Defined Contribution – The Benefits and Limitations
What is defined contribution and how does it work?
With defined contribution, employers determine a fixed dollar amount that the firm will contribute toward a menu of employee benefits. Usually, the plan is coupled with a Section 125 Plan. This allows employees to pay their share of premiums pre-tax and to receive unused employer contribution amounts in cash. The employer knows its cost up front because it is simply the dollar contribution amount times the number of eligible employees. This is in contrast to the arrangement where the employer contributes a percentage of the plans’ costs and the employer cost varies by how many employees and dependents enroll for coverage. Additionally, the full cost of benefits is visible to the employee. This may cause employees to engage more carefully in allocating their employer’s contribution and their own contributions in the most financially appropriate way.
This model has some additional appeal for employers who wish to ‘fix’ their cost increase from year to year, regardless of the actual price increases of insurance products to the employees. While this approach does offer this control, it may be limited by the fact that employees may not be able to afford out-sized increases and this in turn may affect morale, productivity and employee retention.
Defined contribution can work better when employees have multiple benefit designs for each plan type (i.e. medical, dental, vision) to choose from. Plan choices need to provide a sufficient spread of employee contributions from highest to lowest cost. Multiple choices work best when the employees are assisted with a decision modeling tool, education meetings or one-on-one assistance.
The combination of these features will usually result in better employee engagement and appropriate purchase behavior. Employees tend to migrate to the plans that are best for each circumstance. Those who expect high claims and are risk averse will choose a rich plan paying a high contribution amount, and those expecting lower claims will take an inexpensive plan with lower premiums and higher deductibles. This may reduce the effect of the ‘over insured syndrome’ and drive overall costs of the program lower.
Cost reductions may not happen in the first year. However, the engagement of the ultimate consumer in health care, first at the point of purchase of the plan and policy, and second at the point of choice of providers through better transparency tools will eventually lead to better cost control.
Defined contribution does not address the incessant increases in medical care unit prices or the march toward obesity and other lifestyle issues that influence demand for services. It does have the potential to make the best use of dollars today and reduce some wasteful spending.
So what is the “Over Insured Syndrome”?
UBA Partner Firm, Hanna Global. studied their traditional group coverage claimants and found that 60-70% have claims under $1,000 and yet they bought plans that cost and cover a lot more—“Over Insured Syndrome!”. Participants insured on their Private Exchange, which more effectively provides choice along with decision support resulted in 80% of employees migrating to lower cost plans!
Unfortunately, the Affordable Care Act (ACA) adds much complexity and makes defined contribution plans much more difficult to design and administer for small employers (employers with 50 or fewer employees and in 2016 includes employers with 51-99 employees). The ACA requires that medical insurance rates be based on the age of each covered person in the family. There are 45 age bands and this results in premiums for older employees that are 300% higher than rates for younger employees. If the employer defines a fixed contribution amount for all employees, older employees may have contributions that are insufficient while the youngest employees may have disproportionately high employer contributions relative to their premium amounts. Further, the ACA requires 19 different rating regions. Los Angeles rates, for example, may have premium levels as much as 20% below San Diego County levels. Designing the appropriate contribution amount will be very difficult. In addition, the ACA provides that new regulations be written to govern new non-discrimination requirements. These new regulations are expected to be issued some time in 2014 and you can expect them to add additional complexity. This does not mean that you cannot manage a defined contribution plan. You will want to consider all aspects very carefully and with the assistance of a professional knowledgeable in Defined Contribution, Section 125, Private Exchange technologies and the ACA.
Robert Recchia, CLU, ChFC, AIF®
President, California Corporate Benefits Insurance Services
A UBA Partner Firm
Certified Healthcare Reform Specialist