Why Employer-Based Health Insurance Is Unraveling

Published November 1, 2005

In a September 13 statement, the CEO of Starbucks Corp. announced his company will spend more on health insurance for its employees this year than on coffee beans.

Howard Schultz, meeting with Sen. Patty Murray (D-WA) and Rep. Adam Smith (D-WA) and other Seattle business leaders, said his firm provides health care coverage to Starbucks employees who work at least 20 hours a week.

Schultz is not alone in his concern about employee health care costs. General Motors spends more on health insurance than on steel. For GM, the cost amounts to $1,525 per car produced.

However, it is misleading to compare the $200 million Starbucks spends on its 80,000 U.S. employees, or the $5.6 billion GM expects to spend on its 1.1 million workers and retirees this year, to the cost of a cup of coffee or an automobile.

Health Insurance Is Compensation

Health coverage is not a direct input into the production of either coffee or cars. Coffee beans and steel are direct inputs, as is labor. Health coverage is simply a form of noncash compensation for the labor input.

According to Michael Cannon, director of health policy at the Cato Institute, “an employee health plan is merely a way to pay for a portion of the labor provided by workers. The problem is that employers have agreed to compensate workers in part by giving them health care, the cost of which keeps increasing.”

Responding to the fact that Starbucks’ health coverage costs have increased at double-digit rates during the past four years, Schultz told the Associated Press, “It’s completely non-sustainable.”

Some industry experts argue the high prices will force employers to change the way they calculate compensation. According to compensation and benefits expert Richard A. Matthews of the Michigan-based firm Desjardins Matthews & Company, “when insurance costs were 2 percent of payroll no one cared. Now that they approach 33 percent for family coverage everyone cares. Driven by the huge annual increases in the cost of health insurance premiums, I believe it is inevitable that all employers, including Starbucks, will go to some form of ‘total compensation.'”

Automaker’s Decision Backfired

The exorbitant amount GM pays to cover its workers, their families, and retirees has little to do with building cars. GM made the decision decades ago to offer generous health coverage and deferred benefits (such as retiree health care) in lieu of higher cash wages. That made sense at the time because health coverage was relatively inexpensive and the liability created by deferring compensation in this way did not have to be charged against revenue until it occurred. The bill for that decision was not likely to come due for decades.

By deferring the cost of compensation to future years, GM gambled that its market share and profitability would not significantly change. But it did. Competition from Europe and Asia reduced the funds GM has available to pay medical bills that have now come due.

The company also gambled that the cost of health benefits would not rise significantly. But as technology evolved and third-party payment for medical care became common, the prices for health services rose at three times the rate of inflation. GM’s gamble, combined with a health benefit package lacking the incentive for workers and retirees to be wise consumers of health care, proved to be a very poor bet.

In retrospect, the business decision to defer compensation in order to reduce short-term labor costs threatens to bankrupt the automaker. If costs continue to increase at recent double-digit rates, eventually all of GM’s assets will be required to pay for health care commitments made long ago.

Starbucks’ Benefits Unusually High

The situation Starbucks faces is different from GM’s.

Starbucks is a service business dishing out expensive cups of coffee and related goods. The value of coffee beans that Starbucks roasts for retail sale pales in comparison to the revenue raised from selling cups of espresso and café latté. Starbucks pays about $2,500 for health coverage for each U.S. employee, including part-timers, and about two-thirds of its employees are part-time workers.

According to the Bureau of Labor Statistics (BLS), total hourly compensation in the service industry averages $12.09 per hour–$9.17 in (cash) wages and the remainder in fringe benefits (some of which are mandatory). Average spending on health insurance per hour in the service industry is $0.72, or about 6 percent of total employee compensation. At this rate the average cost of health coverage in the service industry is $1,500 per full-time employee.

If we assume Starbucks baristas (servers) receive a similar base pay for entry-level positions, it appears health benefits are a much larger proportion of Starbucks employees’ compensation than the industry norm.

Insurance Isn’t Raising Costs

What firms pay workers, of course, is a function of labor market conditions–the supply of eligible workers and the demand for their services. The optimal proportion of a worker’s pay that is received in the form of noncash benefits depends on the individual worker’s preference. The reason the average service industry firm spends less on health coverage than Starbucks does is because few part-time workers earning $10 per hour feel they can afford to forgo $2,500 in wages per year for health benefits.

Starbucks provides lavish health benefits to encourage employee retention and productivity. Schultz thinks that strategy is successful. Labor economists, however, note that providing workers with a fringe benefit they would not purchase on their own is not an efficient form of compensation. If workers prefer a dollar of cash to a dollar of health coverage, an employer is better served to give the dollar of cash.

If done correctly, the amount Starbucks pays for health coverage should not increase its cost of employing workers, and it therefore should not affect the cost of its coffee. It is merely an aspect of the company’s business model and reflects how its workers choose to be paid. If the cost of health coverage has raised Starbucks’ cost of keeping workers, as Schultz appears to be suggesting, it means Starbucks has misjudged its workers’ preferences and is wasting money.

Here’s a solution both Starbucks and its employees might agree on. According to Robert Hopper, a California insurance agent and author of a forthcoming book on health savings accounts, “instead of paying additional premiums to the insurance company for low deductibles, and copays for office visits and prescription drugs, employers can deposit that cash tax-free in a health savings account. That’s fiscally responsible, since most employees will prefer cash instead of copays they rarely use.”

Devon Herrick ([email protected]) is a senior health fellow at the National Center for Policy Analysis.