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Private exchanges are replacing traditional employer retirement health plans

In 1980 Ted Benna was considering a career change. Working at a Philadelphia benefits consulting firm, he increasingly felt that his client companies wanted benefits to be tilted in favor higher-paid workers. That left less for hourly employees and Benna, who says his passion is helping those who need it most, was thinking of going into some type of ministry in which he could help people.

One Saturday afternoon when working at the office, Benna came across an obscure provision, actually a loophole, in Section 401(k) of the 1978 Tax Reform Act. As he read it, he thought the provision might help the average worker save more for retirement.

In the arcane language of the tax code, the new law appeared to say that, subject to certain constraints, workers could set aside a portion of their salary in retirement investment accounts without having to pay taxes until the money was withdrawn years or even decades later.

The IRS agreed in 1981 that Benna’s reading of the law was correct. As he later recalled, he didn’t realize at the time that he’d just created a monster. Today more than 95% of employers sponsor 401(k) plans holding $3.8 trillion in assets. Instead of having to manage the long-term liabilities of a defined-benefit pension plan, firms have shifted the costs and risks to employees and retirees.

In some cases when companies match a portion of employees’ contributions to a 401k, as 47% of companies do, employees can do better than they would in the pension plan. The evidence, though, as demonstrated in a report from the benefits consulting firm Towers Watson, is that most of them do much worse.

Companies are now introducing the defined-contribution approach to their retirement health coverage. It is a further erosion of what just 25 years ago was a solid benefit for most workers, as the following chart shows.

Today fewer than one-third (28%) of workers at the large firms that currently provide health care benefits get retirement coverage. Added to that, only 5% of workers at small firms get health benefits in retirement.

In the past three weeks, both IBM and Time-Warner have announced that in January they will transfer retirees into defined-contribution private exchanges. IBM’s change affects 110,000 retirees. That number represents only a small segment, however, of the millions of retirees expected to be transferred to Medicare private exchanges in the next few years.

Much of the publicity about private exchanges has dealt with their use for active workers, who are given a subsidy by their employers that they can use in government or in some cases private exchanges. But less attention has been given to their use for retired workers, even though the financial impact out out-of-pocket costs will be greater.

Already some 60 companies in the Fortune 500 have signed up for private exchanges for their retirees. And in a recent survey of 548 companies, the consulting firm Aon Hewitt found that two-thirds of large firms are considering defined- contribution health plans for their retirees.

Firms make no secret that the change is to reduce their future exposure to rising health costs. IBM chief medical director Dr. Kyu Rhee said in his videotaped announcement to retirees that the company is switching to a private exchange to protect retirees and the company from healthcare costs that otherwise would triple in the next few years. As Rhee noted, much of that increased cost would be paid by retirees in premiums and cost-sharing. But IBM would likely shoulder a larger share of the cost than it will now.

That’s not to say that defined-contribution health plans are all bad. For younger retirees who use few medical services, they can reduce costs. Typically the company pays a fixed amount — $100 a month, say – into a Health Reimbursement Account (HRA) for the retiree. The company gets a tax deduction and the retiree does not have to pay taxes on the contribution as long as the money is spent for qualified health expenses in a company-designated plan or private exchange. Most employer HRA rules allow unspent company dollars to be saved for later use (they cannot be used to pay Part B premiums).

Large firms have longed for defined-contribution health plans for more than a decade, according to a study by the Employee Benefits Research Institute. The Affordable Care Act legitimized the concept of exchanges by creating public ones starting in 2014, with the government making defined contributions for lower-income individuals. Private exchanges, however, are administered by for-profit companies that contract with insurance companies. Most of a private exchange’s income is from commissions and shelf-space fees.

An upside for retirees is that they more choices. A traditional employer health plan typically has three or four options – one or two HMOs, a PPO, and a fee-for-service supplement. Sometimes a smaller company will have only a single plan. Private exchanges, however, include several Advantage plans, Medigap policies, and Part D plans. And they sell other insurance for routine dental and vision care.

Medicare Advantage plans in private exchanges can be cost effective because have a twofold discount. First, they receive generous subsidies and bonuses from Medicare that make it easier for them to keep premiums and cost-sharing low. Second, retirees who enroll in Advantage plans through a private exchange use non-taxed money for the costs they do incur. And as an extra, the large Advantage plans use their purchasing leverage to secure bargain prices from pharmaceutical companies and hospitals, which is something most traditional employer plans are unable to do.

The largest Medicare private exchange is operated by ExtendHealth, which advertises that it has “thousands of plans from more than 75 of the nation’s leading health insurers.” A subsidiary of Towers Watson Consulting, ExtendHealth’s prospects are bright enough that it has filed with the SEC for a public offering that’s expected late this year. In 2007 ExtendHealth had only three corporate customers and by the end of 2010 it had 76 employers under contract. Now it provides retiree health coverage for more than 300 large companies including IBM, Caterpillar, DuPont, General Motors, and Whirlpool.

Yet the downside to private exchanges is substantial when they are compared to traditional employer plans. Even though retirees have more choices in private exchanges than in their old plans, the choices may not be as good as for people who don’t have employer coverage. As one example, Kaiser Permanente sponsors more than one-half of the Advantage plans with five-star ratings, but it is not available in a private exchange. That means that the one million retirees currently in private exchanges cannot enroll in Kaiser Advantage plans without permanently losing their defined contribution coverage.

In Los Angeles County, which has more Medicare Advantage enrollees than any other county, ExtendHealth offers 11 Advantage plans, but there are 27 plans listed at the Medicare web site. Also, there are almost twice as many Part D stand-alone plans available on the Medicare web site as there are in the ExtendHealth exchange (27 vs. 15).

Retirees in private exchanges are thus fenced off from roughly one-half of the available options, and in some cases they could wind up paying more than if they had no employer subsidy. If the lowest-cost Part D plan on the ExtendHealth exchange costs $1,500 more for a senior’s drugs than the Medicare web site’s least expensive plan, then a retiree who receives a $100 a month defined contribution will lose money, even after tax savings are factored in.

Those are the probably the rare exceptions, but if companies increase their annual contributions at a rate below healthcare inflation, they could become the norm. IBM has said that it will contribute amounts comparable to what it now pays for retiree health plans, but they have no obligation to increase that amount in future years. And it’s good to remember that the reason companies are moving retirees into private exchanges is that they believe that health care costs will increase at more rapidly than their contributions. That in turn will mean retirees in private exchanges will face ever-greater cost-sharing.

Meanwhile Ted Benna, the father of 401k plans, has regrets about the way they have evolved. He says that the earliest 401k plans were simple and easy-to-understand vehicles with two or three basic investment options. Gradually the number of choices increased, which gave workers more opportunities to chase fads, usually to their detriment. The vanishing company pension plan, by contrast, has always been managed by professionals able to quantify risk.

Likewise a company’s retirement health plan options have always been selected by experts hired by the employers wanting to make sure their money was spent wisely. In many cases companies self-insured their health plans, which meant they bore much of the risk and gave them an added incentive to choose well. ◊◊


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