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.

THE RATIONALE FOR CAFETERIA PLANS

The growth in employee benefits has caused two problems. First, some employers feel that many employees do not recognize and appreciate the magnitude of their employee benefits; indeed, as benefits increase, employee appreciation often seems to decrease. Advocates of cafeteria plans argue that by giving employees a stated dollar amount with which they must select their own benefits (from a list of options), employees become more aware of the actual cost of these benefits and are more likely to appreciate the benefits they choose.

A second problem is that the inflexible benefit structure of conventional employee benefit plans does not adequately meet the various benefit needs of all employees, often leading to employee dissatisfaction. For example, single employees often resent the medical coverage that married employees receive for their families because the single employees receive no benefit of corresponding value. Similarly, employees who have no dependents often see little value in life insurance and would prefer other benefits. Those who favor the concept of cafeteria plans feel that such dissatisfaction can be minimized if employees have the option to select their own benefits. Advocates of cafeteria plans argue that this increased employee satisfaction will result in a better employee-retention record and in greater ability to attract new employees.

Some employers see the cafeteria approach to benefit planning as an opportunity to control the escalating benefit costs associated with inflation and with the new requirements of recently enacted federal and state legislation. Because a cafeteria plan is essentially a defined-contribution plan rather than a defined-benefit plan, it provides a number of opportunities for controlling increases in costs. For example, it may encourage employees to choose medical expense options that have larger deductibles or a greater degree of managed care so that they can more efficiently use the fixed number of dollars allotted to them under the plan. A cafeteria plan may also enable the employer to pass on to the employees any increased benefit costs that result from having to comply with legislation that mandates additional benefits. In addition, because increases in employer contributions are not directly related to increases in benefit costs, the employer can grant percentage increases in the amounts available for benefits that are less than the actual overall increase in employee benefit costs.

It should be noted that early cafeteria plans were designed primarily to meet the varying needs of employees. In contrast, newer plans are much more likely to be instituted as a cost-saving technique.

THE NATURE OF CAFETERIA PLANS

In its purest sense, a cafeteria plan can be defined as any employee benefit plan that allows an employee to have some choice in designing his or her own benefit package by selecting different types or levels of benefits that are funded with employer dollars. At this extreme, a benefit plan that allows an employee to select an HMO as an option to an insured medical expense plan can be classified as a cafeteria plan. However, the more common use of the term cafeteria plan denotes something much broader—a plan in which choices can be made among several different types of benefits and, possibly, cash.

Prior to the addition of Section 125 to the Internal Revenue Code in 1978, the use of cafeteria plans had potentially adverse tax consequences for an employee. If an employee had a choice among benefits that were normally nontaxable (such as medical expense insurance or disability income insurance) and benefits that were normally taxable (such as life insurance in excess of $50,000 or cash), then the doctrine of constructive receipt resulted in an employee's being taxed as if he or she had elected the maximum dollar amount of taxable benefits that could have been obtained under the plan. For example, if an employee could have elected cash in lieu of being covered under the employer's medical expense plan but chose to remain in the medical expense plan, that employee was considered to have taxable income merely because cash could have been elected. Obviously, this tax environment was not conducive to the use of cafeteria plans unless the only benefits offered were normally of a nontaxable nature.

Permissible Benefits

Section 125 of the Code defines a cafeteria plan as a written plan under which all participants are employees and under which all participants may choose between two or more benefits consisting of (1) qualified benefits and (2) cash. Qualified benefits essentially include any welfare benefits excluded from taxation under the Internal Revenue Code except scholarships and fellowships, transportation benefits, educational assistance, no-additional-cost services, employee discounts, and de minimis fringe benefits. The latter include dependent life insurance coverage in amounts of $2,000 or less. The Health Insurance Portability and Accountability Act (HIPPA) expanded this list of exceptions to include any product that is advertised, marketed, or offered as long-term care insurance. Thus medical expense benefits (other than long-term care insurance), disability benefits, accidental death and dismemberment benefits, vacations, and dependent-care assistance (such as day care centers) can be included in a cafeteria plan. The Code also allows group term life insurance to be included, even in amounts exceeding $50,000. In general, a cafeteria plan cannot include benefits that defer compensation except for a qualified Section 401(k) or similar plan.

The prohibition of benefits that defer compensation has an important impact on vacation benefits. If an employee elects vacation benefits for the plan year of a cafeteria plan, the vacation days cannot be carried over into the following plan year because this would be a deferral of compensation. (Note: Regular vacation days are considered to have been taken before the additional days elected under the cafeteria plan.) However, an employee can elect to exchange these days for cash as long as the election is made and the cash is actually received prior to the end of the plan year. If this is not done, the days are forfeited and their value is lost.

The term cash is actually broader than it would otherwise appear. In addition to the actual receipt of dollars, a benefit is treated as cash as long as (1) it is not a benefit specifically prohibited by Section 125 as cash and (2) it is provided on a taxable basis. This latter provision means that either (1) the cost of the benefit is paid by the employee with after-tax dollars on a payroll-deduction basis or (2) employer dollars are used to obtain the benefit, but the employer reports the cost of the benefit as taxable income for the employee. This rule would allow the inclusion of group automobile insurance or long-term care insurance in a cafeteria plan but not on a tax-favored basis. It also allows long-term disability coverage to be provided on an after-tax basis, so that disability income benefits can be received tax free.

The list of benefits that Section 125 specifically prohibits from being treated as cash includes any benefits provided under Section 117 (scholarships and tuition expenses) and Section 132 (various fringe benefits such as discounts and transportation benefits) of the Internal Revenue Code.

As long as a benefit plan offering choice meets the definition of a cafeteria plan, the issue of constructive receipt does not apply. Employees will have taxable income only to the extent that normally taxable benefits—group term life insurance in excess of $50,000 and cash—are elected. An employer can have a benefit plan that offers choice but does not meet the statutory definition of a cafeteria plan. In such a case the issue of constructive receipt will come into play if the plan contains any benefits that normally result in taxable income.

Choice of Medical Expense Plans

Employers often allow employees a choice of medical expense plans for themselves or their employees. However, there is often confusion over whether this choice constitutes a cafeteria plan. If it does, the employer will need to comply with the rules of Section 125 and ERISA or be subject to the statutory penalties for noncompliance.

Assume an employer has a noncontributory medical expense plan that allows employees to elect among two or more managed care plans. If this is the only choice offered to employees, it is not a cafeteria plan because there is no cash option. It is only a choice among qualified benefits.

Now assume that an employer gives employees the option of electing either a noncontributory managed care plan or an indemnity plan for which the employee must make a monetary contribution on an after-tax basis. Again, by itself this is not a cafeteria plan because there is no option of electing cash. However, if employees are allowed to pay their share of the premiums for the indemnity plan on a before-tax basis through a premium-conversion plan, a cafeteria plan has been created under Section 125. Because salary reductions technically become employer dollars, the employees who elect salary reductions are considered to be choosing between cash and a qualified benefit.

Some employers allow an employee to elect out of medical expense coverage and receive cash. For example, some employees may feel that they do not need coverage under the employer's plan because they are adequately covered under their spouse's plans. If the cost to provide coverage to employees is $2,000 per year, the employer might feel financially justified in offering these employees $1,000 to waive coverage. Since these employees have a choice between the medical expense coverage and cash, a cafeteria plan has been created.

Benefit Election

Section 125 requires that benefit elections under a cafeteria plan be made prior to the beginning of a plan year. These elections cannot be changed during the plan year except under certain specified circumstances if the plan allows such changes. While there is no requirement that these changes be included in a plan, some or all of them are included in most plans.

The Internal Revenue Service (IRS) regulations regarding election changes had remained unchanged through most of the 1990s. In 1997, however, regulations with proposed changes were issued, and employers were allowed to use either the old or the new regulations. In early 2000, the proposed regulations were made final with some modifications; they must be used for plan years beginning on or after January 1, 2001. At the same time, the IRS issued another set of proposed regulations to address issues not covered by the new regulations. Employers also are allowed to use these regulations for plan years beginning on or after January 1, 2001.

The regulations allow new cafeteria plan elections for specified changes in status. In addition, the regulations specify that any new cafeteria plan elections are allowed only if an employee, spouse, or dependent gains or loses eligibility for coverage, and the cafeteria plan election change corresponds with that gain or loss in coverage. The acceptable changes in status include the following:

• Legal marital status (including marriage, death of a spouse, divorce, legal separation, or annulment)

• Number of dependents (resulting from birth, adoption, commencement or termination of an adoption proceeding, or death)

• Employment status (the termination or commencement of employment by the employee, spouse, or dependent)

• Work schedule (a reduction or increase in hours of employment by the employee, spouse, or dependent, including a switch between part-time and full-time employment, a strike or a lockout, and commencement of or return from an unpaid leave of absence)

• Dependent status under a health plan for unmarried dependents

• Residence or worksite of the employee, spouse, or dependent

Regulations address several specific issues. For example, increases in group term insurance coverage and disability income coverages are allowed in the case of marriage, birth, adoption, or placement for adoption. Decreases in coverage are allowed for divorce, legal separation, annulment, or death of a spouse or dependent. The regulations also allow employees to make election changes if, during the plan year, (1) a new benefit package is offered or a benefit package is eliminated or (2) a change is made in the coverage of an employee's spouse or dependent. In addition, an employee can make a change as a result of an open-enrollment change by a spouse or dependent whose employer's plan has a different period of coverage. Finally, an employee can make a change as a result of a spouse's or dependent's change under his or her own cafeteria plan, as long as that change conforms to the regulations.

Even if none of the above rules are met, election changes are permitted in cafeteria plans as a result of changes in coverage or premiums because of HIPAA, COBRA, eligibility for Medicare, or a legal judgment, decree, or order resulting from divorce, legal separation, annulment, or change in legal custody.

Payroll Deductions and Salary Reductions

Under some cafeteria plans, employees are allowed to allocate only a predetermined employer contribution to benefits. Other cafeteria plans are designed so that employees can obtain additional benefits with optional payroll deductions or salary reductions.

Many cafeteria plans that provide a wide array of benefits allow an employee to elect an after-tax payroll deduction to obtain additional benefits. For example, under a cafeteria plan an employee might be given $200 per month with which to select varying types and levels of benefits. If the benefits the employee chooses cost $240, the employee has two options—either to decrease the benefits selected or to authorize a $40 payroll deduction. Even though the payroll deduction is on an after-tax basis, the employee gains to the extent that the additional benefits can be selected through a group arrangement at a lower cost than in the individual marketplace.

Section 125 also allows employees to purchase certain benefits on a before-tax basis through the use of a premium-conversion plan or a flexible spending account (FSA). Premium-conversion plans or FSAs, both of which are technically cafeteria plans, can be used by themselves or incorporated into a more comprehensive cafeteria plan. They are most commonly used alone by small employers who are unwilling to establish a broader plan, primarily for cost reasons. The cafeteria plans of most large employers contain one or both of these arrangements as an integral part of the plan.

Before-tax salary reductions reduce taxable income for federal income tax purposes. In most (but not all) states, they also reduce the income subject to state tax.

Premium-Conversion Plans

A premium-conversion plan (also called a premium-only plan, or POP) allows an employee to elect a before-tax salary reduction to pay his or her premium contribution to any employer-sponsored health or other welfare benefit plan. For example, an employer might provide medical expense coverage to employees at no cost but make a monthly charge for dependent coverage. Under a premium-conversion plan, the employee can pay for the dependent coverage with a before-tax salary reduction.

As a rule, premium-conversion plans are established for medical and dental expenses only. If such plans are used for group term life insurance, the cost of coverage in excess of $50,000 must be reported as income, which defeats the purpose of the salary reduction. If these plans are used for disability income coverage, benefits will be taxable as noncontributory employer-provided coverage because the amount of any salary reduction is considered to be the employer's money.

Flexible Spending Accounts (FSAs)

An FSA allows an employee to fund certain benefits on a before-tax basis by electing to take a salary reduction, which can then be used to fund the cost of any qualified benefits included in the plan. However, FSAs are used almost exclusively for medical and dental expenses not covered by the employer's plan and for dependent-care expenses.

The amount of any salary reduction is, in effect, credited to an employee's reimbursement account, and benefits are paid from this account when an employee properly files for such reimbursement. Reimbursements are typically made on a monthly or quarterly basis. The amount of the salary reduction must be determined prior to the beginning of the plan year. Once the amount is set, changes are allowed only under the specified circumstances previously mentioned for benefit elections. A separate election must be made for each benefit, and the funds are accounted for separately. Monies from a salary reduction for one type of expense cannot be used as reimbursement for another type of expense.

If the monies in the FSA are not used during the plan year, they are forfeited. Because forfeited funds are considered plan assets, they can be used only for the payment of benefits and reasonable administrative expenses. Under ERISA rules, forfeitures may be used to do the following:

• Defray the administrative costs of the plan.

• Protect the underwriting integrity of the plan. This includes the use of these funds to reimburse the plan for benefits paid that exceed a terminated employee's contributions. For example, an employee who contributed $100 per month might be eligible to collect a full annual reimbursement of $1,200 in the first month of participation. If the employee terminated employment at that time, the plan would have paid out $1,100 more than it had taken in.

• Reallocate contribution to the following plan year. Such reallocations must be on a per capita basis for all participants and cannot be based on amounts each employee originally contributed.

The ERISA rules specifically prohibit the donating of forfeitures to charity or the reversion of such amounts to the employer for general business expenses.

An election to participate in an FSA program not only reduces a salary for federal income tax purposes but also lowers the wages on which Social Security and Medicare taxes are levied. As a result, those employees who end up below the Social Security wage-base limit after the reduction pay less in Social Security taxes, and their future income benefits under Social Security may be reduced. However, the reduction in future benefits is small in most cases, unless the salary reduction is large. It should be noted that the employer's share of Social Security and Medicare tax payments also decreases. In some cases, the employer's savings may actually be large enough to fully offset the cost of administering the FSA program.

One issue faced by employers over the years has been whether to limit benefit payments to the amount of an account balance or to allow an employee at any time during the year to receive benefits equal to his or her annual salary reduction. For example, say an employee contributes $100 per month to an FSA to provide benefits for the cost of unreimbursed medical expenses. During the first month of the plan, the employee earns only $100 of the $1,200 annual contribution. If the employee incurs $300 of unreimbursed medical expenses during the month, should he or she be allowed to withdraw $100 or the full $300? The objection to allowing a $300 withdrawal is that the employer will lose $200 if the employee terminates employment before making any further contribution. IRS regulations do not give the employer any choice with respect to health benefits (that is, medical and dental expenses); FSAs must allow an amount equal to the full annual contribution to be taken as benefits any time during the year. Therefore, the employee is entitled to a benefit of $300 after the first month. However, IRS regulations do allow a choice in reimbursement policies for other types of benefits, such as dependent-care expenses. For these benefits, most plans limit aggregate benefits to the total contributions made up until the time when benefits are received.