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Defined Contribution: Why It Won't Happen Any Time Soon

MANAGED CARE February 2001. © MediMedia USA
Cover Story

Defined Contribution: Why It Won't Happen Any Time Soon

There's a difference between plausibility and wishful thinking that many who predict the advent of this system fail to recognize. Risk adjusting, adverse selection, and the tax code present hurdles.
Frank Diamond
Senior Editor
MANAGED CARE February 2001. ©MediMedia USA

There's a difference between plausibility and wishful thinking that many who predict the advent of this system fail to recognize. Risk adjusting, adverse selection, and the tax code present hurdles.

Frank Diamond

Senior Editor

This is best gotten out of the way first: "There's always this tendency to a little bit overestimate what can happen in the next two years and underestimate what can happen in the next 10." Bill Gates said this, and no one could have overestimated the legs that this quote has taken on. Maybe Gates is correct and maybe he isn't. What's indisputable is that he's Gates and, therefore, every other expert contacted for this article has felt compelled to repeat this mantra as if it'd been handed down by Moses.

If you sense attitude here, you are correct. This article is not so much about the feasibility of a defined-contribution system, but about why it's not going to happen anytime soon — if ever. To be touched on peripherally: Why has there been so much expectation concerning this? One cannot flip through a stack of health care journals without happening upon some prognosticator prognosticating that defined contribution is on the way.

"In fact, the concept is not new," says Amy Kroninger, the national marketing director for health care at KPMG, and another expert who feels that defined contribution will occur. "There's been discussion about it for 20, maybe 30 years."

It's when this is pointed out — that defined contribution has been imminent for years now — that Gates's quote is trotted out. Oh, we're told, defined contribution is definitely going to happen. Maybe not as quickly as some think, but it's coming. Definitely. Bet the house.

Because this article is contrarian, we feel compelled to trot out another quote, this one being a state motto often quoted by Harry Truman: "Show me."

Despite all the hoopla, defined contribution's promise is only slightly more in focus than it was in 1998, the last time Managed Care did a cover story on the subject. Peter R. Kongstvedt, M.D., with Ernst & Young, recently took a swipe at all the oversell, saying in an article that any growth in defined contribution has been "confined to the small-group market. As employer groups get larger, you see less of it."

At this point, it is perhaps prudent to assert: Some of our best friends (including, but certainly not limited to, Kroninger, Kongstvedt, and every other source contacted for this article) are experts. Our magazine wouldn't be able to survive without the generous contributions of such folk.

That said, it should also be pointed out that even experts are getting a little fed up with the herd instinct. As one of our sources, who did not wish to be identified, put it: "I don't like badmouthing consultants because I'm a consultant, but that [making predictions] is the kind of thing consultants do." (Don't just sit there, say something!)

Kongstvedt put it more bluntly, writing that "All pundits are wrong unless it is by chance...."

Defining the term

It is difficult to be incorrect when predicting the advent of defined contributions, if a definition of that system remains murky.

"I think in some respects defined contribution in health care is here today with large employers who are offering a menu of plans through flexible benefits," says Brad Fluegel, a principal at Tillinghast-Towers Perrin.

What happens when defined contribution is described as a system in which an employer gives a voucher or other stipend to an employee and tells him to go buy health care? In other words, what if we're talking about "pure" defined contribution? Suddenly, the prognosis becomes less rosy.

"There is an enormous amount of other things that would have to happen first," admits Fluegel. "We do not have an individual health insurance market right now, so that would have to change."

In one of their hits, Simon and Garfunkel sang that a "man hears what he wants to hear, and disregards the rest." That, we suspect, may be fueling some of the rush to anoint defined contribution as the next big thing. It needs also to be reminded that anyone who is quoted for any article is quoted out of context, unless you happen to be reading a court transcript.

Some we spoke to were four square in their assessments that defined contribution is on the way. We, however, heard what we wanted to hear and quote some of the interesting caveats that bolster this article's argument.

For instance, Robert Coburn, M.B.A., a principal at William M. Mercer, is one who thinks that defined contribution will "absolutely happen."

"The barriers are overwhelming, and it will happen anyway," he says. He then launches into an anecdote about a CEO of a Fortune 50 company, which he declined to identify, who 18 months ago met with the company's human resources chief.

"He said, 'We're not in the health care business,'" recalls Coburn. "'We never were, we never wanted to be, and we never will be. This is not a health care company. We don't understand it. We cannot control health care costs. You come to me every year and say it's 12 percent, or 15 percent, or 18 percent — or whatever it is and you have no control over it. This company doesn't do anything that we can't control the cost of. We put this in as a benefit for our employees and they hate us for it. They hate the plans. They hate the choice. They hate the quality. They hate the service. They hate the cost. They hate everything about it. Get rid of our health plan. I'm putting it in as your personal goal to abolish our health care plan.'"

Coburn adds: "That is the reason it will happen."

He claims that discussions about this issue are occurring at a "huge number" of Fortune 1000 companies.

Still, the Fortune 50 company he cites hasn't changed its benefits structure. Why?

Unequal access

"Start with the equity issue," Coburn says. "How much do we give to whom? Do single people get the same stipend that married employees do? How about young versus old? How about male versus female? How about hourly versus salary? How about healthy employees versus sick employees? That's the most difficult one of all. People who are healthy and who go to the doctor once a year versus people who are not healthy and generate a cost of several thousand dollars per month. Those are the most difficult problems. How do you protect them? How do you make this equitable?

"The difficulty is that we don't know how to do either of those two things," Coburn admits. "We don't know how to make it equitable for the sickest people. It's just too expensive for them."

Thanks to the current tax structure, it costs more for you or me to buy health care individually than it does for companies to buy it for us.

"The most significant barrier for a model that sends employees out into the individual insurance market — from an employee's standpoint — is a tax writeoff," says Kroninger. "It's going to cost me more than it costs my company, particularly in an after-tax situation. It also puts you at the mercy of the current marketplace, which is not designed at all for an individual. It's designed for a group rate and risk pooling. Those are beneficial when you're buying in bulk, if you will."

Take away the tax barriers and what have you? For many employees, a non-navigable maze.

"I don't know if you've tried to buy health insurance on the open market," says Fluegel, "but it's not a pleasing experience. Even if you're in a well-regulated state, like New York, a lot of it is very complicated. The ratings schemes are just very difficult to understand. Coverage is difficult to understand. When you're out there trying to make those kinds of decisions and you have to deal with a carrier on any kind of issue, you're really at a substantial disadvantage as an individual."

Those who believe that citizens should be able to buy health insurance as they would buy car insurance voice an argument that's too shallow: Because it is voluntary, fewer would buy health insurance, making outcomes decline.

"There's a mandate for car insurance," points out Paul Fronstin, a health insurance specialist with the Employee Benefit Research Institute. No such mandate exists for health insurance. "As long as it's voluntary, it is not going to operate very well on an individual basis."

He points to Republican Rep. Bill Thomas of California, chairman of the Ways and Means Committee. Thomas has been "tearing apart" employer-based coverage for years, he says. "Even he's said we need to talk about individual mandates, because that's the only way it would work."

Pension plan analogy

Most experts contacted agreed that one of the main reasons the idea of switching health care from a defined-benefit to a defined-contribution system has become such a hot topic is because such a switch is said to have worked well with pensions.

However, Fluegel warns that purchasing a health product is "a whole lot more complicated" than purchasing a pension plan. "Most people in 401K programs are investing in broad-based mutual funds that are preselected by their employers."

Mark W. Tierney, executive chairman and cofounder of a company called Ebenx, agrees that the pension analogy doesn't work. (An aside. When a call for experts to talk about defined contribution went out, many executives of companies that spell their names in, shall we say, unique ways [Ebenx prefers eBenX] answered. Most claim to have "solutions," a word that has come to be frowned upon by editors who hope to dodge the marketing. That said, Tierney proved to be a great help.)

"The elements required for it to parallel defined contributions on the pension side are missing in health in very substantial pieces," Tierney says. "In the pension world, it was 'We'll pay you 60 percent of your last three years' salary for the rest of your life.' That was kind of a defined benefit, right? And it was the corporation's responsibility to make sure it had enough money in the bank to be able to do that. Then, corporations found opportunities in the tax law that allowed them to shift to saying, 'We're not going to do that anymore. We're just going to give you so much money per month, while you are employed, and you take responsibility to make sure you've got some kind of a pension out there when you retire. Good luck.'"

So far, this has worked well for most people.

"The uniqueness of that program is that our employers can give all of us a certain amount of money and we can all go out and buy IBM stock for the same price," says Tierney. "But, in health care, if it's a risk-based purchase, you know health plans look at individuals as having different risks. We can't all go out and buy Kaiser for the same price. So, how do you get the employer's money out to employees in a way that recognizes their comparative risk in the marketplace and they can all buy?"

Fronstin, the health insurance specialist, agrees that risk-adjusting isn't easy.

"We don't have perfect risk-adjusters out there," he says. "If we were risk-adjusting the employer contribution based on health status, then you need to reevaluate that adjustment yearly, instead of making a one-time adjustment."

Who needs it?

Adverse selection would also become an issue.

"How do insurers realize a good pool and not just get those who need health insurance the most?" Fronstin asks. "It hasn't been addressed at all. It kind of gets addressed through a voucher — because if you don't spend the money on insurance, you can't spend it on anything else. But what if you're not given enough money in the voucher to buy insurance?"

Despite the assertions of Coburn, the William M. Mercer principal who believes defined contribution will "absolutely happen," the nagging question remains: Why would employers want to change?

Kroninger insists that the large employers KPMG surveyed do not simply want to walk away from current obligations. They might, however, be tempted to do just that, thanks to liability issues that could conceivably make companies responsible for medical mistakes.

That's assuming, of course, that those employers who deal with organized labor have the contractual ability to walk away. Unions like the employer-based benefits system, points out Marilyn Park, a senior health policy analyst with the nearly 13-million member AFL-CIO.

"The employer-based system works well for us, and it works well for the entire work force," she says. "It works, and we're always looking for ways to fill even more of the gap. It's a vehicle that should and can fill the gaps that are there. It's absurd to think that people are going to do as well in the market when they don't have the power of group purchasing. It's ridiculous."

Even in the unlikely event of labor softening this stance, defined contribution still wouldn't offer employers legal protection against liability, says Fronstin. "The way I understand ERISA — and obviously courts are the ultimate authority — is that as long as the employer is paying the insurance company, and that's still going to be true with a voucher, it's still considered an employment-based health plan and it's still subject to oversight by ERISA."

In any case, employers may take their chances with liability in such a tight labor market.

"With a full-employment economy, the last thing employers want to do is take away something that their employees want," says Kroninger. "What the Fortune 1000 employers are saying is that they don't want to take this away from their employees, but they want to make sure that their employees stop coming up to their offices and telling them how terrible their health care options are."

This sort of pressure — the kind of pressure that, some would argue, goes on all the time in every industry over a host of issues — guarantees change. It doesn't guarantee change to defined contribution, however.

"It comes down to: How do you find a one-size-fits-all for something as individual as health care?" Kroninger says. "After I've given my employees this money as a pretax benefit, why would I want to now tell them, 'You're on your own — and I'm not even going to provide you any decision support about the plan?' Why would an employer want to do that?"

Good question.

Sales of medical savings accounts well below what had been expected

Often, consideration of the merits of a defined-contribution system includes a discussion of medical savings accounts.

Robert A. Connor, Ph.D., M.H.A., published an article in Managed Care last November in which he described an MSA as a "personal account funded by tax-exempt contributions with which an individual (employee) pays itemized health care bills, and from which a surplus at the end of the year can be used to pay health care bills in future years or withdrawn for other purposes after payment of taxes and a fee."

MSAs would fit in nicely with a defined-contribution system. As Connor's article stated, "Pressure continues for employers to adopt defined contribution health benefits with some type of individual health benefit account." The only problem is that there's scant evidence that people would take to MSAs.

Connor's article mentioned a government pilot for MSAs that was expected to be discontinued by the end of last year but which was, in fact, salvaged after Connor's article had been published. (The test was authorized under the Health Insurance Portability and Accountability Act of 1996.)

As this magazine reported in October 1998, that pilot was not going well. The U.S. General Accounting Office reported that sales were lower than expected. Sales of the MSA accounts were at 22,051 between January and June 1997, well below the HIPAA cap of 525,000.

A GAO report attributed the dearth in sales to several factors. For instance, insurance brokers needed more training to sell the plans because of the added complexity of the tax effects of the MSAs.

Whatever was wrong does not seem to have been corrected. As of the fall of 1999, the pilot had about 50,000 MSA holders, well below the caps of 600,000 in 1999 and 750,000 in 2000.

Comparing employers', employees' views on defined contributions

For a defined-contribution system to work, both employers and employees must be receptive. In the fall of 1999, two independent market research companies under the auspices of KPMG surveyed 103 senior executives at Fortune 1000 companies, and 14,626 employees who work for them, to test receptiveness to the concept.

The survey was conducted in cooperation with Regina Herzlinger, Ph.D., of the Harvard Business School, and one of the foremost proponents of a defined-contribution system.

The Fortune 1000 companies were chosen because, the survey's authors state, "as leaders in the nation's economy, these were viewed as the most promising candidates for being 'early adapters' of the new concept."

While 46 percent of senior executives contacted were "receptive" to the idea; 31 percent were "unreceptive"; and another 11 percent were undecided. Both the receptive and unreceptive groups admitted that any interest in defined contributions was sparked by attention to two old standbys — cost and choice.

Employers hope that defined contribution would offer better choice, cost...

Perceived advantages of defined contribution*

*Total exceeds 100 percent due to multiple responses to a question....and add that tax laws would have to change.

A changeover to defined contribution could come only if — and this is a huge "if" — senior executives believed that there would be no effect on their or their employees' tax situation. "Under the current system of defined benefits, the employer's contribution to health insurance coverage is tax deductible," the survey stated. "Totaling about $100 billion annually, this tax break represents the third-largest federal expenditure behind Social Security and Medicare."

...but are aware of barriers...

Whether employers were receptive or unreceptive to the defined-contribution concept also influenced what they saw as barriers to implementing such a system. Those barriers, whether real or perceived, were daunting for both sides.

SOURCE: A NEW DIRECTION FOR EMPLOYER-BASED HEALTH BENEFITS, KPMG, 2000

Don't show them the money!

Despite recent signs of an economic slowdown, this is still a tight labor market. Employers are not likely to switch to a defined-contribution system unless they're sure that their employees would back such a move.

A survey by the nonpartisan, not-for-profit Employee Benefit Research Institute indicates that employees like things just fine the way they are. The survey, conducted by phone in February and March 1999, asked 1,004 workers what they thought about the push to put more of the purchasing power in their hands.

Employees now prefer:

The study's authors said that even "if the existing tax exclusion for employment-based health insurance was removed, there is still strong support for the employment-based system...."

If health care benefits were taxable, employees say they'd prefer:

SOURCE: 1999 HEALTH INSURANCE PREFERENCE SURVEY, EMPLOYEE BENEFIT RESEARCH INSTITUTE