree drug expenditures of $2,800, according to Dave Osterndorf, chief health actuary at Towers Watson & Co. in Milwaukee.

A March report by Towers Watson estimates for-profit employers that provide prescription drug benefits to Medicare retirees receive a nontaxable RDS averaging $665 per plan member per year. By comparison, Medicare prescription drug plans receive about $1,050 per retiree per year.

Moreover, the Patient Protection and Affordable Care Act gradually will increase that amount between 2013 and 2020, when it reaches approximately $1,500 per retiree per year, Mr. Osterndorf pointed out.

This increased federal subsidy paid to PDPs is designed to fill the “donut hole.” In 2010, retirees with Part D coverage are uninsured for drug expenditures between $2,830 and $4,550 annually, when catastrophic coverage kicks in.

“It's hard to justify for the employer receiving a $500 per person subsidy when there's going to be a $1,500 subsidy for plans out in the individual marketplace,” Mr. Osterndorf said.

According to a March 16 report by the Moran Co., a health care research and consulting firm based in Washington, as many as 1.5 million to 2 million of the 6 million to 7 million retirees who receive drug benefits from their former employers could lose them because of the tax change.

In fact, most employers that have received the subsidy already have begun re-examining their retiree drug programs, benefit consultants say.

“We're talking to almost all of our clients about what to do,” said John Grosso, a Norwark, Conn.-based principal and actuary in Hewitt Associates Inc.'s health management consulting practice. “What they're going to be looking to do is reduce their costs. We don't see companies terminating their plans entirely. But they'll be looking for new ways to get retirees drug benefits that are cheaper than what they're paying today.”

For example, Mr. Grosso expects some employers will do what General Electric Co. did in 2009. The Fairfield, Conn.-based company contracted with a Medicare-approved prescription drug plan offered to provide drug benefits to its retirees, thereby forgoing the subsidy.

An employer that chooses this route more than likely will do so on a self-insured basis because that often is more cost-effective, according to Mr. Grosso.

And because the PDP receives a larger federal subsidy than employers do, the cost of the coverage may end up being lower for those employers, he said.

Moreover, “from a participant standpoint, the group PDP could be relatively seamless,” he said.

The other option, which may be a little more disruptive to retirees, according to Mr. Grosso, would be “to send retirees to the individual Part D market and provide a tax-free subsidy” to help them pay for it.

With such an approach, the employer contribution is generally deposited into a health reimbursement arrangement that retirees can use to pay their Part D premiums, as well as any other out-of-pocket medical expenses, Mr. Grosso explained.

Derek Guyton, a principal and worldwide partner at Mercer L.L.C. in Chicago, said many of the companies he has consulted adopted the RDS originally because it was the best financial deal for them at the time, and it will continue to be until the end of 2012, when the tax deduction expires.

“Now they are going back to see whether the decision they made five years ago still makes sense,” he said. “But it's a moving target since things will be happening gradually, like the closing of the "donut hole.' Some may find they no longer need to provide drug coverage. Others are looking at immediate changes to offset the hit to earnings.”

“I'm not saying a lot of employers will drop coverage or make huge cuts to coverage, but a lot will be looking at it because the landscape has changed,” Mr. Guyton said.