Managing Employee Benefits

• In addition to the uses in protecting the

organization and its owners, life and health
insurance are also used extensively as an
employee benefit.
• It is common for an employer to offer an
employee some life insurance, health insurance,
or retirement benefits in the employment setting.
• These arrangements fall under the broad
classification of employee benefits.

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 Responsibility for Employee Benefits

• Surveys of risk managers generally indicate that

something less than half of the responding risk
managers have responsibility for employee
benefits.
• The reason that firms assign responsibility for
employee benefits to a department other than
risk management is that employee benefits are
considered both by the employer and by
employees as a part of the compensation
package.

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 The Risk Manager and Employee Benefits

• Some firms recognize that the design of an

employee benefit plan involves essentially the
same types of decisions that are involved in
managing the organization’s own risks.
• Although employee benefits are a part of the
employee-compensation function and are
therefore within the realm of the human resource
managers of the organization, the risk manager’s
expertise in insurance buying has direct
relevance to the design and funding of employee
benefit plans.
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 Employee Benefits Defined

Broadly speaking, any non-monetary

compensation provided by an employer to its
employees can be termed an "employee
benefit."

In a more narrow sense, “employee benefits”

is used by different people to mean what the
user intends it to mean.

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 Employee Benefits Generally

Broad Definition (Chamber of Commerce)

• Any benefit provided to employees other than
wages and salary.
• Includes workers comp, unemployment
compensation, and social security contribution.
• Under this definition, employers pay roughly
38% to 40% of payroll on employee benefits.

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 Limited (Social Security) Definition
Narrow Definition (Social Security Administration)
Any type of plan sponsored or initiated unilaterally
or jointly by employers or employees and providing
benefits that stem from the employment
relationship and that are not underwritten or paid
directly by government...
1. income maintenance during periods when
regular earnings are cut off because of death,
accident, sickness, retirement, or
unemployment; and
2. benefits to meet medical expenses associated
with illness or injury.
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 Limited (Social Security) Definition

• This definition of employee benefits used by the

Social Security Administration limits the term to
death benefits, sickness and disability benefits,
retirement income, and medical expense
insurance or reimbursement.
• This coincides with the insurance-related benefit
plans that might fall within the risk manager’s
responsibility.
• The cost of benefits under the narrow definition
probably ranges from about 12% to 13% of
payroll.
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 Employee Benefits Generally

• Over half of all employees are covered by

employer-sponsored retirement plans.

• Over two-thirds of all employees are covered by

life insurance offered by their employer.

• Although private disability insurance is less

likely to be offered by an employer, it is
estimated that about one of every four
employees is covered by employer sponsored
long-term disability plans.

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 Reasons for Popularity of Employee
Benefits

• There are several reasons for the prevalence of

employer sponsored insurance benefits.
• First, employees may find it advantageous to
accept insurance as part of their compensation,
primarily because of the favorable tax treatment
of employee benefits.
• In addition, most life and health insurance
provided by employers is part of a group
contract which tends to be less expensive than
individual insurance.
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 Employer Objectives in Establishing
Employee Benefit Plans

• In addition to the fact that employees may find

insurance benefits to be an attractive form of
compensation, employers may have other
objectives for offering employee benefits.

• Some plans are established in the hope that they

will improve employee morale and motivation.

• Plans may designed to address certain specific

goals, such as reducing employee turnover or
encouraging early retirement.

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 Considerations in Plan Design

• The design of an employer’s plan must consider

the employer’s objectives and employee’s needs,
the various options available, and their cost.
• Typically, the employer will want to consider how
its employee benefit plan compares to other
firms that it competes with for employees.
• In addition, the employer must decide how the
plan will be financed (whether through insurance
or some other mechanism) and who will
administer the plan.
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 History of Employee Benefits

• The first formal employee benefit plan in the

United States was probably the pension plan
started in 1875 by the American Express
Company for its employees.
• In 1910, Montgomery Ward and Company, which
had funded an employee establishment fund for
its employees, replaced the fund with what is
generally regarded to be the first group health
insurance contract.
• Depression of the 1930s left the employee
benefits arena in complete disarray.
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 World War II

• During World War II, the federal government

imposed price and wage controls throughout the
economy in an attempt to control inflation.

• Interestingly, despite the freeze on wages and

salaries, the Wage Stabilization Board did not
free employee benefit plans.

• Because labor was in short supply, employers

used employee benefits to enhance the
compensation package for workers.

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 Post World War II and Organized Labor

• After World War II, organized labor adopted

employee benefits as an integral part of its
negotiation efforts.
• More importantly, federal legislation, in the form
of the National Labor Relations Act of 1935 gave
workers the specific right to bargain over wages,
hours, and conditions of employment.
• The interest on the part of organized labor in
employee benefits was based on the favorable
tax treatment afforded such benefits.
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Tax Treatment of Qualified Employee Benefits

• Qualified employee benefits are granted one of

two types of preferential treatment:
• Contributions for some employee benefit are
deductible by the employer, but are not taxable
to the employee as income.
• Contributions for other benefits (qualified
retirement plans), are deductible by the employer
at the time made, but are not taxable to the
employee until they are distributed. Tax on the
earnings on the accumulation is also deferred.
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 Cafeteria Employee Benefit Plans

1. Authorized by Section 125 of the I.R.C.

2. Employees are granted credits that may be used

to “buy” from a range of benefits.

3. Employee selects benefits most appropriate to

personal need from a range that may include
any nontaxable benefits.

4. The employer may also permit the employee to

take some or all of the credit in the form of
additional taxable compensation.
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 Flexible Spending Accounts

1. A Flexible Spending Account (FSA) is a cafeteria

plans funded through salary reduction.
2. The employee contributes to a flexible spending
account and his or her taxable income is
reduced by the amount of the contribution.
3. Expenses not covered by the insurance are
covered by the FSA and the reimbursement is
not taxable to the employee.

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 ERISA

• The Employment Retirement Income Security Act

of 1974 (ERISA) is the principal federal law
regulating employee benefits.
• Although ERISA was enacted to address flaws in
the nation’s pension system, it addresses other
employee benefit programs as well.
• Tax aspects of ERISA are administered by the
IRS.
• Otherwise, the law is administered by the
Department of Labor.
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 General Requirements of ERISA

ERISA addressed three general responsibilities of

the sponsors of employee benefit plans:
disclosure and reporting,
fiduciary responsibility, and
claim procedures.

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 Summary Plan Description

• For employee benefit plans that cover 100 or

more lives, ERISA requires the plan
administrator to file a description of the plan with
the U.S Department of Labor.
• The plan administrator (usually the plan sponsor)
must file a Summary Plan Description (SPD) with
the Department of Labor within 120 days after the
plan is initiated.
• All plan participants must be provided a written
copy of the SPD within 90 days of becoming a
participant.
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 Reporting Requirements

• Besides the initial filing of the SPD plan,

sponsors must file an annual report (Form 5500)
summarizing the plans financial operation.
• Separate information is required for pension
plans and for welfare plans.
• The required data includes information on the
name of the insurance company providing the
coverage, the number of persons covered during
the year, and the total amount of fees and
commissions paid to agents or brokers.
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 ERISA Preemption

• One of the more controversial features of ERISA

is a provision in the law preempting state laws
covering employee benefits plans.

• The major exception is that while the states may

not regulate employee benefit plans, the
employers who maintain them, or trust funds
established in connection with such plans, the
states may regulate insurers and insurance
policies that are used to provide coverage under
such plans.

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 Group Insurance Funding Issues

1. Factors that influence funding choices are the

same as those in risk management decisions:
• in cases of high frequency, low severity,
insurance is not cost-effective
• for low frequency, high severity exposures,
retention is inappropriate

2. Because of potential loss severity, only very

large employers have historically self-funded
life insurance or medical expense plans.
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 Group Insurance Funding Issues

• Considerations that lead an employer to self-

fund employee benefits are the same as those
that lead firms to self-insure their own risks.

• Where the risk is characterized by a high

frequency and low severity, and, therefore,
relatively predictable expenses, insurance is not
likely to be cost-effective.

• Retention, on the other hand, is likely to be

appropriate where costs are highly predictable.

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 Reasons for Growth of Self-Funding

• The reasons for the greater interest in self-

funding in recent years are numerous.

• Self-funded plans are not subject to state

insurance laws, due to a preemption in the
Employee Retirement Income Security Act
(ERISA).
• Some see the increasing growth of self-funded
plans as driven by a desire to escape state
regulation.

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 Reasons for Growth of Self-Funding

• In health insurance, for example, many states

have mandated-benefits laws, which require that
certain benefits be included in insured plans.

• Self-insured plans are not subject to these

mandates.

• In addition, most states have passed small group

reform laws that impose rate limitations, require
guaranteed issue of small employer policies, and
limit preexisting conditions exclusions.

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 Funding Issues

1. Self-funding employers typically purchase stop-

loss insurance to protect against catastrophe
losses.

2. Self-funding employers generally retain an

outside party to handle administration.
• third party administrator
• insurance company under Administrative
Services Only (ASO) contract

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 Stop-Loss Insurance.

• Stop loss insurance puts a limit on the amount of

loss the employer is required to fund.
• The most common form of stop-loss insurance is
aggregate stop-loss.

• With aggregate stop-loss insurance, the

employer agrees to pay all claims up to an
agreed upon limit for the year, and the insurer
pays for all claims beyond the limit.

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 Third Party Administrators

• Most employers that self-fund their benefit plans

seek the assistance of an outside administrator.
• Administering a benefit plan can require
significant expertise, and the employer is often
not interested in developing and maintaining that
expertise internally.
• In addition, some employers are concerned that
internal administration creates the possibility for
conflict between the employer and employee
over benefit decisions.
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 Administrative Services Only

• Where the employer has arranged stop-loss

insurance, it is common for the insurer to be the
administrator.

• Where the plan is fully self-funded, the contract

between the administrator and employer is often
called an administrative services only (ASO)
agreement, in recognition of the fact that no
insurance is being provided.

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 Funding Through a 501(c)(9) Trust

1. Section 501(c)(9) of the I.R.C. allows employers

to establish a voluntary employee benefit
association (VEBA) and to use the trust fund to
obtain certain benefits for members.

2. Benefits that may be funded include those

payable because of death, medical expenses,
disability, legal expenses, and unemployment.

3. Retirement and deferred compensation benefits

may not be funded through a VEBA.
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 Levels of Benefits

• Benefit levels vary by industry and employer

size.
• Employee benefits are more likely to be offered
by large employers than by smaller employers.
• In addition, employers typically differentiate
between full-time and part-time employees in the
design of their plans.
• Often, full-time employees are eligible for a
variety of benefits for which part-time employees
are not eligible.
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 Insurance and Disability Benefits

Benefit Workers Covered

Medical care 2 out of 3
Life insurance 2 our of 3
Defined benefit pension plans 1 out of 5
Defined contribution plans 3 out of 10
Deferred profit sharing plans 1 out of 7
Savings and thrift plans 1 out of 10
401(k) plans 1 out of 6

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