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Defined Contribution – The "Double Edged Sword"

double-edge-sword

Over the last several months, my articles have dealt the mechanics of developing a consultative approach to health care delivery. Now it is time to focus in on some of the strategic planning tools that can enable us to "pull away from the pack" and really start to focus on solving some of the root problems facing employers and employees.

I can't tell you how often I have heard veteran brokers talk about how a case was sold or retained by product choices and/or carrier changes that saved significant costs to the employer. Don't get me wrong, product and carrier selection is important. But most experienced brokers on can do a very credible job of product and carrier changes to save money. The only problem is that the next year when you get the premium increase, you are right back on the same battlefield, and if the premium increase is significant, the HR Manager might just get a directive to solicit competitive quotes from other brokers. But I know this wouldn't happen with one of your clients!

One strategy that we have used successfully for well over 30 years is to encourage the employer to utilize a defined contribution benefit payment strategy. Employed wisely it is a "double-edged sword" that has significant benefits to both the employer (edge #1) and the employee (edge #2).

In its simplest form it is a "single edged" cutlass, providing the employer with a tool to control costs, save money and create transparency in the cost of the benefits provided. Used in this fashion, however, it is likely that this payment strategy will be perceived by employees as nothing more than a cost shifting tool, a tool that benefits the employer with little or no benefit to the employee. This can breed mistrust and employee dissatisfaction.

With a little creativity and extra effort on the broker's part it can become a "double-edged" sword that benefits the employer and the employee. The employer can effectively control their cost and in some cases even save money without shifting costs. It can also be used as a valuable tool that "empowers" the employee to utilize employer provided funds for other, more appreciated, ancillary benefits. Employee control over employer provided funds and expanded benefit options allow the employee to tailor benefits to meet their individual needs. This second edge of the sword is a powerful trade-off for the employee to willingly accept the increased financial responsibility that may be required.

Before going further, we need to define our terms. Employer payment strategies fall into two basic categories, "Defined Benefit" and "Defined Contribution". See Diagrams A & B.

Defined Benefit: Here, the employer determines their contribution on a "benefit", either a percent of premium or the cost to the employee. Usually, the employer's contribution is for a base product. The employee then pays the amount not paid by the employer for the products they select. With this methodology, usually all that is communicated to the employee is their cost for the benefits offered. It is simple but not very transparent.

Defined Contribution: Here, the employer determines an overall contribution that is communicated as "dollars" or "credits" that can be utilized by the employee to purchase their benefits. Anything chosen that is not covered by the employer contribution is paid for by the employee. This methodology may appear to be more complex but it is transparent as to the cost and value of the benefits.

Both of these employer payment strategies, of course, have many possible variations to accommodate employer objectives and meet employee needs. Significant benefits can be achieved for employers and employees by utilizing the defined contribution approach. However, to effectively utilize both "edges" of the sword, the employer must have a variety of benefit options from which the employee can choose. An effective education and support system is also critical to achieve optimum benefit. The concept is simple but the implementation is a bit more difficult to communicate.

Communication is the Key to Success

In developing a communication strategy several things need to be carefully addressed to successfully implement a smooth working defined contribution strategy.

Employee engagement is required (partnering): Employees must take responsibility and accountability for their benefit choices. By utilizing "flex credits" (see diagram B) the employee can be empowered to make wise benefit choices and be held accountable for the consequences of their decisions.

Employee education is critical: It is like changing from the American to the Metric system of weights and measures. We know it is better but resist taking the time to learn. If the employer is going to require the employee to take on more of the financial responsibility for their benefits the employee must learn how to make wise choices based on their own budget and risk tolerances. The employer has the controlled environment necessary to adequately educate the employee and the responsibility to do so.

Age rated medical plans create a level of difficulty in the defined communication model. If you are in a state like California that has age rated medical plans up to 50 employee groups, you will have to find a way to deal with this one. It took me several years to get it to work right but we developed software that "does the math" and creates rate charts and contribution levels for all employer-sponsored benefits on a single page. In states that have composite medical rates for groups of 10 or less employees this is not as much of a problem.

Benefits of the "Double Edged Sword"

If you are willing to take the time and effort to learn how to utilize this tool effectively, the benefits are significant to both the employer and employee. Persistence and diligence are required year after year. But, effectively employed, you can get your employer out of the product/premium rut and make your job significantly easier.

When I was selling employer sponsored core benefits it made the renewal process quite simple. I met with the employer 60 to 90 days before renewal and discussed budgetary requirements for the employer contributions the next plan year. The employer would naturally consider possible premium increases as a factor but not by any means the sole basis for any contribution increase. In most cases the new employer contribution was established prior to the receipt of the renewal rates. The employer then relied on me to go back to the drawing board to figure out the best product option mix and a communication strategy. Remember with an employer-employee benefits partnership (see my September article, "Employer/Employee Benefits Partnerships - Helping Solve the Inflation Problem"), product selection is the responsibility of the employee.

The primary benefits to be achieved with an employer defined contribution payment strategy are:

1. Benefits cost control

2. Premium savings

3. Improved recruitment and retention value of benefits

4. Superior benefits management tool

Benefits cost control

Defined contribution is an effective tool to control costs. It supports and makes real the concept of a total compensation communication to employees. Putting a dollar value on the employer's contribution for benefits helps tie contribution increases to normal compensation criteria. Factors such as inflation in the cost of living (CPIU), profitability, competition for employees, employee performance, etc can be considered. True this may entail cost shifting but in the traditional "Defined Benefit" plan design environment this is always perceived as a "take away" by the employees. There is no positive impact to employees when asked to pay more. On the other hand, in an environment where employees partner with the employer, cost sharing is a more acceptable alternative, in fact in many cases is embraced by employees. This is because the employees get positive trade-offs to offset increased costs to them. Some of these benefit enhancements are detailed below in the discussion of the recruitment and retention values of this type of plan strategy.

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Premium savings

The opportunity for premium savings, without cutting benefits, is limited to employers who have a reasonably "rich" benefits package. Employers who pay for all or all but a few dollars of the employee premium for medical, dental or vision insurance have the opportunity for substantial savings.

According to the Health Plan Bench Mark Survey conducted by United Benefit Advisors completed in 2006 which surveyed 9600 employers with 1.52 million employees and 3.52 million lives:

1. 32.3% of employers surveyed require no contribution for employee coverage.

2. 8.3% of employers surveyed require no contribution for families.

This means that more than 30% of the employers you contact and perhaps some of your current employers have double covered employees (approximately 8% the employees with working spouses).

A defined contribution plan design which offers employees "flex credits" (Figure B) allows the employee to utilize a portion of the employer contribution for any benefits offered. This feature makes it too costly for an employee to double cover themselves and does not jeopardize employee participation requirements of the carrier. As an example:

With defined benefit if the employer pays 100% of the employee premium

Employee Male Age 44 Premium - $290.00

Employee takes the medical and is also covered by their spouse

The employee is $0 out of pocket but gets little or no benefit

With defined contribution with "flex credits"

The employer contributes $145.00 for medical (use it or lose it)

$145.00 "flex credits" for any benefits offered

Employee drops their medical and takes

STD (individual ins.) $82.00

LTD (group ins.) $30.00

GTL $300,000 $27.00

Critical Illness $50,000 $42.50

Total Cost $184.50

Less "flex credits" ($145.00)

Employee cost $39.50

In this case, the employee got a $145 per month raise, most of it tax free. The employer saves $145 per month or $1,680 per year in premium costs. This is a "win-win" situation. Oh and by the way, you have increased your compensation as well!

Improved recruitment and retention value of benefits

One might ask, "How can a strategy that tends to shift costs to the employee, improve the recruitment and retention value of benefits?" This is a valid question. A well-designed defined contribution strategy does several things to offset the impact of any necessary cost shifting.

1. It allows for expanded benefits to be made available to employees at no direct cost to the employer (see example above). In fact, in many cases pre-tax employee contributions to new benefits create a significant savings to the employer.

2. It gives the employee greater control over employer dollars which, along with expanded benefit choices, allows employees to tailor benefits to their individual needs and risk tolerances.

3. It makes the employee a "partner" in the benefits – employees appreciate things they own.

4. It communicates the full value of benefits to the employee.

5. Premium increases, if "covered" by the employer, are communicated as a "raise" to the employee. Even if the employer increases its contribution in line with normal inflation but less than the premium increase, it is still communicated as a raise rather than a take away.

Superior benefits management tool

From a financial point of view, defined contribution is a strong management tool. It enables a simple calculation of the real "per employee cost" of benefits. However, this type of calculation is more cumbersome in an age-rated medical plan environment. In this market, employers are more inclined to rely on their brokers for sound financial information.

The real impact of premium increases can be masked by age rating. As an example, one of our clients with 18 employees experienced a 15% rate increase in 2005 and an 11.5% rate increase in 2006. In each of those years the employer's "knee jerk" reaction was to shift costs to the employee. When we were able to show the employer that the "age adjusted increase" each of those two years was actually 7% and 5% respectively, the employer increased their contribution to cover the cost increase. This type of calculation can also identify the negative impact of a premium increase where an employer has experienced an increase in the average age of employees.

With all that is going on in the health insurance industry, we as representatives of the employer and the consumer need to become more creative in helping to solve problems. And we need to remember that our clients are not only the employer but the individual employees that work for them. Design and implementation of a well-crafted defined contribution strategy can do a great deal to benefit the employer and the employee. It can also enable you to put more dollars in your pocket by leveraging employer contributions into more profitable and cost stable products.

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