Rethinking Flex Credit Designs in Light of the ACA

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1 Rethinking Flex Credit Designs in Light of the ACA January 2016 Some employers offer their employees a flex credit usually a flat dollar amount to purchase qualified benefits (medical, dental, vision, life insurance, disability, etc.) through the employer s cafeteria plan. Often this form of employer contribution is a result of negotiations with represented employees in the public sector. This arrangement, however, is not limited to bargained public sector employees and can also exist in the private sector. This type of cafeteria plan design has always presented group health plan compliance challenges, but the Affordable Care Act (ACA) makes it necessary to reconsider and likely restructure these offerings. This memorandum discusses the applicable ACA provisions that create the need for change, and offers possible solutions for the future, while taking into account the unique needs of both represented employee groups and management. Background The ACA Pay or Play mandate requires applicable large employers (ALEs) to offer minimum essential coverage to full-time employees and their dependents to avoid a significant penalty, commonly referred to as the subsection (a) penalty. The annual subsection (a) penalty is $2,000 (indexed) times all of the employer s full-time employees. 1 In addition, the coverage an ALE offers must be affordable and provide minimum value in order to avoid what is commonly referred to as the subsection (b) penalty. Where coverage is unaffordable (or not minimum value), an employer could be subject to an annual penalty of $3,000 (indexed) for every full-time employee who is ineligible for or doesn t enroll in the employer plan 2 and then receives subsidized health insurance coverage in an Exchange. 3 Affordability In order for an employer s coverage to be affordable, the employee portion of the employee-only premium for the lowest cost, minimum value plan cannot exceed 9.66% (indexed) of the employee s household income. Employers generally do not know employees household incomes. Thus, in order to ensure affordability and avoid penalties, employers can use one or more of the three affordability safe harbors provided for in the Pay or Play regulations. 4 Employers that choose not to use one of the three affordability safe harbors can also evaluate the affordability of their plan based on the cost of the coverage in relation to the employee s W2 income. 1 In calculating the subsection (a) penalty the full time employee count is reduce by 30 (80 for 2015). 2 Employers that offer coverage to 95% (70% in 2015) of their full-time employees can be subject to the subsection (b) penalty for those full-time employees not offered coverage (the margin of error group). 3 Only individuals with household incomes of between 100% and 400% of the Federal Poverty Level are potentially eligible for subsidies. That baseline number increases to 138% in states that have expanded Medicaid. Accordingly, only employees with household incomes in that range subject an ALE to potential penalties. 4 The three safe harbors are the Federal Poverty Level (FPL) safe harbor, the rate of pay safe harbor, and the W2 safe harbor.

2 Given that affordability is based on the employee s portion of the employee-only premium, the employer s contribution to the cost of the plan is an essential part of the analysis. Where an employer contributes a flat dollar flex credit into a cafeteria plan for eligible employees to purchase qualified benefits, there is a question as to whether (and how much of) the flex credit will count as the employer s contribution for purposes of determining the medical plan s affordability under the Pay or Play rules. Flex Credits and Affordability For an extended period of time, there was no directly regulatory guidance on how flex credits are treated for Pay or Play affordability purposes, but the IRS addressed the issue in December 2015 with Notice The Notice provides that only health flex contributions will count as an employer contribution to the medical coverage. A flex credit is a health flex contribution if: 1. There is no cash out option; 2. The credit can be used to pay for minimum essential coverage; and 3. The credit may only be used to pay for medical care within the meaning of Code 213 (this means the flex credit cannot be used to purchase life insurance, dependent care, or other non-medical benefits). The Notice offered several examples of fairly common employer flex credit designs that would not qualify as health flex contributions. Example: An employer offers employees coverage under a group health plan through a cafeteria plan. An employee electing self-only coverage contributes $200 per month toward the cost of coverage. The employer offers employer flex credits of $600 for the plan year that can be used for any benefit under the cafeteria plan (including benefits for dependent care or group term life insurance). Because the $600 employer flex credit is not usable exclusively for medical care, it is not a health flex contribution and does not reduce the employee s required contribution for medical coverage. As such, for Applicable Large Employer (ALE) reporting, the employee s required contribution is $200 per month. Likewise, any flex credit that could be received as cash is not a health flex contribution and will not reduce the employee s required contribution. Recognizing that employers with flex credit plan designs may need time to bring their designs into compliance, Notice provides that for plan years beginning before January 1, 2017, an employer may treat a non-health flex credit as an employer contribution for purposes of ALE reporting. Employers should amend their flex credit design to become health flex contributions on or before January 1, What does that mean for my flex credit design? This means an employer providing a flex credit that cannot be cashed out and that can only be used for medical care (medical, dental, vision, health FSA) can count that flex credit as a health flex contribution that counts as an employer contribution for purposes of the affordability analysis. Where these conditions are not met, the IRS does not consider the flex credit a health flex contribution. Problem: Most flex credits programs are not limited as set forth above. Many employers allow individuals to cash out some or all of the flex credit under certain circumstances, and also allow the flex credit to be used for non-medical benefits such as life insurance, disability, dependent care assistance plans, etc. In these situations, the flex credit will not count towards affordability,

3 which can make the medical plan unaffordable for a large number of employees. In that case, an employer has invested a significant amount of money toward each individual employee s benefits, but can still potentially be penalized for not offering an affordable plan. See the example below. Example: Public Agency ABC provides a monthly flex credit of $500 that employees can use to purchase medical coverage, dental coverage, health FSA coverage, life insurance, or long term disability. The cost for self-only medical coverage is $600. An employee who waives medical coverage can cash out $250 of the $500 flex credit as taxable income. What s the implication? None of the $500 flex credit counts toward the $600 medical premium, meaning the employee s portion of the cost for self-only medical coverage would be $600. (Presumably, this is also the cost that the employer will report on Line 15 of the Form 1095-C.) This $600 premium is unaffordable for all employees with household incomes of up to 400% of the Federal Poverty Level in other words, the coverage is unaffordable for every employee that can subject the employer to penalties. If Public Agency ABC did not allow a cash out of the flex credit and limited the $500 to medical, dental, vision, or health FSA coverage, that flex credit would count as an employer contribution in the ACA affordability analysis. In that situation, the employee s share of the premium for selfonly medical coverage would be $100, which is affordable for employees with household incomes of 138% of the FPL and above. See below for an illustration: Flex Credit with No Cash Out and Limited to Medical Coverage Flex Credit with Cash Out and Not Limited to Medical Coverage Employee-only Medical Insurance Premium $600 $600 Employer Flex Credit $500 $500 Impact of Flex Credit Design Cost of Coverage to Employee 5 Employee Cost is 9.56% (indexed) of this Annual Salary N/A -$500 $100 $600 $12,552 $75,314 5 Under the ACA MEC and ALE reporting requirements, this amount generally must be reported on all full-time employees Form 1095-C.

4 What s the Fix? Many flex credit programs are dictated by collectively bargained agreements and, as a result, can be challenging to change. It is imperative that all parties to a negotiation understand the significant financial implications the ACA has created for employers with a flex credit program that permits a cash out and/or the purchase of non-medical benefits. In the example above, the public sector employer would be contributing $6,000 annually to each eligible employee, plus taking on the additional risk of over $3,000 per employee in potential penalties for not offering affordable coverage. Alternatively, many public sector employees have grown accustomed to the cash out option available through some plans and/or to the flexible use of often generous flex credits. These facts must also be considered during negotiations and while devising a solution that is compliant with the ACA. The appropriate solution will be different among public sector employers, largely depending on the amount of the flex credit, the cost of medical coverage, the existing plan design, and status of the existing labor agreements or Memorandums of Understanding (MOUs). Example: Smaller Flex Credit Contribution Where the flex credit is equal to or about the same amount as the cost of employee-only medical coverage, the employer should remove the cash out option. The employer could make the flex credit contingent upon enrollment in medical coverage, or the employer could provide that in the case of an individual who waives medical coverage, a smaller flex credit is available to use for vision, dental, or health FSA benefits. Important Note About Health FSAs: In order for an employer s health FSA to remain an excepted benefit, which is necessary to avoid many of the ACA mandates, ACA, the employer Employer provides a $750 flex credit Employee-only medical costs $700 per month Where an employee enrolls in employee-only medical coverage, s/he can use remaining $50 on dental, vision, or health FSA. No cash out permitted. Where an employee enrolls in family coverage, the flex credit will be entirely allocated to medical and the employee will have to salary reduce to pay the additional cost of family coverage. No issue here. Where an employee waives medical coverage, employer is not required to offer a flex credit, but it may do so. In that situation, an employee may receive some amount to purchase dental, vision, and health FSA coverage. The waiver flex credit amount should be designed accordingly, and with no cash out permitted. should generally limit to $500 the amount of the flex credit that can be allocated to the health FSA. Example with Large Flex Credit Contribution Where the flex credit is much greater than the cost of employee-only medical coverage and employees are accustomed to cashing out all or a portion of that flex credit, the employer can designate a portion of the flex credit that must go toward medical coverage (a defined contribution) and cannot be cashed out as taxable income. The remaining portion can be allocated to purchase any qualified benefit or be cashed out as taxable income.

5 Flex Credit is $1,400 Employee-only medical is $500 per month Employer requires that $400 of the flex credit be allocated toward the medical premium and cannot be cashed out in effect, a defined contribution toward the medical premium. The $400 defined contribution then counts for the Pay or Play affordability analysis, resulting in an employee premium of $100 for employeeonly medical coverage. Employees enrolling in employee-only medical coverage could use the remaining $1,000 to elect any of the qualified benefits available under the cafeteria plan, e.g. dental, vision, health FSA, long term disability, life insurance, etc. This portion would be considered a cashable flex credit for ancillary benefits available under the cafeteria plan. The employer could also allow a cash out of a portion of the $1,000 without adversely impacting the affordability of the medical coverage. In this situation, the employer does not count any of the $1,000 toward their monthly contribution toward medical coverage only the $400 defined contribution. Where an individual elects to waive medical, they forego the $400 defined contribution toward medical. The employer can contribute up to $1,000 in cashable flex credits and allow the employee to purchase any of the other benefits available under the cafeteria plan 6, and also permit allow cash out of the flex credit. In this example, the employer may also want to limit the amount of flex credit allocated to the health FSA to $500 to retain that plan s excepted status. We offer two relatively simple approaches here. Every situation is different and the facts and circumstances can become complex. It is important to understand that solutions are relatively limited. In all cases, at least a portion of the flex credit must be designated as a defined contribution exclusively for medical coverage in order for the employer to be able to use that contribution to assess affordability under Pay or Play counting that amount toward affordability should be a uniform objective for all parties involved in negotiations. Shift Away From Flex Credit Design Public sector employers could also move entirely away from a flex credit program and simply cost-share with employees on the premiums for each line of coverage in a fashion similar to most private sector employer plans. Any perceived loss of benefits could be addressed with bargained employees outside of the group health plan, e.g. wages, paid-time off, etc. Action Items 1. Evaluate flex credit arrangements against the three requirements for flex credit to count as an employer contribution towards medical coverage for employer Pay or Play affordability 2. Review MOUs and collective bargaining agreements for provisions about flex credits 6 Note where an employer allows employees to use a flex credit to purchase voluntary benefits such as a critical illness benefit or other AFLAC-type benefit, that benefit is applicable coverage for purposes of calculating the Cadillac Tax. To ensure voluntary benefits are excluded from the Cadillac Tax calculation, employers should require those benefits be paid for on an after-tax basis.

6 3. Review cafeteria plan documents for flex credit descriptions and specifications documents may need to be amended 4. Where the flex credit does not meet the three requirements, open a dialogue among all pertinent parties regarding a solution 5. Ensure any changes are properly and consistently documented in MOUs and bargaining agreements, in the cafeteria plan document and enrollment materials, and other employee communications 2015 Alliant Insurance Services, Inc. All rights reserved. Alliant Employee Benefits, a division of Alliant Insurance Services, Inc. CA License No. 0C36861