Analyze Benefits Presently Available

The next step in the functional approach is to analyze the benefits, terms of coverage, and plan participation by employees in terms of how well the existing or proposed employee benefit plan meets employee needs and goals in the various functional categories for those classes of persons the employer wants to protect or benefit. This step involves measuring the employee benefit plan against the objectives and coverage criteria set up for it under the functional approach just outlined.

Types of Benefits

A common application of the functional approach to employee benefit planning is to outline the different types of benefits under an employee benefit plan that apply to each of the categories of employee needs and goals. For example, employee needs, goals, and exposures to loss are shown on the left-hand margin of the grid, while the components of the corporation's employee benefit plan are shown across the top of the grid.

Levels of Benefits

In a similar fashion, the levels of benefits under the various components of the employee benefit plan can be determined or shown, or both, for each of the categories of needs or goals.

To supplement this analysis, it may be helpful to use benefit illustrations to determine or illustrate the levels of benefits that would be provided under the various components of the employee benefit plan or proposed plan in the event of certain contingencies and using certain assumptions. For example, it might be assumed an employee with certain earnings and using certain salary projections will retire at age 65 with 30 years of service with the employer. This employee's total retirement income then may be estimated from various components of the employer's employee benefit plan as well as from Social Security as of the assumed retirement date. This can be expressed as a percentage of the employee's estimated final pay, which often is referred to as the employee's retirement income "replacement ratio." The employee benefits used in such an analysis may include only the employer's pension plan and Social Security, but it would be more logical to include all potential sources of retirement income available through the employee benefit plan, such as a pension plan, profit-sharing plan, thrift or savings plan, supplemental executive retirement plans, and perhaps other kinds of plans or benefits intended primarily to provide capital accumulation or stock-purchase benefits. Naturally, assumptions must be made for a variety of factors if all these sources of retirement income are considered. Also, different assumptions as to employee earnings, year of retirement, final pay, years of service, and so forth may be used to test the adequacy of retirement income for employees.

The same kind of analysis can be made for disability benefits from all sources under the employee benefit plan. When the analysis of disability benefits is made, it may be found that excessive benefits will be paid under certain conditions and for certain durations of disability, while inadequate benefits will be paid under other conditions. Thus, better coordination of disability benefits may be called for in making recommendations for changes in the plan.

This approach also may prove fruitful for other employee loss exposures, such as death, medical expenses at various levels and under various conditions, long-term care (custodial care), and so forth. Finally, the adequacy of benefit levels can be tested for different categories of persons the employer may want to protect.

Another interesting kind of analysis in terms of benefit levels is to estimate the potential for capital accumulation available to employees under the components of an employee benefit plan designed primarily for this purpose. These may include, for example, profit-sharing plans, thrift or savings plans, stock-purchase plans, stock options, restricted stock, employee stock ownership plans (ESOPs), other stock-based performance plans, and so forth. Employees often are pleasantly surprised to learn how much capital can be accumulated under such plans over a period, even using relatively conservative investment assumptions.

In evaluating levels of benefits and benefit adequacy, consideration also may be given to optional benefits that may be available to employees under the employee benefit plan. Such options may involve the opportunity for employees to purchase coverage or additional levels of coverage beyond a basic level of benefits. Through such optional benefits, the employer in effect is giving employees the opportunity at a given cost to themselves to make their total benefits more adequate in certain specific areas. As an example, the life insurance plan allows eligible employees to purchase additional life insurance at favorable group rates up to three times their base pay over and above the employer-provided benefit of three times annual base pay (subject to certain individual underwriting requirements). Another such area of optional benefits exists when employers allow employees to purchase long-term care (LTC) insurance for themselves or specified dependents on an employee-pay-all group basis. At present, this generally is the way employers make LTC coverage available to their employees, if they do so at all.

Of course, an employer may extend the idea of optional benefits or employee choice-making even further by adopting a flexible benefits (cafeteria compensation) program as part of its employee benefit plan.

Probationary Periods

In assessing how well an existing employee benefit plan meets the needs and loss exposures of employees and certain other individuals, it also is helpful to analyze the probationary periods required for the various types of benefits contained in the plan. Such probationary periods, or the length of service otherwise eligible employees must have with the employer before they become eligible to participate in the various types of benefits, will have an effect on the plan's protection for employees, their dependents, and possibly others, as well as on plan costs for the employer. The longer the probationary period required, the greater the exposure of employees and others to a loss not covered by the plan. But, many employers believe only employees with certain minimum periods of service, and hence demonstrable connection with the employer, should be eligible for at least certain types of benefits.

Probationary periods by their nature create gaps in coverage for newly hired or newly eligible employees and their dependents. Thus, probationary periods should be analyzed as part of the functional approach to determine whether the resulting gaps in coverage are appropriate and consistent with the employer's objectives and the employees' needs.

It seems desirable that the use of probationary periods in an employee benefit plan should be based on a reasonably consistent employer philosophy. One possible philosophy in this regard is to divide employee benefits into "protection-oriented" benefits and "accumulation-oriented" benefits. Protection-oriented benefits would consist of medical expense benefits, life insurance benefits, short- and long-term disability benefits, and so forth. These benefits protect employees and their dependents against serious loss exposures which, if they were to occur, could spell immediate financial disaster for the employees or their dependents, or both. For such benefits, where the need/protection orientation is great, there might be no probationary period, or a relatively short one. The rationale for this would be that the need for immediate coverage would override the traditional reasons for using probationary periods or longer probationary periods.

Accumulation-oriented benefits, such as pension plans, profit-sharing plans, thrift plans, stock-bonus plans, stock-purchase plans, and so forth, could involve relatively long probationary periods if desired by the employer and could be subject to legal requirements. The theory might be that these kinds of benefits should be a reward for relatively long service with the employer. Also, an employee who stays with the employer would have a relatively long time in which to accumulate such benefits, and thus longer probationary periods would not really place the employee at any serious disadvantage or risk.

Of course, cost control may provide another rationale for longer probationary periods, depending on the employer's compensation philosophy.

Eligibility Requirements

Requirements for eligibility for benefits, including definitions of covered persons, obviously affect those who may benefit from or be protected by various employee benefits. In this area, for example, the employer, or the employer and the union or unions with whom the employer negotiates, should consider such issues as:

1.     Which dependents of active employees (and perhaps dependents of retired former employees, disabled employees, and deceased employees—see 2, 3, 4, and 5 below) should (or must) be covered for medical expense benefits?

2.     Should retirees (and perhaps their spouses and other dependents) continue to be covered, and if so, for what benefits?

3.     Should survivors of deceased active employees continue to be covered, and if so, for what benefits and for how long?

4.     Should survivors of retired former employees continue to be covered, and if so, for what benefits?

5.     Should employees or former employees on disability (and perhaps their dependents) continue to be covered, and if so, for what benefits, how long, and under what conditions?

6.     Should (or must) coverage be extended to employees during layoffs, leaves of absence, strikes, and other temporary interruptions of employment, and if so, for what benefits, how long, and under what conditions?

7.     Should coverage be limited only to full-time employees (or employees meeting ERISA requirements) or should coverage, or some coverage, be extended to part-time employees as well?

8.     What coverage should (or must) be continued or made available to persons (or for the dependents of such persons) after termination of employment with the employer and on what basis?

The resolution of some of these issues depends in part on statutory or other legal requirements, insurance company underwriting rules, collective bargaining agreements, and similar factors. However, the philosophy or rationale of the employer, or the employer and union, concerning the employee benefit program will have a substantial impact on how some of these coverage and eligibility issues are resolved. At the heart of many of these issues is the basic question of how far an employer (or union) should feel obligated to go, either legally or morally—or possibly can afford to go—in meeting the various needs and loss exposures of its employees, their dependents, and persons who once were employees or dependents of employees but who now have various other relationships or no relationship with the employer.

Employee Contribution Requirements

If certain employee benefits under an employer's employee benefit plan are contributory (i.e., the employees or possibly their surviving dependents must contribute to the cost of the benefit), this will have an impact on employee participation and hence on how well the plan meets the needs of the employee group as a whole. 

This really represents a trade-off: between the financing (cost) and other advantages of a contributory plan—and the loss of employee participation in the plan, which results from requiring employee contributions, assuming employee participation in the contributory plan is voluntary. Thus, an employer, and union if the plan is negotiated, may have to decide whether a particular employee benefit will be noncontributory or contributory, and, if it is to be contributory, how much the employees will have to contribute toward the cost of the plan.

Further, if the plan is contributory, the employer (or employer and union) will have to decide whether participation will be voluntary or mandatory as a condition of employment. Making a contributory plan mandatory solves the employee participation problem, but it may create serious employee relations and morale problems. Therefore, most employers do not have mandatory contributory plans. Still another possibility is for employers simply to make the coverage available to employees (usually on a more favorable basis than they could purchase it individually) on an employee-pay-all basis.

In the context of this cost/employee participation trade-off, one approach that can help planners strike an agreeable balance is to rank employee benefits in terms of the relative degree to which the employer feels that all employees and their dependents should be protected, and hence what benefits should the plan aim for 100 percent participation, compared with benefits for which such a high level of participation is not deemed essential. This same kind of analysis also might be helpful in determining the level of employee contribution if it is decided to have the plan be contributory. Another factor bearing on this decision is whether other benefits in the employer's overall plan also may be available to meet the same functional need. For example, employee benefit plans frequently contain a number of kinds of benefits intended to help provide retirement income for employees. Still another factor to consider is the extent to which employees or their dependents, or both, may have similar benefits available to them elsewhere. Those employees or dependents who have an alternative source of similar benefits may opt not to participate if the plan is made contributory, thereby helping to avoid duplication of benefits. An example of this is the availability of multiple plans of medical expense benefits when both a husband and wife are employed outside the home.

There is a tendency toward providing employees with alternative benefits or levels of benefits, with varying degrees of employee contributions (if any) required. In any event, as part of its benefit planning system, it will be helpful for an employer to make a benefit-by-benefit analysis, within the context of its total benefit and compensation philosophy, to evaluate the desirability of any employee (and possibly dependent) contributions to the cost of the various employee benefits or levels of benefits.

Of course, to the extent that voluntary salary reduction (normally before-tax) is part of a flexible benefits (cafeteria compensation) plan, the covered employees themselves really are making the decision as to the level of their contributions (through salary reduction) to pay for the benefits they select within the scope of the plan. To this degree, the decision-making regarding contributions into these plans is at least partly shifted to the covered employees, depending on the benefit options they select.

Flexibility Available to Employees

The degree to which employees have flexibility in making such choices as to whether they will participate in a given employee benefit; the amounts of additional coverage they may wish to purchase; the opportunity to select from among two or more alternative plans of benefits; and even the opportunity to structure their own benefit program, as under a flexible benefits (cafeteria compensation) approach, clearly has an impact on the extent to which employees may tailor an employee benefit plan to meet their own needs and goals within the functional categories described previously. In fact, it may be argued that the more flexibility employees have, the more likely it is that the benefit program they select will meet their individual needs and goals. It thus can be argued, on the one hand, that flexibility in employee benefit plan design should facilitate the goals of the functional approach to employee benefit planning. On the other hand, it also can be argued that allowing too much employee flexibility in choosing types and amounts of employee benefits may work against the functional approach, because employees may misperceive or not understand their and their families' needs and hence leave some important needs uncovered. This concern often is addressed by limiting the choices of employees or by specifying a core of benefits that are not subject to employee choice.

A distinct trend exists toward giving employees more flexibility in the structuring of their own benefits. As just discussed, this trend probably buttresses the functional approach, in that it may be presumed that rational employees will opt for those benefits and benefit amounts that will best meet their individual needs and goals.

Actual Employee Participation in Benefit Plans

It was noted previously that, under the functional approach, an employer may analyze the types of benefits provided to employees and their dependents according to the various functional categories. The employer also may estimate or project benefit levels for the benefits in the different categories under certain assumptions and given certain contingencies or events. However, these analyses and estimates of benefits and benefit levels may not completely show how well certain employee benefits actually reach a given employee group. Therefore, an employer also may want to calculate the actual participation ratios for its employees and their dependents for given employee benefits. These ratios can be calculated in terms of the employees (and their dependents) actually participating in the plan as a ratio of total full-time employees, as a ratio of total eligible employees, or both.

A given employee benefit plan may have many good features, and may even be quite liberal in some respects; but if the ratio of employee participation is low, the particular benefit may not be meeting the employer's objectives in terms of its total compensation system.

Of course, if a given employee benefit is noncontributory, and if its eligibility requirements are reasonably liberal, all the eligible employees will be covered and, probably, a reasonably high percentage of total employees also will be covered. However, when employee benefit plans are contributory, or are optional benefits under a flexible benefits plan, and/or eligibility requirements are tighter, participation ratios may drop significantly. When this is the case, an employer may wish to evaluate the reason(s) for the low participation and what steps, if any, it might take to increase participation in the particular plan or plans.