Subject: Notice Comments on Possible Modification of Use-or-Lose Rule for Health FSAs

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1 Submitted electronically via to: CC:PA:LPD:PR (Notice ) Room 5203 Internal Revenue Service P.O. Box 7604 Ben Franklin Station Washington, DC Dear Sir or Madam, Subject: Notice Comments on Possible Modification of Use-or-Lose Rule for Health FSAs Aon Hewitt appreciates the opportunity to submit comments on modifications to the health flexible spending arrangement (FSA) use-or-lose rule, given the $2,500 annual health FSA limit (the $2,500 cap) included in the Patient Protection and Affordable Care Act (Affordable Care Act), and suggestions for structuring a modification. Who We Are Aon Hewitt is the global leader in human resource solutions. The company partners with organizations to solve their most complex benefits, talent, and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates, and administers a wide range of human capital, retirement, investment management, health care, compensation, and talent management strategies. Aon Hewitt currently handles HR-related customer interactions for more than 21 million employees and retirees. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. Proposed Modification The United States Department of Treasury and the Internal Revenue Service (IRS) have indicated that the use-or-lose rule was adopted in part to reduce the potential to defer income through a cafeteria plan by allowing otherwise unused balances to carry over into future years. While Aon Hewitt does not believe that a right to future contingent health reimbursement is deferred compensation in the first place, we believe that the $2,500 cap, which applies beginning in 2013, virtually eliminates any potential abuse from allowing a welfare benefit to carry over into future years. As such, Aon Hewitt strongly supports a modification to the rule that would allow account holders to roll over unused health FSA balances at the end of the plan year (or grace period) for use in the subsequent year. Aon Hewitt proposes the Treasury and IRS modify the use-or-lose rule by adopting various allowable alternatives that employers sponsoring health FSAs can choose to adopt, at their option, in the first plan year beginning on or after January 1, Moreover, participants should be given the opportunity to opt out on either of the rollover options summarized below to give the participants the opportunity to enroll in a high-deductible health plan (HDHP)/health savings account (HSA) option. For administrative ease, we recommend that this opt-out must take place before the beginning of the new plan year.

2 Page 2 Even with the new $2,500 limit, there will continue to be participants who will overestimate their medical expenses in making their annual health FSA election. A planned surgical procedure or an expected orthodontia treatment may be delayed to the following year. An individual taking maintenance medications for a chronic illness such as hypertension may improve enough to discontinue his or her maintenance medication. There are numerous factors that are out of the control of the participant that could impact the individual s original estimate of medical expenses in making his or her annual health FSA election. The use-or-lose rule currently forces participants who have overestimated their medical expenses into the difficult choice of spending their account down on unnecessary items or forfeiting their remaining balance. Aon Hewitt Comments Aon Hewitt proposes the following modifications to the use-or-lose rule, any of which could be used at the employer s option: Roll over unused amounts under one of the two allowable methods; Cash out unused amounts; and Retain existing rules governing health FSAs. Roll Over Unused Amounts Aon Hewitt supports a modification to the use-or-lose rule that would allow account holders to roll over unused health FSA balances at the end of the plan year (or grace period) for use in the subsequent year only. In 2013, no participant will be able to contribute more than the statutory limit under the Affordable Care Act, which only limits contributions by salary reduction and does not limit employer contributions or any other type of contribution. Consequently, the Affordable Care Act would appear to allow a rollover of unused salary reduction amounts made in the prior year without running afoul of the requirement that salary reduction contributions not exceed $2,500, indexed for CPI-U. To address the deferral of income issue, participants should only have the remaining calendar year to spend the amount down. From an administrative perspective, it will be cleaner for plan administrators to provide a rollover where the salary reduction limits for each year are not blended and do not require midyear adjustments. It is Aon Hewitt s expectation that any requirement to blend the salary reduction cap would be difficult to program and communicate. These difficulties would substantially undermine the value of allowing a rollover. To simplify administration, employers should be allowed to choose either the rollover or the grace period, but not both. Aon Hewitt proposes the following allowable rollover methods. The First-In-First-Out (FIFO) Rollover Method Under the FIFO rollover method, participants would be allowed to roll over the entire unused balance in their account that was contributed by salary reduction in the prior year.

3 Page 3 Under the FIFO rollover method, plan administrators would process claims out of the rollover amount first. Claims would be processed from the current election only after the rollover is exhausted, making this approach very similar to the current administration of the grace period. As a result, this method would require very few changes to administrative systems, and would be easier to communicate to participants. Illustration Single parent Perry Participant makes an election to enroll in his employer s calendar year health FSA for Since Perry s teenage son Paul needs orthodontia work, Perry makes an election of $2,500 (the maximum allowable contribution) since he anticipates the orthodontia services will cost $6,000. During the course of 2013, Paul s orthodontist determines that Paul should wait until 2014 before he is treated to achieve the best result. Both Perry and Paul are very healthy, so aside from several office visits to their primary care physician for common colds, Perry has no other medical expenses for At the end of the plan year, Perry has $2,300 left in his health FSA that consists solely of salary reduction contributions he made in connection with his $2,500 election for Under the FIFO rollover method, Perry would be able to roll over his entire balance of $2,300 to The plan administrator would process claims first out of the rollover amount, and then out of any amounts contributed by Perry by salary reduction or his employer for If Perry elects to contribute $2,500 for 2014, he will have a total of $4,800 to use in Under the FIFO method, if Perry submits claims for $4,000 in 2014, he will have exhausted his entire rollover of $2,300 in unused salary reduction contributions from 2013 and will have $800 of unused salary reduction contributions from 2014 to roll over to By contrast, assume Perry submits claims for only $300 in Under FIFO, he will forfeit $2,000 of the amount rolled over from 2013, and will have the full $2,500 from 2014 contributions to roll over to In sum, the FIFO rollover method is just an extension of the grace period for the remainder of the calendar/plan year. This method is easy to administer and for employees to understand. The Last-In-First-Out (LIFO) Rollover Method Under the LIFO rollover method, participants would be allowed to roll over the entire unused balance in their account that was contributed by salary reduction in the prior year. Under the LIFO rollover method, plan administrators would process claims out of amounts contributed by the participant and his or her employer in 2014 first, and only after those contributions are exhausted, would claims processed be applied to rollover amounts. This method would require more administrative system changes than the FIFO method, but is a workable option. In addition, like the FIFO method, the LIFO method is easier to communicate to participants than any blended method or a method requiring midyear adjustments. Illustration Single mother Penelope Participant makes an election to enroll in her employer s calendar year health FSA for Since Penelope s teenage daughter Payton needs orthodontia work, Penelope

4 Page 4 makes an election of $2,500 (the maximum allowable contribution) since she anticipates the orthodontia services will cost $6,000. During the course of 2013, Payton s orthodontist determines that Payton should wait until 2014 before she is treated to achieve the best outcome. At the end of the plan year, Penelope has $800 left in her health FSA that consists solely of salary reduction contributions made by Penelope in connection with her $2,500 election for Under the LIFO rollover method, Penelope would be able to roll over her entire balance of $800 to The plan administrator would process claims first out of any amounts contributed by Penelope or her employer for 2014, then out of the rollover amount. If Penelope elects to contribute $2,500 for 2014, she will have a total of $3,300 to use. If Penelope submits claims for $2,500, she will have used the entire amount contributed in 2014 under the LIFO method, leaving $0 to be rolled over into In addition, Penelope will forfeit the $800 rolled in from 2013 since it was not spent by the end of In sum, the LIFO rollover method is a more conservative approach in that it results in fewer rollovers and more forfeitures. It would likely be chosen by employers that have high turnover levels, and subsequently, a higher percentage of overspent accounts. Cash Out Unused Amounts Consistent with recent bipartisan legislative proposals, Aon Hewitt proposes the Treasury and IRS modify the use-or-lose rule to give employers the option to offer a cash-out of up to $750 of unused health FSA contributions. The cash-out method avoids putting participants in a position of having to spend down their accounts on unnecessary items or forfeiting the remaining balance. Under this approach, upon the expiration of the runout period, the employer would cash out any participant with a remaining balance of up to $750. The payment would be taxed as wages, converting wages that were originally tax free to taxable wages. The cash-out would be taxed in the following plan/calendar year and reported on the IRS Form W-2 as wages. Since this method tips the risk scale in favor of the participant, employers should be given the option to choose whether to offer the cash-out. Retain Existing Rules Governing Health FSAs Along with those options, we recommend retaining rules regarding the forfeiture of unused balances upon an employee s termination of participation in the plan. We also recommend three limited modifications to the uniform coverage rule, excepted benefit rule, and COBRA rule, as well as a modification to the health FSA definition: Uniform Coverage Rule (UCR): We believe that the UCR is an important element of the health FSA and that the proposed rollover can be readily accommodated without any changes to the UCR. Under the UCR, an employee s entire election must be made available to the employee on the first day of the plan year and throughout the plan year. Given that an employee s election will be made prior to determining the rollover amount, we recommend basing the uniform coverage amount on the employee s elected salary reduction at the outset of the plan year. However, once any rollover amount is determined, the uniform coverage amount would be increased by the amount of the rollover. Should

5 Page 5 the account holder file claims during the runout period, the amounts reimbursed would reduce amounts remaining from the previous plan year consistent with current regulations. Excepted Benefit Rule for Health FSAs: Under current agency guidance, health FSAs will be excepted benefits (for HIPAA and Affordable Care Act purposes) provided certain requirements are satisfied. We believe that a health FSA s excepted benefit status should be determined irrespective of whether a rollover exists, and irrespective of the amount of such rollover. Health FSA COBRA Rule: A special COBRA continuation rule applies to health FSAs that meet the excepted benefit rule. Should the IRS adopt the above recommendation on the excepted benefit rule, it would be useful to make a conforming change to the COBRA rule to ensure that employers understand that the exclusion of rollover amounts for purposes of the excepted benefit rule also applies for purposes of the health FSA COBRA rule. Health FSA Definition: The current health FSA definition prohibits the maximum health FSA reimbursement amount from substantially exceeding the total salary reduction and employer flex credits. The maximum reimbursement amount is not considered to be substantially in excess if the maximum amount is less than 500% of the combined salary reduction and employer flex credits. We recommend that the proposed regulations should indicate that the rollover amount should be considered made by salary reduction and employer flex credits for purposes of determining the maximum reimbursement amount. Rationale for Proposed Modifications Health FSAs have long been an important benefit tool for both employers and employees. Health FSAs allow employees to take salary deductions to fund accounts to pay for out-of-pocket health expenses with pretax dollars they are the employees own funds. Millions of American families rely on their health FSA to pay for benefits not otherwise covered and to meet their cost-sharing obligations, which have increased in recent years. These accounts are also particularly helpful for individuals with chronic illnesses, who often have numerous provider visits and fill multiple prescriptions each month and for whom even nominal cost sharing can quickly add up. Health FSA dollars can help these patients ensure they get the care, services, and medicines they need to maintain their health and avoid costly complications or hospitalizations, which can reduce overall health care spending. Modifying the use-or-lose rule would further enhance the value of health FSAs for patients with chronic illnesses by allowing them to set aside funds without the prospect of losing them at the end of the year. Aon Hewitt has long heard from policymakers who maintain that health FSAs contribute to additional and wasteful health care spending. In our view, the prospect of forfeiting unused balances is a significant contributing factor to that outcome. If account holders are allowed to roll over unused balances, they will no longer feel compelled to make potentially unnecessary purchases at the end of the year. Simply stated, modifying the use-or-lose rule will eliminate the incentive for such behavior, remove the biggest deterrent to establishing and adequately funding a health FSA, and allow employees to better plan and fund their health care needs. In sum, Aon Hewitt feels that allowing rollovers and cash-outs will make participants better stewards of their health FSA funds by ensuring individuals use their accounts only for necessary medical expenses, and more closely align the tax preference accorded health FSAs with the intent of allowing amounts reimbursed for ordinary and necessary medical expenses to be tax free to the recipient.

6 Page 6 Closing If you have any questions or comments, please contact the undersigned at the telephone number or address provided below. Sincerely, Aon Hewitt J. Scott Sims Senior Vice President, Health & Benefits Legal (847) scott.sims.2@aonhewitt.com Julie Jagla Assistant General Counsel, HR Outsourcing (847) julie.jagla@aonhewitt.com Kim Tippens Spending Account Delivery Leader, Aon Hewitt Emerging Solutions (847) kim.tippens@aonhewitt.com