Shifting toward Defined Contributions — Predicting the Effects

By Kevin A. Schulman, M.D., Barak D. Richman, J.D., Ph.D., and Regina E. Herzlinger, D.B.A.
The New England Journal of Medicine, June 26, 2014

When Representative Paul Ryan (R-WI) attracted national attention by joining Senator Ron Wyden (D-OR) in proposing a sweeping privatization of Medicare, he was variously vilified and praised for suggesting that Medicare should be converted from a defined-benefit program to a defined-contribution program. Although there has been little congressional action to advance the Wyden–Ryan plan, defined-contribution programs are becoming increasingly prevalent in employer-sponsored health insurance and may ultimately bring about substantial changes in U.S. health care.

A defined-benefit program provides specific benefits to enrollees when those benefits are needed. For example, a defined-benefit pension program provides payments of specified amounts to retirees. Defined-benefit health insurance, such as Medicare and most private plans, pays for specific health care services when eligible beneficiaries demand such services. In contrast, a defined-contribution program — like most typical 401(k) retirement plans — provides certain financial support to beneficiaries before any benefits are consumed, and beneficiaries then spend those funds to meet their eventual expenses. In defined-contribution pension plans, only the financial contribution is defined, and the extracted benefits are determined by the payment and investment preferences of the beneficiary.

Economists have posited that defined-contribution health insurance plans offer two key benefits. First, enrollees in such plans receive more choice than they would in the one-size-fits-all plans typically offered by employers. They can thus consider the quality of plans and express their preferences for various features of benefits packages, such as open or limited provider networks and low or high deductibles. Second, defined-contribution plans can give employers greater certainty about costs, insulating them from unpredictable health care inflation. Such plans might also curb or reverse the trend toward employees’ passively shouldering the growing costs of employer-based defined-benefits plans. (Between 2003 and 2013, employer spending increased by 77%, while employees’ costs increased by 89%.1) In a competitive labor market, with the transparency of a defined-contribution plan, employers would have to compensate employees through higher wages for any shifting of additional health care costs, although increased compensation might only need to match employees’ perceptions of the value of the lost benefits.

One largely overlooked attraction of defined-benefit plans is related to the political economy of firms. Because the tax exemption for employer-provided health insurance often hides what employers pay for employees’ health insurance, many employees demand costly plans without realizing that the employer’s contribution ultimately reduces their own take-home pay. A defined-contribution plan, in contrast, makes insurance premiums more transparent, thereby inducing employees to demand more affordable health plans because they are aware of the full amount they pay. For example, when human resources consultancy Aon Hewitt helped companies implement insurance plans under a defined-contribution system in 2013, 42% of employees purchased less expensive plans, 32% purchased coverage similar to what they had previously had, and only 26% bought more expensive coverage.

The intellectual appeal of the Wyden–Ryan plan rested on this logic. Its supporters argued that because the risk of higher-than-expected health care inflation would be shifted onto Medicare enrollees, who would be empowered to exercise consumer choice, the market dynamics would change. On one hand, there would be greater cost consciousness behind consumer demand; on the other hand, supply would reflect greater competition for consumers’ premium dollars.

If Medicare reforms do not adequately address the excessive costs of health care, converting the program to a defined-contribution plan could leave many seniors uninsured or exposed to unaffordable health care bills, thereby undermining one of the fundamentals of the Medicare program — protection against financial risk — while leaving providers with major revenue shortfalls.

Although Medicare seems unlikely to be transformed into a defined-contribution program in the immediate future, the private insurance market is shifting toward defined contributions. Many large companies — including IBM, Duke Energy, and Time Warner — are now pursuing defined-contribution strategies for their retirees; others, including Walgreens, are doing so for current workers. Some companies have designed private insurance exchanges through which workers and retirees can purchase insurance plans, and others may encourage retirees to purchase insurance through private exchanges or the public exchanges established under the Affordable Care Act. A recent survey suggests that 58% of employers have confidence in private exchanges as a viable alternative to the plans they currently offer employees and that “employers are intrigued by the potential of private exchanges to control cost increases, reduce administrative burdens and provide greater value.”

Some observers have expressed legitimate concerns that employers could limit their payments for health benefits by increasing wages by amounts less than those of employees’ medical costs. In theory, a competitive labor market would ensure that total employee compensation remained at competitive levels, thereby preventing employers from using defined-contribution mechanisms in this way. But competitive labor markets require compensation to reflect productivity. In rigid sectors of the economy, defined-contribution strategies could burden employees disproportionately with the weight of medical inflation.

Yet the appeal of defined-contribution plans — whether as part of Medicare reform or in the form of changing benefits for retirees and workers — remains potent. Defined-contribution strategies reveal to employees and health insurance customers any cost increases that exceed the growth of wages, and individuals purchasing insurance on exchanges have shown a growing preference for lower-priced plans that increase cost sharing for health expenditures. In 2013, for example, Aon Hewitt found that the proportion of employees who selected high-deductible plans (most of which included a contribution to a health savings account) increased from 12% to 39%, while enrollment in preferred provider organizations decreased from 70% to 47%.

Defining the contributions to health care expenditures before containing health care costs might be placing the cart before the horse. On the other hand, making such inflation visible and painful to consumers is one tool for bringing costs under control.

Whether or not providers and consumers are ready, defined-contribution benefit plans are growing in popularity. They will unquestionably have both short- and long-term consequences for providers. They will bring greater transparency to health care costs and health care inflation, and they will probably give insurance purchasers greater motivation to attend to insurance prices, stimulating the provision of lower-cost insurance.

Because insurance premiums are ultimately the primary source of revenue for providers, cost consciousness among consumers will impose new fiscal constraints on providers. For some highly leveraged providers — especially those who expanded costly infrastructures that relied on lucrative fee-for-service revenue models — even small changes in the private health insurance market could have substantial financial effects. In this world, providers’ future success will depend on their ability to sustain themselves on a flattening allowance.

Over the long term, greater consumer sensitivity to insurance premiums will affect all providers. It is a truism that the growth of health care costs — or, phrased differently, the growth of provider resources — will be bounded by the growth of health care revenue. A dramatic shift in the revenue available to providers will impose strong cost pressure. And such pressure, in turn, can be seen as a new opportunity for developing more cost-efficient delivery mechanisms.

This article from the prestigious New England Journal of Medicine should alarm anyone who cares about ensuring that everyone has access to health care. We are now seeing a rapid conversion of health care financing from defined benefit (paying for appropriate health care) to defined contribution (paying a specific dollar amount while placing upon the beneficiary the responsibility of using those funds to find affordable care, if possible). This places the burden of health care inflation most heavily on those who have the greatest health care needs when these individuals and families are already over-burdened with our deficient system of health care financing.

Look at the explanation that these authors give as to why defined contribution is a superior method of financing health care:

  • Patients would not be stuck with a one-size-fits-all plan of comprehensive benefits that covers their essential care but rather would be allowed to forgo crucial health care services that they could not afford (permitting them to accept suffering, disability and even death as a small price to pay for not selecting a plan that they couldn’t afford).
  • They would have the right to plans that exclude from provider networks physicians and hospitals that they might need in the future but would not be able to afford.
  • They would have the right to enroll in plans with high deductibles that have been proven to impair access and create greater personal financial hardships.
  • They can rest assured that their employers will be insulated against future increases in health care costs, while graciously accepting for themselves the costs of unpredictable health care inflation.
  • They can personally experience the ongoing deterioration in labor markets as employers decline to provide as wage increases the savings in the costs of their health benefit programs – a valuable lesson in the differences between market ideology and the actual application of market dynamics.
  • They need not understand the value of their lost benefits (i.e., “increased compensation might only need to match employees’ perceptions of the value of the lost benefits” – the fools know not what they are deprived of).
  • With greater transparency in premiums under defined contribution, employees would be in a position to demand only the lower premium plans that they could afford, even though that can be disastrous should health status change for the worse. (Employees choose low premium plans not because they want less coverage but rather because they cannot afford the higher premiums of more comprehensive plans.)
  • Employees can be reassured by the fact that their “employers are intrigued by the potential of private exchanges to control cost increases, reduce administrative burdens and provide greater value” – for the employers that is. There is nothing like a work environment that takes good care of the employers.

Perhaps there is a limit to what the employee/patient/beneficiary/consumer may support in this transition to defined contribution financing of health care. According to these authors, “Defining the contributions to health care expenditures before containing health care costs might be placing the cart before the horse. On the other hand, making such inflation visible and painful to consumers is one tool for bringing costs under control.”

Ah ha! We need to switch to defined contribution financing because it will make health care inflation “visible and painful to consumers.” Clearly there had to be more advantages than just those listed above. There ain’t no gain if there ain’t no pain.

Regina Herzlinger is an icon in the consumer-directed policy community. They are winning the battle, and the people are losing. If you like the policies listed above, you don’t need to do anything. Regina and her friends will take care of it for you.

For the rest of you, get over the lousy satire and go out and fight the battle for health care justice for all.