Traditionally, public sector employers have generously provided some type of employer-paid health insurance benefit for their early retirees (under age 65) as a way to bridge the gap between early retirement and Medicare eligibility. In a time when health insurance was reasonably affordable, it was common to offer what is known as a “defined benefit” plan, in which an employer promises a specific benefit (such as health insurance) over a specific time period.
Unfortunately, with premiums rising and budgets being strained, it may be challenging for schools, cities, and counties to plan effectively for the retiree health benefits awarded to former employees now in retirement, or for the health benefits promised to current employees as they retire. Yearly expenditures to fund these benefits become a tremendous liability, draining budgets, and forcing schools to deflect money away from classroom instruction and municipalities to reduce spending on needed services and infrastructure.
Employers are now realizing they need to reconsider the benefits packages they offer in an effort to contain costs and long-term financial obligations, yet still provide an impactful retirement benefit to their employees. A Defined Contribution Retirement Plan may be the solution. Contrary to a defined benefit plan which provides a distinct benefit over time, no matter the cost, the defined contribution plan allocates a specific contribution toward that benefit. The contribution is not tied to rising insurance costs, which makes cash flows more predictable, and results in the reduction, or even elimination, of OPEB (Other Post-Employment Benefits) liability. Below are the most noteworthy characteristics that distinguish a defined benefit plan from a defined contribution plan:
|Defined Benefit||Defined Contribution|
|Reportable OPEB liability under GASB 74/75||Eliminates OPEB liability since benefit is fully funded in real time|
|Higher fiduciary liability||Reduced administrative burden|
|Higher administrative burden due to ongoing funding level reviews, contribution tracking, and benefit eligibility||Helps attract and retain talent|
How a Health Reimbursement Arrangement Can Help
One of the most ideal funding options for a defined contribution plan is a Health Reimbursement Arrangement, or HRA. The HRA is designed to reimburse employees for their eligible medical expenses to offset their out-of-pocket costs. The employer regularly deposits funds into individual accounts on behalf of employees while they are employed. These funds, along with any earnings from interest, are free from federal income and FICA taxes, and can be used at any time, upon eligibility. To be eligible to use the funds, the participant must have either separated from service or retired. Participants are 100% vested immediately, meaning that they own the account balance as soon as the account is established.
Migrating an employer’s benefit plan design from a defined benefit to a Defined Contribution HRA (dcHRA) will enable that employer to reduce existing liability and minimize future costs, all while keeping its promise to employees and freeing up resources to better serve students, citizens, and the community.
Employers may also consider establishing a Trust—like a Post-Employment Benefit or Section 115 Trust—as a vehicle to pre-fund employee and retirement benefits. A trust enables the employer to set aside funds while the employee is still actively employed in order to minimize, or even eliminate, the liability later on. Funding through a trust reduces what can be a substantial liability on the financial statement. The trust is generally considered a separate legal entity and trust funds are safe from the employer’s creditors.
The Advantages of Defined Contribution
The beauty of a defined contribution plan is the built-in versatility of the plan design. With this design, the employer has the flexibility to modify their contribution structure and vesting schedules as time goes on, allowing them to take a “wait and see” approach. All the while, they are reducing their OPEB liability and increasing plan reliability by establishing a Post-Employment Benefit Trust as a vehicle to pre-fund retiree benefits.
To current and prospective employees, the dcHRA is an attractive incentive. It’s a great retention tool that enables employees to see their account balance as contributions are added and interest accrues tax-free over time, making the retirement benefit more tangible. Best of all, employees have the guarantee of a consistent contribution that will provide a tax-free avenue to pay for medical expenses in retirement.
If you’d like to learn how HRAs and trusts can help you achieve your financial goals, contact us today using the form below!