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What Are the Advantages of Defined Contribution Plans?

Last updated August 6th, 2020

Reviewed by Frank Lalli

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About a decade and a half ago, defined contribution health plans appeared to be the wave of the future for employer-sponsored benefits. In the late 90s, more than 62% of healthcare leaders predicted employers would switch to such an arrangement by 2010. Then, defined contribution fell out of fashion. But boosters say there are reasons why businesses may want to revisit the plans and offer them to their workers.

What Is a Defined Contribution Health Plan?

Defined contribution health plans are not really health plans, at least not in the traditional sense. Essentially, under a defined contribution health plan, the employer gives workers a set amount of money to choose from an array of employee health insurance coverage options — like getting money to shop the cafeteria menu for your individual meal. 

In short, employers contribute a defined amount toward their employees’ healthcare benefits. Rather than companies paying, say, 80% of ever-rising group health insurance costs for all workers, the company contributes a set amount for health care. Then each worker is able to spend his or her share on any individual health plan option offered through an insurance plan exchange, thereby hopefully picking a plan better tailored to the worker’s specific needs and budget.

How Does Defined Contribution Work?

 Employers decide how much the company will spend on health insurance for all employees and their dependents in a given year. They may then divide their total into lump sums for each worker. Or the company may reimburse all workers up to the company’s defined contribution limit. The employers may manage their companies’ defined contribution arrangements themselves, use special software, or they can hire a third-party administrator.

 Businesses may offer employees access to a private health insurance exchange they create, which is actually a menu of plan options. The private exchange usually offers a variety of health plans from multiple carriers — typically three to five insurance companies and up to 25 plan options. The company can also contribute varied allowances or reimbursement amounts to different individuals based on their employment status. This flexibility is helpful to employers with a range of employee types — part time, hourly, salaried, seasonal,  — or with workers in high-cost-of-living areas as well as low-cost areas.

Employers may also opt to pay employees extra, taxable income earmarked for health insurance premiums each month. Employers are prohibited from providing pre-tax dollars. Employees could then use that taxable amount to shop for health insurance through the Affordable Care Act’s (Obamacare) health insurance exchanges or through the employer’s private exchange.There are many rules and restrictions. Companies with 50 or more full-time employees must provide access to credible health insurance under the ACA’s employer responsibility provision. If they fail to provide access to decent coverage, they could face hefty penalties.. Additionally, it is important to consider that any extra money paid to employees may push them into a higher tax bracket and make them exempt from Obamacare subsidies.

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Why Should Small Businesses Offer Defined Contribution Health Plans?

With the ACA prohibiting denial of coverage to workers and also preventing collecting higher rates based on health history — as well as rising group health costs — defined contribution health plans may well appeal to small businesses for reasons beyond the obvious: With defined contribution, companies cap how much they’ll spend on their workers’ health insurance each year. Other potential advantages:

  • Tax Breaks: Employer defined health insurance contributions are a tax-deductible business expense.
  • Streamlined process: Small business owners may find defined plans easier to manage. 
  • Choice: A defined contribution health plan allows employees to choose among a selection of health plans based on their personal healthcare needs and budgets.
  • Transparency: Employees can more easily appreciate how much their companies are spending on their health coverage benefits. As a benefits attorney pointed out to the Society for Human Resource Management: “When employees see the gross monthly rate of their insurance and the gross monthly contribution that [the employer is] making toward that, it’s enlightening. They are exposed to the true costs.”
  • Savings: Workers who qualify for ACA financial assistance on state-based or federal health insurance exchanges can reduce their monthly premiums and out-of-pocket expenses through tax credits and cost-sharing subsidies.
  • Flexibility: If the employer’s defined contribution exceeds a worker’s actual premium costs, the worker can shift the savings into a health savings account (HSA) to help pay for qualified medical expenses tax-free. Or the worker might buy supplemental coverage. 
  • Satisfaction: Some workers may perceive gaining control over their healthcare decisions as a benefit and a good reason to remain a loyal employee. 

What Else Should Employers Know?

The ACA employer mandate comes with sizable fines. Those who do not provide access to decent health insurance could have to pay $2,000 per employee above 30 employees. The mandate applies to the following: 

  • Employers with 100 or more full-time employees or a number of full- and part-time employees that equals 100 or more full-time employees;
  • Employers with 50 or more full-time employees or a number of full- and part-time employees that equals 50 or more full-time employees;
  • Employers that meet the requirements above must offer health insurance coverage to 95% of their full-time employees

Still, employers with 50 or fewer employees are exempt from the employer mandate, also known as the employer responsibility provision.

It is also important to note that the IRS prohibits the practice of giving employees pre-tax money to purchase health plans through the Obamacare exchanges or private marketplace. Those who do could face a $100 per day excise tax per applicant.

How Can Small Businesses Set Up Defined Contribution Health Plans?

Small business owners who want to move to defined contribution health plans should consult a licensed health insurance agent.

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