October 2004

AC116 continues to challenge companies

It?s more than two and a half years since AC116 (dealing with balance sheet provision for post retirement health care funding) has been on the statute books. From an accounting point of view it?s now a routine entry but it has surely affected companies' relationships with their employees and is proving harder to resolve from a people point of view than it was from an accounting point of view.

Having to make provision for post retirement health care has made employers think hard about the underlying risks associated with employing people and this has hastened the transfer of the risk to the workforce so that the company doesn't bear the risks of medical inflation.

In the wake of AC116 attempts have been made to outsource pensioners and some employers have met with little resistance to such plans. More often than not, however, employers that have met with strong resistance - particularly from older employees and pensioners.

The conversion of pension funds towards defined contribution was driven by pension fund members themselves, in the wake of booming equity markets. The timing of the drive towards defined contribution in medical pre-funding is unfortunate because it has coincided with poor equity markets, which has effectively put the brakes on these types of conversions.

AC116 has made employers more aware of the risk of providing health care benefits and many have stopped offering this once customary benefit to new employees. Others have tried to negotiate with staff and pensioners for them to accept alternative benefit structures that spread the risk between the employer and employee. However, in a market vying for an ever shrinking skills base, some companies may have to revisit the issue if they wish to retain skilled staff.

Medical inflation and volatile equity markets in recent years have contributed to soaring medical aid premiums and, while this trend continues, it will become increasingly difficult for employers to convince employees and pensioners to buy into anything other than what was originally promised. However, if regulation or government action succeeds in reigning in medical inflation, companies may find that employees are more open to considering defined contribution schemes.

Another major pitfall of AC116 is that the provision has resulted in an annual cost to the income statement. Companies don't fully understand the interest issue: they raise a provision for a liability and review it periodically but don't expect it to change dramatically. However, this provision, by its very nature, is expected to increase and one needs to service the liability and charge interest on an ongoing basis.

Hence, although AC116 has been implemented successfully the implication or value of funding is not necessarily properly understood by the market. Only when financial directors see the full impact of these charges and realise that there is potentially value in having an asset to match the liability, will they appreciate the benefits that alternative risk transfer vehicles can provide in a flexible and transparent manner.

Because the liability needs to be serviced on a ongoing basis as it increases with interest, even environments where there is resistance to insurance, will recognise that, at the very least, alternative risk transfer vehicles facilitate an asset on which there is a return, and which, in part, funds what would otherwise be a full cost to the company's income statement.

Medical aid contribution increases are expected to be significantly lower in 2005 than in recent years, as the technical impact of various changes in legislation have now worked through the system and should start to show results next year. If medical inflation continues to be kept under control companies may soon find themselves in a position to revisit balance sheet provisions and reconsider funding.