Most employers offer a defined benefit plan, where they select one or two health insurance options to offer their employees. This approach is being replaced by defined contribution plans.
“Under a defined contribution plan, the employer is choosing a fixed dollar amount for employees and they use this money to purchase their benefits. Employees can select from multiple options, not just the traditional one or two plans, and personalize their selections based on their needs,” says Mary Spicher, sales executive with JRG Advisors, the management arm of ChamberChoice.
Smart Business spoke with Spicher about utilizing defined contribution plans.
Why the shift to define contribution plans?
The shift is directly related to health care reform and an effort to reduce insurance costs. This is not a new concept; for the past 20 years most employers have used a defined contribution plan for retiree benefits. Retirees are given a defined amount of income to apply toward defined contribution 401(k) plans, removing employer risk and allowing employees to make investment decisions based on their needs.
In the 1990s, rising costs led companies to evaluate retiree health plans and cap the amount they pay for benefits. As costs continued to rise, companies declined to raise the capped amount, creating a defined contribution health plan. This has now migrated to active employee health plans.
How do these plans work?
Employers can control costs and keep expenses more predictable from year-to-year. A defined contribution plan creates a consumer-driven health plan where employees use the employer’s defined contribution to purchase health insurance specific to their needs. The employer can keep the defined contribution the same for all or use a tiered structure where employees pay the difference for more expensive plans and benefits. Exchanges, including benefit options with low to high deductible plans combined with a health savings account, copayments and ancillary products, were developed so employees can purchase plans with defined contributions.
An employer can change the defined contribution by a set amount annually, regardless of the actual plan increase, or simply keep it the same based on its financial stability. The decision to alter benefits plans — i.e. increase the deductible, change the copayments on medical and prescription drugs, etc. — is the employee’s responsibility.
What’s the effect on ancillary products?
The one-stop shopping through exchanges simplifies administration and allows employees to purchase ancillary products as part of their health plan. The convenience predicts substantial growth in everything from short- and long-term coverage to pet insurance.
Insurance is viewed as protection of an employee’s income and assets against unpredictable events. If employees get sick, they use their health insurance. If they need time off work for an illness or accident, they have short-term or long-term disability insurance. Some expenses for a serious illness like cancer might not be covered by the employee’s health plan. And, if the employee were to die from the illness, life insurance protects the family financially.
What does health care reform mean for the future of defined contribution?
Employers are deciding whether to continue to offer a health plan, and if so, what type, based on the new legislation and cost. So, employees may become more familiar with a defined contribution health plan through the public insurance exchanges. Products sold through the state or federal exchanges will be limited to essential health benefits or a benchmark plan for health, dental and vision. Health plans in a private health insurance exchange offer more inclusive coverage.
Bottom line, defined contribution is the future. Employers have been waiting to see how reform affects rising costs before changing their traditional thinking. Early indications predict that health care reform won’t eliminate increases, so providers still need to deliver more efficient care, especially with high-cost cases. However, defined contribution, consumer-driven plans are helping employers control their costs.
Mary Spicher is a sales executive at JRG Advisors, the management arm of ChamberChoice. Reach her at (800) 377-3539 or email@example.com.
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Yes, there are still many companies that maintain defined benefit plans, but most ceased crediting benefits years ago to stop the pension liability growth. However, even though the majority of Fortune 100 and 500 companies have frozen their plans, they often still have contributions due for what participants have already accrued, as plans typically aren’t 100 percent funded at the time they are frozen. If a company hasn’t settled its obligation or transferred the risk, then it still owns it.
Rich McCleary, Director, Actuarial Service, at Tegrit Group, says, “It’s a popular discussion topic. Our firm has over 300 defined benefit plan clients with whom we work, and many traditional plan sponsors we talk to want to find a way to terminate their plan.”
Smart Business spoke with McCleary about how business owners can mitigate their defined benefit plan risk.
How do defined benefit plans differ from other retirement plans?
A defined benefit plan promises a certain amount of benefits, typically in an annuity form, at retirement to plan participants. The company contributes to the plan and maintains the obligation to provide those benefits once they are earned or accrued. Much like the Social Security system, promises to plan participants are virtually irrevocable. If a company can’t fulfill them, the Pension Benefit Guaranty Corporation (PBGC), the governmental agency that insures pension plans, will step in.
What’s the current situation for defined benefit plans?
On the investment side, pension plan performance has been lackluster over the last decade, remaining steady or decreasing slightly against expectations. In addition, in this severely declining interest rate environment, liabilities have consistently gone up. Along with that, the federal government has continually passed regulations to make the funding requirements more stringent.
Companies maintain this liability and risk on their balance sheets, and the liability remains until the last participant or contingent beneficiary is paid out. Manufacturing in particular has been hit hard, as the industry often used these plans to meet union benefit demands. Also, the liabilities on the balance sheet don’t truly reflect the entire economic cost of the plan. There are numerous administrative expenses, such as fees for investment management, actuarial, legal and accounting, as well as PBGC premiums, which can add 3 to 5 percent to the liabilities.
What are some strategies for plan sponsors to mitigate risk?
Liability-driven investments are a popular way to drive down the risk. Investment managers can help with transferring the risk into fixed income investments that closely match the duration of the pension liabilities.
In order to reduce their pension risk, some large companies have offered lump sum payments to retirees and beneficiaries. Although there might be a higher initial cost, the pension liability is transferred either directly to the participant or an insurance company, which improves the stability of the balance sheet and ultimately, shareholder value. Amazingly, some companies have pension plans with liabilities that approach or exceed the total market capitalization of the company, creating volatility and jeopardizing profits.
Although a smaller company may not be publicly traded, it can find ways to get the necessary cash from other sources besides loan covenants or issuing bonds. As an example, one business took out a second mortgage on its building because it happened to be cheaper at the current mortgage interest rates and loan period than paying down the pension plan liability. However, there are accounting and tax implications that occur when transferring risk, so use expert advisers to carefully review the balance sheet and make sure the risk transfer makes sense.
Rich McCleary is Director, Actuarial Service at Tegrit Group. Reach him at (330) 983-0539 or firstname.lastname@example.org.
Insights Retirement Planning Services is brought to you by Tegrit Group