A company wants to offer health care funding of $25,000 for its employees at retirement. The employer faces a current marginal tax rate of 21% (in year 1) but expects it will face a 28% in the next year (year 2) and all future years. The firm employees face a current tax rate of 27%, which they expect will be lower at 15% on average at retirement. Funds reinvested in the company earn a risk-adjusted 7% pre-tax rate of return while its pension investments earn a 9%. Employees are expected to retire in 20 years, on average. To fund these health care costs, the company considers two options:

• A sweetened pension benefit approach where it makes contributions in the current period and allow it to grow to the funding level needed at retirement
• A pay-as-you-go approach where it waits to make payments to employees until retirement (year 20) when the expenses come up and the payment is treated as a fringe benefit (excludable from taxable income for employees but still deductible for the employer).

1. What is the after-tax cost of the sweetened pension benefit approach?

2. What is the after-tax cost of the pay-as-you-go approach?