Next Stop — Defined Contribution Health Plans (2001)
by Ginny Cady
Recent surveys show that health care costs increased an average of 8 percent in 2000 and are expected to rise by over 12 percent in 2001. This is the fourth year in a row that costs have increased significantly and there is no slowdown in sight. Last year the tight labor market prompted many employers to absorb the higher costs, rather than lose employees to competitors with lower employee health care cost sharing. This year, however, more employers are responding to increasing costs by passing them on to employees in the form of higher premium payments, deductibles, and co-payments.
Rising premiums have caused some employers to rethink how they provide health insurance benefits. Some are considering shifting more responsibility for paying and obtaining health care coverage to their employees. Employer-sponsored health care coverage has been traditionally provided in the form of a “defined benefit” plan. That is, the employer purchases or self-insures a health plan with specific benefits and employee cost-sharing provisions. Some employers are beginning to consider a switch to defined contribution health care coverage.
The term “defined contribution” (DC) typically refers to a type of retirement plan, rather than health insurance. There are two basic types of retirement plans — defined benefit (DB) and defined contribution. A DB retirement plan guarantees a specified benefit, just like a DB health care plan. The employer’s contribution to the plan is the amount necessary to pay the cost of the benefit, less amounts paid through employee contributions. In a DC retirement plan, on the other hand, only the employer’s contribution is guaranteed. The retirement benefit depends on the employer’s contribution, the employee’s ability to save money and the employee’s investment decisions. Likewise, in a DC health care plan, the benefit that an individual would be able to purchase would also depend on a number of factors.
How does a Defined Contribution Health Plan work?
There is no standard definition for a DC health care plan. However, one commonality is that DC health care plans would shift the responsibility for payment, selection of health care plans and risk from employers to employees. How employer contributions are made and the availability of plans from which to purchase is what varies.
In some respects DC health plans already exist in the form of Internal Revenue Section 125 cafeteria plans. Under Section 125 plans, the employer makes non-taxable contributions on behalf of each employee. Employees can elect to have additional pre-tax dollars withheld from their paychecks to supplement the employer’s contribution. The employer must offer a plan that employees can purchase and must retain responsibility for administration of the plan. Employees select a plan or may elect cash in lieu of health care coverage.
Cafeteria plans allow the employer to shift the risk of future health premium increases to employees. Instead of being responsible for paying a specified percent of the premium, the employer is liable only for contributing the negotiated dollar amount. That contribution almost never keeps up with increases in health care costs. Over time, employees become responsible for a larger portion of the premium.
Because many employers want to get out of the health care business, they are taking this idea a step further. Instead of a cafeteria plan, they might provide employees with a voucher or other stipend. The employee would use the stipend to purchase health insurance. This is a DC health care plan in its purest form and is fraught with problems — the most prominent being the current tax structure and risk-sharing issues.
- Loss of Tax Advantage — Currently employees do not pay income tax on health insurance premiums contributed by their employer. And private-sector employers are able to deduct insurance premiums as a business expense. Employer contributions made outside of a Section 125 cafeteria plan would be considered taxable income to the employee and there would be no tax break to the employer.
DC plan advocates argue that federal legislation authorizing Medical Savings Accounts (MSAs) would eliminate the tax problem. A MSA is a combination type of health care coverage that includes a tax-advantage savings plan from which funds are drawn to pay for routine medical expenses, and a catastrophic health plan with a very high deductible. MSAs bring with them many of the same problems associated with DC health care plans. Several years ago Congress authorized a four-year MSA pilot program for small employers. The program was not highly utilized, was generally considered unsuccessful, and has since expired.
- Higher Cost — Employer-sponsored group health coverage costs less than coverage purchased in the individual market because of the benefits of economies of scale and administrative efficiencies. Administrative costs in individual plans are often as high as 40 percent of premiums, while these costs average 15 percent or less in group plans. Employers have substantial purchasing clout because they are purchasing coverage on behalf of a large group. In group plans, the risk is spread across a large number of participants; the lower costs of healthy individuals offset the high costs of less healthy individuals, which lower overall premiums. Some experts estimate that the cost of an individual plan could be double that of a group plan with equivalent benefits.
- Unequal Access — Premiums for individual health plans are typically based on personal health risks and other factors such as age, occupation and geographical location. There is no average premium in the individual market. One expert’s research found that the premiums for two healthy individuals, one age 20, one age 25, living in the same city but in different zip codes, ranged from $1,400 to $2,328 per year. The premium range widened with increasing age. Two healthy 60-year-old individuals in different zip codes, but again in the same city and in the same health plan, were charged premiums of $3,732 and $8,724. Both were healthy individuals, the same age and had no pre-existing conditions.
This example shows that equal employer contributions will not necessarily purchase equal benefits. Employees with chronic conditions, such as high blood pressure or diabetes, would be charged a higher premium than the premiums charged to healthy employees. Older workers would be charged higher premiums than younger workers. Similarly situated employees could be charged different premiums, depending on where they live. And employees in riskier working environments, such as highway workers, or corrections employees, would be charged more.
- Adverse Selection — Adverse selection occurs when high risk individuals (older and/or sicker) buy health care coverage and those with lower risk do not, or when those who are high risk select plans with generous benefit levels and low risk individuals select plans with limited coverage. Those in the high risk group utilize more plan services, driving up the premiums. Since there are fewer healthy people in the generous plan to offset its costs, that plan becomes unaffordable.
DC plan proponents argue that adverse selection can be avoided by specifying that employer contributions only be used to purchase health coverage. But what if the contribution is not enough to purchase coverage? Employees could be forced to forfeit the employer’s contribution simply because they are not financially able to pay the difference in the premium cost. Under many AFSCME plans, the employer currently pays a significant portion of the group premium. Most people sign up for coverage, which expands the risk pool and helps keep cost at a reasonable level. This would all change in a DC plan environment.
- Education — DC advocates tout the ability to control one’s own health care as a major advantage of these plans. Along with that freedom goes the responsibility of comparing different plan benefits and costs, filling out the paperwork and paying premiums. Think about how tough it is now to compare and choose among plans offered by the employer. Then consider the types of knowledge and information an individual would need to select a plan with sufficient benefit levels and reasonable cost-sharing provisions for a fair premium. Even employers with many years of health care purchasing experience have a difficult time comparing various health care plans. Extensive employee education would be required.
- Health Marts — Advocates of DC health care plans claim that the education issue can be resolved by organizing “health marts” for employees. In a health mart, competing health plans would bid on a standard package so that employees could compare “apple to apple” health care plans. But there is one main issue that no one has been able to resolve. Most employers currently experience rate plans within their own group of employees. That is, the premiums paid are based on the risk factors and benefit utilization within the employer’s group. In a health mart, premiums would be based on the risk factors and benefit utilization of everyone covered. Employers with young, healthy workforces would not participate because their contributions would be higher than they would be if only their employees were covered under the plan. As in the individual market, adverse selection would occur and only employers with high risk employees would consider the health mart option. One insurance underwriter sums it up in the following statement: “Allowing employees to select health care coverage from an undetermined number of health plans leads to volatility in risk evaluation and essentially creates individual policies.”
- Exclusion of Coverage — Individual health care plans do not offer protection against exclusion from coverage for pre-existing medical conditions. There are relatively few insurers that offer individual health care coverage. Most that do often will not cover individuals with pre-existing health conditions, charge astronomical premiums for such coverage, or exclude those conditions from coverage indefinitely.
- Plan Quality — Employers have been the leaders in demanding quality and consumer satisfaction data from health plans. Who will police quality in an individual market? As volume purchasers, employers have clout in insisting on quality plans. Without the employers, this responsibility falls to individuals.
The future of DC health plans remains to be seen. Continued premium increases, a change in the tax code and a downturn in the economy are three factors that could pique employer interest.
For more information, please contact the Department of Research and Collective Bargaining Services at (202) 429-1215 or research@afscme.org.