HOW DEFINED CONTRIBUTIONS WORK

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.

HOW DEFINED CONTRIBUTIONS ADDRESS TODAY'S PROBLEMS

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.

• Lack of choice for patients. Despite ever-rising health plan expenditures by their employers, employees may feel frustrated with the health plan selected by their employers and the restrictions those plans place on their access to medical services. In every other sector of the economy--be it clothing, restaurants, computers, or other sectors--Americans enjoy significant choice. Yet, in the critically important arena of health insurance, consumers have few choices of plans, if any. A RAND Corporation study in 1998 showed that only 43 percent of employees whose companies offered health insurance had a choice of plans.⁵ Those who did have a choice typically had a very limited list of employer-selected options from which to choose. Many companies spend millions--even billions--of dollars on health coverage yet find it increasingly difficult to satisfy the varying needs of all of their employees.
  
  
• Impaired doctor-patient relations. Many physicians also feel that managed care has damaged the doctor-patient relationship by limiting treatment options on the basis of cost rather than patient need. Doctors want to make treatment decisions in consultation with their patients, not with the third-party payers whose primary motivation is to contain costs.
  
  
• Rising costs. In an effort to contain the costs of health benefits, many employers have switched to managed care plans that monitor and often restrict patient access to medical services. However, many are finding that, despite the initial cost savings, their premium costs are once again on the rise. In many areas, the increases have reached double digits in 2001. A study by Watson Wyatt reported health plan rate increases of 9.8 percent from 1999 to 2000, compared with a smaller increase of 7.5 percent from 1998 to 1999.⁶ And costs are expected to rise even faster in 2001.

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

• Counterproductive regulations. A major factor in the rising costs of health care are state regulations and mandates that drive up the cost of insurance and drive people into the ranks of the uninsured.¹⁰ Typically, excessive regulation in any sector will drive up prices; restrict innovation, competition, and choice; and force businesses to cater to regulators instead of consumers. That is exactly what has happened in the individual and small group health insurance market.
  
  
• Growing dissatisfaction. Employers are increasingly frustrated with their inability to find affordable health coverage that also satisfies their employees' demands. In addition, the growing threat of liability forces many companies to consider ways to protect themselves from lawsuits if a situation should arise in which a plan they have selected denies medical service to an employee.
  
  
• Lack of confidentiality. Under the current system, employees do not buy and own their own plans; their employers do. As the paying customer, employers too often have access to sensitive medical information about their employees.

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.

• Greater confidentiality. The defined contribution approach offers employees something that the employment-based system cannot: more say over the confidentiality of their medical records. Because plans would contract directly with employees, there would be greater incentive for them to satisfy their customers with the best coverage and greater confidentiality. Employees who became dissatisfied with their plan's coverage, service, or confidentiality could take their business elsewhere or even sue for breach of contract or violation of their privacy.

SIMILAR SUCCESSFUL APPROACHES

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 Program.
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.

OTHER CONCERNS

A number of concerns have been raised regarding the implementation and impact of defined contributions on employers and employees.

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.

Employee Receptiveness.
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.

Complexity.
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.

Adverse Selection.
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

Concerns about adverse selection fail to recognize several factors that would affect the market in a system of defined contributions.

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.

Finally, a number of older and often chronically ill employees who do not now have access to their employer's plan would find a defined contribution a significant aid in purchasing health insurance.

Administrative Costs.
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 Contribution.
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

HOW TO FACILITATE DEFINED CONTRIBUTIONS

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:

• Ensure that the employer's tax deduction is maintained for defined contributions and the contribution is not considered taxable income to employees. As the KPMG survey showed, employers would be more willing to move toward a defined contribution approach for employee health benefits if they are reassured about the stability of the tax implications for the company and employees.
  
  
• Provide tax credits to the uninsured for the purchase of private health insurance. The current system of offering generous tax benefits to those with employment-based health insurance and little or no help to those who purchase their health insurance outside their employment is regressive and unfair. It increases the numbers of uninsured. Tax credits for the uninsured is an idea that is gaining broad bipartisan support in Congress.³³ Congress should move forward with that approach.
  
  
• Amend ERISA to allow interstate pools for health insurance and to enable employees to purchase a state-regulated individual plan. ERISA should be amended to allow people to band together across state lines in association health plans and individual membership associations. A federal allowance for the creation of multi-state purchasing groups (such as AHPs or IMAs) would enable a wider range of organizations to self-insure, a capability that most medium-size and large employers enjoy in terms of exemption from state mandates. These groups would give individuals without employer-sponsored insurance--or those wishing to use their defined contribution for health insurance outside the employment-based setting--a way to purchase more economical group coverage. ERISA should also be amended so that employees who receive a defined contribution can purchase a state-regulated individual plan if they choose to do so. Employees who can choose between state and federally regulated banks should be allowed to do the same with health insurance.
  
  
• End the caps on medical savings accounts. This would be in line with the official position of the American Medical Association on MSAs, which states that "MSAs should be made available to everyone with full latitude for the market to determine specific MSA product features such as health plan deductible amounts, amount of contributions to MSA savings accounts, and maximum annual out-of-pocket spending amounts."³⁴
  
  
• Request governors to review the impact of state regulations and mandates on health plans. State-level regulation and mandates undermine the individual and small group insurance markets, which are fully exposed to these burdens, and dramatically increase costs while decreasing choices. As a first step, states should halt enacting further mandates and regulations until they can determine their impact on costs and choices. States should require that new benefit mandates be tested in state-sponsored programs before they are applied to private employers who voluntarily offer coverage.
  
  
  Some states, such as Texas, recognize that mandates and regulation on health coverage drive up the cost of insurance. These states have passed legislation to exempt some activity from these mandates and regulations, such as allowing the purchase of catastrophic-only health insurance. Other states should follow their lead to revitalize their health insurance markets and allow insurers to create a variety of plan choices, at a range of prices, for consumers.