Smart employers and their benefits advisors annually review their benefit offerings to identify areas in which they can control the cost of medical insurance premiums. Employers and employees recognize that most of the increase in employee compensation during the past decade has flowed not to employees’ bank accounts, but rather to medical insurers in the form of higher employer contributions to premium. As a result, a growing number of employers are exploring the advantages of and potential issues around a defined-contribution approach to funding employee benefits.

Unfortunately, the term defined contribution is frequently associated with a program through which an employer places a fixed amount of money tax-free into a Health Reimbursement Arrangement, or HRA, so that an employee can purchase individual (nongroup) insurance on a public exchange. In five separate statements during the past three years, the IRS has declared that using HRAs in this manner violates key provisions of the Affordable Care Act, or ACA.

This paper discusses defined contribution in the context of an employer contribution to employees’ group insurance premiums.

Defined Benefit Defined

Employers who offer more than one medical plan to their employees traditionally have used a “defined benefit” approach to set the amount of the premium that the employer pays. For example, an employer pays 75% of the total premium, regardless of which medical plan an employee chooses. Let’s assume that the monthly premiums are $400 for the high-deductible HMO ($2,000 deductible)  and $500 for the low-deductible HMO ($1,000 deductible).

In a defined benefit approach, contributions look like this:

Product Total Premium Employer (75%) Employee (25%)
High-deductible HMO $400 $300 $100
Low-deductible HMO $500 $375 $125

 

Defined benefit has several shortcomings:

  • Employers can’t set their final benefits budgets until after open enrollment because employer costs vary depending on each employee’s choice of medical plans. In this example, every employee who enrolls in the low-deductible plan costs the employer an additional $75 monthly ($900 annually).
  • Employees tend to overconsume medical insurance. More employees enroll in a richer plan than they otherwise would because they pay only a percentage of the full premium difference between the two plans – in our example, only $25 of the $100 difference – rather than the full difference.

Defined Contribution Defined

Defined contribution works very differently. An employer sets a dollar figure that it gives to all employees (or, more likely, a dollar figure for each rating tier, such as individual, employee+1 and family). Employees then can spend that fixed-dollar voucher on whichever plan they choose.

With a defined-contribution approach, the employer and employee responsibilities look like this:

Product Total Premium Employer Employee
High-deductible HMO $400 $300 $100
Low-deductible HMO $500 $300 $200

 

Defined contribution addresses the two concerns raised above about defined benefit: Employers can set their benefits budgets independent of employee coverage choices and employees are unlikely to purchase richer coverage at a higher premium unless they value that additional coverage at least as much as the full (unsubsidized) difference in cost – in this case, the full $100 rather than the subsidized $25 difference under a defined-benefit program.

An Analogy: Defined Benefit vs. Defined Contribution

My son wants to buy a ticket to see his current school, Baylor University, play football against one of my alma maters, the University of Texas, in Austin this fall. I’ve located two tickets: one in the upper deck for $81 and one in the deck below that for $214. The tickers haven nearly the same sight lines, though one is closer to the field than the other. The difference in price is $135. If I offer to pay 75% of the cost of the ticket (defined benefit), the difference between the two options is $33.75 to him. With defined benefit, he upgrades if the value of the better ticket is worth only $33.75 to him, while I, in effect, give him permission to spend an additional $101.25 of my money (my portion of the $135 difference in ticket prices).

On the other hand, if I offer to pay the first $100 of his expenses, he’s on the hook for the remaining $114 difference in ticket prices. I strongly suspect that he’ll buy the $81 ticket and enjoy some good stadium barbecue. With defined contribution, I have a fixed liability, he can experience the game at little or no out-of-pocket cost if he chooses and economic incentives are restored.

Advantages of Defined Contribution

A growing number of employers are adopting a defined-contribution strategy for these reasons:

Set Budget in Advance with Fixed-Dollar Contributions

First, as discussed, employers can set their annual benefits budget in advance because they contribute a fixed-dollar amount regardless of an employee’s product choice. They also can set multi-year budgets because they can increase future years’ contribution independent of premium increases (though, it’s important to note, they can continue to increase their defined contribution based on premium increases if they wish). Employers who choose to decouple their defined contribution from premium increases must be careful. Any savings that they generate represent cost increases to employees, who must either pay more in employee contributions or but down to a less rich plan.

The graph below depicts what happens when an employer increases a defined contribution by 7% (the red line) each year and premiums rise by 10% (the blue line) annually. The graph shows total premiums rising more rapidly than employer contributions – a gap that employees fill with higher employee contributions. The green line shows how much the employer would pay when continuing a defined-benefit strategy that pays 75% of premium. The space between the red and green lines represents the lower employer direct contribution to premium under defined contribution. Employees make up the difference, as their share of premium under this defined contribution model rise from 25% in Year One to 43% in Year 10.

Comparing Overall Costs Defined Contribution and Defined Benefit

Well-Informed Employees Making Smarter Coverage Decisions

Second, as noted earlier, employees are far less likely to buy richer coverage when they’re absorbing the full cost. In our example, employees pay an additional $1,200 under a defined-contribution approach to reduce their deductible by $1,000 – probably not an investment of their personal funds that they value. By contrast, with defined benefit, they pay only $300 of personal funds to reduce the deductible by $1,000.

Reinforcing ‘Benefits as Compensation’ Mentality

Third, defined contribution reinforces the notion that benefits are part of employee compensation – not a bottomless bucket of money that the employer accesses at any time. Employers don’t “pay” a portion of premiums as much as they direct a portion of employee compensation to medical premiums. Defined contribution makes this concept more visible to employees.

DC More Valued by Performance-Driven Employees

Fourth, in many cases, shifting to defined contribution aligns compensation with corporate objectives. Employers who offer rich benefit medical plans and require only small employee contributions tend to attract and retain workers who value medical benefits.

By contrast, employers who offer more of their total compensation budget in the form of performance bonuses and less in medical coverage tend to attract and retain workers who value cash compensation and recognition more than they value medical coverage.

Conclusion

Employers who adopt a defined-contribution strategy can manage their benefits budgets more accurately, reduce the incidence of overinsurance among their employee population and align medical benefits with corporate objectives. A thoughtful implementation and an approach that balances employer and employee costs in the long run can allow employers to hire, retain and reward productive talent while extending to employees the medical security that they need.

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