The Defined Contribution Revolution

Published March 1, 2001

An idea that has greatly benefitted over 55 million Americans holding 401(k) retirement plans may also be the best idea for making health insurance more available and affordable. That idea is “defined contributions.”

Prominent industry analysts view the emergence of defined contribution (DC) health plans as the next stage of evolution in health insurance in the U.S. Chicago-based management consultants from Booz-Allen & Hamilton say “a large-scale conversion of employer-sponsored health plans to defined contribution formats is inevitable.” The firm predicts a substantial nationwide movement to DC health plans in three to five years.

A report issued last summer by U.S. Bancorp Piper Jaffray describes the movement as a fundamental change in the health care market. The authors contend that DC health plans will “propel the health care world from the Neolithic, fragmented sector it is today into a twenty-first century competitive environment.”

The Need for Change

Analysts consider the change inevitable because immense market forces are at play in the health care field. Product choice is limited in today’s health care market because three out of every four people have insurance provided by either their employer or the government. As a result, health care costs have escalated, because the consumers of health care are not the payers of health care. That is, employees ask the health benefits question, “What do I get?” instead of “What do I get for my money?”

Managed care plans that kept medical inflation in check through most of the last decade have run their course. Such cost-containment practices came at the expense of employee satisfaction and, many argue, quality of care. Political leaders from both major parties have called for a “patients’ bill of rights” that would bring greater regulation of, and recourse against, managed care administrators.

Employers are tired of their role as the middle-man in disputes between employees and insurance companies. That sentiment is paving the way for DC health programs with a more consumer-oriented alternative.

How Defined Contribution Works

Under a defined contributions approach to health care, employers would pay a fixed dollar amount on behalf of each employee for the employee’s choice of health insurance. The employee would select a policy that costs less than the amount of the employer’s contribution, or would add personal funds to the employer’s in order to purchase a more expensive plan.

The basic idea, then, is to have employees choose insurance policies much like they would the mutual fund in their 401(k) retirement accounts. There are several variations on the theme, beginning with the simple scenario in which employees buy their own individual policies. Employers would play no role other than contributing premium support to the employee’s choice of coverage. This gives pure portability of the benefit to employees who may change jobs; they simply continue the same insurance policy using a new employer’s contribution.

Alternatively, employers may retain a greater role in the matter. The DC approach is likely to evolve over time, beginning with employer-sponsored DC health variations that will gradually introduce consumers to the purer DC model. Employers will still find advantages to pre-qualifying insurance plan options or using their size to negotiate better rates, so they’ll not immediately shed the group purchasing paradigm under which health care operates today.

“We believe the new model could have many forms,” USB-Piper Jaffray explains. “However, all these forms will center on individuals selecting, managing, and ultimately being accountable for their own options/health—in effect defining their own risk programs.”

Specific mechanisms for implementing DC insurance options include open and competitive health purchasing cooperatives, modified cafeteria plans, medical savings accounts, and special health trust arrangements. Each offers a different degree of consumer selection and competition. The approaches can often be combined as hybrid insurance products.

Obstacles on the Road Ahead

The road ahead for DC health plans is not entirely free of obstacles. In fact, a wide variety of DC insurance ideas are emerging precisely because companies must look for creative ways around legal and regulatory obstacles.

A major consideration is tax policy. The current market for individually owned health insurance policies is relatively expensive, but employees would be hit with even greater sticker shock without the pre-tax advantage of the benefit. According to the Lewin Group, people receiving employer-based health insurance last year received a tax savings of $141 billion—40 percent of the cost of coverage. Insurance strategies must be designed to avoid “constructive receipt” by employees of their employers’ health contribution dollars.

Two federal regulatory obstacles, the Employee Retirement Income Security Act and the Health Insurance Portability and Accountability Act, also stand in the way of DC options.

The ERISA obligations on DC health plans—plan disclosure, and reporting and fiduciary responsibilities—are relatively minor. HIPAA, on the other hand, goes much farther. It precludes employee ownership of “nongroup” policies if the benefit is to retain its tax advantage. Hence, it effectively locks in the employer as the purchaser of health benefits and the decider of coverages.

But where there is a will, there’s a way. While federal and state legislation could greatly facilitate the move to DC health, innovative companies that see the merit of consumer-owned health insurance are finding ways to implement it today, without relying on the goodwill of lawmakers.

Some firms—including Honeywell, IBM, Carlson Companies, Xerox, and Ingersoll-Rand—have taken it upon themselves to evaluate or implement DC health options. Others are developing DC health insurance products to sell on the open market. Three Minnesota-based companies—Definity Health , eBenX and Vivius—are among the leaders in this field, joined by others around the country, including Healthmarket (Connecticut), HealthSync (Ohio), Lumenos (Virginia), Myhealthbank (Oregon), and Sageo (Illinois).

Although the idea is just beginning to take hold, hundreds of millions of dollars in venture capital have already been invested in these DC marketing efforts. Its future is being driven by market fundamentals that bureaucratic alternatives can no longer afford to ignore. Consumerism of this magnitude created the 401(k) retirement revolution, and it will do so again for health care.

Bob L. Corkins is president of the Kansas Public Policy Institute, a nonpartisan, nonprofit, free-market research organization based in Topeka, Kansas.