June 28, 2001 | Backgrounder on Health Care
The debate in Washington over enacting a patients' bill of rights ignores its potential result: a barrage of lawsuits that will further increase health care costs and compound the nation's health care problems. A far more effective means of addressing the health care needs of Americans is a system that offers defined contributions to an employee's health plan. This innovative approach to health coverage, which would empower employees to make decisions about their own health coverage, reflects the successful approach of the health insurance system that currently covers 9 million federal workers, dependents, and retirees. It also builds on the success of 401(k) plans that are enabling more Americans to control their savings for retirement.
A defined contributions approach would address many of the problems in the current system, including limited choice, uncontrolled costs, and bureaucratic micromanagement. The marketplace is already beginning to respond positively to the defined contribution idea. On April 1, 2001, for example, Blue Cross of California began to offer defined contribution plans in the small group market. Employers are able to determine one fixed or "defined" price to contribute to their employees' health coverage costs, and employees are able to apply that contribution to the premium for the plan they have chosen based on their particular needs.
Surveys show that both employers and employees appreciate the potential this system offers. Both are increasingly dissatisfied with the current system--employees because they are forced to choose only from among plans selected by their employers, and employers because they are troubled by increasing employee dissatisfaction, rising costs, and the threat of liability for their decisions. Congress and the Administration could facilitate the move to defined contributions by taking steps to ensure that such a move carries with it no adverse tax consequences or additional liability and that the broadest range of insurance pools are available.
The combination of employer-employee frustration and capacities for new information technology has fueled interest in a new paradigm for health care benefits--providing a defined contribution to employees' health plans instead of defined benefits. Under this approach, employees would choose a plan that best suits their individual needs and their employer would then simply write a check for a "defined" amount to the designated insurance company to apply to the premium. Employees could contribute additional dollars, or dollars from a spouse's employer, to augment that defined contribution. Employer defined contributions are now the norm in retirement planning through 401(k) plans. Early indications are that they may soon become the norm in health care as well.
A recent survey of Fortune 1000 employers and employees conducted by the accounting and consulting firm of KPMG, LLP, revealed remarkable support for the concept of defined contribution among employees. Of the more than 14,600 employees from 117 Fortune 1000 companies who were surveyed, 73 percent were "extremely," "very," or "somewhat" interested in defined contributions to enable them to purchase their own health insurance instead of their current health care options.2
A survey of 103 senior executives of Fortune 1000 companies, which was conducted and analyzed by KPMG, found that 46 percent were receptive to the idea of switching to a defined contribution system. Among those who were receptive, 80 percent said they would be likely to change their company's plan to the defined contribution concept if there were "no impact on the company's tax situation or on their employees."3 A recent PriceWaterhouseCoopers survey showed that 60 percent of health care leaders expect employers to move to a defined contribution plan for health benefits by 2010.4
The defined contribution system is similar to the approach used by the 401(k) retirement system in which employees direct their employer to send a designated amount to a mutual fund or other investment vehicle they have selected. As this approach became available in the early 1980s, the financial services market responded by providing employees with a broader range of options for investing their retirement dollars. The health care market is likely to respond in the same vibrant manner to employees' choices. This has been the case with the Federal Employees Health Benefits Program (FEHBP), in which the employer--in this case, the federal government--contributes up to 75 percent of the premium costs of 9 million federal workers, dependents, Members of Congress, and retirees.
A defined contribution approach in the private sector would give employees a much greater say in their health care coverage. Some companies would provide their employees with a suggested plan or menu of plans to assist them in selecting coverage, but employees eventually could use the defined contribution to purchase a policy individually or through such vehicles as professional associations, labor unions, church groups, and civic associations.
Many supporters of defined contributions believe they create a win-win scenario: Employees are empowered to choose health insurance that better suits their families' needs while their employers are better able to control costs and satisfy their employees. The concept of defined contributions is compelling and looms as the best prospect for improving the options for health insurance in the near future.
Answering Frequently Asked Questions About Defined Contributions
Q. If employers simply give the money they have been spending to purchase health insurance directly to the employee, won't many employees have difficulty finding their own coverage?
A. Employers who currently offer health insurance could find resistance among their employees in making changes to the structure of their health benefit programs unless they provide assistance. Initially, for example, they could provide their employees with a menu of health plan options that they have already evaluated for quality and solvency, in addition to the current health insurance plans they offer.
Buying cooperatives also would emerge to help organize a broader range of choices, especially if regulatory and legal obstacles were lifted, just as mutual funds emerged to provide options for millions of new investors seeking ways to control their 401(k) investments. An education program would be an integral part of the success of the defined contribution option to show employees how they would benefit in terms of choice, control, and even savings. The success and longevity of the Federal Employees Health Benefits Program (FEHBP) proves that people can make decisions about their health coverage (and that companies will have an incentive to offer insurance).
Q. So why hasn't this happened already?
A. A broader range of health insurance choices has not emerged because of America's antiquated tax structure that ties health insurance to the workplace. Health insurance companies and health plans market their products to those who pay the bills for their services. Today, the customer is the employer, not the individual. If health plans knew that their customer was also the consumer of those services, they would be forced by competitive pressures to be more responsive and to create more consumer-friendly insurance products.
Q. If employers just give people the money, what's to stop young and healthy employees from not buying insurance at all?
A. To qualify for the current tax exclusion, money has to be spent on health coverage. Employers would assert that the defined contribution for health insurance also would be available only if it is spent on health insurance.
Q. Employers provide a pool in which younger and healthier workers subsidize older workers. Under a defined contribution, won't older workers who are most likely to need health services be more likely to get less help in purchasing health insurance than they do now, and risk not finding coverage at all?
A. First, older workers are more likely to be higher-paid workers who also may have longer service with a company. Companies can account for these factors in determining their defined contribution formulas. If employees contribute to health insurance coverage over a lifetime, as they often do with life insurance, they would build up a pool of resources paid in younger years to draw upon when they are older. The defined contribution model would foster a new system in which people have much more longevity with their health plans.
Q. Wouldn't employees who now benefit from their employer's purchase of more economical group coverage be unable to afford a policy on their own because they would have to pay the much higher cost of an individual policy?
A. The current system is distorted by policies that encourage employees to negotiate health plans with extensive benefits and with low co-payments and deductibles. This happens because the notion that the employer pays for coverage encourages employees to press for generous untaxed benefits. If employees were given a fixed sum with which to purchase health insurance, they likely would look for ways to economize and stretch their health insurance dollar further.
Q. Is it possible to make sure that the money that had been going to health insurance on a pre-tax basis be taxed?
A. Yes. Congress can and should provide assurance that the existing tax laws governing employee health benefits will provide protection for employees and employers in the move toward a defined contribution approach.
In spite of massive funding invested in health care, the current system generates frustration for both employees and employers. A number of factors are at work in propelling the structure of health care to change.
The actuarial firm of Milliman & Robertson has reported that annual HMO premiums for 2001 will increase 11.3 percent for large employers (over 50 employees) and 12.3 percent for small employers (2 to 50 employees).7 This trend puts added pressure on employers--particularly, small employers with thin profit margins that could be forced to drop health benefits altogether. Employers that do offer health benefits would be forced to reduce costs elsewhere, including wage and salary increases, require employees to pay more, or try to raise prices to cover their increased health expenditures.
On average, 88 percent of the increased costs of health benefits are offset by lower employee compensation, according to the Lewin Group, a leading econometric firm.8 As Mark Zandi, chief economist with RFA-Dismal Sciences in Pennsylvania, explains, rising health care costs have a significant impact on product prices: "Slow and low benefit-cost growth was a boon to business and a key factor helping to protect their margins and keep inflation low.... But as [health care costs] rise, it'll be increasingly difficult for businesses to ignore them and not raise their prices aggressively."9
Such problems heighten calls for patients' rights legislation and additional regulation, but increasing the threat of litigation will have unintended consequences. Rather than turning more of the health sector over to lawyers, a better alternative is to give consumers the control and choice they want by allowing them to make their own health coverage decisions.
The growing popularity of defined contributions is a positive reaction to the way in which such a system would address these problems. Among the benefits of a defined contributions approach for employees and employers are the following:
These and similar groups include huge numbers of members among whom the risks would be spread. Currently, under ERISA, if an employer makes a contribution to an employee's health insurance, it is automatically considered a group plan, and its employees may not purchase "individual" plans in their state-regulated market. Employee choice could be augmented by amending ERISA to enable employees to purchase a state-regulated plan.
When Congress established medical savings accounts (MSAs) in the 1996 Health Insurance Portability and Accountability Act, it took a good first step toward creating a system that empowers employees with health care choices and more control over their plans.14 MSAs offer them an alternative to traditional group health insurance and to managed care. A limited number of individuals and small employers can now make regular tax-free contributions to their health care spending accounts that, combined with their high-deductible catastrophic policies, provide comprehensive coverage for their health care needs. Having such accounts allows these individuals to go to any doctor or specialist of choice without first consulting a primary care physician or HMO bureaucrat. Eliminating third-party payers for low-end, routine doctor visits leaves patients and doctors free to make decisions about the treatment or service they need.15
Unfortunately, however, Congress capped the number of people who could use MSAs. Not only should this cap should be removed to enable more Americans to take control of their health care expenditures, but more should be done to build a better system based on broad patient empowerment. Congress should study other models that clearly demonstrate why defined contributions are the coming change in health care, such as 401(k) retirement plans and the Federal Employees Health Benefits Program.
401(k) Retirement Plans.
When business consultants talk to employers about making the transition to a defined contribution system, many say they are reminded of the trepidation employers voiced about introducing 401(k) plans in the 1980s. Some recall that employers were skeptical of employees' interest in and ability to make their own retirement investments and did not believe they could negotiate the complex investment world on their own. While most employers were hesitant about making such a major change in their retirement benefits structure, a brave few forged ahead. This is very similar to the initial reaction among employers today regarding the idea of switching to defined contributions for health care.
Employers should note the unexpected success and popularity of the 401(k) system. With 401(k) plans, a mechanism was created that put individuals in the driver's seat when it came to their retirement savings. Most employers and employees feel that they have the best of both worlds in 401(k) plans. Employees enjoy the empowerment that comes with the ability to chart their own investment course without giving up the pre-tax benefit and, often, a matching employer contribution. Many employers are relieved of the pressure, responsibility, and costs of funding and administering their own pension plans.
The growth and popularity of mutual funds has been fueled largely by millions of individual investors armed with 401(k) dollars. The health industry is just as likely to respond to a new client base with its own version of consumer-friendly choices. The popularity and success of 401(k) plans should serve as an inspiration to Congress and a model for employers considering defined contributions for health benefits. The 401(k) model also provides a guide to how employers might allocate their defined contribution payments to employees. Many employers give their workers an incentive to stay with the company by increasing the amount of 401(k) matching funds based on seniority. Under a defined contributions system for health care, employers might similarly decide to increase the dollar contribution for health coverage as employees accrue seniority. Both employers and employees would be winners; the employer gains a committed worker, and the employee gains more money for health benefits.
The Federal Employees Health Benefits
In the arena of health care, a model already exists for how a defined contribution approach would work: the Federal Employees Health Benefits Program (FEHBP). The FEHBP has enjoyed four decades of success in serving over 9 million federal employees, dependents, and retirees around the country. The government pays up to 75 percent of the average health insurance premium for federal workers, up to a maximum of $2,250 for singles and $5,090 for families.16 The enrollee pays costs above that defined contribution, depending on the type of plan he or she chooses.
Nationally, there are nearly 300 plans participating in the FEHBP. In most locations, federal employees can choose from between 12 and 20 plans.17 Federal employees are allowed to choose among competing private plans, and insurance companies compete against one another for the employee's business. The result: Satisfaction rates for federal workers in the FEHBP are higher than in the private market, and average annual premium increases have been lower.
The FEHBP also includes a defined benefit. The Office of Personnel Management (OPM), which oversees the FEHBP, sets a benefit floor that must be met by all participating plans. This guarantees that all plans have certain core benefits. Plans compete on the basis of how efficiently they can deliver those set benefits, but also with regard to what other benefits they can offer at competitive prices.
In March 1999, eight Republicans and two Democrats of the 17 members appointed to the National Bipartisan Commission on the Future of Medicare backed a reform of Medicare based on an FEHBP-style plan. The majority proposal would give each Medicare beneficiary a generous amount of premium support based upon the average cost of insurance determined by a formula. The government would give seniors a defined contribution to spend on a plan, and seniors would then shop with those dollars for the private insurance plan that best suited their needs. Alternatively, seniors could choose to remain in the traditional Medicare fee-for-service program. The reformed Medicare program would require, like the FEHBP, that participating private plans include a core set of benefits.
If defined contributions become widely available in the private sector, more employees would be familiar with this approach and could easily make the transition to a new Medicare system, with fewer concerns, once they reached the age of eligibility. Ideally, they could remain in their pre-retirement plan if they wished. A new generation of workers accustomed to defined contributions would be likely to reject Medicare's current one-size-fits-all benefit structure, its sluggish bureaucracy, and its lack of flexibility.
Federal Tax Treatment.
Although defined contributions to an employee's health care premium costs can be implemented under current law, some groups are concerned that switching to a defined contribution approach could result in adverse tax consequences. They fear that employers might lose the ability to deduct the cost of those contributions or that such contributions would become taxable income to employees. Section 106 of the Internal Revenue Code provides that the value of health benefits need not be counted as part of the taxable income of employees, but some employers believe that this section of the code could still be interpreted to mean that workers will receive this tax-favored treatment for health insurance only if the health coverage is provided by an employer.
In 1961, the Internal Revenue Service issued a ruling to clarify Section 106 (RR 61-106). The ruling specified that "The employer may contribute to an accident or health plan either by paying the premium...or by contributing to a separate trust or fund...which provides accident or health benefits directly or through insurance to one or more of his employees."18 The U.S. District Court for Northern Ohio confirmed this ruling in 1988 in Adkins v. United States.19
Although some tax attorneys are advising their clients to wait until the defined contributions approach has been tested, legislative analysts on Capitol Hill are confident that Section 106 provides the necessary protections. Senior congressional staffers are among those who have studied the relevant laws and rulings, and are convinced that employees in a defined contribution system could continue to benefit from the existing tax exclusion for employee health insurance.20 In addition, since the cost of health premiums would still be a cost of doing business for the employer, the premium would still be deductible in a defined contribution system.
Congress could alleviate this concern entirely, of course, by ensuring in future legislation that employers who make the move toward defined contributions toward their employees' health coverage would not suffer any adverse tax consequences.
State Tax Liability.
Under current law, companies that are self-insured do not have to pay state premium taxes, which add about 2.5 percent to the cost of health insurance. Some tax attorneys are advising their clients that switching to defined contributions could mean exposure to these taxes. Employers should realize that the cost of the premium tax could be more than offset by the savings they would recoup in not administering complex health plans. Furthermore, making these taxes more visible to working Americans would give them more incentive to work to reduce them through the political process.
Many executives surveyed about their views on a defined contribution approach expressed some willingness to try it. Booz-Allen & Hamilton, in a survey of employer attitudes toward a defined contribution-type approach among executives of Fortune magazine's "best 100 companies to work for," found that about two-thirds of such employers are aware of the defined contribution approach, are convinced it will happen some day, but are unwilling to be the first to do so on a large scale largely because they fear employee reaction.
These employers may be underestimating their employees' appreciation of the benefits of defined contributions. Whereas 45 percent of employers predicted that their employees would not be interested in choosing their own health insurance,21 73 percent of employees in the study indicated they were at least "somewhat interested" in doing so; of those, 25 percent said they were "extremely interested" and another 19 percent were "very interested."
Reluctance among employees to move to a system of defined contributions is often due to a fear of increased financial risk or to a lack of attractive options for health coverage outside the workplace. Employers changing to a defined contribution model would very likely help their employees negotiate their way through the selection process by organizing a range of options, just as the Office of Personnel Management does for federal workers. Employers could educate their employees about the benefits of the new system, including more choice, control, and flexibility.
Some opponents of the defined contribution approach argue that employees are not capable of understanding health insurance or health issues enough to choose a plan on their own. Yet these same employees choose their own mutual funds, car insurance, home mortgages, banks, and even schools for their children. In fact, employees who have a personal stake in the quality of the medical care they and their family will receive may do an even better job of selecting a health plan than their employers do.
In addition, rapidly advancing developments in information technology and e-commerce will facilitate employees' efforts to identify an insurance company that best fits their needs. Even now, consumers are searching the Internet voraciously for information on health care. An estimated 15,000 to 20,000 Web sites provide health information; moreover, a Harris Poll found that between June 1998 and June 1999, 70 million Americans went online to search for information on health topics,22 and the number has surely grown dramatically since then. Many companies are offering their plans on Internet- and Intranet-based formats so that their employees can study their choices and select the most appropriate delivery system or plan.23
There is no doubt that individuals have an interest in, and want control over, their own health care. That is why the world of e-commerce is anticipating, and is ready for, the revolution that defined contributions will bring to health care. An article in The Standard (the Internet's premier industry magazine) has noted that "The latest buzz centers on `defined-contribution' health plans.... In the age of Internet medicine, health insurers face a basic task: Get online or get left in the dust."24
It should also be expected that buying cooperatives will emerge to help organize a broader range of choices, especially if regulatory and legal obstacles are lifted. This is the experience with mutual funds that emerged offering options to millions of new investors in 401(k) plans. Moreover, the success of the 41-year-old FEHBP proves that people can make good decisions about their health coverage and that companies will have an incentive to offer more options. A 1999 survey by the Employee Benefit Research Institute found that 81 percent of employees were confident that they could choose the best available health insurance if their employer stopped offering coverage.25 An even higher number (89 percent) said they would be able to choose the best health plan if their employer offered them a choice of plans.
Some opponents of a more individually based health insurance market fear that it will create "adverse selection"--that breaking up the larger workforce pool into those who use defined contributions and those who use defined benefits would result in older, often less healthy employees having a harder time getting coverage without paying the often high premiums that reflect their higher costs, while younger and typically healthier workers would reap huge savings from their lower costs. Analysts have recommended restricting insurance rates or cashing out benefits to adjust for risk. While the latter approach is preferable, it is not easily done. However, some entrepreneurial e-commerce companies are developing creative solutions to this problem.26
First, the workplace is not the only stable pool of Americans. As discussed above, there is a spectrum of associations and organizations that could provide large insurance pools, such as association health plans (AHPs) or individual membership associations (IMAs) for their members. Many of these groups are much larger than most employer-based groups. In addition, high-risk insurance pools could be created to meet the needs of the "uninsurable" population--the 1 percent to 2 percent of people who are turned down for private coverage based on their health status. With a high-risk pool, they could still get coverage. Currently, at least 28 states have established high-risk pools.27
Second, a defined contribution made by an employer could be a percentage of the worker's salary rather than a fixed sum, meaning that older workers for whom health insurance is more expensive would likely receive a larger contribution.
Third, defined contributions offer a continuity of care that is now only associated with staying in the same plan for many years. Continuity of care is particularly important for people with costly chronic ailments.28 A person's health and expected health costs could be a barrier to employment that is largely removed if individually purchased plans become more common.
Concerns have also been raised regarding administrative costs for employers that they could pass on to their employees. According to a study done by University of Pennsylvania Professor Mark Pauly, the administrative cost differential between individual and group policies has been shrinking steadily since 1970. Pauly predicts further reductions in administrative costs, especially if individuals achieve tax neutrality in health insurance relative to employer group purchases of insurance.29
As more people buy into the individual market, the quality of the risk pool would improve and costs would come down for all participants. A brief scan of insurance policies available on the Web, such as those at www.ehealthinsurance.com and www.simplyhealth.com, shows that individually purchased health insurance is widely available and affordable.
For example, e-HealthInsurance, a company that provides on-line access to health policies for individuals and families, has compiled data on 20,000 recently sold policies. The analysis shows that premiums for individuals average $1,200 to 1,500 a year. The study contains real data proving that health insurance coverage purchased directly by individuals and families is both less expensive and more comprehensive than previously believed.30
An important study by Mark Pauly and others also showed that the individual health insurance market is healthier than many have believed and that affordable, comprehensive policies are available.31
Determining the Amount of a Defined
One of the greatest challenges for companies will be to calculate the amount of the defined contribution for their employees. Health benefits are a part of employee compensation, and a defined contribution approach will force employers to specify how much of a worker's pay is dedicated to paying for this benefit. To determine this amount, employers should rely on major consulting and accounting firms that are actively investigating the defined contribution model and on negotiations with their employees and employee groups. This is not something that can or should be decided by the government. Regardless of its size, employers who switch to a defined contribution model likely would require that the contribution be spent on health insurance as a "use it or lose it" benefit.
The Evergreen Freedom Foundation in Olympia, Washington, offers an excellent primer for business owners on the defined contribution alternative, with explanations about how it already is working in large and small firms, and suggestions for employers to make the transition work.32
Congress and the White House can take steps to facilitate the evolution of a defined contributions system. The reforms they promote should strengthen the individual health market, as well as the creation of new insurance pools to supplement traditional employer-based plans, and encourage further innovation in the health care marketplace. Working together, the Administration and Congress should:
The defined contribution system will become the standard as more consumers demand greater control and choice over their health care decisions and employers explore their options for offering their employees health benefits. Employers who adopt a defined contribution approach will gain greater control over their health insurance costs and increase employee satisfaction.
Policymakers should clear the way for this revolution in health care by reducing the regulatory obstacles. Though there is much work to be done, the implementation of defined contributions will result in satisfied employees and employers and will also liberate federal and state officials from the increasingly impossible burden of micromanaging the health sector.
James Frogue, Legislative Director for U.S. Representative Kay Granger (R-TX), contributed to this paper in his previous position as Policy Analyst for Health Care at The Heritage Foundation. Grace-Marie Turner is President of the Galen Institute, a research organization in Alexandria, Virginia, that focuses on health and tax policy.
4. PriceWaterhouseCoopers, "HealthCast 2010: Smaller World, Bigger Expectations," November 1999, available at /static/reportimages/F86CA932BEC937B0B11BE57A62E09894.pdf .
5. Stephen H. Long and M. Susan Marquis, "Center for Health System Change," RAND Corporation and Research Triangle Institute, Data Bulletin No. 12, 1998, available at www.hschang.com.
10. See, for example, Melinda L. Schriver and Grace-Marie Arnett, "Uninsured Rates Rise Dramatically in States with Strictest Health Insurance Regulations," Heritage Foundation Backgrounder No. 1211, August 14, 1998.
14. The law caps the number of tax-free accounts at 750,000. In addition, it limits eligibility to persons in companies with fewer than 50 employees and mandates high deductibles for families who want to purchase an MSA policy. It does, however, allow funds left over in the accounts at the end of the year to roll over.
20. The tax code offers an exclusion from taxable income to those who get their health insurance at work. Employment-based health insurance is part of the compensation package many employers provide to their employees--a form of non-cash wage. Employers can take a tax deduction for the cost of this health coverage, as they do for most other forms of employee compensation. They write the check for the premiums, and some pay medical bills directly if they self-insure. Businesses can deduct these costs from their earnings since they are part of the total compensation package paid to workers and must be deducted to measure net profits correctly. What makes health insurance different from cash wage or salary compensation, however, is that workers do not pay taxes on the part of their compensation package they receive in the form of health benefits. Section 106 of the Internal Revenue Code provides that the value of health benefits is not counted as part of the taxable income of employees: In tax terminology, it is excluded from taxable income. However, workers may receive this tax-favored benefit only if health coverage is provided through an employer.
22. Devon Herrick, "Patient Power and the Internet," National Center for Policy Analysis, Brief Analysis No. 317, March 31, 2000, at www.ncpa.org/ba/ba317/ba317.html.
24. Christina LeBeau, "Insurance Online," The Standard, April 3, 2000, at www.thestandard.net.
30. "Analysis of National Sales Data of Individual and Family Health Insurance: Implications for Policymakers and the Effectiveness of Health Insurance Tax Credits," released by e-HealthInsurance, June 21, 2001, at ehealthinsurance.com.
31. Mark Pauly and Bradley Herring, "Expanding Coverage via Tax Credits: Trade-Offs and Outcomes," Health Affairs, Vol. 20, No. 1 (January/February 2001), pp. 9-26, and Pauly, et al., "Individual Versus Job-Based Health Insurance: Weighing Pros and Cons," pp. 28-44.
32. "Defined Contribution Health Benefits: Enabling Employee Choice," Evergreen Freedom Foundation, Olympia, Washington, April 2001, at www.effwa.org.