Defined Contributions: The Search for a New Vision

Issue Brief No. 37, April 2001 -- Sally Trude

Advocates of defined contributions for health benefits sought to expand choice and rein in costs by heightening employees' awareness of what health care actually costs. Although the concept had generated substantial debate, it had not gained traction among large employers. Given the tight labor market and consumer resistance to paying more for health care, employers were not expected to adopt defined contributions in the near term, according to a panel of business and union representatives at a recent Center for Studying Health System Change (HSC) conference. This Issue Brief presented the panelists' views on the likelihood of employer adoption, the strengths and weaknesses of defined-contribution approaches and the potential role of Internet-based solutions. Policy implications were also discussed.

Looking for a New Vision

Facing recent premium increases, employers were searching for a fresh approach to health benefits. The consumer backlash against managed care and the loosening of plan restrictions had left employers without an effective mechanism to control rising costs. David S. Blitzstein, director of the Negotiated Benefits Department of the United Food & Commercial Workers International Union, put it plainly: "There's a desperation because we have not fixed the health care problem in this country. Medical costs are coming back with a vengeance, and the low-lying fruit for savings has already been picked. Employers are now looking for something that's going to protect us for the next five years."

Beyond cost reduction, employers were eager to lighten the heavy administrative load that came with managing health benefits. Companies offering plan choices had to select health plans, evaluate plan performance and communicate that information to employees. Increasingly, employers found themselves mediating between plans and workers. "With a consumer choice model, the concept is to get the employer back out of being in the middle and let employees make the decisions and be more responsible for adjudicating what happens," said Lawrence Atkins, president of Health Policy Analysts.

Defined contributions for health benefits borrowed from the defined-contribution model for pensions. As with retirement benefits, the employer would contribute a fixed dollar amount toward health coverage and transfer the risk and responsibility to the employee. In addition to making costs more predictable, employers expected to reduce their administrative burden, broaden choice, give consumers more control and avoid being held accountable for plan management decisions. The advantages and challenges varied with the specific approach taken.

Under a cash-out option, the employer would pay workers higher wages instead of providing insurance, and the worker could choose to buy coverage on the individual market or spend the money elsewhere. Under a fixed-dollar approach, the employer would continue to pool risk and administer payroll deductions and plan options. The most likely defined-contribution alternative was the voucher, which ensured the money was used for health benefits while preserving tax advantages.

Whether defined contributions for pensions or health benefits truly relieved employers of their obligations was uncertain. "You've got to keep your employees happy. If two or three 401(k) options plummet for some reason, depending on how profitable and paternalistic the company is, the company is going to go in there and do something about it. Employers do not necessarily get out of playing a role just because of a defined-contribution approach," cautioned Helen Darling, senior consultant for Group Benefits and Health Care for Watson Wyatt & Company and former manager of international compensation and benefits for Xerox Corp.

Tight Labor Market Hinders Change

Despite recent premium increases, the panelists considered it unlikely that employers would shift to defined-contribution approaches in the short term. "Given the war for talent" that affected every market and every employer, Darling suggested that employers would do "whatever makes their employees happy." Defined-contribution approaches were likely to be perceived as a reduction in benefits. Over the next two to three years, as long as the economy remained strong, employers could be expected to absorb most premium increases. Companies were making small changes to copayments and formularies but not overhauling their contribution strategies.

Employers were worried about what lay ahead, however, and were beginning to think strategically about their next moves. Atkins expected that health benefit managers would develop alternative approaches within three to four years but implement them over a longer timeframe. Employers particularly wanted employees to have "more skin in the game" because of deep concern about long-term costs. According to Pamela Krol, director of health benefits at Lucent Technologies, employers were emphasizing health promotion and working to increase the flexibility of benefits over time, letting individuals decide which benefits mattered most to them. Blitzstein's survey of his union members found that health insurance ranked second only to wages in financial importance.

Cash-Out: An Unlikely Solution

Although the prospect of swapping employee benefits for higher wages had generated the most controversy, the panelists regarded it as impractical. "The cash-out option is highly unlikely for quite some time because of huge technical issues," said Atkins. Under a cash-out, employers would pay higher wages and employees would purchase health insurance on the individual market. The panelists highlighted the many problems facing any employer that took this path. The employer would not only face tax consequences from losing the exclusion of health benefits from income tax, Atkins noted, but would also owe a higher Social Security tax contribution. Darling added that because of the difficulty of collecting premiums from individuals, individual insurance would carry higher administrative costs. Employers were unlikely to pay the higher wages needed to offset these costs simply to exit their role as health benefits manager.

Krol and Darling explained how the cash-out approach also raised equity issues and forced the employer into the role of risk adjuster. The employer would have to decide whether to provide higher wages to older and sicker employees who would face steeper premiums on the individual market. National employers also faced the challenge of maintaining equity across different geographic regions.

Furthermore, offering employees cash instead of health benefits might increase the number of uninsured workers, and companies could have reservations about how wisely workers would spend the extra money. Already, about 20 percent of all uninsured Americans were workers who were eligible for employer-sponsored health insurance. Many had modest incomes and may genuinely have felt they could not afford it, but others were young adults in good health who would rather forgo coverage to buy other things. "To assume that people will take the money and do the wise thing is a risk I personally would not want to take," Darling warned.

Pros and Cons of Defined-Contribution Approaches

Many of the goals behind defined contributions resonated with the panel. In particular, the experts cited the need to increase cost consciousness by giving employees a greater economic stake in their decisions. With their own money on the line, employees would be more likely to engage actively in medical decision-making. Panelists also believed cost awareness would grow if tax laws were changed to allow portability of health benefits and the ability to build up a health spending account over time.

According to Krol, "As a large employer, the solution we'd like to see is medical savings accounts. I think portability is important, as is the ability for people to have money earmarked like a 401(k) plan for medical expenses with options within that account." Darling added, "People could feel, whether it's a medical savings account or another approach, that if you don't spend, you still get it."

The panelists also valued the potential for expanding choice and flexibility by letting employees customize coverage to fit their individual needs. This was seen as critical for recruiting and retaining employees. Greater choice and customization might also spur new models of care delivery. Darling explained, "If employees are given more choices and have the ability to control the payment in a different way and go wherever they want, that's going to appeal to employees."

The panelists did not view defined contributions as a way for employers to abandon their role in managing health benefits and urged caution. Employers played a vital part in pooling risks so that sicker workers paid the same for insurance as healthier ones. Darling warned that before adopting defined contributions, proper risk adjustment needed to be in place so that "people who are seriously ill are not harmed in any way. If not implemented correctly, the seriously ill might not get care. Risk adjustment would be crucial to ensure that the seriously ill are not left out."

Employees also valued their employers' bargaining power. "The one thing employees all value and understand is the power of a group-purchasing model. Employees know that, as a company, we can leverage price and quality on their behalf," noted Krol. She also explained, "A good part of my day now is dealing with hospital and physician network disruption. So those roles are things that our employees value."

Role of the Internet

A surge of Internet ventures offering health plan innovations had fueled expectations for a shift toward defined contributions. Some ventures were developing online health marketplaces to let employees customize benefits and reduce the employer's management role.

For example, some companies let employees comparison-shop for physicians based on capitation rates or prices for specific services. Other alternatives included risk-adjusted payments to health plans to reduce plans' fear of adverse selection and foster competition. Companies using this approach established a marketplace for health plans by risk-adjusting payments or pooling risk across employers.

Internet ventures could make important contributions toward expanding consumer choice, improving individual decision-making and making information more accessible. "From the technological standpoint," Blitzstein said, "there are tremendous potentials for price and quality transparency and using information to make employees better and stronger purchasers of health care." Darling concurred: "The more we open up the system, and the more we allow choice, the more we will see new models of delivery." She also noted, however, that employees did not want to do extensive work to figure out their benefits.

The Internet showed potential for providing risk pools and risk adjustment that could extend the leverage of large employers. Ray Herschman of HealthSync explained that under his model, the employer's risk pool was maintained so that "the young subsidize the old and the healthy subsidize the sick, so the social contract of insurance is maintained." A young worker and an older worker entering this online marketplace might each have the same defined contribution of $150 from their employer. When they enrolled in a health plan, $100 would follow the young worker and $200 would follow the older worker. Atkins called this "an intriguing model because it takes the employer's pool, maintains it intact and then creates a risk-adjustment mechanism as individuals then move into plans."

The panelists cautioned, however, that these ventures were unlikely to provide the quality information for plans and providers that had been absent to date. Atkins warned, "There is a great danger that, in the absence of really good information on providers, which distinguishes them based on quality and health outcomes, the higher price that a provider charges would be used as a proxy for quality."

Moreover, many of the fundamental challenges of defined contributions remained unresolved. "There is a big gap between the goals of the Internet ventures and what many of us hope would be the ideal set of solutions," Darling added. Blitzstein further warned, "Sophisticated actuarial models have often crashed, and we've seen many of these models fall apart on the managed care side in terms of pricing and capitation, especially over the last five years. And it is an incredibly difficult task to put networks back together for workers where you've had managed care products under contract and, all of a sudden, the next day they no longer exist. The chaos that creates with the provider community is phenomenal."

Implications for Policy Makers

Because most Americans had employer-based health insurance, policy makers needed to be attentive to any erosion of such coverage, particularly among large employers. According to the expert panel, large employers were unlikely to make dramatic changes in the near term and, given the tight labor market, were unwilling to shift costs to employees. The panelists also considered it improbable that employers would adopt the cash-out option and forgo the tax advantages and cost savings of group purchasing. A significant increase in the uninsured as a direct result of defined contributions was therefore unlikely in the short term.

Policy makers also needed to be concerned about the potential harm to seriously ill individuals if adequate risk adjustment was not part of any new defined-contribution scheme. Blitzstein warned that sophisticated risk-adjustment technology or entities to manage risk did not yet exist. "It's wishful to think that you can have consumers go online, pick a health provider, give them an amount of money and that that's all going to work well without a substantial amount of risk selection."

Gaps in quality information were another central concern raised by the experts. They expressed some skepticism that new defined-contribution approaches, whether Internet-based or not, would be able to provide the quality and cost information that had been lacking. Expanding choice and allowing customization of products demanded accurate data on price, provider quality and outcomes. "Unfortunately," Krol said, "in this marketplace there is no information on cost readily available to consumers, and the information on quality is even poorer. We would love to be in a market-driven system, but a market has to provide that information."

Although employers played an important part in patient safety, quality improvement and ensuring accountability, they appeared conflicted about this role. While they did not relish serving as middlemen between employees and health plans, employers recognized their value to workers. "A primary aspect of my job is helping people navigate through this system. It is very complex, and I don't think that could be mitigated," Krol said. If employers moved to defined contributions to sidestep the managed care backlash or potential liability, there might be calls for the government to assume a stronger role in patient protection and regulation to fill the gap employers left behind.

Internet Companies

HealthSync established a marketplace of health plans by maintaining a risk pool and risk-adjusting payments to plans. According to CEO Ray F. Herschman, "Employers will not migrate to defined contributions if there's any risk that any of their employees would get priced out of the market."

Vivius, Inc., provided a supermarket of providers, from primary care physicians to specialists, hospitals and pharmacies. Consumers made choices based on monthly capitation rates set by each participating provider. Executive Vice President and Chief Medical Officer Lee N. Newcomer, M.D., said, "Vivius brings the physician and patient back together again by taking out the third party."

HealthMarket, Inc., created a self-directed health plan that provided pricing by provider and service or episodes of care, available to employees, the uninsured and those on the individual market. Chairman and CEO Stephen F. Wiggins said, "HealthMarket will be the 'Intel inside' insurer that enables it to administer and execute a new family of insurance products."

Notes

1. Trude, Sally, and Paul B. Ginsburg, "Are Defined Contributions a New Direction for Employer-Sponsored Coverage?" Issue Brief No. 32 (October 2000).

2. Cunningham, Peter J., Elizabeth Schaefer and Christopher Hogan, "Who Declines Employer-Sponsored Health Insurance and Is Uninsured?" Issue Brief No. 22 (October 1999).

This Issue Brief was based on a roundtable discussion, "Defining 'Defined Contributions': New Directions for Employer-Sponsored Health Insurance Coverage," sponsored by HSC on October 10, 2000, in Washington, D.C.

Sources and Further Reading

Kaiser Family Foundation — Employer Health Benefits Survey — Annual data on employer-sponsored health insurance trends.

CMS — Health Insurance Marketplace — Federal marketplace information and enrollment resources.

Health Affairs — Peer-reviewed health policy research and analysis.

Robert Wood Johnson Foundation — Health policy research and programs.

Commonwealth Fund — Research on health care system performance and coverage.