Nov./Dec Vol. 29/No. 6

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1 Nov./Dec Vol. 29/No. 6 IRS TO BEGIN COMPLIANCE CHECKS OF NON-GOVERNMENTAL SECTION 457(B) PLANS 5 Mary K. Samsa, McDermott Will & Emery LLP The Internal Revenue Code of 1986, as amended (the Code ) permits governmental and tax-exempt entities to sponsor taxadvantaged retirement plans meeting the requirements of Code Section 457(b) ( Section 457(b) Plans ). Although governmental Section 457(b) Plans primarily operate and act like Code Section 401(k) plans and Code Section 403(b) Plans (i.e. a quali ed retirement plan), Section 457(b) plans maintained by tax-exempt entities must be top-hat plans, thereby limiting participation to a select group of highly-compensated individuals and management employees. Numerous non-pro ts sponsor Section 457(b) Plans as a means of providing additional nonquali ed deferral opportunities for their highly-compensated executives. The Internal Revenue Service ( IRS ) has decided to take a closer look at these arrangements, announcing recently that it would begin conducting compliance checks of Section 457(b) Plans maintained by non-governmental entities (e.g., health systems, educational institutions, museums, etc.). Though the compliance checks are not full audits, plan sponsors can expect the IRS to request extensive information regarding written and operational plan compliance. RISING HEALTHCARE COSTS-CHALLENGES AND OPTIONS FOR BUSINESSES 19 Robert Trumble and Priyadarshini Pattath Healthcare costs in the U.S. are among the highest in the world and they keep on rising. Managing bene ts costs is one of the biggest challenges facing the human resource manager in the current economy. HR managers have to determine the best bene t plan for their workforce to ensure employee satisfaction and reduce healthcare spending. Numerous types of healthcare coverage including consumer driven, group insurance, de ned bene ts, de ned contribution, exible bene t plans like cafeteria plans and exible spending accounts are some of the options. Also in the face of rising healthcare costs, there is a growing recognition that preventing disease and the maintenance of good health for the workforce not only boosts morale but also increases productivity, thereby reducing the healthcare costs of the employer. UNDERSTANDING HEALTH BENEFIT EXCHANGES: A FRAMEWORK FOR DECISION MAKING 28 Randall K. Abbott The emergence of health bene t exchanges has stimulated considerable interest on the part of employers who are intrigued with the possibility of an exchange as a potential delivery channel for employee health bene ts. This article examines the concept of health bene t exchanges and provides a contemporary framework for determining if and when a health exchange could make sense for an employer. The author examines this topic from the perspective of the larger employer that is typically covering employees and retirees under a traditional self-funded bene t arrangement. This article updates and expands on the author s recent article in the May/June 2013 issue of this Journal. EMPLOYEE BENEFITS TOOLS AND STRATEGIES TO PREPARE FOR BUY-SIDE M&A ACTIVITY 33 Perry C. Papantonis, Human Capital, Ernst & Young LLP This article highlights several best practices and lessons learned related to employee bene ts programs in buy-side corporate transactions. These lessons learned and best practices will assist any organization as they prepare for buy-side M&A activity and are focused on the assisting buyers with developing there employee bene ts negotiating and integration strategies and facilitating the e ective integration of acquired entities. These strategies are gleaned from work with highly acquisitive organizations over the course of hundreds of transactions. Managing Editor s View Michael B. Snyder, J.D. 3 The Excellent Fiduciary Ronald E. Hagan 13 Reward Strategy and Practice Bob Russell 41 Real World Bene ts M. Scott Mahood 48 Mat #

2 REWARD STRATEGY AND PRACTICE Are De ned Contribution Health Plans Destined to Replace Traditional Models? Bob Russell * This article will examine the past evolution and current state of de ned contribution health plan models. The mandated 2014 implementation of the public health exchanges, coupled with the rapid emergence of competing private exchanges has brought de ned contribution health insurance to the forefront. The author believes that exible bene t programs utilizing exible bene t credits are becoming a viable alternative for plan sponsors to consider. As key A ordable Care Act (ACA) requirements come into e ect starting in 2014, including the public health exchanges, the xed subsidy approach is attracting more attention of employers who currently o er health coverage to employees, especially in light of the increasing availability of private health exchanges in the market. Even though the Obama administration recently extended the deadline for complying with the employer shared responsibility ( pay or play ) mandate from 2014 to 2015, other compliance issues must still be addressed. Many employers are still exploring their pay or play options and re ning their business strategies to minimize penalties and health plan costs in the era of ACA. This might involve a combination of changes to plan designs, expanding or reducing the number of plans being offered, or changing the way that premium costs are shared with employees. This article will examine the past evolution and current state of de ned contribution health plan models and why they are expected to become more prevalent in the future. We will discuss and compare three di erent approaches to de ned contribution that are in existence today: E High Deductible Plans with Employee and/or Employer Contributions E Private Health Exchanges with Employer Subsidies * BOB RUSSELL, ASA, MAAA, FCA, is a senior bene ts consultant in the Dallas o ce of Hay Group. He advises public and private sector employers in the design, funding, and accounting for health and welfare bene t programs. The de ned contribution (DC) concept in employer health plans has been around for a number of years but the pure DC approach, in which an employer allocates a xed subsidy to employees to apply toward the purchase of health insurance, has not been prevalent except in certain labor sectors, such as county governments and public school districts. 41

3 E Flexible Bene t Plans with Flex Credits GROWTH OF HIGH DEDUCTIBLE HEALTH PLANS High deductible health plans (HDHPs) with either health reimbursement accounts (HRAs) or health savings accounts (HSAs) have become increasingly prevalent as an e ective means to control healthcare costs through a combination of higher medical plan deductibles and through the use of employer contributions to medical accounts within the plan structure to mitigate some, but not all, of the employee's annual deductible and other out of pocket costs. HSA's and HRA's were introduced in the early 2000's as a means of increasing employees' awareness of the true costs of health care, coupled with the idea that employees would make di erent health spending decisions if they had control over their own personal health accounts. Experience over the past decade has shown that the level of health spending in these plans is signi cantly less than in traditional plans designs, and most employers typically o er a high deductible HRA or HSA plan as an option to employees, along with other more traditional plan options. Less frequently, HDHP plan have become the only type of option o ered by some employers. Journal of Compensation and Bene ts The market prevalence of HDHP plans o ered by employers has risen from 4% in 2005 to 31% in 2012, according to the Kaiser Family Foundation's 2012 Employer Health Bene ts Survey. HSA quali ed plans are far more prevalent than HRA plans (26% of employers versus 5% of employers). HSA accounts, when attached to an IRS-quali ed high deductible plan, are designed to be a pre-tax savings vehicle for employees to manage and reimburse themselves for out-ofpocket expenses such as deductibles, co-pays, and coinsurance. Under IRS rules, employees can carry over unused balances (unlike Flexible Spending Accounts) and may retain ownership of the accounts upon leaving employment. Employers are also allowed to contribute to employees' HSA accounts (subject to combined IRS limits), and typically they do contribute a discretionary amount to encourage employees to enroll in these plans. According to the 2012 Kaiser survey, 72% of employers o ering an HSA plan made an annual contribution to employees' accounts, with an average of annual contribution of $609 to employees with single coverage and $1,070 to employees who have family coverage under the plan. 42 In contrast with HSA accounts, HRA's are notional accounts to which only an employer can contribute, and the account is usually an integral part of the medical plan's design. Unlike an HSA account, the actual money isn't moved into an employee's account until money is needed to pay claims as incurred, and whether any remaining balance at the end of the year is carried over or forfeited is a employer's plan design choice. HRA plan designs have gained less popularity with employees than HSA designs, even though the entire account comes from employer contributions. This is probably due to the lack of a carryover feature and employees feel that they have less ownership in the account. RECENT EMERGENCE OF PRIVATE HEALTH EXCHANGES As the ACA mandated public health exchanges go into e ect on January 1, 2014, privately owned health exchanges are rapidly growing in the marketplace as an alternative to the public health exchanges. In the private exchange model, the employer contractswith a private company and chooses the health plan options that will be made available to its employees through the online market. It is up to the employer to determine the method for determining the subsidy it will provide to each

4 eligible employee to be used as an o set to the premiums the employee will pay for the bene- t package he or she elects on the exchange. The exchanges promise to take over many of the administrative responsibilities and decisions that the employer's HR and payroll departments would typically handle in a traditional environment. However, participating in a private health exchange doesn't mean the employer no longer has to comply with ERISA, the ACA, and other applicable laws and regulations A few key questions for employers to consider early in the process when evaluating whether to send their employees to a private exchange for health coverage: E How many and what type of health plan options will be o ered to your employee population? Do you also want ancillary bene ts such as dental, life and disability to be o ered? E Which segment of the employee population will be given access to the exchange? Full time employees? Pre-65 and Post-65 Reward Strategy and Practice retirees? Part-time and seasonal workers? E How will the billing system work, and what employer interfaces with payroll will be necessary? E What wellness and health management programs will be available? E What type of reports will be provided and how often? E Who will be the ongoing point of contact for the employer? E How will annual renewals be handled will premium cost increases be negotiable by employers? E What type of online tools and call centers will be used to assist individual employees in enrolling in plans? SECTION 125 CAFETERIA PLANS Most employers today take advantage of IRS Section 125 Cafeteria Plan rules to allow employees to make their required contributions toward health plans on a pre-tax basis through reduction in salary through payroll deductions. This is a tremendous bene t for both employees and employers from a tax standpoint, since the pay that is deducted and converted to certain allowed bene ts is not subject to federal income tax, FICA or FUTA. The application of state and local taxes under cafeteria plans depends on individual state laws. The rules for cafeteria plans are lengthy and complex, and we will not discuss a great many of them here, but to understand the basic construct of cafeteria plans, employees may elect to reduce their otherwise taxable compensation in order to contribute toward the cost of certain quali ed bene ts that are allowed to be part of a cafeteria plan under IRS regulations. Because a cafeteria plan by law must o er at least one quali ed taxable bene t (or cash compensation) as a choice, employers often include quali ed bene ts that may be paid for by employees on an after-tax basis as part of the cafeteria plan. Table 1 below lists examples of quali ed cafeteria plan bene ts, and bene ts that IRS regulations speci cally exclude from being part of a cafeteria plan (but may still be o ered outside of a cafeteria plan). Quali ed Cafeteria Plan Bene ts Medical Dental Table 1 Nonquali ed Bene ts Long Term Care Insurance Scholarships 43

5 Journal of Compensation and Bene ts Quali ed Cafeteria Plan Bene ts Vision Group Disability Group Term Life and Accident Insurance Health Flexible Spending Account (FSA) Dependent Care Spending Account (DCA) Adoption Assistance plan Health Savings Account (HSA) 401(k) plan contributions Buying/Selling of paid time o Employer ex credits to purchase quali ed bene ts Nonquali ed Bene ts Educational Assistance Programs Employer Provided Meals and Lodging Health Reimbursement Accounts Fringe Bene ts Deferred Compensation other than 401(k) contributions Dependent life insurance FLEXIBLE BENEFIT PLANS WITH FLEX CREDITS VERSUS TRADITIONAL COST-SHARING Cafeteria plans are also widely known as Flexible Bene- t plans, because they allow employees a great deal of exibility in choosing from a menu of bene ts the employer o ers, in order to best t their particular wants and needs. During annual enrollment, employees can also make decisions on contributing to exible spending accounts or dependent care accounts, and 401(k) plans, and may be able to purchase voluntary bene ts such as supplemental life policies or long term care insurance. Starting in the 1980's and 1990's the concept of providing each employee a de ned ex credit ( xed subsidy) that could be used to select among available exible bene t options gained a certain amount of popularity, and many such plans still exist. The ex credit approach to health care is a true de ned contribution method in that the employer de nes a xed amount designated for bene ts spending per employee, and employees must decide how they will make their selections using their ex credit as a budget. As previously mentioned, the ex credit concept did not evolve as the standard method for sharing premium costs between employers and employees. The most common cost-sharing method that employers use today is setting a target percentage of total costs it wishes to subsidize, such as splitting the premium costs 80% paid by employer, 20% paid by employee. While the current method may seem fair and understandable to employees if well communicated, a ex credit approach makes the employer dollars paid per employee very transparent, and might cause employees to choose di erently when presented data in this way. Let's illustrate this di erence with a simple example contrasting the two cost-sharing methods for a typical employee, using illustrative numbers: An employer o ers a choice between a core health plan with a $500 per person deductible ($1,000 family) and a HSA quali ed plan with a $1,500 deductible for single coverage and $3,000 for family coverage. The Monthly employee contribution costs, representing one-third (33%) of the total premium costs for the two plans, are as follows: 44

6 Reward Strategy and Practice Employee Monthly Contribution Rates Core $500 Deductible Plan $1,500 Deductible Plan Employee only $100 Employee only $80 Employee plus Spouse $200 Employee plus Spouse $160 Employee plus Family $350 Employee plus Family $280 The employer has many different ways to go about setting the amount of the ex credit, but let's say the credit is communicated to be $700 per month. Employee A is a 30 year old male, with a non-working spouse and one child. Under the old cost-sharing method he has a choice of two medical plans, costing either $350 per month or $280 per month for family coverage. He is also aware that if he decides to take the high deductible option, the $70 di erence in monthly premium could be put into an HSA account, which would accumulate to $840 the rst year. However, the $840 HSA account would only partially o set the cost of paying the family deductible of $3,000, should the family have signi cant medical expenses during the plan year. Alternatively, under the ex credit cost-sharing method, Employee A would be presented with a choice of the same plans, but working with an entirely di erent set of numbers, communicating the plans' total price tags instead of net employee contributions. Remember that in this hypothetical example, the original employee contribution rates were set to be 33% of the total premium costs. Monthly Price Tags Core $500 Deductible Plan $1,500 Deductible Plan Employee only $300 Employee only $240 Employee plus Spouse $600 Employee plus Spouse $480 Employee plus Family $1,050 Employee plus Family $840 Under the employer's new ex credit method, Employee A has a $700 monthly ex credit to use toward purchasing health coverage. He can easily see (by subtracting the monthly credit from the price tags) that his net cost will be either $350 for the core plan, or $140 for the high deductible plan. Under this scenario, Employee A could pay $350 (coincidentally the same amount he would have paid for family coverage under the old method) or $140 per month for a high deductible plan a signi cant savings for this employee. If he elects the high deductible plan, he would then have several choices for the $210 he saved, depending on what choices the plan document actually allows: i) Re-direct cash into an HSA, FSA, or DCA account on a pre-tax basis ii) iii) Contribute to 401(k) plan Purchase other quali ed cafeteria bene ts such as group life or disability 45 iv) Receive in paycheck as taxable income Before leaving this example, suppose a di erent employee (employee B) is single or she has a working spouse who is electing health coverage from his own employer. Assuming that the employer grants the same $700 ex credit to single employees as married employees, Employee B would have even more choices: She could elect single coverage under the health plan

7 and have an excess ex credit of either $400 or $460 per month. The excess credit could then be used to purchase a combination of any of the other bene t plans as shown above, or if the written plan allows, receive the excess credit (or a percentage of it) as taxable compensation. This is only an illustrative example, and does not represent any employer's actual design. There is a very wide range of examples possible depending on the number and type of plans o ered and how the ex credits and price tags are determined. WHAT SHOULD EMPLOYERS THINK ABOUT BEFORE TRANSITIONING TO A FLEX CREDIT PROGRAM? Employers who are considering a de ned contribution ex credit approach have a number of design and administration issues to examine, and decisions to make before moving forward with implementation of the necessary changes. Below are listed a few of these key issues: E Should the same amount of ex credits be given to every employee, regardless of family status, or would you give additional ex credits to employees with a spouse or dependents? E What credits should be Journal of Compensation and Bene ts given to part time employees? E What credits should employees who decline medical coverage receive? E Does the exible bene ts program have to stay cost-neutral to the current bene ts program, or is there a willingness to make an investment to minimize disruption? E For what types of bene ts will ex credits be allocated? For example: Medical only at dollar credit Medical plus Dental at dollar credits Medical plus Dental plus Vision at dollar credits, plus payrelated credits for pay-related bene ts such as disability and life insurance? E Is it acceptable for one plan to subsidize other plans in order to keep the employee premiums reasonable under all options? E Should ex credits be given (or taken away) depending on wellness program participation, tobacco usage, etc. E Should buying and/or selling vacation or PTO be 46 part of exible bene ts program? E Are current administrative systems fully capable of tracking employees' usage of ex credits, withholding taxes correctly, and handling online enrollments? FLEX PRICING CONSIDERATIONS One of the most critical steps involved in implementing a xed credit exible bene ts program (or alternatively transitioning employees to a health insurance exchange) is taking an analytical and thoughtful underwriting approach to determining the price tags and ex credits, and how these amounts will be adjusted from one year to the next, as health costs increase with in ation. For the initial determination of the ex credits, one approach would be to calculate the average dollar cost per employee that the employer is now contributing to the current plans. This approach is easy to communicate, and it may generate a net savings to the organization if a signi cant number of employees migrate to the higher deductible, less costly medical plans in the rst year. This favorable result would give the employer more exibility in setting the ex credit the second year. A di erent approach would

8 be to initially set the ex credits somewhat lower than current average costs, in anticipation of employees migrating to the lower cost plan options. However, caution should be exercised in designing the range of plans to be o ered, and in setting the relative price tags that employees will pay for the di erent plan options, to account for the possibility of adverse selection. In short, adverse selection means that if any employees perceive that one plan option or feature is a very good deal, then they will likely select and over-utilize that plan or feature and thus drive up the plan's costs more than anticipated. Reward Strategy and Practice There are many other ways to set the ex credits, and since both the credits and price tags are highly visible to employees, methods should be used that are not overly complicated and which can be logically explained to all employees and other interested parties in layman's terms. At the same time, the employer should involve an underwriter or health actuary in the technical analysis phase. CONCLUSION Pure de ned contribution approaches to health insurance will become more prevalent in the future, the author believes. The mandated 2014 implementation of the public health exchanges, coupled with the rapid emergence of competing private exchanges, which have enjoyed success in the retiree health insurance market, has brought de ned contribution health insurance to the forefront. Health plan sponsors of course have the option to maintain complete control over their own health and welfare bene t program design. Private health exchanges, which are relatively new, may not be the right t for many employers for a variety of reasons. Flexible bene t programs utilizing ex credits, such as described above in this article may be a more attractive de ned contribution alternative for an employer to consider for its employees. 47