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Small Business Employee Benefits and HR Blog

Pros and Cons of Pure Defined Contribution Healthcare

January 13, 2014
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As a small business evaluates how to offer employees health insurance coverage, they will likely consider a "pure" defined contribution approach. With "pure" defined contribution healthcare, the employer offers employees a healthcare allowance to use on their choice of individual health insurance, instead of offering group health insurance.

"Pure" defined contribution healthcare is not health insurance, but rather a "business expense" type of health benefit.pros_and_cons

What are the pros and cons of "pure" defined contribution healthcare for a small business, and for employees? 

"Pure" Defined Contribution Healthcare: Pros for Small Businesses

The four main pros of defined contribution for small businesses are: controllable costs, more time, tax savings, and employee recruiting and retention.
  • Controllable Costs: With defined contribution, the business sets and controls the cost of health benefits. Unlike traditional group health insurance, there are no minimum contribution amounts. Additionally, the small business owns the allowance funds and the benefits are entirely employer-funded. Reimbursements are only issued to employees once they show proof of their expense. And, when the employee leaves the business, any unused funds generally stay with the business.

  • More Time for Strategic Work: Defined contribution healthcare reduces the administration time of health benefits. Using the right defined contribution software admin, managing health benefits takes 5 minutes per month online.

  • Tax Savings: By using a Section 105 Plan as the foundation of the defined contribution plan, small businesses will see tax savings. Small businesses can deduct reimbursements as a business expense, and exclude them from wages subject to FUTA (0.8%) and the employer portion of FICA (7.65%).

  • Recruiting & Retention: Many small businesses struggle to afford group health insurance, or cannot meet participation requirements. Offering defined contribution healthcare allows a small business to offer (and advertise) health benefits when recruiting key employees. It also shows employees that the business cares about employees' healthcare.

"Pure" Defined Contribution Healthcare: Pros for Employees

The three main pros of defined contribution healthcare for employees are: cost savings, choice of plans, and plan portability.
  • Cost Savings: Individual health insurance plans, on average, cost less than group health insurance plans. Eligible employees are able to access discounts on their health insurance with the federal health insurance tax credits. And as an additional cost savings to employees, defined contribution reimbursements are generally excluded from employees' gross income.

  • Choice of Any Insurance Plan: With defined contribution healthcare, employees choose the individual health insurance plan best for them, including which network of doctors. Employees can choose from any carrier, and any type of plan (HMO, PPO, HDHP, etc.). Employees can purchase a plan through the new health insurance marketplaces, through a broker, or directly from an insurance company. Additionally, employees can use their defined contribution allowance to cover the cost of supplemental coverage like dental or vision insurance.

  • Insurance Plan Portability: Employees are purchasing individual health insurance plans. Since individual health insurance plans belong to the employee (not to the small business), the plan stays with employees if they leave the business. 

"Pure" Defined Contribution Healthcare: Cons for Small Businesses

So, what about the cons of defined contribution healthcare? Here are potential cons for small businesses.
  • A Change in Benefits Administration: Using a defined contribution strategy changes health benefits from a plan management role to a payroll function. Some small businesses perceive the administration as a con of offering health benefits in this way. And, with the wrong defined contribution TPA or administrator this can be true. What's the work around? Use an online defined contribution software to completely alleviate this. With the right defined contribution software, administration takes 5 minutes a month and integrates with existing payroll systems.

  • Limited Tax-Benefits for Some Owners: With defined contribution that uses a Section 105 Plan as the foundation, some types of business owners receive limited tax benefits from reimbursements. In other words, some business owners may need to report reimbursements as taxable income. Read more on small business owner participation in Section 105 Plans here.

"Pure" Defined Contribution Healthcare: Cons for Employees

There are some perceived cons for employees. Likewise, with planning, education, and the right defined contribution software, these concerns can be addressed.

  • Reimbursements are Just That...: With a defined contribution approach, employees must show proof of their insurance premium before being reimbursed. Paying up front for health insurance (rather than it being automatically taken out of a paycheck), is a change. To significantly alleviate this, small businesses should use defined contribution software that provides same-day processing of employees' reimbursement requests ("claims").

  • Change is Hard: Let's be honest, transitioning to defined contribution healthcare is a significant change in how small businesses offer health benefits, and how employees receive them. Even with all of the employee benefits listed above, it still means employees take on a new responsibility of managing their own health benefits. Employees become health insurance consumers (just like they are car insurance consumers). What makes all the difference? Work with an insurance broker to help employees choose individual health insurance policies, and choose a defined contribution administrator that will help educate, train, and support employees on their new health benefits.

What are other pros and cons of "pure" defined contribution healthcare? Let us know in the comments below.


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