Employee Benefit Plan Financing

This article will focus on employee benefit plan financing. This article will describe employee benefits plans, their history, primary regulations (including the Employee Retirement Income Security Act), and financing. This article will provide an analysis of the different types of benefit plan financing, including pooling, captive insurance, self-funding, and voluntary employee beneficiary association, as well as a brief discussion of the advantages and disadvantages of each financing choice. The issues associated with retirement and pension plan financing will be addressed.

Keywords Captive Insurance; Employee Benefit Plan; Employee Retirement Income Security Act (ERISA); Pooling; Self-Funding; Voluntary Employee Beneficiary Associations

Insurance & Risk Management > Employee Benefit Plan Financing

Overview

The most common employee benefit plans available to full-time, and in some instances part time, workers in the United States include retirement plans, health plans, leave plans, severance benefits, and life-insurance benefits. These benefit plans are generally financed with different financial tools and approaches. The plans are generally funded by employer contributions, employee contributions, or some combination of funding arrangements agreed upon through negotiation and bargaining. Variables that effect plan financing include government regulations, organizational resources, plan sponsor and plan member relationship and negotiations, plan enrollment, and plan coverage.

Employee Benefit Plan Process

The overall employee benefits process or system includes stages of design, finance, and administration. Benefit design and administration, which are responsive to the stakeholder needs, organizational resources, and government requirements, rely on sufficient financing to support member needs and claims. The range of employee benefit financing options is large. Employers may be fully insured, self-funded, or adopt a hybrid risk-sharing approach. Variables that affect an employer's choice of benefit plan financing schemes include the average age of the employees, level of benefits, cash flow, multiple plan options, and multiple locations. Employee benefit plans may be classified as a ‘defined contribution plan’, in which benefits are delivered into individual accounts for each member; a ‘funded defined benefit plan’, in which contributions from the employer are invested in a fund towards increasing the benefits; or an ‘unfunded defined benefit plan’, in which no funds are set aside by the employer.

Financing of Employee Benefit Plans

Employers finance employee benefit plans through four main tactics or approaches: Pooling, self-funding, captive insurance, and voluntary employee beneficiary associations (VEBA). The federal government regulates and oversees how employee benefit plans are financed to protect the interests of the labor force and their families. Organizations without sufficient funds to pay out retirement benefits and pensions, health-care claims, or leave benefits potentially harm individual employees and the economic health of the nation in general. The federal government regulates and encourages certain sorts of employee benefit plan financing through tax exemptions and deductions and discourages the use of other employee benefit plan financing options through restrictions, regulations, and penalties. The Employee Retirement Income Security Act of 1974, the federal legislation that governs the administration and design of employer pension, health and welfare plans, is one of the main regulatory forces shaping the type of financing used to fund employee benefits plans (Halterman, 2000).

This article will describe and analyze employee benefit plan financing in the public and private sectors of the United States. The following section, an overview of the history of employee benefit plans in the United States, will serve as a foundation for later discussions on the main types of employee benefit plan financing. The issues associated with employee retirement and savings plan financing will be addressed.

History of Employee Benefit Plans in the United States

At the end of the Industrial Revolution in America, American workers were left without much of their traditional familial safety net and economic self-sufficiency and instead had a new financial dependence on their employers and the government. Employee benefits became common in the United States during the early twentieth century. During this time, the social safety net switched from private sector (family, charity, community) to public sector (social policies such as welfare). The government became a source of labor regulations, such as mandated employee benefits and safe working conditions, and social welfare provisions, such as public education, welfare payments, pensions, and social security for disadvantaged groups such as poor families, elderly, disabled and students (Amenta & Bonastia, 2001). Significant labor policy of the twentieth-century includes the Organic Act of the Department of Labor, National Labor Relations (Wagner) Act, the Labor-Management Relations Act (also referred to as the Taft-Hartley Act), and the Employee Retirement Income Security Act. These laws established the parameters used today for finance, coverage, and administration of employee benefit plans.

U.S. Department of Labor

In 1913, the Organic Act of the Department of Labor (Public Law 426-62) established the U.S. Department of Labor (DOL) to administer and oversee a wide variety of laws and regulations concerning employment benefits. Public Law 426-62 states that "the purpose of the Department of Labor shall be to foster, promote, and develop the welfare of the wage earners of the United States, to improve their working conditions, and to advance their opportunities for profitable employment" (29 USC Sec. 551, 2010). In 1935, the National Labor Relations (Wagner) Act established the regulations governing labor relations of enterprises engaged in interstate commerce. The National Labor Relations Act established the National Labor Relations Board (NLRB) to protect the right of the labor force to organize in a way that will allow for collective bargaining either through chosen representatives or to avoid such activities entirely. The National Labor Relations Board includes five presidentially-appointed members and 33 regional directors. This board decides appropriate bargaining units, hosts elections for union representatives, and pursues accusations of unfair labor practices by employers. Unfair labor practices include interference, coercion, or restraint in the labor force’s right to organize; interference with the creation of labor unions; encouraging or discouraging union membership; and refusal to bargain collectively with a chosen employee representative.

Labor-Management Relations Act

In 1947, the Labor-Management Relations Act (also referred to as the Taft-Hartley Act) (Public Law 29-141) was passed to ensure that the rights of individual employees are not infringed upon in their association with labor organizations whose activities have an affect on commerce; define and guide labor and management practices which affect commerce and are adverse to the common good, and to protect the rights of the public in labor disputes that affect commerce. The Labor-Management Relations Act significantly affected how employee benefit plans are designed and implemented today. The Labor-Management Relations Act made fringe benefits part of collective bargaining and allowed tax-free employer contributions to employee benefit trust funds. In 1974, the Employee Retirement Income Security Act (ERISA) was passed “to protect the interests of participants and their beneficiaries in employee benefit plans. ERISA requires that sponsors of private employee benefit plans provide participants and beneficiaries with adequate information regarding their plans; individuals who manage plans must meet certain standards of conduct derived from the common law of trusts; and that benefit plan administrators meet standards for reporting to the government and disclosure to participants” (“About PWBA,” 2004, ¶5). ERISA includes civil enforcement provisions to protect plan funds and plan members.

The Employee Retirement Income Security Act is administered, overseen, and enforced by the Employee Benefits Security Administration (EBSA). Prior to 2003, the Employee Benefits Security Administration was known as the Pension and Welfare Benefits Administration (PWBA). The Employee Benefits Security Administration, a part of the Department of Labor, protects pensions, health plans, and other employee benefits for over 150 million American people. The Employee Benefits Security Administration operates to meet the following goals and provide the following services: help workers obtain the information necessary to take advantage of their benefit rights; help officials understand the different requirements of relevant statutes so they can meet their legal responsibilities; work to develop policies designed to promote the growth of employment-based benefits; and either avoid or correct statute violations through strong administration, civil enforcement, and criminal enforcement efforts to ensure that workers receive their promised benefits.

Applications

Types of Employee Benefit Plan Financing

There are four main types of employee benefit plan financing including pooling, captive insurance, self-funding, and voluntary employee beneficiary associations. These four financing types differ in their applicability to different benefit plans, their amount of risk, their regulations and parameters, their tax status, and their popularity in different sectors and industries.

Pooling

Organizations that are working to reduce their benefits costs and increase coverage and benefits for employees often use a pooling finance strategy. Pooling, which is used to finance life insurance, health benefits, and annuities, refers to the process of “treating employees in different locations as though they were in the same group of insured individuals” (Cole, 2001). Large organizations receive cost savings from benefit insurers due to the large enrollment figures. Pooling saves large organizations ten to twenty-five percent a year on the cost of benefits. Other financial benefits offered by pooling include lowering risk management costs; identifying excessive insurance margins from the insurance carrier; and permitting experiencing rating. Pooling also creates numerous non-financial benefits such as increasing guaranteed coverage levels; improving reporting quality for premiums and claims; and improving the organization's ability to move employees between locations without complicating benefit coverage (Cole, 2001).

Captive Insurance

Organizations are increasingly using the technique of global arbitrage (the practice of taking advantage of a price differential between two or more markets) to control the rising costs of benefits financing. Organizations use strategic international arbitrage to profit from the cost and accounting discrepancies in different locations around the world. The use of captive insurance to finance benefit plans is a form of global arbitrage. Captive insurance refers to “an insurance company that is owned by the parent company that insures, or reinsures, the risks of the parent” (Cole, 2001). Captive insurers protect employees, and their dependants, against loss of earnings or savings, due to illness or accidental injury, disability or death. Benefits covered by captive insurance include death benefits in lump sums; death benefits in dependants' pensions; personal accident benefits; short-term sickness benefits; long-term disability income benefits; medical and hospital expenses benefits; and retirement benefits.

Organizations use captive insurance to lower the costs for many kinds of business insurance and to keep control of financial assets that would, in other financing situations, be funding the insurance costs. Captives offer numerous advantages including gaining control over reserves and investment return; evening out rates for individual country operations; proving coverage not readily available in the commercial market; and improving health care costs by analyzing health related trends and offering managed cared in place of increased rates (Cole, 2001).

Captive insurers were first used in the mid-19th century and have been used as a benefit risk management tool ever since. Despite the advantages of captive insurance as a means of financing employee benefit plans, the use of captive insurance has been slowed somewhat in the United States by tax and legal restraints (Salter, 2003). In particular, ERISA prohibited the transactions between related entities and welfare benefits plans. In 1979, the Department of Labor issued an exemption clause that "allowed related entities to transact business with one another if 50 percent or more of the captive's business came from unrelated sources" (Rosser, 1998). In the final analysis, captive insurance is a popular employee benefit risk funding vehicle.

Self-Funding

Self-funding refers to a method of funding the claims of a benefit plan directly from the employer on an ongoing basis. Organizations choosing self-funding may be partially or fully self-funded. Organizations with a small number of employees, between 30 and 1,000, or those wanting greater control over the costs and services of benefit plans may choose to self-finance their employee benefit plan. Small employers find that self-funded insurance offers both cost-savings and benefits flexibility. Variables that affect the effectiveness of self-funding include the average age of the employees, level of benefits, cash flow, multiple plan options, and multi-state locations. The potential disadvantages of self-funded insurance are many. In particular, catastrophic situations, such as multiple employee sicknesses or deaths, may result in significant financial burden for the company as it pays for medical bills and life insurance. Small companies may protect against catastrophic scenario, and share some of the insurance risk with an outside party, through the purchase of stop-loss insurance. Stop-loss insurance is a type of security coverage that small and mid-sized employers use to limit the actual claims liability to the employer. Ultimately, stop-loss insurance is the key for many companies to making self-financed benefit plans a feasible option. Stop-loss coverage transforms self-funding from a high-risk option to a moderate risk option that many small companies choose (Halterman, 2000).

Voluntary Employee Beneficiary Associations

The voluntary employee beneficiary associations (VEBA) refer to “a trust established to fund certain benefit plans of the employer” (Moran, 2003, p.83). Plan sponsors consider the segregation of plan assets into separate trusts to offer numerous advantages. Examples of perceived advantages include the following: Setting aside or earmarking funds from the employer’s general assets; satisfying obligations to a union; generating tax benefits from pre-funding; and creating an asset to offset an employer’s liability. In certain situations, as specified by the Internal Revenue Service tax code, the income earned by VEBA trusts can grow tax-free. Organizations evaluate their benefit plan needs to assess whether or not their plan meets the IRS Code requirements for tax free growth. For example, VEBA trusts that finance retiree health benefits do not meet the IRS requirements for tax free growth.

VEBA trusts are used by organizations to fund their employee health, life insurance, and disability plans. One common use for a VEBA trust is to collect employee health, disability, and life insurance co-payments. This particular trust is one way of meeting the Department of Labor’s requirement that employee co-payments be kept separate from other organizational assets. VEBA trusts are governed by the regulations and parameters expressed in Section 501(c) of the U.S. Code. “A VEBA must be a beneficiaries’ association, controlled by its members, that provides life, sick, accident, health, or other benefits to its members or their dependents or beneficiaries” (Moran, 2003, p.84). VEBA receive tax exempt status only after application to and approval by the Internal Revenue Service. The tax status of VEBA-financed benefits is determined by the tax status of the particular benefit. For example, health benefits are not taxed while severance benefits are usually taxed.

VEBA trusts must meet certain nondiscrimination rules as specified in Section 505(b) of the U.S. Code. Some benefit planners add their own organization’s anti-discrimination rules to their VEBA trusts to satisfy the government requirement. Other organizations simply abide by the U.S. Code’s nondiscrimination rules. The minimum nondiscrimination rules state that VEBA benefits cannot be delivered to a class of employees that unfairly favors highly paid employees. Employees with fewer than three years of service, those under age 21, part-time, seasonal, and collectively bargained status are not subject to the nondiscrimination rules. The U.S. Code requires that the VEBA trustees either be elected or accountable in some other way to employees. VEBA assets cannot, by law, create profit for any individual other than through VEBA trust payments to plan members. Employers may make contributions to the VEBA trust but do so knowing that the payments cannot be returned and become plan assets.

In 1984, Congress passed legislation that reformed the VEBA process. The reform made it illegal for employers to pre-fund VEBA trusts for the future costs of employee benefits as a means of increasing fiscal year tax deductions. Congress put limits on the amounts that employers could contribute to welfare benefit trusts such as VEBA trusts. The limit varies based on the type of benefit plan being funded by the VEBA. VEBA trusts that are exempt from certain account limits that are applicable to other VEBA benefits include collectively bargained VEBA trusts, employee-pay-all VEBA trusts, and multi-employer VEBA trusts. When an organization's circumstances change, due to acquisition, merger, or market conditions, VEBA trusts can be amended to add another benefit to be funded by the VEBA but VEBA trusts cannot be liquidated for the organization's profit. In the final analyses, while VEBA trust account limits and administrative costs pose challenges, VEBA trusts are a popular and secure means for financing many types of employee benefit plans (Moran, 2003).

Issues

Overseeing Retirement & Pension Plans

The federal government regulates and oversees how employee retirement and pension plans are financed to protect the interests of the labor force and their families. Organizations without sufficient funds to pay out retirement benefits and pensions potentially harm both individual employees and the economic health of the nation in general. The International Foundation of Employee Benefit Plans asserts that, based on the uncertain future of Social Security to support the rising retirement-age population, employer-sponsored retirement plans are currently the most valuable retirement tool available to American workers. As a result of the importance of employer-sponsored retirement funds to the health of the U.S. society and economy, the federal government extensively regulates the financing and administration of retirement plans.

The federal government and the health of the economy in general, rely on members of the workforce saving and preparing for retirement. Retirement and pension plans, which are usually contributed to by both employers and employees, have very strict government regulations regarding how they are financed and operated. The most recent retirement-related legislation, the Pension Protection Act of 2006, prioritizes consumer information and plan transparency. The Pension Protection Act “requires both single and multiemployer defined benefit pension plans to provide annual plan funding notices that inform pension plan participants about the financial status of their pension plans” (“Pension Funding Notices”, 2007, ¶1). The funding notices must contain the information necessary for plan members to make informed decisions about their retirement. Examples of required information includes: providing basic information such as the name of the plan, contact information for the plan administrator, and the plan identification number; plan financing information; a comparison looking at the value of the plan’s assets compared to the amount of benefits being paid out; the number of participants currently receiving benefits, the number entitled to currently receive benefits, and the number of active participants in the plan; and information on the funding policy and allocation of plan assets under the plan.

The Pension Protection Act, along with ERISA which regulates pension plans and welfare-benefit plans, ensures that members of the labor force have access to the financial information concerning their retirement accounts. The effort to pass legislation that protects and regulates pension plans, and employee benefit plans in general, is shared by interest groups, such as the Pension Rights Center, and the federal government. The Pension Rights Center, along with other interest groups and watch-dog organizations, is working to ensure that the federal government continues to protect the interest of the labor force both young and old.

Conclusion

In the final analysis, the type of financing an organization chooses to fund their employee benefit plans will depend on variables such as the average age of the employees, level of benefits, cash flow, multiple plan options, and multiple locations. Options for employee benefit plan financing include pooling, captive insurance, self-funding, and voluntary employee beneficiary associations.

Terms & Concepts

Captive Insurance: “An insurance company that is owned by the parent company that insures, or reinsures, the risks of the parent company” (Cole, 2001).

Department of Labor: The government agency responsible for protecting the rights of the labor force and working to improve working conditions and opportunities for the wage earners of the United States.

Employee Benefits: The non-wage compensation that many employees receive in varying amounts, such as income protection and services and income supplements paid by the employer.

Employee Retirement Income Security Act: The federal legislation that governs the administration and design of employer pension, health and welfare plans.

Global Arbitrage: The practice of taking advantage of a price differential between two or more international markets.

Plan Member: An employee or former employee of an organization who might become eligible for employee benefits .

Plan Sponsor: The party that establishes and maintains the benefits plan.

Pooling: The process of treating employees located in different places as if they were in the same group of insured individuals.

Retirement Benefits: A series of regular payments, usually for life, payable monthly or at other specified intervals.

Self-Funding: A method of funding the claims of a benefit plan directly from the employer on an ongoing basis.

Voluntary Employee Beneficiary Associations: A trust established to fund certain benefit plans of the employer.

Bibliography

29 USC Sec. 551. (2010). Retrieved August 9, 2010 from http://uscode.house.gov/download/pls/Title_29.txt

“About PWBA.” (2004). Pension and Welfare Benefits Administration Strategic Plan. Retrieved August 9, 2010 from http://www.dol.gov/ebsa/gpra/main.htm

Amenta, E., Bonastia, C., & Caren, N. (2001). U.S. social policy in comparative and historical perspective. Annual Review of Sociology, 27, 213-232. Retrieved June 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5163022&site=ehost-live

Cole, M. (2001). A new perspective on global benefits: Using captive insurance. Employment Relations Today (Wiley), 28, 1-11. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4428289&site=ehost-live

Fromme, L.N. (2011). Unreliable securities for retirement income security: Certifying the ERISA stock-drop class. Vanderbilt Law Review, 64, 301-348. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=59649027&site=ehost-live

Geisel, J. (2004). Captive benefits plan gets tentative OK. Business Insurance, 38, 1-6. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=13195968&site=ehost-live

Halterman, S. (2000). Self-funding health insurance for small employers: Is it the right way to go? Employee Benefits Journal, 25, 3-7. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=3719183&site=ehost-live

Knorr, R., Schleifer, L, & Friedloh, G. (1993). Managing employee benefit plans. Management Accounting, 75, 49-52.

Moran, A. (2003). VEBAs: Possibilities for employee benefit funding. Employee Relations Law Journal (00988898), 29, 83-95. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9946008&site=ehost-live

Morgan, C., & Coleman, D. (1996). Emerging trends: Unified defined benefit/defined contribution retirement program designs. Benefits Quarterly, 12, 43-50. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=13202841&site=ehost-live

Peller, T. (2011). To be an ERISA plan, or not to be an ERISA plan. Journal of Pension Planning & Compliance, 36, 60-85. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=55069693&site=ehost-live

Pension Funding Notices. (2007). Pension Rights Center. Retrieved June 26, 2007, from http://www.pensionrights.org/policy/legislation/pension%5ffunding%5fnotices.html

Rosser, R. & Dove, N. (1998). Taking employee benefits offshore. Risk Management, 45, 18-19.

Salter, T. (2003). Captive insurers as employee benefit risk funding vehicles. Pensions: An International Journal, 9, 34.

Stamer, C. (2010). Tough times are no excuse for ERISA shortcuts. Employee Benefit News, 24, 12-13. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=49676621&site=ehost-live

Woodward, N. (2006). Is self-funded health a path for small firms? HRMagazine, 51, 84-90. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21865139&site=ehost-live

Suggested Reading

Brown, M. (2006). Funding retiree health benefits. Journal of Accountancy, 202, 74-75. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22040205&site=ehost-live

Ceniceros, R. (2004). Good fronts vital to benefits funding. Business Insurance, 38, 24-24. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=15277587&site=ehost-live

Geisel, J. (2004). Fast-track approval encourages use of captive benefits. Business Insurance, 38, T8-T10. Retrieved June 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=13851789&site=ehost-live