Employers are turning to alternative financing strategies as they face the loss of a federal tax deduction in 2013 for a subsidy they receive for providing drug coverage to Medicare-eligible retirees. While most companies are implementing an employer group waiver plan, many anticipate ending direct sponsorship of the drug benefit by giving a defined contribution to retirees to purchase coverage in the individual market, observers say.

Under an EGWP, a Medicare Part D plan is offered to retirees through a pharmacy benefit manager or insurer that contracts directly with the Centers for Medicare & Medicaid Services. An employer wraps a supplemental plan around the Part D plan to close the gap in coverage known as the doughnut hole.

The 2003 federal law that created the Medicare Part D prescription drug program gave employers powerful tax incentives to retain the prescription drug plans they offered to Medicare-eligible retirees.

Employers received tax-free payments from the government based on a percentage of prescription drug expenses. In addition, employers could continue to take a full tax deduction for prescription drug expenses.

The 2010 health care reform law continued the tax-free status of the subsidy to employers, but starting in 2013, their tax deduction for prescription drug expenses must be reduced by any subsidy amounts received.

For example, assume an employer paid $100 in prescription drug expenses for a Medicare eligible retiree and received a $30 government subsidy. In that example, under the health care reform law change, the employer could only take a $70 deduction for the expense.

As a result, “Most large employers have decided to implement an EGWP,” said Sherri Bockhorst, principal for health and productivity at Buck Consultants L.L.C. in St. Louis.

A final CMS regulation expected in April would eliminate the need for a supplemental/wrap plan and simplify administration of the EGWP, sources said. The regulation would allow the manufacturer's discount for brand drugs in the doughnut hole, which Part D plans do not now provide. An employer no longer would have to wrap a supplemental plan around the Part D plan in order for the retiree to get that manufacturer's discount for brand drugs in the doughnut hole.

Implementing an EGWP could result in pretax costs 20% lower than what employers pay for retiree drug coverage under the Retiree Drug Subsidy program, said Martin Hill, director and actuary at PricewaterhouseCoopers L.L.P.'s human resource services in New York.

The 2012 Towers Watson/National Business Group on Health annual employer survey showed that 57% of employers plan to or are considering implementing an EGWP over the next three years. A November 2011 survey by Aon Hewitt showed that 62% of plan sponsors who have already decided to change their Medicare Part D retiree strategy are implementing an EGWP.

“Early adopters typically gravitated toward the EGWP,” said John Grosso, health care actuary and leader of Aon Hewitt's retiree health care subpractice in Norwalk, Conn. “It requires less analysis, and fewer approvals are required than for sending people to the open market” to purchase coverage, he said.

ConAgra Foods Inc., which is implementing an EGWP on Jan. 1, 2013, for most of its retirees, “decided to work with a PBM far earlier than otherwise,” said Bart Karlson, Omaha, Neb.-based ConAgra's senior director of benefits. One advantage is the company could account for the additional liability of the RDS change on its 2011 financial statement, he said.

With the EGWP, ConAgra is able “to keep pretty much the same benefits” for retirees, and benefits were improved for some groups as plans were consolidated, he said.

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The second most-popular strategy, called the Connector model, is for an employer to give a retiree a defined contribution to purchase Part D coverage through a private administrative entity or insurer, sources said. The Aon Hewitt survey showed that 19% of employers plan to use the defined contribution approach.

The Towers Watson survey said that “53% of companies plan to consider or are already considering dropping their employer-managed drug coverage for Medicare-eligible employees and relying on Part D plans.” Mark Olson, senior consulting actuary at Towers Watson & Co. in Boston, said that some of those companies will provide a defined subsidy to purchase a Part D plan, while others may not.

“We think that most employers over time will have defined contribution subsidy funding,” although they may begin with an EGWP, Mr. Grosso said. “There are pretty strong arguments to be made for a company to send retirees to the individual market,” he said, including “the robustness of the individual market and Part D enhancements,” such as the phase-out of the doughnut hole.

ConAgra is using the Connector model for about 6,000 of its retirees, some of whom worked for companies ConAgra acquired. Through My Medicare Advocate, sponsored by ACS, the parent of Buck Consultants bought by Xerox in 2010, retirees will be able to choose among several Medicare Advantage plans that include drug coverage, Mr. Karlson said.

Major PBMs are early implementers of the EGWP, said Mr. Hill, who cautioned that not all vendors are as prepared to help employers with the transition. “You don't want to be a guinea pig,” he said.

“The No. 1 item they (employers) flag as being a challenge is communication,” he said. CMS requires communication in a specific format for retirees, who may not have received a lot of information about their drug benefit in the past and will now “get this big packet in the mail.”

Mr. Karlson said that by being an early adopter of the EGWP, “our objective was to get the A team at Medco (Health Solutions Inc.),” the PBM that is working with Buck Consultants on communicating the changes to retirees.