In sickness and in health

Whether they'll reduce health care costs or erode the quality of care remains to be seen.

As companies confront newly resurgent health care costs, they are revisiting an old idea: offering medical benefits through the rough equivalent of a 401(k).

Here's how a typical plan works: The employer contributes a certain pretax amount to an employee's account - say, $1,000 - to cover out-of-pocket or premium expenses. It's actually a notional amount, unfunded by the company until the employee presents a bill to be reimbursed. In this sense health care 401(k)s are unlike traditional defined contribution plans because they provide no pool of assets to be managed.

The employer's contribution is credited toward the employee's deductible. In addition, through a payroll deduction made with pretax dollars, the employee pays a share of his health care premium, which is usually somewhere between 10 and 25 percent. A family typically makes a health care plan payroll deduction of $1,000 to $1,400 a year. This payroll deduction funds the cost of the premium, but not the cost of the deductible.

Once the employee has accumulated enough health care expenses to exhaust the employer's pretax contribution (the $1,000 cited above), the employee assumes the obligation for remaining out-of-pocket expenses up to a specified cap of, say, $3,000 or $5,000. After that, the insurance policy kicks in, with most plans covering about 80 percent of expenses deemed to be, in the critical phrase, "reasonable and necessary."

In these new 401(k)-style plans - dubbed consumer-driven plans by their creators - the firm's basic insurance coverage determines which health care providers can be used and under what terms, depending on whether they are in or out of the firm's network. But unlike traditional plans, if an employee does not spend, say, the entire $1,000 before the year is out, the worker can "bank" that money in a tax-deferred plan similar to a 401(k), reserving it to pay medical expenses in future years. But some plan sponsors' lawyers are concerned that the money could pose a tax liability if it is rolled over.

Proponents of the new style of plan argue that it is designed to offer employees more flexibility in spending their health care dollars. But at the same time, the plan aims to wake up both consumers and providers to the real costs of medical care. Health care economists predict that consumer-driven plans will encourage competition for patients, which should have the effect of restraining the rise in health care costs.

Only a handful of companies currently offer consumer-driven health plans, generally as one option among several. Consultants report that roughly 15 percent of eligible employees usually choose the new option.

Among the early adopters: Medtronic, Textron, Raytheon Co., Budget Group (Budget Rent a Car Corp.) and the University of Minnesota. In November the Pacific Business Group on Health - a consortium of 45 large California employers, including the California Public Employees' Retirement System, the University of California, Bank of America Corp. and Intel Corp. - endorsed the idea of consumer-driven plans for its member companies. And in a recent survey by the Henry J. Kaiser Family Foundation, 24 percent of the polled executives expect to offer some sort of defined contribution health plan within the next five years.

Since January 2001 Medtronic, a Minneapolis-based medical technology company, has offered its own version of a health care 401(k). The firm contributes $1,000 to single employees, $1,500 to married employees and $2,000 to those with families. The employee then chooses how to spend those dollars on medical care, much as a 401(k) participant chooses his investment options. Medtronic employees might choose to pay for preventive medical care or routine checkups for babies - or whatever they need - through a provider or institution that may or may not be in the approved network. Going out of network would pose no added burden to the employee as long as the expenses incurred did not exceed the employer's contribution (the $1,000 in the example cited above). Of course, that would change once the cap was reached.

"The biggest problem with traditional health plans is that the employee is the receiver of health benefits. He's not the consumer of medical care," says David Ness, vice president of compensation and benefits at Medtronic.

As with all health insurance policies, though, the critical question is what happens when an employee gets sick and faces unusually high medical expenses. "These plans are not favorable to low-income folks, because of the out-of-pocket expenses," says Anthony Kotin, who heads up the health and group benefits practice for William M. Mercer. "Traditional health plans are also unfavorable to lower-wage earners," he adds.

Robert Cosway, a consultant with Milliman USA who advises plan sponsors, suggests that the plans are usually a better deal for employers than their workers. "In a tight labor market, no one would have considered consumer-driven plans," he says. But amid widespread corporate layoffs and a rising unemployment rate, companies can afford to offer less attractive benefits packages.

This past year Medtronic offered a consumer-driven health plan as an alternative to two traditional options to 10,500 employees; 1,300 signed on. Ness contends that the costs to the employee are comparable to those of traditional health plans but estimates that the consumer-driven model is about 25 percent cheaper to administer. If all 10,500 employees chose the 401(k) style plan, Medtronic would save $50,000 on its annual health care administrative costs of $200,000.

"Many companies are exploring the possibility of consumer-driven health plans," reports Susan Kunreuther, director of benefits at Burger King Corp. Kunreuther will soon propose the idea of including a consumer-driven plan among the company's health options to senior management.

But many issues remain unresolved: "What do you do about vesting? Retirement? Do you allow investment options and risk?" asks Kunreuther. "This is still an immature product."

Over the past six months, several established insurers have come out with this new type of plan, among them Aetna, Humana, Health Net and WellPoint Health Networks, while Regence Group (a regional insurer in the Pacific Northwest) has linked up with MyHealthBank. Smaller health insurers offering the plans include Definity Health, Vivius, Lumenos and others.

Obstacles remain. First and foremost is the uncertain tax treatment of these accounts. The Internal Revenue Service said it would not issue a private-letter ruling on consumer-driven health plans. A similar product, the flexible spending account, funded with pretax dollars, must be used within a calendar year. These accounts operate under the so-called cafeteria plan rules of taxation, Section 125, which would strip the accounts of their tax-favored status if the funds were rolled into the following year.

Another precursor to the health care 401(k), the Archer medical savings account, operates under Section 220 of the Internal Revenue code, which permits the holdover of funds from one year to the next. However, the Archer MSA is a temporary program, currently authorized only through 2002.

But even if Congress resolves that uncertainty, another question remains: How does a company guarantee the actuarial soundness of a consumer-driven health plan? Under the current structure of health benefits, most large employers self-insure, drawing on a large risk pool. Smaller employers frequently purchase their health insurance through affiliated programs to benefit from a larger pool of employees with whom to share the risks. Offering employees a choice among medical packages necessarily fragments the risk pool.

Companies must consider the possibility of "adverse selection," actuarial shorthand for distorting the composition of a risk pool. This would occur if, for example, healthy employees chose the consumer-directed option and less healthy workers were left to dominate the company's traditional health plan. An employer might respond by limiting coverage to only 50 percent of reasonable costs, as opposed to the more traditional 80 percent.

"The more an employee has to pay, the more this addresses adverse selection," says Daniel Plante, a senior consultant and actuary with PricewaterhouseCoopers. Of the approximately 10,000 employees eligible for the three plans for which Plante consults, those opting for the consumer-directed model tend to be slightly older and thus are at higher risk of getting sick.

What happens to unspent medical benefit dollars in a consumer-driven account when the account holder changes jobs, retires or dies? ERISA does not address this issue, nor do the sections of the Internal Revenue code that cover employee benefit programs. If that question is favorably answered, it will represent a major boost to the young market.

"It will be a huge step," says Thomas Beauregard, a health care consultant with Hewitt Associates. "Then we'll be talking about '401(h) plans.' "