Why is LTC A Pressing Issue?

Long-term care is an important concern for several reasons:

• The demographics of the baby boom lead to projections of a population explosion in the higher age groups. In 2000, approximately 34 million Americans, 12.6 percent of the population, were older than age 65. By 2030, that age group will have grown to over 70 million, more than 20 percent of the population. Further, the population at greatest risk of needing LTC, those 85 years old and older, is expected to grow in number from 4.3 million in 2000 to between 8.9 and 10.1 million in 2030.
• Medical advances, ironically, have helped to convert many critical short-term health problems into long-term health problems. New techniques and technology save the lives of heart attack and stroke victims, premature babies, and many other people whose diseases or injuries would have been fatal in the past. Yet, while modern medicine prevents death, it often cannot restore health. Particularly for older people, life-saving medical treatment often is the threshold to months or years of custodial care. And even without a major health "event," some people's health and strength deteriorate slowly and steadily. Those who think the need for long-term care "won't happen to me" stand on shaky ground; for example, at age 65, there is a 40 percent probability of staying in a nursing home sometime before death. More will need some type of support at home.
• Changes in family structure have made it less likely that long-term care can be provided at home by the patient's family. Few people enjoy the built-in support system of a large, local extended family to provide help with occasional nonmedical affairs, such as financial paperwork, meal preparation, or transportation, much less physical care or 24-hour supervision. And now, women, who were the traditional informal caregivers, regularly work outside the home for pay. Women who work outside the home, some 59.5 percent of women age 16 and over in 2003, cannot necessarily be counted on to care for their ailing parents, in-laws or husbands. Even if family members and friends are able to provide LTC, there are other costs to consider such as personal stress, the need to reduce or terminate employment, and out-of-pocket expenses for travel, supplies and babysitting for other dependents.
• The high charges for LTC services are surprising, if not shocking. Long-term care costs vary considerably depending on location, and are beyond the means of many Americans. (See Table 1.)

  Table 13–1: Privately Paid LTC Costs in Selected U.S. Cities, Mid-2004

  	Annual Cost of Nursing Home Confinement (semi-private rooms)	Annual Cost of Five Four-Hour Home Health Aid Visits/Week (at average hourly rate)
  Atlanta, GA	$49,275	$17,680
  Chicago, IL	$45,260	$16,640
  Dallas/Fort Worth, TX	$39,785	$16,640
  Milwaukee, WI	$63,510	$22,880
  New York City, NY	$109,865	$15,600
  Philadelphia, PA	$76,650	$18,720
  Phoenix, AZ	$51,465	$19,760
  San Francisco, CA	$74,825	$21,840
  Seattle, WA	$69,715	$21,840
  Based on daily and hourly data from the MetLife Market Survey of Nursing Home and Home Care Costs, September 2004.

• Existing medical coverage is inadequate to pay for long-term care. Government and private medical insurance programs cover nursing home care and home health care, but generally for limited time periods or as a response to an acute medical problem. Such benefits generally are capped. For example, Medicare covers up to 100 days in a skilled nursing facility per "benefit period" (effectively a service interval involving an illness or injury requiring hospitalization) and in very restricted circumstances, and Medicaid is only available to individuals below certain income thresholds and those who have "spent down their assets." Other coverages such as long-term disability insurance and pension plans are typically not structured to pay the significant out-of-pocket costs associated with purchased LTC services. Since most insurance plans provide little or no coverage for LTC expenses while traditional sources of LTC caregiving are contracting, individuals and families are exposed to a potentially huge financial risk.
• Low public awareness about the risks and costs of long-term care has been an ongoing concern for policymakers and industry experts. Unless someone's family or friends have had to address a long-term care situation, he or she is unlikely to recognize the amount of physical and emotional attention required, may underestimate actual LTC charges, and may believe that Medicare, Medigap or other insurance policies will cover the full cost of long-term care. In the past, surveys found that about half the population had the misconception that traditional insurance products would cover this care although this is now changing.
• Government help is limited. The 2002 offering by the federal government of a private, participant-paid group LTC insurance (LTCI) plan for its workforce, retirees and their families sent the message that government would not provide broad, publicly financed LTCI for all citizens. And it is unlikely that this will change in the foreseeable future because of the high cost of such programs.

Since most people cannot save enough money to cover ongoing LTC costs, private LTC insurance may serve as the only realistic option for people to pay for personal care and certain health care services if and when they are needed. More Americans are recognizing this need—from 1987 through 2001, almost 8.3 million LTC insurance policies had been sold.^[7] And at the end of 2003, over six million persons retained LTC coverage, almost one-third of whom were in group (typically employer-sponsored) plans.

MANAGEMENT ISSUES IN DESIGN OF DISTRIBUTION PROVISIONS

Employee interests are best served by maximum flexibility in plan distribution provisions. However, plan designers may find it necessary to reduce this flexibility somewhat to meet the employer's management objectives.

First of all, flexibility increases administrative complexity and costs. In addition, flexibility can potentially cause cash-flow and liquidity problems to the plan fund. Finally, flexibility can create extremely complex federal income tax problems, due to the inordinately complex rules in this area. The rules are merely summarized, but the reader will undoubtedly note that even this summary is startlingly complicated. The complexity is probably due more to congressional inattention to this issue rather than to any clear policy rationale. Simplification is on the congressional agenda.

The complex distribution rules are management's problem as well as the participant's because employees often ask employers about the tax treatment of a plan distribution. An employer's wrong answer likely will subject the employer to liability to reimburse the employee for any excess tax payments that result. And management cannot simply "stonewall" on this issue by refusing to advise employees on tax treatment of distributions because employee resentment as well as legal liability may result that can negate the value of the plan as an employee incentive.

The planner's objective in designing plan distribution provisions is to provide employees with the maximum amount of distribution flexibility that is consistent with management's needs as outlined above. In a small business with limited personnel management resources, this may dictate only very limited distribution flexibility. For example, some smaller plans provide for distributions only in the form of a lump sum at retirement or termination of employment.

Normal Form of Benefit

A qualified plan must specify not only the amount of the benefit but the form of the benefit. In a defined-benefit plan, the normal form of benefit is the basic "defined benefit," the form that quantifies the benefit due and provides a standard for calculating equivalent alternative benefits. At one time, the normal form was the form a participant received if he or she did not choose an alternative form, but this is not necessarily true because of joint and survivor provisions.

The normal form in a defined-benefit plan is usually either a straight-life annuity or a life annuity with period certain. A straight-life annuity simply provides periodic (usually monthly) payments for the participant's life. A life annuity with period certain provides periodic payments for the participant's life, but additionally provides that if the participant dies before the end of a specified period of years, payments will be continued until the end of that period to the participant's designated beneficiary. Specified periods of 10, 15, and 20 years are commonly used.

In comparing defined-benefit plans, it must be remembered that straight-life and life annuities with periods certain are not equivalent; a plan providing an annuity of $100 per month for life with period certain as the normal form of benefit provides a significantly larger benefit than a plan providing $100 per month as a straight-life annuity. Period-certain annuities as the normal form of benefit are most commonly found in plans using insurance contracts for funding.

A pension plan must provide a qualified joint and survivor annuity for the participant and spouse automatically to a married participant (unless the participant elects otherwise). To avoid discrimination against single participants, most plans provide that the qualified joint and survivor annuity is "actuarially equivalent" to the normal form. For example, if the normal retirement benefit would be $1,000 per month as a straight-life annuity, the qualified joint and survivor annuity might be something like $800 per month to the participant for life, then $400 per month to the spouse for life. However, the plan can partially or fully subsidize the joint and survivor annuity; for example, it might provide a straight-life annuity of $1,000 per month or a $1,000/$500 joint and survivor annuity. This might be desirable to the employer even though it would discriminate against unmarried participants.

Defined-contribution pension plans can provide an annuity as the normal benefit form. This is particularly common if an insurance contract is used for funding. The amount of the annuity depends on the participant's account balance at retirement, with annuity purchase rates specified in the insurance contract, if any. Optional forms of benefit, particularly a lump sum, are usually provided in defined-contribution plans.

Optional Alternative Forms of Benefit

Participants generally benefit from having a choice of benefit forms as an alternative to the normal form. Participants can then choose a benefit that is structured in accordance with their individual financial needs, family situations, and retirement activities. In defined-benefit plans, the most common alternative forms (assuming a straight-life annuity as the normal form) are, in addition to the qualified joint and survivor annuity that must be offered, (1) joint and survivor annuities for the participant and spouse or other beneficiary, with varying survivorship annuity percentages such as 50 percent, 75 percent, and 100 percent, and (2) annuities for the participant and beneficiary, with varying periods certain, such as 5, 10, 15, or 20 years. The plan also can allow payouts over a fixed period of years without a life contingency. All these options are subject to the limitations described below.

To avoid undesirable or prohibited discrimination among employees in different situations, the plan should provide that any optional benefit is actuarially equivalent to the normal form of benefit. Under Code Section 401(a)(25), the actuarial assumptions used for this purpose must be specified in the plan, either by stating the actuarial interest and other factors or by specifying an equivalency table for the various benefits, to avoid employer discretion in favor of highly compensated employees.

Lump-Sum Option

A lump-sum distribution can provide planning flexibility for participants. Lump-sum distribution provisions are most common in defined-contribution plans; in fact, in a profit-sharing plan, the lump sum is often the only distribution option. However, even a defined-benefit plan can offer a lump-sum option. The Code provides in Section 417(e) that the lump sum must be at least that determined on the basis of interest and mortality factors specified in the Code.

Higher-income participants often would like a lump sum because they have other sources for retirement income and wish to invest their plan funds in riskier, high-return investment vehicles. A defined-contribution plan can be designed to accommodate this need to some extent within the plan, however, by providing participant investment direction. Also, investment results within the plan are enhanced by the tax deferral on plan income and may provide an effective rate of return that the participant cannot match outside of the plan. However, funds cannot be left in the plan indefinitely; distributions must generally begin at age 70½ or retirement, if later.

In some defined-benefit plans, particularly insured plans, the assumptions used for funding are too conservative. For example, a plan may have accumulated $140,000 to fund a benefit of $12,000 per year to a retiree. In many cases, however, it might be possible for a retiree to individually invest $140,000 and receive a better return than $12,000 per year for life. Thus, the retiree might rather have a $140,000 lump sum from the plan fund than the plan's annuity benefit. In some cases, this situation results from bad plan design, while in others it is done deliberately to increase the benefit for key employees. The Code limits the extent to which this can be done by prescribing minimum interest and mortality assumptions.

Distribution Restrictions

Plan distributions can be designed to provide considerable flexibility, but they must be designed within a rather complex network of rules that have been accumulating in the law over many years. These rules are aimed at protecting the financial interests of participants and, more significantly, they are designed to limit the use of qualified plans merely as a tax-sheltered investment medium for key employees. The significant rules are as follows:

• Distinctions between the types of distributions permitted in pension plans as opposed to profit-sharing plans

• Rules preventing employers from unjustly delaying benefit payments

• Minimum distribution requirements

• Early distribution penalties

• Incidental benefit requirements

• Nonalienation rules

Pension versus Profit-Sharing Plans

The IRS generally will not allow a pension plan to pay benefits prior to retirement, early retirement, death, or disability, although some limited cash-out provisions may be allowed in the event of termination of employment prior to these events, as previously discussed. With a profit-sharing plan, there is much more flexibility, and the plan may allow in-service distributions. However, the 10 percent penalty described below may deter employees from making certain withdrawals.

Delaying Benefit Payments

Under Code Section 401(a)(14), all qualified plans must provide for payment not later than the 60th day after the latest of the following three dates:

1. The earlier of age 65 or the plan's normal retirement date

2. The tenth anniversary of the participant's entry into the plan

3. The participant's termination of service with the employer

The plan may allow the participant to elect a payout that begins at a date later than this maximum limit. However, the extent to which a participant can stretch out payments is limited by the rules.

Minimum Distribution Rules

Congress does not like qualified plans to be used as tax shelters for funds that are not actually needed by participants for retirement income. Therefore, Code Section 401(a)(9) requires that plan distributions begin no later than April 1 of the calendar year following the later of the year in which the employee attains age 70½ or the year of actual retirement. If the employee owns more than 5 percent of the employer, deferral to the actual retirement date is not permitted.

Furthermore, the distribution must be either in a lump sum or a periodic distribution over a specified period. Basically, the distribution must be paid in substantially equal annual amounts over the life of the employee or the joint lives of the employee and a designated beneficiary. Alternatively, the distribution may be made over a stated period that does not exceed the life expectancy of the employee or the life expectancy of the employee and a designated beneficiary. This permits period-certain annuity payouts, as long as the period certain does not exceed the life expectancy limits. A periodic distribution based on an ongoing recalculation of life expectancy is permitted, which tends to stretch out payments somewhat because life expectancy is extended by continuing survival. However, life expectancy can be recalculated no more often than annually. Cost-of-living increases in pension payments to retirees are permitted as long as they are not designed to circumvent the minimum distribution rules.

The minimum distribution rules also have provisions applicable to distributions made to a beneficiary if the employee dies before the entire plan interest is distributed. If distributions to the employee have already begun, the remaining portion of the employee's interest must be distributed at least as rapidly as under the method in effect prior to death. For example, if the employee elected a 20-year period certain annuity and the employee died after ten years, the remaining interest could be distributed in equal annual installments over a term not exceeding ten years. The beneficiary could, however, elect to accelerate these payments.

If the employee dies before distributions have begun, the plan's death benefit must be distributed within five years after the employee's death, with an exception. The five-year restriction is not applicable if (1) any portion of the plan benefit is payable to a designated beneficiary, (2) the beneficiary's interest will be distributed over the life of the beneficiary or over a period not extending beyond the life expectancy of the beneficiary and (3) distributions begin no later than one year after the employee's death. If the designated beneficiary is the surviving spouse, the beginning of the distribution can be delayed to the date on which the employee would have attained age 70½.

Early Distribution Penalty

Code Section 72(t) provides a tax penalty for early distributions from qualified plans. This penalty provision was added by Congress to encourage plan participants to use qualified plans primarily for retirement and not merely for deferral of compensation. The 10 percent penalty tax applies to distributions from a broad range of tax-advantaged retirement plans. As applied to regular qualified plans and 403(b) plans, the penalty applies to all distributions except distributions

• made on or after attainment of age 59½;

• made to a beneficiary or employee's estate on or after the employee's death;

• attributable to disability;

• that are part of a series of substantially equal periodic payments made at least annually over the life or life expectancy of the employee, or the joint lives or life expectancies of the employee and beneficiary (separation from service is required);

• made after a separation from service after age 55;

• related to certain tax credit ESOP dividend payments;

• to the extent of medical expenses deductible for the year under Code Section 213, whether or not actually deducted.

The penalty also applies to IRAs and IRA-funded plans (SEPs and SIMPLE/IRAs), with a somewhat different list of exceptions. Under this penalty provision, a plan may be permitted to make a distribution to an employee without disqualifying the plan, but the distribution may nevertheless be subject to penalty. For example, many hardship distributions from 401(k) plans or 403(b) tax-deferred annuity plans will be subject to the penalty tax.

Despite the penalty, withdrawals from qualified plans may still be important to participants in many situations—to obtain emergency funds, for example. Therefore, plan designers may wish to provide withdrawals in plans, where permitted, despite the existence of the 10 percent penalty.

Incidental Benefit Requirements

Some types of optional benefit forms provide substantial payments to persons other than the participant after the participant's death—for example, a 20-year-certain annuity with payments continued to a beneficiary. Because these are death benefits, they must be incidental.

Code Section 401(a)(9)(G) and corresponding regulations provide rules for determining whether survivorship benefits are incidental. For example, if a participant has a 10-year life expectancy at retirement, he or she could not elect a 25-year certain annuity because this would result in too much of the expected benefit to be paid as a death benefit. This incidental rule does not apply to a survivor annuity for spouses; thus, for example, a plan could provide a joint and 50 percent survivor annuity for a 65-year-old retiree and his 25-year-old spouse, even though actuarially, the participant's present interest in the benefit would be less than half of the total.

Nonalienation Rules

A qualified plan must provide that plan benefits may not be assigned or alienated [Code Section 401(a)(13)]. This means, for example, that a plan participant can't pledge future anticipated qualified plan payments as security for a bank loan. For divorce, child support, and similar domestic disputes, there are special provisions.

Examples

The distribution restrictions described in the preceding pages appear so complex as to defy summary. Probably the best way to see how these restrictions work is to look at some examples. Consider the following proposed plan distribution options, offered to a married male participant in a qualified defined-benefit plan retiring at age 65. Assume that the participant and his spouse have waived any required joint and survivor annuity. The following options will be analyzed to see if they are permissible under the distribution restrictions:

• A joint and 100 percent survivor annuity for the lives of the participant and his daughter, age 35

• A 25-year period-certain annuity for the lives of the participant and his spouse

• Equal periodic distributions over five years beginning when the participant reaches age 75

• Equal monthly payments over a fixed period equal to the participant's life expectancy, but if the participant survives, the payout period is extended (the monthly payments are actuarially reduced) annually to reflect the increased life expectancy

The first potential distribution would meet the first restrictions of Section 401(a)(9), because it extends over the lives of a participant and named beneficiary, but it does not meet the incidental benefit tests under the regulations. According to tables in the regulations, no more than a 60 percent survivor annuity could be payable to the daughter.

The second distribution—the 25-year period-certain annuity for the lives of the participant and spouse would meet Section 401(a)(9) as long as the joint life expectancy of the participant and spouse is at least 25 years. As for the incidental test, the regulations provide that a survivor annuity for a spouse will generally qualify regardless of the difference in ages.

The third option, a distribution beginning at age 75, is not permitted because distributions must begin not later than April 1 following the calendar year in which the employee reaches age 70½.

Finally, a fixed-period payout over the participant's life expectancy, with annual recalculations of life expectancy, is permitted. This can be an advantageous way of receiving the benefit because payments can continue to a relatively advanced age, reducing the danger that retirement income will stop while the participant is still living.

THE GOVERNMENT'S ROLE—PENSION POLICY ISSUES

Management objectives are one major factor in pension design; the other is the government regulatory structure. This section discusses the development of the government's role in this area.

Most employees covered under an employer-sponsored retirement plan are covered under what is known as a qualified retirement plan. A qualified plan is one that receives certain valuable federal tax benefits, but its design, funding, and administration must meet an extraordinarily complex set of federal statutory and regulatory requirements. Most federal regulation in this area specifically preempts state and local regulation. The tax benefits from such plans to both employer and employee are generally (though not always) adequate to justify the inconvenience of this severe regulatory regime. A nonqualified plan is any other retirement or deferred compensation plan. Nonqualified plans are subject to much simpler federal regulation, along with less favorable tax treatment. Nonqualified plans are used primarily for executive compensation arrangements that replace or supplement qualified plan coverage for a selected group of highly compensated executives.

The government's role in the retirement income area has been dictated primarily by historical factors. Beginning in the late 19th century, the economy of the United States changed fairly rapidly from predominantly agricultural to predominantly industrial and service oriented. Coinciding with this change—and probably in response to it—the large, supportive extended family of the agricultural economy was largely replaced by smaller, more fragmented family units. The shift away from agriculture reduced the amount of economically useful work available to older people, and family structural changes reduced the amount of family support for the aged.

Because of these economic and social trends, people generally must make specific plans for their retirement. This is a difficult matter for most individual employees to do alone and, consequently, employer-sponsored pension plans have become increasingly important.

In the 20th century, federal government involvement in retirement plans for the aged also greatly expanded. The federal government's involvement is twofold. For most people, the most obvious federal government program in this area is the Social Security system adopted in the 1930s to provide direct benefit payments to the aged. But even before the Social Security system was adopted, the federal government became involved in a more traditional way by measures designed to encourage the private pension system.

Governments tend to be reluctant to adopt direct payment arrangements for dependent individuals, particularly in the United States—a reflection of the generally conservative social values of the American public. Historically, governments have tended to look first at private organizations to act in this area. This is one reason why charitable institutions, such as orphanages and hospitals, have for centuries been granted various forms of tax exemption.

In the tradition of encouraging private initiatives, in the 1920s the federal government began encouraging private, employer-sponsored retirement plans by providing two kinds of tax benefits. First, pension funds were made tax exempt under the Revenue Acts of 1921 and 1926. Then, in the Revenue Act of 1928, employer contributions to plan funds were made currently deductible by the employer, even though benefits were not paid to employees until later years. These basic provisions still apply and form the basis for today's vast federal regulatory scheme for qualified plans.

The embryonic private pension system of the 1920s declined significantly during the depression of the 1930s. This was one reason for the adoption of the Social Security system. However, since the 1940s, private pension plans have revived to an enormous degree. Assets in private pension plans now amount to more than three trillion dollars, which constitutes a very substantial portion of the nation's entire capital.

Because of the large sums involved, any tax benefits provided to qualified plans cost the government a great deal in lost tax revenues; the government estimate is well over $75 billion annually. This large "tax expenditure" is often given as a primary justification for the exhaustive scheme of government regulation that now applies to qualified pension plans. Fundamentally, the argument is that the large tax expenditure is designed to help prevent individuals from becoming dependent on the government in retirement. Consequently, the government attempts to make sure that plan benefits go where they are most needed so that this tax expenditure is cost effective. Much pension regulation is aimed at discouraging plans that primarily benefit highly-compensated employees who have other sources of retirement income. Other rules are intended to assure that the large sums set aside for plan benefits are managed in the exclusive interest of plan participants and beneficiaries.

In practice, the government frequently adopts new or modified statutes and regulations relating to pensions without clear or articulated long-range policy objectives. The absence of a coherent federal retirement policy is currently a critical federal policy issue. Current issues in pension regulation include those covered in the following sections.

Tax Revenue Loss

At times, revenue-raising needs outweigh retirement policy issues in Congress. The tax benefits for qualified plans cause a substantial apparent decrease in tax revenues. The criticism is also frequently made that too much of the tax benefit goes to high-income individuals who don't need government help. Whatever the merits of this argument, it is indisputable that "fine tuning" the rules to reduce tax benefits for certain plan participants can increase tax revenues in the short run, without the political pain of visibly "raising taxes." The need to raise revenue has motivated many recent changes in the qualified plan law, and it probably will be a factor in future legislation. Changes of this type are often enormously complex as a result of the need to carefully target the group whose benefits are to be reduced, typically the owner-employees of closely held businesses. Revenue-motivated changes are often criticized as resulting in bad retirement policy.

Discrimination in Favor of Highly Compensated Employees

Although a major thrust of virtually all qualified plan legislation since the 1940s has been to discourage employers from discriminating in their plans in favor of highly compensated employees, a considerable amount of such discrimination is still possible, as discussed throughout this text. Because of this, much qualified plan legislation has been designed to reduce the "tax shelter" aspects of qualified plans, particularly those for smaller businesses whose owner-employees receive substantial benefits. Many of the most complex and awkward provisions of the law, such as the top-heavy rules, were designed in this vein.

Seemingly, it would be easy to eliminate the discrimination problem by simple, appropriate benefit or contribution limits. However there is a counter-vailing policy consideration. Small businesses, collectively, employ a large and increasing segment of the work force. Owners of these businesses may not be interested in maintaining a qualified plan for their employees unless the plan provides substantial, and possibly disproportionate, benefits for the owners themselves. This policy issue, therefore, involves tension between tax-benefit equity and efficiency on the one hand, and the need to encourage small business retirement plans on the other. No simple resolution of this is likely in the near future, and complex legislative compromises on this issue will probably continue to emerge from Congress.

Encouraging Private Saving

Surprisingly, in view of the trillions invested in pension plans, relatively little policy emphasis has been given to the role of the qualified plan rules in encouraging private savings. One problem is that policy makers agree neither on the appropriate level for private savings nor on whether government policy should encourage savings rather than allowing the free market to set the level. Another factor is that economists are divided about the efficacy of the qualified plan provisions in encouraging savings. Some economists argue that these plans merely displace private saving that would take place in any event. Nevertheless, the savings issue is an ongoing factor in the policy debate.

Interest-Group Pressures

As the foregoing discussion indicates, retirement policy poses difficult problems even if viewed from a neutral intellectual viewpoint. The actual political climate, of course, is not neutral. The qualified plan business is large and involves many firms and individuals. Most of these organizations eagerly and frequently convey their views to Congress in great technical detail. This complicates the resolution of issues and makes change more difficult.

Mandatory Retirement Plan Coverage

A presidential commission formed in the late 1970s to study pension policy recommended the establishment of a Minimum Universal Pension System (MUPS) for all workers, to be funded by employers at an initial rate of at least 3 percent of payroll. The MUPS benefit would be completely portable from job to job. In general, the MUPS approach is not popular with employers and benefit plan designers, who prefer the flexibility of current rules; at the present time, Congress is not considering it seriously.

Age and Sex Discrimination

Age and sex discrimination have not been addressed by Congress specifically as retirement plan issues. However, recent federal legislative and regulatory activity related to employment discrimination in general has affected retirement plans

ISSUES IN PLAN DESIGN | Cafeteria Plans

Before committing itself to the establishment of a cafeteria program, an employer must be sure a valid reason exists for converting the company's traditional benefit program to a cafeteria approach. For example, if there is strong employee dissatisfaction with the current benefit program, the solution may lie in clearly identifying the sources of dissatisfaction and making appropriate adjustments in the existing benefit program, rather than in shifting to a cafeteria plan. However, if employee dissatisfaction arises from widely differing benefit needs, conversion to a cafeteria plan may be quite appropriate. Beyond having a clearly defined purpose for converting from a traditional benefit program to a cafeteria program and being willing to bear the additional administrative costs associated with a cafeteria approach, the employer must face a number of considerations in designing the plan.

The Type and Amount of Benefits To Include

Probably the most fundamental decision that must be made in designing a cafeteria plan involves determining what benefits should be included. An employer who wants the plan to be viewed as meeting the differing needs of employees must receive employee input concerning the types of benefits perceived as most desirable. An open dialogue with employees will undoubtedly lead to suggestions that every possible employee benefit be made available. The enthusiasm of many employees for a cafeteria plan will then be dampened when the employer rejects some—and possibly many—of these suggestions for cost, administrative, or psychological reasons. Consequently, it is important that certain ground rules be established regarding the benefits that are acceptable to the employer.

The employer must decide whether the plan should be limited to the types of benefits provided through traditional group insurance arrangements or be expanded to include other benefits. At a minimum, it is important to ensure that an overall employee benefit program provide employees with protection against all major areas of personal risk. This suggests a benefit program with at least some provision for life insurance, disability income protection, medical expense protection, and retirement benefits, but it is not necessary that all these benefits be included in a cafeteria plan. For example, most employers have a retirement plan that is separate from their cafeteria plan because of Section 125 requirements. Other employers make a 401(k) plan one of the available cafeteria options.

In some respects, a cafeteria plan may be an ideal vehicle for providing less traditional types of benefits. Two examples are extra vacation time and child care. Some plans allow an employee to use flexible credits to purchase additional days of vacation. When available, this option has proven a popular benefit, particularly among single employees. A problem may arise, however, if the work of vacationing employees must be assumed by nonvacationing employees, in addition to their own regularly assigned work. Those not electing extra vacation time may resent doing the work of someone else who is away longer than the normal vacation period.

In recent years, employers have been under increasing pressure to provide care for employees' children, which represents an additional cost if added to a traditional benefit program. Employees who include child-care benefits in a cafeteria plan can pay for the cost of such benefits, possibly with dollars from an FSA. However, lower-paid employees may be better off financially by paying for child care with out-of-pocket dollars and electing the income tax credit available for dependent-care expenses.

One question that sometimes arises is whether dependent life insurance should be included in a cafeteria plan. As mentioned previously, amounts of $2,000 or less do not fit the definition of a qualified benefit and cannot be included. If the amount of coverage available exceeds $2,000, the benefit can be provided as long as it is treated as a cash benefit. An employee who elects coverage with employer-provided dollars will have taxable income as determined by Uniform Premium Table I. Because this amount will exceed the actual cost of the coverage in some cases, dependent life insurance is often made available outside a cafeteria plan. When it is included in a cafeteria plan, there is frequently a requirement that it be purchased with after-tax salary reductions.

Cost is an important consideration in a cafeteria plan. The greater the number of benefits, particularly optional benefits, the greater the administrative costs. A wide array of options may also be confusing to many employees and require extra personnel to counsel employees or to answer their questions.

Level of Employer Contributions

An employer has considerable latitude in determining the amount of dollars that will be available to employees to purchase benefits under a cafeteria plan. These dollars may be a function of one or more of the following factors: salary, age, family status, and length of service.

A major difficulty arises in situations in which the installation of a cafeteria plan is not accompanied by an overall increase in the amount of the employer's contributions to the employee benefit plan. It is generally felt that each employee should be provided with enough dollars so that he or she can purchase optional benefits that, together with basic benefits, are at least equivalent to the benefits provided by the old plan.

Including a Premium-Conversion or FSA Option

A premium-conversion or FSA option under a cafeteria plan enables employees to lower their taxes and, therefore, increase their spendable income. Ignoring any administrative costs, there is probably no reason not to offer this option to employees for benefits such as dependent care or for health insurance premiums. However, salary reductions for unreimbursed medical expenses pose a dilemma. While such deductions save taxes for an employee, they may also result in his or her obtaining nearly 100 percent reimbursement for medical expenses, which may negate many of the cost-containment features in the employer's medical expense plan.

Change of Benefits

Because employees' needs change over time, a provision regarding their ability to change their benefit options must be incorporated in a cafeteria plan. As a rule, changes are allowed prior to the beginning of the plan year. Additional changes may be allowed as long as they are permissible under Section 125 regulations.

Two situations often affect the frequency with which benefits may be changed. First, charges to employees for optional benefits must be adjusted periodically to reflect experience under the plan. If charges for benefits rise between dates on which employees may change benefit selections, the employer must either absorb these charges or pass them on to the employees, probably through increased payroll deductions. Consequently, most cafeteria plans allow benefit changes on annual dates that are the same as the dates when charges for benefits are recalculated as well as the dates on which any insurance contracts providing benefits under the plan are renewed.

The second situation arises when the amount of the employer's contribution is based on compensation. If an employee receives a pay increase between selection periods, should he or she be granted more dollars to purchase additional benefits at that time? Under most cafeteria plans, the dollars available to all employees are calculated only once a year, usually before the date by which any annual benefit changes must be made. Any changes in the employee's status during the year will have no effect on the employer's contribution until the date on which a recalculation is made in the following year.

WORKERS' COMPENSATION LAWS : Problems and Issues

Problems and Issues
As with unemployment insurance, there are problems and issues associated with workers' compensation insurance. These involve the extent of coverage, the size of benefit payments and increasing costs. One often-discussed issue is whether a system of 24-hour coverage would be an improvement.

Extent of Coverage
Labor unions have been particularly critical of workers' compensation insurance because of its incomplete coverage of workers. State laws do not cover all workers because of elective laws, numerical exemptions and exclusions, or less-than-full coverage for certain groups, such as agricultural, domestic, and casual workers. It is estimated that, nationally, between 10 percent and 15 percent of workers are without coverage and that this figure is as high as 30 percent in some states.

Adequacy of Benefits
Benefits have been criticized as inadequate because they seldom exceed two-thirds of a worker's earnings prior to injury, and most states do not adjust income benefits for inflation. However, some lower-paid workers may have little incentive to return to work because benefits may actually exceed their prior take-home pay. This results from relatively high minimum benefits and the fact that workers' compensation benefits are not subject to Social Security and Medicare taxes or personal income taxes. In terms of the replacement of lost income, the situation is worse for higher-paid employees because of the maximum dollar limits on benefits.

Increasing Costs
A major concern of employers is the soaring cost of workers' compensation coverage. Estimates are that costs have tripled over the past decade. This increase is the result of a combination of several factors, including the following:

Soaring increases in the cost of medical care.

Increased benefits. Most states have increased benefits faster than average wages have increased. One interesting result of higher benefit levels is that they tend to result in an increased number of claims filed and an increase in the duration of claims.

Expansion of coverage to additional workplace injuries and diseases, such as mental stress.

Increased litigation. Estimates are that approximately one-quarter of workers' compensation costs are associated with attorneys' fees and other legal costs.

These increasing costs have resulted in large underwriting losses for many insurance companies, leading in turn to higher premiums and more stringent underwriting. As underwriting has tightened, more employers have been forced into the substandard insurance market, where costs are even higher. These higher costs are ultimately passed on to consumers and increase inflationary pressures. Some firms, particularly small ones, are also finding their financial survival threatened by these high costs.

At the state level, there always seems to be talk of workers' compensation reform. However, labor equates reform with increased benefits, and employers equate it with lower costs. As a result, fundamental changes often do not occur.

The Concept of 24-Hour Coverage
When workers' compensation laws were first passed, most employees did not have employer-provided benefits for medical expenses or disability income. Today both types of benefits are common. As a result, it has been suggested that the old systems are obsolete and that the concept of 24-hour coverage should be adopted. Under this concept, employees would have a single benefit plan that would respond to injuries whether they occurred on or off the job. This concept could be applied to medical expense coverage only or to medical expense coverage and some or all types of disability income coverage. Arguments in favor of 24-hour coverage include the following:

The financial needs of employees are the same regardless of whether an injury or illness is work-related.

It is often impossible to determine whether an injury or illness is work-related.

Medical costs would be better managed because cost-containment techniques used in group insurance could also be used for work-related claims.

The current system is fragmented and may contain both gaps and overlapping benefits. A single comprehensive system may be able to provide better benefits at a lower cost.

Naturally, there are also arguments against 24-hour coverage:

The principle of liability without fault would be violated if employees were required to assume deductibles, copayments, or a percentage of work-related claims.

Smaller firms that have few employee benefits could not afford 24-hour coverage and might be forced out of business.

The strong emphasis on loss control that is associated with workers' compensation insurance might be jeopardized if the program were merged with traditional group insurance programs.

The concept of 24-hour coverage continues to receive a considerable amount of attention. It is an integral part of some proposals for reforms to the nation's health care system. In addition, some states now allow 24-hour coverage to be written for medical expenses, with the employer purchasing a workers' compensation policy to provide benefits other than medical expenses.

UNEMPLOYMENT INSURANCE : Benefits, Problems and Issues

Benefits
The majority of states pay regular unemployment insurance benefits for a maximum of 26 weeks; the remaining states pay benefits for slightly longer periods. In most states, the amount of the weekly benefit is equal to a specified fraction of a worker's average wages for the calendar quarter of the base period during which the highest wages were earned. The typical fraction is 1/26, which yields a benefit equal to 50 percent of average weekly earnings for that quarter. Other states determine benefits as a percentage of average weekly wages or annual wages during the base period. Some states also modify their benefit formulas to provide relatively higher benefits (as a percentage of past earnings) to lower-paid workers. Benefits in all states are subject to minimum and maximum amounts. Minimum weekly benefits typically fall within the range of $20 to $75, maximum benefits in the range of $200 to $375, and the average benefit in the range of $150 to $225. In addition, a few states currently provide additional benefits if there are dependents who receive regular support from the worker.

States also provide reduced benefits for partial unemployment. Such a condition occurs if a worker is employed less than full-time and has a weekly income less than his or her weekly benefit amount for total unemployment.

Since 1970, there has been a permanent federal-state program of extended unemployment benefits for workers whose regular benefits are exhausted during periods of high unemployment. The availability of these benefits is automatically triggered by a state's unemployment rate exceeding a specifed level. The benefits are financed equally by the federal government and the states involved, and they can be paid for up to 13 weeks, as long as the total of regular and extended benefits does not exceed 39 weeks. This program is operable when the insured unemployment rate in a state exceeds a specified level. The insured unemployment rate is the percentage of workers covered by unemployment insurance who are receiving regular benefits. Benefits can also be triggered if a state's total unemployment rate exceeds specified criteria. In this case, an additional 20 weeks of benefits can be paid.

In periods of severe unemployment, the federal government often enacts legislation to provide additional benefits that are financed with federal revenue. The last such program expired in 1994.

Problems and Issues
The current system of unemployment insurance has become increasingly subject to criticism, especially regarding the level of benefits. At current levels, the majority of employees would receive benefits that are less than half of their former wages. Because of maximum limits on the amounts of benefits, higher-income employees would receive proportionately smaller benefits than lower-paid employees.

In addition to the level of benefits, the percentage of persons receiving benefits at any point in time has dropped over the last two decades. Typically, fewer than 40 percent of the unemployed are receiving benefits. Some persons have benefits denied because of more stringent rules, particularly those dealing with initial benefit disqualification. Other persons exhaust the benefits that are available. Of course, there are those who argue that without disqualifications and limits on benefits, there would be little incentive for many of the unemployed to seek work.

Few employers provide any type of supplemental unemployment benefits. The plans that do exist are in highly unionized industries and result from collective bargaining.

There seems to be a feeling among economists that unemployment insurance programs today are less effective in dealing with unemployment issues than they were in the past. In theory, unemployment compensation insurance should be a counterbalance against recessions. In practice this is often not the case, perhaps because of the low percentage of persons receiving benefits. In addition, the degree of experience rating has declined over time, reducing the incentive for employers to retain employees in bad times rather than laying them off. It also has shifted an increasing burden for financing the program to employers in industries with stable employment.