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Benefits that bend.

Over the last decade, the employee benefit component of the compensation pie has been getting more and more attention from employees and employers. While the reasons differ, the conclusion is the same: Employee benefits are a source of dissatisfaction.

From the employee's perspective, the last decade has been an ongoing process of takeaways, and most employees believe the trend will only accelerate. From the employer's perspective, the cost of benefits, both in absolute dollars and as a percent of payroll, continues to escalate much faster than other costs. Even more troublesome for companies is the realization of just how little control they have over their benefit programs, given the rate of medical inflation, changes in Medicare provisions, and an Internal Revenue Code that changes frequently and doesn't always consider the need for efficacy in employee benefits.

One answer to these problems is flexible benefits. Under flexible programs, companies provide employees with a benefit allowance and the opportunity to choose the benefits they'd like from among options the firm determines.

WHAT'S IN IT FOR YOU?

The concept of flexible benefits has been a very emotional issue. Some people see it as a panacea; some see it as the worst thing that could happen to employee benefits. It's neither. It's a delivering mechanism, with advantages and disadvantages.

What will flexible benefits help you and your company do?

* Minimize negative reactions - Say your company has a fixed medical plan and the employee is paying 10 percent of the costs. Then costs go up 20 percent. Of course, you could increase both the employee's and your own contributions. But even if the company and the employee maintain the same ratio of cost-sharing, the employee only sees his increased contribution. He doesn't focus on the company's increase.

Simply put, flexible benefits allow an employee to choose what to give up. He can have a lower plan that won't require a greater contribution, or he can have a higher plan that will.

* Contain costs - There's no doubt that you can design a flexible benefits plan to increase your costs, decrease your costs, or keep your costs level. However, a mechanism within all flexible benefit programs tends to dampen the effect of benefit cost increases. It's called the portfolio effect or, in less esoteric circles, chicken or beef.

Look at it this way: Putting taste aside, we are theoretically indifferent to eating chicken or beef for dinner if both cost $5 per pound. However, when beef goes u to $8 per pound, we tend to buy less beef and more chicken. A flexible benefit program permits normal economic forces to influence employee selection of benefits in much the same way. When the cost of one benefit option goes up much more rapidly than other benefits, employees buy less of it. Therefore, fewer of your compensation dollars are spent on benefits that are increasing in price, relative to those that aren't.

What are the disadvantages of flexible compensation? First, it's a new concept for employees and you may face some resistance. Second, short-service employees who are close to retirement have no method of directly supplementing the plan, although you may be able to help redirect some retirement money among the categories of pension, savings plan, and retiree medical. In either instance, companies have to do a careful job of communicating with employees.

THINK TOTAL COMPENSATION

Today, companies must take the total compensation perspective, of which flexible benefits are a key part. The total compensation philosophy says the decision of how much should be spent on compensation needs to be separated from the decision of how it will be spent.

By providing each employee with a total compensation allowance, you gain control over what is spent. By giving employees control over how the allowance gets spent, you can be sure the employee knows the true value of his total compensation and each dollar spent will be spent in a way that most satisfies the employee.

The market realities of the 1990s are going to make total compensation the absolute reality because companies today have to pay competitive compensation. If you don't, as much as an employee may love your company, as loyal as he may be, he won't work for you.

Economically, companies can pay only so much total compensation, whether in cash or benefits. After all, money used for compensation can't be used for investments or for customers. And money spent on benefits isn't available as cash. We have to accept this concept of a finite compensation pool. Companies that compensate inefficiently will have to spend more. That's why providing benefits, as opposed to cash, has some real disadvantages:

* Loss of control - Companies lose control over benefits as compensation. When an employee retires, increases occur without your control. When medical inflation pushes up health care costs, you have no control. If Medicare decides to scale back, your costs go up. With cash, when you give it to an employee, the amount doesn't increase unless you decide it should.

* Distorted allocation - When you pay an employee his salary, it's based on the contribution the individual is making. Not so with benefits. Each benefit has its own allocation function. Who gets more in a medical plan? Most likely an older employee or an employee who has a large family, not necessarily the people making the biggest contribution to the company. The allocation function is seldom consistent with the company's business objectives.

* Limited usefulness - Given the diverse demographics of today's workforce, the possibility of satisfying every employee with the same benefit is low. That means the value of the benefit to the employee may be much lower than its cost to you.

* Lack of appreciation - A couple of years ago, a national survey organization asked employees how much they thought their benefits were worth. More than half felt their benefits were worth less than 5 percent of their pay. The Chamber of Commerce at the time reported that benefits were worth, on average, 38 percent of pay.

So, why offer benefits at all? There are several reasons. First, as technology and the work environment changes, we need people to retire. If you don't provide employees with some resources for retirement, you'll find it difficult to get the employees to retire. Second, companies want to provide a benefit whose value is greater than the cost. This used to happen in two ways: through economies of scale or through tax incentives. Today, however, neither of these strategies is reliable.

What makes the most sense is to provide the minimum amount of benefits to meet your needs and give the rest of the compensation in cash. Then offer the opportunity for those employees who depend on certain benefits to convert their cash into those benefits. And that's essentially the kind of tranformation of the benefits program that flexible benefits can provide.

To expand your traditional flexible benefit programs, first consider the characteristics of the ideal compensation program: You aren't in business to provide benefits; you provide benefits to stay in business. You need to attract and retain individuals who help you perform the activities of your business. Compensation, including benefits, is one of the main ways to do this. Because of the way benefit practices evolved, people tend to view benefits in an isolated, fragmentary context. The notion of "fringe" benefits implies a compensation policy of pay with some extras added on. With benefits nationally approaching 38% of direct pay, neither employers nor employees can view them as fringe any longer.

How does the total compensation plan come together? First, you need to identify your employees' needs for protection and financial security. Then you must identify the company's needs - the minimum levels the firm feels comfortable providing its employees. Then structure the program so that all benefits are provided in the most tax-advantageous way.

Right now, companies have the ability to give employees a total compensation allowance, subdivided into a pay allowance, a welfare benefit allowance, and a retirement benefit allowance - all denominated in dollars, so the employee knows he's not making $50,000 a year, for example, but $70,000 a year. (Look at the sample compensation sheet, below left.) Then the employee has the choices of welfare benefits, medical plans, dental plans, life insurance, dependent reimbursement, health care reimbursement, and even the ability to trade off between pension benefits, profit-sharing benefits, and retiree medical benefits.

NOW FOR SECTION 125

One early obstacle to flexible benefits programs has been an underlying tenet of the Internal Revenue Code: the doctrine of constructive receipt.

Under this principle, if an employee had a choice of the form in which he received his compensation, and that choice included either receiving a taxable form of compensation (such as cash) or a nontaxable form (such as a medical plan), he was taxed as if he took the taxable form, regardless of which form he actually took. The fact that he could have received his compensation as taxable cash, if he chose, meant that he constructively received that cash.

What did this mean to employers? Those who wanted to provide employee choice in compensation were going to forfeit the tax incentives that were built into the Internal Revenue Code for many benefits.

Fortunately, a number of forward-looking companies convinced Congress that this was very undesirable. In 1978, Section 125, the so called "cafeteria plan" section, was introduced into the Internal Revenue Code. It waived the doctrine of constructive receipt if various requirements were met.

As a result, flexible benefit plans could offer employees a choice among various levels of medical insurance, life insurance, disability insurance, other welfare plans, vacation, and cash. Participants would be taxed only to the extent that the options they selected were taxable.

The success of the initial attempts to implement cafeteria plans under Section 125 encouraged many companies to implement them. Unfortunately, in many cases, the code section itself became the blueprint for the benefit plan design. At the expense of meeting their own benefit program objectives, many employers designed plans to satisfy Section 125 requirements. In short, the tail began to wag the dog.

At the same time, regulations governing Section 125 plans have become more restrictive as the need for benefit restructuring has extended beyond welfare benefits to retiree benefits, including retiree medical.

Section 1 25 stipulates that 401 (k) cash or deferred compensation is the only type of deferred compensation that may be included in a Section 125 plan. This means that other deferred compensation benefits, such as pension plans, non-401(k) profit-sharing plans, and retiree medical benefit programs, cannot be included.

For this reason, employers who want to implement relevant flexible benefit programs today must be creative and "get out of the box," realizing that flexible benefits are much more than Section 125. Indeed, Congress may need to reconsider the framework and limitations it has established for programs offering employee choice.

ALTERNATIVE DESIGNS

Despite the significant limitations of Section 125 (particularly when you attempt to add retiree benefits to the total compensation package), several viable plan designs remain. (See the comparison chart on the following page.)

Choice and constructive receipt only become a problem if the plan design creates a situation in which tradeoffs between taxable and nontaxable benefits are allowed. So, by structuring a flexible benefit plan with choice among nontaxable benefits only, you can create a so-called "benefits-only plan" that is less restrictive than Section 125 plans.

The Benefits-Only Plan - A benefits-only plan can include deferred benefits, such as defined benefit pension plans, defined contribution plans, and retiree medical plans. It can also include non-taxable, current welfare benefits, such as medical, dental, life insurance less than $50,000, and long-term disability. However, it doesn't allow salary conversions, in or out of these plans, because the inclusion of the choice to include cash would create a taxable option. Consequently, all credits must come from the employer.

The Parallel Plan - A plan structure that allows even greater flexibility and choice is the "parallel plan," which is really two plans working in tandem. The first plan is a benefits-only plan, which could include nontaxable welfare benefits, qualified retirement plans, and postretirement medical benefits. The second plan is a cafeteria plan, which could include any of the permitted welfare benefits, a 401 (k) plan, or cash.

While the general architecture of these plans is straightforward, the detail design is critical. Each of the plans included in the program must meet the legal requirements associated with that plan type. When including qualified plans in these programs, companies must remember that, when all is said and done, they must satisfy all of the eligibility and benefit tests required of these plans.

FROM PARENT TO PARTNER

Under total compensation, the relationship of the employer to the employee changes from parent to partner. The employee assumes a much greater role in decision-making and responsibility for meeting his personal financial and security needs. This shift requires - in fact obligates - you as employer to communicate directly, personally, and sensitively with employees. You must guide them through the process, providing them with the information and the tools they'll need to make good decisions.

You must become an honest broker. Many people are trying to get their hands on your employees' money, and you're in a much better position to sort the good deals from the had deals. You have the responsibility to identify and in some way endorse good opportunities for your employees.

This shift in responsibility presents tremendous opportunity, too. The partnership relationship and the new attitude it creates can manifest itself in many forms, including increased productivity, because employees feel more connected to the core of the business. They'll see that what they get is directly proportional to what they put in.

Companies can seize this opportunity through - once again - careful and thoughtful communication. Brochures and booklets won't do it. Reeducation and training, highly personalized communication that tells employees what this means for them individually, and person-to-person transfer of enthusiasm and motivation will do it. And, remember, the benefits of having employees who believe they're in control of their total compensation outweigh any increases in the cost for communication.

If you take these steps, eventually you'll find you're no longer perceived as the source of medical care, the source of cost increases, and you'll help your employees get the most value from their total compensation dollar.
COPYRIGHT 1992 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:flexible employee benefits
Author:Tane, Lance D.
Publication:Financial Executive
Date:Mar 1, 1992
Words:2387
Previous Article:Accounting across borders.
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