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20.4: The Flexibility Issue, Cafeteria Plans, and Flexible Spending Accounts

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    • Anonymous
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    Learning Objectives

    In this section we elaborate on the flexible features of employee benefits, including the following:

    • How flexible benefits allow employees to have choices
    • The major components of cafeteria plans
    • The tax incentives of premium conversion plans
    • Savings made possible by flexible spending accounts (FSAs)

    The Flexibility Issue

    Employers have been interested in flexible benefit plans since the early 1970s. These plans give the employee the ability to choose from among an array of benefits or cash and benefits. Few flexible plans were adopted until tax issues were clarified in 1984. At that time, it became clear that employees could choose between taxable cash income and nontaxable benefits without adversely affecting the favorable tax status of a benefit plan. These are the cafeteria plans and flexible spending account (FSA) rules. Rules regarding these plans have continued to change, resulting in some employer hesitancy to adopt them. Despite the uncertain legislative environment, flexible plans became very popular in the mid-1980s, particularly among large employers. Employers are attracted to flexible benefit plans because, relative to traditional designs, they do the following:

    • Increase employee awareness of the cost and value of benefit plans
    • Meet diverse employee economic security needs
    • Help control total employer costs for the benefit plan
    • Improve employee morale and job satisfaction

    How flexible benefit plans accomplish these goals will become clear through discussion of cafeteria plans and flexible spending accounts.

    Cafeteria Plans

    Flexible benefit plans are frequently called cafeteria plans because they allow selection of the types and amounts of desired benefits. A cafeteria plan usually involves five elements: flexible benefit credits, minimum levels of certain benefits, optional benefits, cash credits, and tax deferral.

    In a cafeteria plan, the employer generally allows each employee to spend a specified number of flexible credits, usually expressed in dollar amounts. The options in a cafeteria plan have to include a choice whether or not to take cash in lieu of benefits. The cash element is necessary in order for the plan to be considered a cafeteria plan for tax purposes. There may be a core plus cafeteria plan where basic benefits are required, such as $50,000 death benefits in a group life insurance and basic group long-term disability. The employee then has a choice among a few health plans, more disability coverage, dental coverage, and more. The additions are paid with the flexible credits. If there are not enough credits, the employee can pay the additional cost through payroll deduction on a pretax basis using a premium conversion plan. Usually, employees pay for dependents’ health care on a pretax basis using the premium conversion plan.

    Another cafeteria plan may be the modular cafeteria plan. This type of cafeteria plan includes a few packages available to the employees to choose from. It is less flexible than the core plus plan and requires less administrative cost. The number of credits assigned each year may vary with employee salary, length of service, and age. Cafeteria plans are included under Section 125 of the Internal Revenue Code. Qualified benefits in a cafeteria plan are any welfare benefits excluded from taxation under the Internal Revenue Code. The flexible spending account (explained later) is also part of a cafeteria plan. Long-term care is not included, while a 401(k) plan is included.

    Benefit election must be made prior to the beginning of the plan year and cannot be changed during the plan year unless allowed by the plan; they can be changed because of changes in the following:

    1. Legal marital status
    2. Number of dependents
    3. Employment status
    4. Work schedule
    5. Dependent status under a health plan for unmarried dependents
    6. Residence or worksite of the employee, spouse, or dependent

    The employer may restrict employee benefit choice to some degree because the employer has a vested interest in making sure that some minimal level of economic security is provided to employees. For example, the organization might be embarrassed if the employee did not elect health coverage and was subsequently unable to pay a large hospital bill. Most flexible benefit plans specify a minimum level of certain benefits judged to be essential, such as those in a core plus plan. For example, a core of medical, death, and disability benefits may be specified for all employees. The employee can elect to opt out of a core benefit by supplying written evidence that similar benefits are available from another source, such as the spouse’s employer or the military retirement system.

    Cafeteria plans also help control employer benefit costs. Employers set a dollar amount on benefit expenditures per employee, and employees choose within that framework. This maximizes employee appreciation because employees choose what they want, and it minimizes employer cost because employers do not have to increase coverage for all employees in order to satisfy the needs of certain workers.

    Cafeteria plans have been especially effective in controlling group medical expense insurance costs. Employees often are offered several alternative medical plans, including health maintenance organizations (HMOs) and preferred provider organizations (PPOs), plans designed to control costs (discussed in "22: Employment and Individual Health Risk Management"). In addition, employees may be charged lower prices for traditional plans with more cost containment features. For example, a comprehensive medical insurance plan may have an option with a $100 deductible, 90 percent coinsurance, a $1,000 out-of-pocket or stop-loss provision, and a $1 million maximum benefit. A lower-priced comprehensive plan may offer the same maximum benefit with a $2,000 deductible, 80 percent coinsurance, and a $4,000 stop-loss provision. The employee uses fewer benefit credits to get the lower option plan, and the cost-sharing requirements likely reduce claim costs, too. Likewise, long-term disability insurance choices attach lower prices per $100 of monthly benefit with an option that insures 50 percent of income rather than 60 or 70 percent. Here again, lower prices attract employees to options with more cost sharing, and the cost sharing helps contain claims.

    Cafeteria plans are well suited to meet the needs of a demographically diverse work force. The number of women, single heads of households, and dual-career couples in the work force (as discussed in "17: Life Cycle Financial Risks") has given rise to the need for different benefit options. A single employee with no dependents may prefer fewer benefits and more cash income. Someone covered by medical benefits through a spouse’s employer may prefer to use benefit dollars on more generous disability coverage. An older worker with grown children may prefer more generous medical benefits and fewer life insurance benefits. Clearly, economic security needs vary, and job satisfaction and morale may improve by giving employees some voice in how benefits, a significant percentage of total compensation, are spent.

    However, both higher administrative costs and adverse selection discourage employers from implementing cafeteria plans. Record keeping increases significantly when benefit packages vary for each employee. Computers help, but they do not eliminate the administrative cost factor. Communication with employees is both more important and more complicated because employees are selecting their own benefits and all choices must be thoroughly explained. Employers are careful to explain but not to advise about benefit choices because then the employer would be liable for any adverse effect of benefit selection on the employee.

    Cafeteria plans may have some adverse selection effects because an employee selects benefits that he or she is more likely to need. Those with eye problems, for example, are more likely to choose vision care benefits, while other employees may skip vision care and select dental care to cover orthodontia. The result is higher claims per employee selecting each benefit. Adverse selection can be reduced by plan design and pricing. The employer may require, for example, that employees who select vision care must also choose dental care, thus bringing more healthy people into both plans. Pricing helps by setting each benefit’s unit price high enough to cover the true average claim cost per employee or dependent, while trying to avoid excessive pricing that would discourage the enrollment of healthy employees.

    Flexible Spending Accounts

    Flexible spending accounts (FSAs) allow employees to pay for specified benefits (which are defined by law) with before-tax dollars. In the absence of a flexible spending account, the employee would have purchased the same services with after-tax dollars. An FSA can either add flexibility to a cafeteria plan or can accompany traditional benefit plans with little other employee choice. The employer may fund the FSA exclusively, the employee may fund the account through a salary reduction agreement, or both may contribute to the FSA.

    The employee decides at the beginning of each year how much money to personally contribute to the FSA, and then he or she signs a salary reduction agreement for this amount. The legal document establishing the employer’s program of flexible spending accounts specifies how funds can be spent, subject to the constraints of Section 125 in the Internal Revenue Code. For example, the simplest kind of FSA is funded solely by an employee salary reduction agreement and covers only employee contributions to a group medical insurance plan. The salary reduction agreement transforms the employee contribution from after-tax dollars to before-tax dollars, often a significant savings. A more comprehensive FSA, for example, may allow the employee to cover medical premium contributions, uninsured medical expenses, child care, and legal expenses. Dependent care is a nice addition in the FSA. The catch with an FSA plan is that the employee forfeits to the employer any balance in the account at year-end. This results in flexible spending accounts primarily being used to prefund highly predictable expenses on a before-tax basis.

    Employees also pay their portion of the health premium in a premium conversion plan, which allows the funds to be collected on a pretax basis. These are usually the premiums for dependents.

    Key Takeaways

    In this section you studied the following ways that employee benefit plans can give flexibility to diverse employee groups at low cost to employers:

    • Flexible benefit programs like cafeteria plans and flexible spending accounts allow the employee to choose from among an array of benefits or cash and benefits.
    • Flexible benefit plans allow employers to retain the tax advantages of group coverage, give employees more choice, increase employee awareness and morale, and control costs.
    • Cafeteria plans allow employees to spend flex credits on a selection of types of benefits at desired amounts.
    • Cafeteria plans must have an option for cash in lieu of benefits.
    • Some basic types of coverage (such as choice of death benefits, health plans, disability, dental, etc.) may be required in cafeteria plans.
    • Employees can purchase additional coverage on a pretax basis under a premium conversion plan after exhausting flexible credits.
    • Flexible spending accounts (FSAs) allow employees to pay for eligible out-of-pocket health care costs with before-tax dollars.
    • FSAs may be part of a cafeteria plan selection or they can accompany traditional nonflexible benefit plans.
    • Funds (from the employer or employee) must be contributed to an FSA at the beginning of the year and exhausted by year-end (use it or lose it).

    Discussion Questions

    1. Cafeteria plans have become increasingly popular. What factors contributed to the increased use of these plans?
    2. How might a flexible benefit plan achieve desirable goals for your employer as well as for you?
    3. Create examples of core plus and modular cafeteria plans that include many benefits and cash.
    4. Under what circumstances can employees change flexible benefit elections during the year?
    5. In what ways are costs controlled by allowing employees more choice among benefits?
    6. How can adverse selection be combated in benefit selection?
    7. How are FSAs funded? What are the limitations of FSAs?

    This page titled 20.4: The Flexibility Issue, Cafeteria Plans, and Flexible Spending Accounts is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by Anonymous.